andreswd
Investing action
I recommended a buy rating for Health Catalyst (NASDAQ:HCAT) when I wrote about this last time (November 14, 2023), as I expected, HCAT would become a stronger business with a better profitability profile as management executes in their growth strategies. Based on my current outlook and analysis of HCAT, I recommend a Buy rating. I am confident that HCAT can meet management's FY28 guidance, generating >$100 million in EBITDA. As HCAT shows evidence of achieving this over the years (e.g. by widening margins), the valuation should begin to appreciate upwards to peer levels.
Review
HCAT reported 4Q23 (February 23, 2024) revenue growth of 9% to $75.1 million, placing at the upper end of the guided range of $70.1 million to $75.1 million. By segment, technology revenue grew 5% to $47.1 million and professional services revenue grew 14% to $27.9 million. Adj gross profit amounted to $34.7 million, which translates into margins of 46.2%, which decreased 450 bp due to the contraction of the gross margin in Technology (215 bp to 66.6%) and Professional Services (584 bp to 11.8%). As for adj. EBITDA was $1.4 million, in line with guidance of $0.3 million to $2.3 million.
I think the results were excellent and the outlook for HCAT remains positive. The falling stock price represents another opportunity for investors to buy stocks again at a cheap price. The macro backdrop has certainly improved compared to 2023, especially after the Federal Reserve reiterated its view of reduce rates this year. This should lead to a better spending environment for the healthcare industry, which translates into better reserves for HCAT. At a micro level, I remain positive about HCAT's growth initiatives, particularly its TEMS offering and next-generation data platform.
Regarding TEMS, I am very positive about this growth momentum and margin expansion. At its core, TEMS addresses a number of critical issues facing clients, such as outsourcing, financial constraints and expenses, and recruitment and retention. During the investor day, graph abstraction was highlighted as one of the key features. Reducing the time to extract data per use case, as well as the costs and burdens associated with data collection, are all benefits of the HCAT solution. By doing so, customers can focus on their patients and other stakeholders rather than manual extraction. The addition of AI makes this product even better because it has the potential to evolve into an even more efficient version. Management says they anticipate a 24% reduction in abstraction time as a result of Chart Abstraction AI, which could lead to labor cost savings. Translating this into financial terms, it means higher growth and margins. In terms of growth, since HCAT can help customers reduce total cost of ownership and improve efficiency, I expect the adoption rate to accelerate. As for margins, because a lot of manual work is done through AI, meaning lower labor costs per use case and human error, HCAT has become more profitable, and this makes the goal of Margin run rate of 25% is much more plausible. Finally, as the financial situation of the end market is expected to improve (as the cost of capital drops due to rate cuts), the adoption rate of TEMS offerings should also improve.
The next-generation data platform is anticipated to close the spending gap between DOS and non-DOS customers with its more adaptable design. Currently, HCAT has more than 500 non-DOS clients in addition to 100 DOS clients. Management noted a significant disparity in the amount of money spent by the two groups: DOS customers typically spent several million dollars and HCAT and non-DOS customers spent only a few hundred thousand dollars. With the increased modularity and flexibility of this new platform, HCAT can better meet customer needs; In other words, HCAT is able to offer solutions that meet the needs of customers in the middle of the spending ability spectrum. The next-generation platform also makes it easier for HCAT to incorporate new capabilities as applications and key performance indicators are developed. This means that HCAT can launch more products that can be used for cross-selling to its current customer base, increasing DBR.
Looking ahead, I am confident that HCAT can deliver on management's long-term guidance of >$500 million in revenue by 2028 and $100 million in EBITDA, equating to a revenue growth CAGR of 11%. % in 5 years with EBITDA margins of 20%. This effectively implies ~34% EBITDA growth over the next 5 years.
Valuation
author's work
As I believe HCAT is capable of achieving long-term management guidance (FY28), the question is: at what multiple should HCAT trade? To figure this out, I looked at other application software companies in the healthcare industry to get an idea of the possible range of multiples. There are two key factors to pay attention to here: (1) expected revenue growth rates; and (2) margin profile. Based on management's long-term guidance, HCAT will grow at a minimal level over the next 5 years and achieve an EBITDA margin of 20%. Using these factors, I approached 3 peers for HCAT due to their similar target audience (healthcare companies) and medium-term growth profile (2nd year growth): Simulations Plus (SLP), Doximity (DOCS), and Evolent Health (EVH). You'll notice that EVH is trading at a lower multiple despite higher growth, and that's due to a lower margin profile. I believe this is also a key reason for the current HCAT multiple. Showing that EBITDA margin can expand, the valuation should improve to SLP and DOCS levels. In my model I have presented four multiple scenarios and all of them offer an attractive IRR over the next four years.
Note that this is a different valuation methodology than my previous model that focuses on revenue growth. Now that we have an EBITDA target, I think it makes more sense to value it based on earnings rather than revenue.
author's work
Risk and final thoughts.
Recovery in macroeconomic conditions is quite important for HCAT's performance in FY24. If the macroeconomic situation worsens, spending on the healthcare sector will be further delayed until FY25/26. This is definitely possible, as the housing situation in the US remains a supply shortage situation. If the Federal Reserve cuts rates and inflation starts to rise again, we could see another round of rate hikes.
I reiterate a buy rating for HCAT despite the recent drop in share price. I believe HCAT's TEMS offering and next-generation data platform position them well for future growth and margin expansion. As such, management's long-term guidance of surpassing $100 million in EBITDA by FY28 is achievable. A near-term catalyst is a potential rate cut by the Federal Reserve, which should drive an improvement in the healthcare spending environment. As HCAT demonstrates its ability to execute its growth strategies and expand margins, its valuation should improve to reflect its peer multiples.
