MODN - Model N: No Wow Factor Here But It's A Steady Ship

2023-05-15 04:40:51 ET

Summary

• Verticalized software company Model N has suffered a ~30% correction year to date, despite strong fundamentals so far.
• Revenue growth has accelerated to the high teens, as the company continues to more aggressively push its SaaS business model.
• Operating leverage is allowing MODN to boost its adjusted EBITDA.

Chances are, you've never heard of the software company Model N ( MODN ). A verticalized software solution for revenue management that is specifically tailored to clients in the life sciences and technology industries, Model N has long been one of the lowest-profile, out-of-the-spotlight software stocks in an industry dominated by buzzy cloud names.

Year to date, shares of Model N have sunk ~30%, unwinding what I believed to be an unjustified rally last year - yet in spite of the poorer stock performance this year, the company's fundamental performance has held up relatively well in a tough macro environment that has seen sharp deceleration and deal momentum slowdowns elsewhere in the sector.

Toward the end of last year, I issued a bearish outlook on Model N when the stock was trading closer to the $40 mark. Especially in a volatile market environment, however, I'm closely tracking all of these positions - and as prices and fundamental stories change, I'm willing to change my tune. In light of the company's weaker stock price amid solid fundamentals, I'm putting Model N back on my watch list as a neutral name.

Right now, I see Model N as a relatively balanced bag of positives and negatives. These two major concerns still weigh on me for this stock:

• Where does Model N go from here? Model N is a vertical software company that is designed specifically for customers in the life sciences and technology (primarily semiconductor) industries. Within these sectors, the company has already signed some of the biggest names as clients, including Pfizer ( PFE ), Qualcomm ( QCOM ), Abbott ( ABT ), Micron ( MU ), Johnson & Johnson ( JNJ ), and several other mega blue-chips. It's unclear what the company's strategy is to grow substantially from here, beyond simply defending its current base.
• Gross margin deficit to other SaaS peers- Though Model N saw slight expansion in gross margins in its most recent quarter, its low-60% pro forma gross margins are a full 10-15 points lower than most other SaaS companies, reducing its ability for operating leverage at scale.

At the same time, however, parsing through Model N's latest results have me encouraged on the following drivers:

• Model N is building up a strong SaaS foundation. Though relatively late to catch up to a full cloud-based delivery model, the company notes that SaaS ARR growth is accelerating, and net retention rates in the high 130s indicate that the switch is resonating well with customers.
• Adjusted EBITDA expansion. Model N was never a buzzy tech stock, and by virtue of that, it never had bloated expenses and a bent toward large losses. Now, economies of scale are allowing Model N to generate substantial adjusted EBITDA expansion, both in terms of margin and nominal dollars.

Note as well that due to Model N's correction since the start of the year, the stock has floated down to a fairer valuation. At current share prices near $29, Model N trades at a market cap of just $1.09 billion. After we net off the $270.6 million of cash and $279.5 million of debt on Model N's most recent balance sheet, the company's resulting enterprise value is $1.10 billion.

For the current fiscal year FY23 (the year for Model N ending in September 2023), the company has guided to $244-$246 million in revenue, representing 11-12% y/y growth, and $39-$41 million in adjusted EBITDA (a 16% margin at the midpoint):

Though not yet profitable enough to justify Model N's valuation from an adjusted EBITDA standpoint, Model N's revenue multiple at 4.5x EV/FY23 revenue doesn't look overly engorged.

All in all, I'd be a buyer of Model N again if the stock dropped to the $25 level (a price target that represents ~14% downside from current levels and a ~3.9x FY23 revenue multiple). Put this name back on the watch list and be ready to pounce as the stock moves.

Q2 download

Model N recently released fiscal Q2 (March quarter) results, which came in well ahead of the company's guidance and Wall Street expectations. Take a look at the earnings summary below:

Model N's revenue grew 17% y/y to $62.6 million, beating Wall Street's expectations of $59.7 million (+13% y/y) by a significant four-point margin. Note as well that this is the fourth consecutive quarter of revenue growth for Model N (versus 15% y/y growth in Q1, 13% y/y growth in Q4, and 10% y/y growth in Q3).

SaaS continues to be an important momentum driver for Model N. SaaS ARR grew 40% y/y in the quarter to $125.8 million, while dollar-based net retention rates for SaaS customers hit 138%, versus just 116% in the year-ago Q2.

CEO Jason Blessing noted on the Q2 earnings call that while the current macro environment caused a slowdown in deal cycles and added more approvals to the process (consistent messaging with what other software companies have reported), Model N enjoyed broad-based strength:

Given this, I am often asked about the impact of the macro on our business, so I would like to proactively address this question. First, we serve 2 resilient end markets with secular tailwinds, and Life Sciences in particular is a naturally defensive vertical in times of macro uncertainty. Second, we believe that companies in both verticals that we serve are prioritizing IT investments that deliver tangible ROI and help companies respond to dynamic operating environments, both of which played to Model N's core value proposition. That said, during the quarter, we did see some customers applying more scrutiny to incremental spend, and in some cases, additional approvals were required to get deals done.

Despite the challenging macro, our financial performance this quarter highlights our ability to execute while also delivering further margin expansion with adjusted EBITDA growing 39% year-over-year. We remain focused on finishing our business model transition and driving long-term profitable growth. In fact, several of our newer solutions are resonating now more than ever given the focus on profitability and increasing complexity of pharma regulations.

Next, I'd like to share some of the business highlights from the quarter. Success in Q2 was driven by a healthy contribution from all areas of the business. We signed new deals, closed another large SaaS transition, saw numerous customer expansions, and we also enjoyed solid renewals."

Success in subscriptions was a major driver behind adjusted EBITDA performance, which grew 39% y/y to $9.2 million:

Adjusted EBITDA margins also clicked up to 14.7%, a 230bps y/y improvement versus 12.4% in the year-ago Q2.

Key takeaways

Model N isn't a buy just yet (with so few true growth catalysts under its belt, it's difficult to justify investing in this name unless it's a value play), but the combination of this year's stock correction plus strong fundamental momentum (especially on its accelerating SaaS transition) have made Model N an interesting proposition again. Keep a close eye on this one.

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