|Shares Out. (in M):||34||P/E||0||0|
|Market Cap (in $M):||1,488||P/FCF||0||0|
|Net Debt (in $M):||75||EBIT||0||0|
|TEV (in $M):||1,563||TEV/EBIT||0||0|
|Borrow Cost:||General Collateral|
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I believe Benefitfocus (BNFT) is a short, mischaracterized as a software company, and set up to disappoint consensus expectations of a pending turnaround with real operating leverage. The 16-year-old outfit has been lauded by Wall Street as a transformational software platform player in the benefits administration space. In reality the company is an overvalued, low-quality, consulting-intensive “software light” system integrator with a history of execution/implementation problems and a marginal industry reputation. The business took more than a decade-and-a-half to cross $250m in annual run rate revenue, and in the last 5 years total revenue of $918m has yielded paltry operating cash flow of (-$78m). Recent significant changes in management and a hyped business model enhancement have renewed Wall Street’s love affair with the name, but my primary research and fundamental analysis reveal that the future holds little promise for BNFT. I think shares could trade down 65%, to $15.
What They Do
BenefitFocus describes themselves as “a leading cloud-based benefits management platform for consumers, employers, insurance carriers, and brokers.” In a nutshell, they sell an enterprise portal that allows corporate administrators to offer and process employee benefits, enables employees to make online elections, and connects carriers with companies to process payment and eligibility. Much of the offering is system integrator-like in nature, people-intensive, and ongoing, with a light software front-end that provides enough cover for the company to present themselves as a true “SAAS” vendor. The stated business model has evolved over time to fit a shifting narrative focused on 1) connecting insurance carriers, 2) selling new implementations to medium/large “employer” clients, and 3) more recently, providing marketplace-like functionality for elective benefits on corporate portals.
The table below, sourced from public filings, aggregates several key annual and recent trends in the business which are instructive for the remainder of my qualitative discussion and a general framing of the company:
|Software Services Revs||75,931||97,713||125,083||161,447||201,797||218,443||89,065||96,458|
|Pro Services Revs||5,805||7,039||12,337||23,666||31,538||38,292||23,647||26,486|
|Operating Cash Flow||12,408||1,067||(18,878)||(31,545)||(22,826)||(5,937)||(6,996)||(4,773)|
They are NOT who we thought they were (Thank you, Dennis Green)
From a high level, the Benefitfocus financials show a ~10% topline grower with blended gross margins of 50% and no earnings or cash flow. Ever. This is not your mother’s sexy software company. With 32m shares outstanding, $53m in cash and $128m in debt, investors today are paying a lofty 5x for expected 2019 revenue of $286m—which also presumes accelerating topline growth of 12%. From the table it’s clear that growth in the employer business has slowed materially from over 50% four years ago and is now pedestrian in the 10-15% range. The Carrier business, which sports 60% margins, has not grown in 2 years and is at best a 3-5% growth segment. I will delve into the “Software Services Revenue” line item later, but the numbers show it’s now growing at roughly half the rate of professional services, a money losing line of business that carries negative gross margins and has lost money for 16 years. I don’t mind professional services revenue as a loss leader, but it should provide a gateway to super high margin software revenue, not the 60% GM flavor you get here. It’s also rare to see a “software company” generating only $177k in revenue per employee. With 1,450 full time heads as of FY17-end this is one of the least efficient software enterprises around.
History of Management Turnover, Curious Endings, and Salesforce Churn
From a people perspective, BNFT’s life as a public company has been an adventure. Founder and corporate culture zealot Shawn Jenkins (“Winning with Culture”) was the face of the company until late 2017 when he somewhat shockingly announced plans to retire as CEO and abruptly left the Board. The news blindsided many former employees I interviewed, as he was the lifeblood of the company and something of a local Charleston business icon. I presume his decision to leave the board was motivated by a desire to sell stock unencumbered, but it’s rare and unusual to see an impassioned founder distance themselves so markedly from the company they built. The office of the CFO has candidly been a revolving door, with 3 fresh faces over the last 5 years, even after excluding the 2 interim heads. The second CFO hire, Jeff Laborde, lasted only 7 months.
Salesforce and implementation churn at BNFT has been a constant and well documented issue, but my research has picked up a noted acceleration in departures over the last 6-12 months after the company missed Wall Street expectations for much of 2017. Rates of 50-60% turnover over the last year in the oversized 130 person team have been quoted to me, and a former rep suggested fewer than 5% of his Employer team colleagues made their quota in 2017, which likely explains the mass exodus.
The Product is Just Not that Good, The Market is Competitive, and Implementation is a Drag
While I certainly find the financial model underwhelming, the team turnover alarming, and many other qualitative circumstances surrounding BNFT questionable, I also turned up generally negative product feedback during my due diligence. Furthermore, in a crowded market, the core BNFT offering is considered undifferentiated and costly to implement, with administrators sighting quality alternatives like Businessolver, Benefitexpress, Hodges-Mace, PlanSource, and for larger implementations, ERP companies like Workday. On a scale of 1-10, one customer testimonial gave BNFT only 6.5 stars. Like many similar vendors, the company sells through both a direct salesforce and also through brokers and consultants. I was alarmed to hear a quoted win rate of only 5% when consultants are involved, because unfiltered references are typically unflattering. I was told by a former senior sales team member that the company pushes direct sales to better manage the “reference process.” The ROI pitch for customers also struck me as a bit underhanded when recounted. Administrators are told that the BNFT platform can effectively push employees to elect high-deductible plans, therefore saving the parent company hard dollars on premiums—which are now funneled to BNFT of course.
Implementation was frequently highlighted as a negative sticking point for BNFT, with criticism coming from both former employees and current customers. One customer who has been up and running for several years said they still do a weekly call with the customer success team to address persistent ongoing problems in payroll and back end integration. A former high-ranking executive at BNFT suggested that almost every implementation is highly-customized and the system isn’t designed to enable customer self-customization. As a result, users remain permanently dependent on BNFT for rudimentary adjustments and tweaks. This might sound like a moat, but many deals are 3-years in nature with 1-year opt-outs, and “consulting fatigue” is not uncommon. Annual benefit onboarding creates an additional recurring cost burden, with multi-day onsite visits required to refresh the system and present employees with the latest menu of options. Most of these vignettes describe what I view as a complicated managed-services like implementation, with some software involved. The persistent low margins outlined above reflect this narrative. BFNT management has started to push a narrative that margins will improve as the partner network assumes more of the professional services burden going forward. My direct feedback from former salespeople, however, indicates that customers have consistently refused to pay the external consulting premium (sometimes 3x), electing instead to stick with the BNFT inhouse team. This simply leads to additional low margin revenue.
BenefitsPlace & the Broker Channel: Houston We Have a Problem
Earlier I referenced a recent business model tweak that has Wall Street excited and has been a partial catalyst for the recent run-up in shares. BNFT has always maintained a tenuous relationship with the brokerage community, which is the primary curator of benefits offerings to enterprises, and a crucial channel that frequently recommends BNFT to corporate customers. Several years ago, BNFT released the “BenefitsStore,” a module intended to allow employers to contract directly with insurance providers, remove the middleman (broker), and offer employees an online shopping-like experience for voluntary benefits (vision, dental, pet insurance, disaster, etc.). The initial version required BNFT to appear as the broker of record, and it created an enormous backlash in the market, with many channels feeling the company had infringed on their turf. Referrals were cut back and BNFT’s reputation took a hit.
Recently, the company took another shot, rebranded what is essentially the same offering as “BenefitsPlace,” stepped away as a broker of record, and agreed to an undisclosed and non-standardized split of commissions with the other parties involved. Feedback from the broker community has been very mixed, with most regarding the “new” offering as fresh “only in name.” This is still viewed as a trojan horse, and while BNFT pitches the offering as unique, most of their competitors offer virtually the same functionality. Candidly I don’t understand the second layer commission structure and would like to know who exactly is fitting the bill. In company filings BNFT outlines the value proposition: “Benefitfocus receives repeatable transaction revenue from carriers and suppliers…we generate referrals from brokers and provide better protection for consumers.” Interestingly, I was told by a former BNFT sales rep that the company has been using the earned commission revenue as a “discount” to software revenue in order to keep total costs down for the customer. In other words, if a customer that was paying BNFT $100k/year is willing to implement BenefitsPlace and it yields $20k in additional transaction revenue to BNFT, the company will then discount the remaining “technology fee” to only $80k/year so that the total bill remains stable at $100k. If this practice persists, it will challenge the notion that BenefitsPlace can be a truly additive component to the topline.
Time will tell if this new offering ends up alienating the company, but one thing is for sure, this new stream of revenue is definitely NOT “software.” The company offers no further disaggregation of the “Software Services Revenue” line item in filings, but it clearly reflects a mix of standard software revenue, and increasingly, commissions and “transactions.” Depending on the precise makeup, one could consider the company an agency or broker, which would certainly cast a different light on the value of the business as a whole.
The Mercer Moment
In February of 2015, BNFT investors were briefly aroused when industry consultant Mercer announced a partnership and ~10% strategic investment/cash infusion. Since then, little excitement has come of the deal. My due diligence and most industry feedback suggests that the relationship has basically been a dud. Mercer was initially over-controlling and treated BNFT as if they owned the entire company, a posturing that was not well-received by then-CEO Shawn Jenkins. More recently, my research has confirmed that Mercer remains disenchanted with the ongoing BNFT implementation issues and heavy workforce turnover. They’ve also recently rolled out a few directly competitive solutions to the BenefitsPlace offering, “Mercer Marketplace,” which at the very least indicates a desire to hedge their bets. From the outside, this appears to be an evolving relationship in flux.
Grab Bag: The Changing of Metrics, Fuzzy EBITDA, and Heightened Risk Factors
One of my favorite red flags to look for with good shorts is a change in reported metrics. Quoting the Q2 earnings call, CEO Ray August announced, “In conjunction with our 2019 reporting, we plan to introduce new metrics associated with the lives on our platform. We believe this will increase insight into our business model, and we believe the [employer] logo count will be a less meaningful metric to evaluate our business. We plan to stop providing logo count as a measure in 2019.”
The announcement caught my attention for a variety of reasons, including 1) my research indicates an increasingly competitive market, which means BNFT probably wants investors to focus less on wins and losses, 2) “lives” is a non-traditional statistic that can be proactively managed and inflated (multiple products to the same person = multiple lives), and 3) it reflects a tempered enthusiasm for the supposedly vast new client opportunity.In addition, my red-line reading of the FY17 10-k (below), which highlights changes from the FY16 version, reveals a noteworthy redaction in how the company describes the employer segment. Note, the employer segment represents the key “sizzle” in the BNFT story, with big goals for rapid acceleration in lives and transaction revenue stemming from consistent new customer wins. Nobody is paying 5x sales for a Carrier segment that has almost no growth. Employer account growth is crucial to the story:
In what I also think may be a related move, the company re-ordered a direct sales-forced-related risk bullet, moving the following factor up several pages in the latest filing. A retired CFO once told me to always focus on the order of risk factors in the 10-k, suggesting that if something has moved, there’s usually a good reason.
· “Failure to adequately and effectively expand our direct sales force will impede our growth.
When added together, I think the company is communicating a murky picture or quietly warning investors. They no longer want to talk about logo wins, they won’t describe their core employer business in legal filings as “fastest growing,” and they now see failure to expand the already-bloated salesforce (which drives logo wins) as a risk to future growth.
Lastly, on “profitability:” with no cash flow to speak of, Wall Street has naturally gravitated towards valuing BNFT on a price/sales multiple and the more insidious “Adjusted EBITDA.” This is frequently a place companies play games and this case is no different. I was amused by the line item adjustment for “Costs not core to our business,” which showed up as a new addition in the 2017 filings and has reached almost $3 million of the “near-breakeven” adjusted EBITDA target. It would be nice if we all could report “costs not core to our business!”
In my modest opinion, a money-losing company in a competitive market with a spotty track record and 50% gross margins growing topline at only ~10% should not trade at 5x forward revenue. Outside the hype of Wall Street with the reality of “what it is” in plain sight, I think a 2x revenue multiple on 2019 estimates of $275m (5% below consensus) is generous and fair. That yields a fair value of $15, or downside of 65%.
As with all “software” companies, I worry most about M&A. Mercer would seem like a logical acquirer but the partnership results, as we’ve mentioned, have been lackluster. What would they be getting? A more recent partnership with SAP is probably a bigger threat since they’ve been known to be price insensitive and desperate. I could see either company buying BNFT but at what multiple? Are they really going to pay 6-7x forward revenue for this business?
In the shorter term, Q3 is a big selling season for BNFT and they’re also hosting a fall analyst day which will likely be filled with grandiose visions of “long term” industry-leading 5-10% operating margins. Newsflow for the rest of 2017 could be pretty positive, and the stock has a decently high short interest (18% of the float, 13 days to cover).
I see several catalysts for a correction in BNFT shares. In the shorter term, earnings are an interesting setup. Shares rallied (or squeezed) almost 20% after the Q2 report but management couched the widely-cheered results as follows: “The revenue in excess of the high end of our prior guidance was primarily driven by the timing of professional services, commissions associated with off-cycle enrollments and favorable accounting treatment from a large customer contract that shifted revenue recognition to the second quarter.”
That doesn’t sound sustainable, repeatable, or high quality. Forward expectations for the company are generally to resume growing 12-14% (some puts and takes with ASC 606 changes), but I simply don’t see the evidence to support that sort of forward trajectory, particularly with turnover in the salesforce and management’s recent logo-related commentary that I think many investors are ignoring.
Medium and longer term I do not think the broker community will allow BNFT to impede on their turf with a successful marketplace-like offering. The structure and embedded interests of the industry simply won’t allow it. Moreover, it sounds as though in many cases transaction revenue is simply substituting for software revenue, which could prove a headwind for expansion in current accounts. On the profitability front, I don’t see how this company will ever make a lot of money. It’s simply too services-intensive and the solution is not that sticky. One industry expert told me winning customers is easy, getting them up and running is costly, and losing them is only a matter of time. While not fundamental in nature, we would add that Goldman Sachs owns more than 6m shares and has previously filed to liquidate their position. In a stock that trades ~250k shares/day this could leave quite the mark if they run for the hills.
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