With the direction of the market for the rest of this year still uncertain (will we continue to see a correction, or is a rebound ahead of us? Investors are split into two camps here), it’s never a bad idea to remain in favor of valuing equities. The tech correction we’ve seen over the past two quarters has certainly turned a lot more growth stocks into value stocks, but that doesn’t make value stocks any less attractive as they have quietly advanced and put solid figures despite the lack of attention from most investors.
Model N (NYSE: MODN) falls into this category. Model N, for investors unfamiliar with the name, is a revenue management software company. This is what we would consider a “verticalized” game, as it does business exclusively with life science and technology companies. Although a seemingly small market, Model N has continued to experience strong revenue growth of over 20% annually through organic expansion and acquisitions, particularly by absorbing a unit of Deloitte’s business services to expand its professional services practice and onboard clients more seamlessly.
Year-to-date, Model N shares are down -11%, which is a more modest loss than most growth stocks. Since mid-March, however, the stock has been on an uptrend, indicating potential room for a further rebound:
I will admit that directly compared to last year, I am less enthusiastic about the prospects of Model N compared to other value stocks. So many other SaaS companies have become value-added names (a non-exhaustive list here includes Zoom (ZM), C3.ai (AI) and Twilio (TWLO) – all hard-hitting investor favorites before the excessive pessimism of 2022. the way) that the Model N’s relative uniqueness as a cheap stock no longer stands out from the crowd. That said, in emptiness and isolation, I am still bullish on the N model. This is a business that balances everything security-focused investors want: consistent and reliable double-digit growth, recurring revenue, double-digit adjusted EBITDA margins and attractive value.
For investors who are newer to this stock, here is a recap of what I see as the bullish drivers for this company:
- More and more software vendors are adopting a vertical playbook. The major software companies in the portfolio (the two largest are Salesforce.com (CRM) and Oracle (ORCL)) have adopted a strategy of building or acquiring specific clouds vertically in recent years to distinguish themselves from their competitors . Companies in the life sciences and semiconductor industries have specific requirements, and the Model N’s mindset in this space gives it an edge over more generic software products.
- The N model serves growing industries. Needless to say, Model N’s growth is largely based on the attractiveness and growth prospects of its end markets, and fortunately for Model N, its customers are all companies in the innovation sector who are expected to show the most strong growth of any other industry.
- Interest in verticalized software may lead to a merger and acquisition exit for the N model. With such a small market capitalization, the Model N is the perfect acquisition for a large software company looking to stand out in its industries. For example, a few years ago Salesforce bought a company called Steelbrick for $360 million to increase its presence among heavy industry customers. These types of acquisitions make sense for a company like Salesforce because it can attract new leads with the specific product vertical, and later sell something else from its extensive portfolio.
- Constitution of a subscription base. Model N becomes a more reliable SaaS company. In its most recent quarter, Model N saw 21% year-over-year growth in subscription revenue, which is pretty incredible for a company with such a low profile and valuation. It aims to continue to grow the ARR at a rate of 20% per year until 2022.
- Large cap client orientation. Although little known to the average person, Model N’s customer base includes some of the most recognized companies in the industries it serves.
- Profitability. Model N recorded an adjusted EBITDA margin in the mid-teens, which is also an anomaly for software companies of its relatively small size.
A quick look at the valuation: At the current stock price near $27, Model N trades at a market cap of just $1.00 billion. After offsetting the $155 million in cash and $127 million in debt on the company’s most recent balance sheet, this results in the enterprise value is $972 million.
Meanwhile, for the current fiscal year FY22, the company achieved revenue of $212-214.5 million:
In this context, the N model is trading at 4.6x EV/FY22 revenue – a cheap, single-digit earnings multiple that should leave plenty of room for upside.
The bottom line here: no, the Model N isn’t the most exciting software stock out there, especially since so many former top flight pilots have joined it in the value camp. That being said, the Model N is still a proven quantity with solid execution and cheap value, so staying here long doesn’t hurt.
Let’s now talk in more detail about the latest quarterly results of the Model N. The first quarter revenue summary is shown below:
Overall Model N revenue increased 22% year-on-year in the quarter to $51.5 million, beating Wall Street expectations of $49.9 million (+17% year-on-year) ) with an impressive margin of five points. We note, however, that revenue growth slowed two points from 24% year-on-year growth in the fourth quarter.
The company called the first quarter the strongest quarter for reservations in its history, while making progress toward its goal of migrating more legacy on-premises customers to the cloud. Here are some helpful go-to-market earnings comments prepared by CEO Jason Blessing during the first quarter earnings call:
The first quarter was the best gross bookings quarter in the company’s history. As we have noted over the past few quarters, we have a strong pipeline and it is encouraging to see this convert to reserved business.
All our growth levers contributed to our good quarter as well as to the continued growth of the pipelines. To recap, our strategic growth levers are the SaaS transitions that occur when we move our on-premises customers to the cloud, cross-selling to our existing customers, acquiring a new logo, and finally expanding internationally.
In short, we had a good start and we feel good for the year ahead. In a few months, we closed four SaaS transitions. As indicated on the last call, we expect this year to be pivotal as we launch plans to move a substantial portion of our remaining on-premises customers to the cloud. […]
The first quarter demonstrates the continued momentum of our SaaS activity. Given the success we are seeing with SaaS transitions, we also continue to see our maintenance decrease at an accelerated rate from recent levels. We view this as a positive, as it demonstrates that our strategy of redesigning the N-Model as a cloud enterprise is working.”
The company also noted that it had achieved a net revenue retention rate of 119% over the last twelve months, compared to a target of around 110% (which would be in line with most software peers). This indicates that the average customer increases their spending on Model N by 19% the following year, suggesting strong traction in upselling – a core strength indicator for SaaS companies. Model N also reiterated its goal to continue to increase ARR by approximately 20% per year, through expansion, adding new logos and converting customers to the cloud.
A black eye in the quarter was gross margin, which fell 300 basis points from 63.4% in the prior year quarter to 60.3% in the current quarter:
The company blamed the revenue mix here, with Deloitte’s enterprise services contribution representing a lower gross margin than its core software products, which are still generating gross margins in the mid-70s. The only positive note here is that professional services margins, which many software companies are making at a loss, saw gross margins improve to 39.7%, about six points better than a year ago.
Similarly, Model N’s Adjusted EBITDA was roughly flat year-over-year in dollar terms, but Adjusted EBITDA of $7.2 million this quarter represents a lower margin of 14.0% , compared to 17.5% in the quarter of the previous year.
Key points to remember
With steady growth, the tailwind of a SaaS transition below, positive Adjusted EBITDA, and upbeat feedback on sales momentum so far for the start of FY22, there’s no reason to not stay invested in the N model at a