HCAT - Health Catalyst: After Q3 Earnings I Continue To See This As A Buy

2023-11-14 08:26:12 ET

Summary

• I reiterate a buy rating for HCAT stock due to its potential for growth acceleration and improved profitability.
• Management remains focused on profit improving initiatives.
• The stock has been derated, but if HCAT can improve margins, its valuation should improve.

Investment action

I recommended a buy rating for Health Catalyst ( HCAT ) when I wrote about it the last time , as I expected fundamentals to continue being strong and healthy despite the tough macro environment. Based on my current outlook and analysis of HCAT, I recommend a buy rating. While the stock has derated majorly over the past few months, tough growth comparisons and industry-wide downward re-rating were a big part of the reasons. Structurally, HCAT should emerge as a better business with better profitability if the margin improvement initiatives play out. In this scenario, valuation should rerate upward, closer to peer level.

Review

Giving a brief update on the share price movement since my last update. In the 2Q23 results, HCAT saw a major deceleration in growth to 3.7% (vs. 8.5% in 1Q23), which I believe spooked the market and caused a major downward rerating (alongside the industry). While I believed the growth slowdown was mainly due to the tougher comp, the market was evidently worried about further growth slowdowns.

3Q23 results dismissed the market’s worry of further growth slowdowns as performance was in line with its pre-release. Total revenue increased by 8% to $73.8 million, with growth of 4% in the technology sector to $46 million and 14% in professional services to $28 million. Below the revenue line, however, adj gross profit was reported at $35 million, which is equivalent to a 47% margin, a significant decrease of 429bps compared to 3Q22. The big step down was largely driven by the Professional Services segment, whose gross margins contracted by 888bps.

Separating the discussion into two parts: Revenue growth and Profitability, I will start by touching on the growth outlook.

I expect growth to accelerate from here, given the positive commentary made by management. They noted that the operating environment has not changed, as they are still benefiting from the same tailwinds, and that bookings so far this year are trending in line with their projections. For FY23, management is reiterating their expectations for a low double-digit increase in net new DOS subscription clients and a dollar-based retention rate between 102% and 110%. As for FY24, growth should get off to a great start given the timing difference between bookings and revenue. According to management, 4Q23 will be a big bookings quarter (driven by demand for the TEMS offering as clients continue to look for short-term ROI solutions), which paints a positive outlook for 1Q24.

In addition, management's continued focus on enhancing its product should translate to an increased value proposition for users, which should support growth ahead. Take, for instance, the recently announced acquisition of ERS . ERS offers cancer registry compliance and informatics services, which help clients meet their clinical and commercial goals for their cancer centers and ultimately improve cancer care for all patients. Although this acquisition will not have a major impact on HCAT's bottom line in FY23, I believe it is a good move because the combination of ARMUS , which HCAT bought last year, and ERS's CRStar platform should improve HCAT's data abstraction and registry management capabilities.

Next on profitability, while the headline gross margins step down to 429bps is definitely not a positive one. The 888bps y/y contraction in professional services gross margins was primarily due to lower utilization levels and also lower growth (7.9% vs. 10.7% in 3Q22). This seems to be more of a cyclical problem than a structural one. Recall that I previously wrote that “HCAT's professional services division supplies the company's clients with the strategic guidance and engineering talent they need to propel innovation.” In a tough macro environment, I would expect less demand from companies as they reallocate resources to other, more important aspects of the business, relative to driving innovations. This also means that as the economy recovers, the gross margin should recover to its historical level.

Despite the significant hit to gross margin, it was reassuring to see management remain committed to the company's profitability targets. I believe HCAT long-term margin profile is going to emerge structurally stronger as the economy recovers. Additional cost initiatives to optimize HCAT's cost structure were announced during the 3Q23 call, with the expectation that they would lead to higher professional services gross margins in 1Q24. Specifically, management is taking steps to bring expenses in line with current utilization rates; one of these is a 10% reduction in the workforce, with a particular emphasis on the professional services segment. Additionally, management plans to increase R&D efficiency by concentrating on R&D while slowing spending on Snowflake and the Databricks enabled data platform.

The management's profitability improvement plan appears to be paying off, as evidenced by the management's recent remark that operating margins have slightly improved over the past few months. I would extrapolate this comment as an indication that 4Q23 should see margin improvements.

Valuation

I believe HCAT can grow at the same rate I expected previously for FY23, given that management has reiterated their guidance (with just 2 months left for 4Q23). My growth expectation remains the same for FY24, as the latest update regarding bookings suggests growth acceleration. As for FY25, I upgraded my growth outlook marginally as I expect the latest acquisition to further enhance HCAT’s product, which should drive growth.

Another key part that drove the stock price downward was the downward rerating of the entire comp set, from ~3.4x forward revenue to ~1.9x forward revenue. Consequently, HCAT valuation came down from ~2x to 1x today. However, I believe 1x might be too low given that HCAT is still expected to grow roughly in line with peers over a 2-year period. This led me to believe that the key catalyst for multiples to rerate is for HCAT margins to improve. Compared to peers, HCAT margin is nowhere near, and if HCAT can improve margins as I expect them to, driven by all the points mentioned above, we should see HCAT valuation improve. I am modeling a 0.2x increase from the current levels to incorporate this step up in valuation.

Risk and final thoughts

Based on my expectations, the key driver for valuation to rerate is that margin must improve. This works the other way as well. If margin improvement initiatives do not play out as planned, the stock could see further derating. In conclusion, I maintain my buy rating. I believe HCAT remains well-positioned for better profitability, contingent on successful margin improvement strategies.

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