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Small-Cap Confidential
Undiscovered stocks that can make you rich

Cabot Small Cap Confidential 248

Today’s addition is a familiar story – a small software company with a purpose-built solution that works better than the patchwork of legacy solutions many companies still rely on, but which don’t work very well.

But there is another angle. This company is transitioning from an on-premise to a Software-as-a-Service (SaaS) business model. The switch should accelerate growth and make the stock a lot more attractive to investors.

Shares did very well in 2019. And there should be plenty more gas left in the tank.

All the details are inside.

Cabot Small Cap Confidential 248

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The Big Idea
If you want to find markets where purpose-built software can make life a lot easier look no further than life sciences and high tech.

Both are defined by the ever-present need to develop new products, launch them into the market, appropriately manage them through their specific life cycles, then pull them from shelves and release the next version, all while making sure pricing makes sense, regulations in different markets are adhered to, and competition is kept at bay.

In the dark ages before cloud software, companies managed these critical processes with manual, error-prone methods, spreadsheets and legacy enterprise systems, none of which were all that great at getting the job done.

Then, just like in many other arenas, like sales tax collection, financial accounting, supply chain, and project management, a software solution was built that did most of that manual work far more accurately and a heck of a lot quicker.

In many ways, today’s Big Idea is a story we’ve heard many times before. It’s about disrupting a market where the right software for the job represents a big improvement on the old way of doing things.

In this case we’re talking about revenue management software. Purpose-built solutions, designed specifically for the needs of life sciences and high tech companies, are helping global players like Gilead, Novo Nordisk and Micron generate higher ROI while better attacking opportunities and slashing risk.

One specific example is AMD, the global semiconductor designer and manufacturer. The company sells directly to distributors, who then sell to re-sellers, who then sell to end-customers. AMD management knew a lot about sales to distributors, but not a lot about what happened after that. Without visibility into sales by vertical market, timing of sales or even selling price or discounts used, AMD felt like it was flying blind. Now, with an industry specific revenue management software solution AMD is collecting point of sale (POS) and inventory data from hundreds of partners and making impactful decisions based on hard numbers.

Another example is an unnamed top 10 pharma company that faced complex calculations related to commercial and Medicaid rebating (one-third of revenue), including variables such as drug categories, inflation, divestiture and launch date. In the first year after switching to a modern revenue management solution the company reclaimed millions in revenue, including over $250,000 in over-payments in one state and ongoing Medicaid rebate payments on expired drugs.

As you’ve likely guessed, today’s addition to the Cabot Small-Cap Confidential portfolio is the company behind these solutions. It’s a story of a better solution, sold by a company that’s transitioning its business model and unlocking huge value in the process.

The Company
Model N (MODN) is a $1.2 billion market cap company that specializes in revenue management solutions for the life sciences (82% of revenue) and technology industries (18% of revenue). It helps customers maximize their revenue, find growth opportunities and cut compliance risk by giving them software tools to manage the revenue life cycle as a strategic process, not the disjointed one that often plagues the big players in its target markets.

The company has been in business since 1999. But Model N is reinventing itself as the world transitions to the cloud. This shift began eight years ago when Model N’s first cloud-based revenue management solution hit the market. Coupled with an ongoing transition to a software-as-a-services (SaaS) business model that began a few years ago, and an entirely new executive leadership team that began with the hiring of CEO Jason Blessing in May 2018, Model N is now better suited to help clients pursue opportunities and reduce risk in an increasingly digital world.

In the markets where Model is focused, including biotech, pharma, medical device, generics, semiconductor, electronic components, consumer electronics and software, this means cloud-based software that covers pricing, quoting, contracting, regulatory compliance, rebates and incentives.

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The roster of 169 current customers is impressive, including J&J, Pfizer, Gilead, Abbott, Stryker, AMD, Seagate, Sonos, STMicorelectronics, AstraZeneca, Sanofi, Boston Scientific, ConMed and more. Many customers have been with Model N for years and have already transitioned their perpetual licenses to SaaS agreements that cover both subscriptions and implementation services.

Beyond hiring a new CEO, Model N has also hired a new Chief Marketing Officer (November 2019), Chief Product Officer (September 2019), Chief Revenue Officer (April 2019), Chief People Officer (December 2018), VP of Corporate Strategy (December 2018) and VP of Cloud Engineering & Operations (December 2018). There are also several new board members.

Let’s take a closer look at what Model N offers its clients.

The Product
Model N’s solutions often serve as the system-of-record for customers’ revenue management processes. As such they span sales, marketing and finance departments, powering critical processes that integrate with client ERP and CRM applications. Being purpose-built, Model N’s solutions typically cover valuable data sets that are not typically found in those legacy systems.

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The company currently offers four Revenue Cloud suites (Pharma, MedTech, High Tech Manufacturing and Semiconductors & Components), each of which includes several applications that work together, but which can also be deployed individually to allow customers to scale up their relationship with Model N depending on their growth.

In terms of software development architecture, Model N’s solutions are built on industry standards, including Java EE, HTML5, Amazon Web Services and Force.com, all of which help give the end user a familiar browsing experience that’s intuitive, and which works on mobile devices running both iOS and Android.

As you would expect, reliability and scalability are of utmost importance given the global operations of clients. The current user base is nearly 50,000 strong among 169 customers operating in 100 countries and processing billions of dollars of revenue. It is expected to get much larger in the future.

Revenue Cloud For Pharma
Global pharmaceutical sales should top $1.2 trillion this year as new products hit the market and global populations continue to climb. Model N’s solutions for this market can handle everything from global product launches to contract management, government price reporting and more. In a nutshell, it handles all that’s needed to help clients achieve profitable growth while staying compliant with the global web of ever-changing regulations.

Revenue Cloud For MedTech
As in the pharma market, the world of MedTech is ever-changing. This creates challenge after challenge for companies that are trying to navigate increasing competition, pricing pressure and technology evolution. Model N’s solutions help them price products that are competitive but profitable, communicate prices to channel partners and potential customers, manage price changes and contracts, and navigate legal and regulatory webs.

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Revenue Cloud For High-Tech Manufacturing
Just like in MedTech and Pharma, change is the only constant in high tech. Companies plan multiple generations of products at the same time so they can consistently put the latest and greatest in front of users. But as innovation cycles speed up so too do product life cycles, meaning high-tech manufacturers need to get products to market quicker and with more efficient supply chains. That can squeeze revenue and profit margins if not done properly. Model N’s High-Tech Revenue Cloud offers solutions that span pricing, contract management, rebate management and channel management.

Revenue Cloud For Semiconductors & Components
Model N’s solutions for the semi industry can automate 70% of quoting and pricing transactions, which has been shown to increase revenue by 2% to 3%, boost channel sales by 10% and slash channel incentive overpayments by 10%. With solutions similar to the product suite for High Tech but layering in industry specific solutions for deal management and intelligence, as well as pricing intelligence, Model N is helping the world’s biggest semi companies streamline their sales organizations and dramatically reduce pricing errors.

The Business Model– Navigating A Transition to SaaS
Model N is transitioning from a software company that sold perpetual licenses (i.e. an on-premise business model) to one that sells software subscriptions (i.e. a SaaS business model). This is a bit of a messy transition that leads to inconsistent numbers for a few years. But it is a more familiar path now than in the past and one which many other companies have traveled down with great success, including Adobe, Microsoft and Rapid7. In most cases the shift works out quite well, driving more profitable growth and higher cash flow while opening up new revenue-generating opportunities. As it stands now, Model N has 20 existing customers that it is working to migrate off older cloud environments. The transition should be largely complete in another 24 months. New customers are coming in under the SaaS model.

There are many changes to Model N’s business model as a result of this transition. But the biggest ones are that professional services revenue is falling (as is typical when this transition is made) and is now in the “normal” SaaS range of 25% of total revenue (from almost 40% previously). Concurrently, revenue from old maintenance subscription contracts is declining at a single-digit rate and being replaced by new subscription revenue, which is expanding at a roughly 20% rate. They’ve also tweaked the sales strategy, which is now organized around the two core activities of hunters, who go out looking for new deals, and farmers, who harvest the deals the hunters have identified.

Model N has also built out its Global Customer Success (GCS) services organization, which helps customers realize the full benefits of the company’s solutions. GCS actively serves and supports clients through a global team of experienced project managers and consultants. This is an important function in any software company, but particularly for one going through the perpetual license-to-SaaS transition.

The punchline here is that Model N should emerge from this transition as a leaner and meaner company better positioned to grow revenue, profits and cash flow, all of which will help drive investments back in the company. From an outside perspective the transition creates a much more attractive company with a stock price that should justify a higher valuation.

The Bottom Line
Model N’s growth rate has been inconsistent because of the ongoing transition from the on-premise to the SaaS business model and a change to new accounting standards (ASC 606), which was adopted in Q1 2019. In 2018 revenue was up 23% and adjusted EPS was $0.04. In fiscal 2019, which ended on September 30, revenue declined by 9% to $141.2 million but EPS jumped 450%, to $0.22. Total subscription revenue in 2019 was $105.2 million (75% of total revenue) and is growing at around 10%, despite the aforementioned headwinds.

Looking forward things should be more consistent now that the SaaS transition is well underway and the 2020 vs. 2019 numbers will represent an apples-to-apples comparison (both reported on an ASC 606 basis). Management has guided for FY 2020 revenue of $153.5 (at the midpoint), which implies 9% growth, with adjusted EPS guided for a range of $0.22 to $0.31 (flat to up 41%). Looking to FY 2021, analysts see revenue up around 12%, to $170 million.

Equally important, free cash flow, which jumped by four times from $2.3 million in 2018 to $10.2 million in 2019, is expected to surge with the transition to SaaS after a short-term leveling off in FY 2020, when it is seen dipping by 6% to $11.6 million. In FY 2021 free cash flow should jump around 130% to $27 million, and then grow in the high 25% to 30% range through 2025. This free cash flow is being used to slash debt; over the last five quarters management has repaid 25% of debt and now has just $39.4 million in long-term debt. At the end of September cash and cash equivalents stood at $60.8 million.

Risk
Transition to SaaS Model: While the writing is on the wall and Model N’s shift to SaaS makes perfect sense, there are still numerous risks arising from this transition, not the least of which are that the expected revenue, profit and cash flow growth might not materialize. It is also possible that some customers might have bumpy transitions and get frustrated with the company, or that potential new customers might hold off on contracts until Model N’s transition is complete.

Longer-Than-Expected Path To Growth: The SaaS transition may take longer to bear fruit, which could hold the stock back and cause analysts to look less favorably on management’s ability to execute on other major initiatives.

New Senior Leadership: Model N has new leadership that may or may not work as well together as previously expected.

Changes In End Market Dynamics: Model N is “all in” on the life sciences and high-tech markets. If it fails to innovate and/or keep up with regulatory changes potential customers could go elsewhere.

Competition
Revenue management software represents a fragmented marketplace where competition includes manual spreadsheet processes, internally developed solutions, and customized enterprise resource planning (ERP) and/or customer relationship management (CRM) solutions. Model N management says most common competition comes from custom-configured SAP and/or Oracle solutions that have been tweaked to be “good enough,” and from smaller companies that offer more specific solutions, but which have somewhat limited functionality.

The Stock
Trading Volume: Model N has a market cap of $1.2 billion and trades an average of 275,000 shares daily. That means roughly $9.6 million worth of stock trades each day. Our subscriber group shouldn’t move this stock. Over the last six months heavy days have been over 500,000 shares traded daily. There have been roughly 25 such days, and MODN traded up on nearly all of them.

Historical Price: MODN had a tough go in its early years as a public company. For most of the time between its 2013 IPO (at 15.5) and the end of 2017 MODN traded well below its IPO price. A convincing rally took shares as high as 20 in August 2018, but a nearly 40% retreat broke up the party. The breakout above 20 came this past July, then a massive gap up to all-time highs above 26 happened in August after a big Q3 earnings report. MODN then consolidated in the 26 to 30 range before breaking out again to trade into the mid-30s in December.

Valuation & Projected Price Target: Valuing a stock like this requires some realization that the multiple should change dramatically as the SaaS transition wraps up and the “new and improved” company spreads its wings. Right now, MODN trades with a 2020 EV/Sales multiple of 7.4, using the midpoint of management’s guidance (2020 revenue of $153.3 million). That’s roughly in line with peers. But given that we’re expecting the story to keep improving, I’m going to value the stock based on expected revenue in 2021 ($170 million). Applying an 8 multiple to that figure implies 20% upside now, which I think is relatively conservative given that Model N’s management team has worked on achieving a beat and raise cadence. Let’s start with a price target near 45 for now (25% upside).

Buy Range (next two months): My wide preferred buy range is between 29 and 40. That takes us down to what should be support (roughly 25% below where MODN is now) and gives a little more than 10% upside to buy into. In the near term, a buy range between 32 and 36 is likely where you’ll begin accumulating shares.

The Next Event: Management should announce Q1 FY 2020 results and host a conference on or around February 3.

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Model N (MODN)
777 Mariners Island Boulevard
Suite 300
San Mateo, CA 94404
United States
650-610-4600
http://www.modeln.com

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Updates on Current Recommendations

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Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.
Happy 2020
As in previous years there was little to no company-specific news flow over the holidays. On average, our stocks have only moved by 1% since my last update.

The biggest upside moves have been in Health Catalyst (HCAT), up 10%, Avalara (AVLR), up 7%, and Cardlytics (CDLX), up 6%, while the biggest downside moves have been in Veracyte (VCYT), down 9%, Construction Partners (ROAD), down 6%, and Domo (DOMO), down 5%.

Now that the final quarter of the year is in the books and most of the end-of-year-related weird trading is behind us, we should be able to get back to business as usual. That said, for this week, there’s not a heck of a lot to say with respect to our positions. Rather than come up with extra material, I’ll keep today’s update short and focused only on the three stocks that I have something to say about right now.

Changes this Week
Construction Partners (ROAD) moved from BUY to HOLD

Updates

Arena Pharmaceuticals (ARNA) recently announced it would expand its strategic partnership with Beacon Discovery, which has worked with Arena on clinical development initiatives for a while. This deal, named Project Cabrillo, will see Beacon develop novel therapies targeting G protein-coupled receptors (GPCR) to treat immune and inflammatory indications. Beacon will handle drug discovery, while Arena will handle commercialization of the most promising compounds. We’ll see if anything comes out of it. BUY

Construction Partners (ROAD) took a hit after reporting Q4 results in early December and I kept at buy thinking the reaction was a bit overdone. Shares then climbed back to 18 in late December but have slid over the last two weeks. At this point I’m on the fence with the stock and don’t want to see a small loss turn into a larger one. I’m moving to hold and will watch ROAD closely. I still think it has a good future – I just don’t want to hold the stock if it doesn’t stand up in the near term. Moved to hold. HOLD

Health Catalyst (HCAT), which moved to hold a couple of weeks ago, is looking better but not enough to move back to buy. This was our December selection and started out great, then fell apart in December. It’s a young stock, having just gone public in July. It just needs some time. HOLD

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.


The next Cabot Small-Cap Confidential issue is scheduled for February 6, 2020.

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