There's More In The Clouds At Medidata Than Just The Valuation

There’s More In The Clouds At Medidata Than Just The Valuation…Executive Compensation Is As Well

During the process of screening stocks for my analysis work, I am always looking for businesses that either provide products and services that are critical to our way of life or provide products or services to those businesses that do.

Therefore, I spend a great deal of time looking at businesses related to the insurance, healthcare and software industries. These three businesses are crucial to almost all of our lives and are inextricably intertwined with each other, and spending so much time looking at these types of businesses really aides me in knowing in advance what to look for in terms of red flags or warning signs.

Generally speaking, when I am analyzing a stock, I am simply looking for a compelling reason to buy it or any reason not to take a long position. One of the stock screens I run is named “Trouble Looking For A Place To Happen” and it is designed to identify stocks that are carrying extremely high valuations. I use it mostly as a way to gauge the number of stocks that are valued at an extreme level and whether that number is rising or falling. It is just one of the informal ways that I evaluate investor optimism.

While reviewing the results of this screening program today, I came across a business call Medidata Solutions, Inc (MDSO, Financial). What caught my eye was that fact that this company serves the healthcare industry through analytical analysis of data in a cloud based format. It hits so many of the popular buzz words I thought it deserved a closer look. What I found of quite interesting.

What Is Medidata?

Medidata Solutions, Inc. provides cloud-based clinical development solutions for life sciences in the United States and internationally. The company offers applications and data analytics for clinical development. It offers Medidata Rave, a platform for capturing, managing, and reporting clinical data; Medidata CTMS, a clinical trial management solution that streamlines operational workflows; Medidata Designer, which enhances the efficiency of clinical trial start-up; Medidata Insights, a clinical business analytics platform; and Medidata Balance, a randomization and trial supply management solution.

The company also provides Medidata Patient Cloud application for electronic patient-reported outcome; Medidata Grants Manager, which enables to develop and manage trial budgets; Medidata contract research organization (CRO) Contractor, an analytical tool for CRO outsourcing, budgeting, and negotiation; and Medidata SQM, a set of cloud-based site quality management dashboards. In addition, it offers Medidata Coder that provides medical coding and synonym management solutions; Medidata Safety Gateway, which offers a solution for collecting and transmitting adverse events and related data from the EDC system; and Medidata Targeted SDV that provides auditable and scalable solutions, as well as offers hosting, support, and professional services.

Medidata Solutions, Inc. markets and sells its cloud-based solutions through direct sales force, as well as through relationships with CROs and other strategic partners. The company serves pharmaceutical, biotechnology, medical device, and diagnostics companies; and academic institutions, contract research organizations, and other entities engaged in clinical trials.

Its general purpose is to assist customers in design, conduct and analysis of clinical trials in a way that lowers the overall cost and improves the outcomes through more effective and efficient analysis of study data.

It is a business that provides important cost-saving services to a critical industry. There is not much to dislike about that.

Is The Business Profitable?

Businesses that provide critical products and services to critical industries are a good place to start looking, but they also need to be profitable before they can be considered good candidates for investment. In the case of Medidata, the analysts’ estimates shown in the table below, available on Yahoo! Finance, seem to once again provide reassuring results.

What Are The Future Prospects For The Business?

Investing is much more about the future prospects for a business than it is about the present. And the future prospects for Medidata look fairly bright as well, if we can believe the analysts covering the stock. Once again, I have referred to Yahoo! Finance for the information in the table below

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At first glance, with an eye on the first five lines of this table, Medidata continues to look like a profitable business, operating in a crucial industry, with excellent future prospects. Unfortunately for current shareholders, that appears to be just about where the good news ends for this business.

How Is The Business Valued?

Generating exceptional investment returns, or any returns for that matter, is as much about the price we pay as it is buying profitable businesses. After all, lots of businesses make money but don’t qualify as good investment opportunities at all times. The current valuation of Medidata to its present and future value gives us the first serious indications that this business is not currently priced as a good place to allocate new capital.

The last two lines of the preceding table give us our first glance at just how expensive this business is right now. With the stock having closed trading last Friday at $57.94, the business is currently valued at 65.1 times this year’s estimated earnings of $0.98/share and 52.2 times next year’s projected earnings of $1.11/share. This is one highly priced business by the most common valuation metrics of price to earnings multiple and price to earnings growth multiple (PEG).

When compared other lesser used valuation metrics, the stock looks every bit as expensive. Even in an industry that tends to carry a high valuation, the business is far from cheap compared to the averages in its industry. The price to cash flow, price to sales and price to book values, available from the Fidelity Investments website and displayed in the table below clearly illustrate that this business is valued as if it should be the best run business in its classification.

How Well Run Is This Business?

In 2010, Medidata generated $32 million in operating profit on $166 million is sales. In 2014, the company earned $36 million of operating profit but required $335 million in sales to do it. In well-run businesses, the percentage of operating profit to sales normally rises as sales move higher since the fixed costs are assumed to be spread across a broader base of sales and gross margin dollars. That has obviously not been the case with Medidata, as sales have more than doubled, but operating profits have only risen by 12.5% over the last 4 years.

The chart below also shows the performance of the share price, net income and what that stock price would be based on the company’s median price to earnings and price to sales ratios. The divergence between these values is very evident and shows the stock is becoming quite expensive.

The Business Isn’t The Only Thing With A High Valuation

I often state that I don’t mind owning shares of businesses where management is highly compensated as long as the results they deliver justify the compensation they receive. Share price is one way to value a business, but that is far more driven by investor excitement or fear than it is by the real value of the business. Shareholder equity is, to me, one of the better metrics to use in assessing how much real value management is adding to the net worth of a business.

In the case of Medidata, shareholder equity as of December 31, 2013 was $226 million and increased by $39 million to $265 million by December 31, 2014. While a 1-year increase of 17% in equity might sound attractive, imagine how much more attractive the results might have been had the top five executives of the company not received compensation equal to 39% of that number.

That’s right. You won’t find it in the company’s annual report filed with the SEC. You have to look in the April 15, 2015 Schedule 14A on page 38. There buried in the midst of a rather long and boring document is the following summary of compensation awarded to the top 5 executives. Earlier in this document, on page 32, the salaries (which don’t sound unreasonable at all) are listed and no reference is made to the substantial compensation received in stock based compensation. It would completely escape notice if someone were not specifically looking for it and reviewing the entire document.

Here is where I have a problem. All of the shareholders combined saw the real value of their ownership in this business grow by a total of $39 million dollars last year while the top 5 executives combined had total compensation valued at $15,196,887. I am sorry if I sound old-fashioned or selfish, but that just doesn’t sound equitable to me.

Part of the problem with this business is that we have an executive team that is receiving a huge part of their compensation through stock awards, which gives them an incentive to run the business with an eye toward pushing up the share price immediately rather than being fully focused on building long-term intrinsic value for shareholders. This kind of short term performance is quite often detrimental to the interests of long-term investors. Only time will tell if that is the case in this situation.

In addition, in 2013, the company took on $230 million in long-term debt and added another $11 million in 2014. This debt generated an obligation of $15 million in interest and related expense in 2014 against operating income of $36 million before depreciation. Over the last 4 years, the company has spent $57 million in capital expenditures for an average of $14.25 million/year. This is not leaving a lot of free cash flow after capital needs and interest expense are met. This goes a long way toward explaining why the price to cash flow number is so high.

What Is Medidata Worth?

When I am considering a long position in any business, I approach my valuation very conservatively so I maintain an extra margin of safety for my capital. When I start considering a short-sale of a stock, I want to assess the fair value from a very aggressive and optimistic point of view for the same reason.

As we have seen throughout this analysis, Medidata is valued at 2 to 3 times the industry average valuation. We have also seen that the top executives seem to be far more interested in returning value to their own bank accounts than they are in building long-term, sustainable value for the shareholders, who are the true owners of the business.

The industry carries a price to earnings growth ratio of 0.79 and the sector is valued at a PEG of 1.07. If we use the company’s projected forward earnings growth rate of 19%/year and the sector PEG multiple of 1.07 coupled with the estimated earnings of $1.12/share for 2016, we end up with a fair value estimate of $22.77/share. A price of $22.77/share would require a drop of 60.7% in the share price for this business to be valued on par with its industry sector. Even if it were to be valued at a 50% premium to the sector, it would still need to fall to 34.16/share; equaling a decline of 41.05%.

Final Thoughts And Actionable Conclusions

Investors wishing to guard their capital should at the very least avoid this stock at all costs. However, those investors who are becoming concerned about the age of the current bull market and wishing to create a hedge for a portfolio of long positions, might do well by creating a short position in shares of Medidata when it is trading above $50.00/share and using a buy to cover order at 10% above the lowest share price reached while you are holding the stock short.