Teladoc Health: A Quantitative Valuation

This article is the third in my 'quantitative valuation' series in which I explore valuations of high-growth technology companies. My first article on this topic was about Slack (WORK); that article contains an overview of my way of thinking quantitatively about companies that are growing quickly but are not profitable. As a brief refresher, my model relies on five key estimates: Total Addressable Market (TAM), the share of the total market that the company can reasonably hope to capture, the company's net margin once it has reached scale, the PE multiple the market will be willing to assign to the company once it has reached its peak market share, and the annual rate at which the company will compound revenue growth until it reaches peak market share. The goal is to estimate what the company's market cap will be by the time it stops growing and how long it will take the company to reach that point. The final result will be an estimated annual rate of return an investor can expect to receive if they invest in the company. In this article, I will be applying the model to Teladoc Health (TDOC).

A Quick Overview of Teladoc Health

TDOC describes itself as:

" ...the largest and most trusted global leader of comprehensive virtual healthcare services. We are forging a new healthcare experience with better convenience, outcomes and value. Our mission is to transform how people access healthcare, delivering an improved experience with better convenience, outcomes and value for individuals, providers and Clients. We provide virtual access to high-quality care and expertise, with a portfolio of services and solutions covering more than 450 medical subspecialties from non-urgent, episodic needs like flu and upper respiratory infections, to chronic, complicated medical conditions like cancer and congestive heart failure."

(Source: Company 10-K)

The company has recently completed a merger with Livongo Health (LVGO), and the combined company will be the largest player in the virtual healthcare space, with a strong data analytics offering and a large network of multi-specialty physicians.

I am keeping the business overview section brief, as the goal of this article is to explore valuation scenarios rather than provide a deep dive on the inner-workings of the company. I will assume the reader has at least a basic understanding of how TDOC conducts its business. There are many other articles here on SA that go into a lot more detail about TDOC's business structure; I would encourage those looking for a deeper dive on the company's operations to check them out.

A quick overview of TDOC's recent financial performance, based on reported Q3 results: the company is on track to bring in about $1 billion in revenue for 2020, an increase of nearly 100% compared to 2019. The company's gross margins are north of 60%, though the company's net margins are negative. TDOC generated positive cash flow from operations in 2019 and is on track to do so again in 2020. The company's balance sheet has net $0 debt, with ~$1 billion in cash being offset by ~$1 billion in debt, as of the end of Q3. At the time I was putting this article together, TDOC had a market cap of $18 billion.

Some Discussion Around Estimates

A valuation model is only as good as the estimates it uses, so I want to talk about each one at a high level before going into the valuation scenarios:

TAM

TAM is always a bit tricky to estimate, especially the further out into the future you go. For these valuation exercises, I generally accept a company's own estimate for their TAM, but I take it with a grain of salt when considering conservative scenarios. I understand that a company has an incentive to inflate their TAM, but it is also true that many of these companies operate in growing industries and industry growth is not fully baked into my model. TAM rarely ends up being the constraining factor in a valuation anyway; if the TAM I use in my model underestimates the true TAM, then the revenue growth rate and time to reach peak market share end up constraining the model instead. TDOC uses $121 billion as their estimated addressable market, post Livongo merger.

Market Share

Market share is the most subjective estimate I use in my model; if you disagree with the ranges I use I am more than happy to hear a counterargument. That being said, I am unwilling to estimate that any company can capture more than 50% of a total market on a long-term basis. Despite consolidation in the tech industry, it is rare to find unassailable monopolies and new players are entering the market all the time to compete with existing successful companies. Even a company like Google, which controls over 90% of search traffic, owns only about 30% of the online ad market from which it derives the majority of its revenue. I'm not saying there can't be exceptions, but 50% is my default maximum. I am going to start lower at 40% for TDOC; I perceive that some parts of their offering can be replicated by competitors (such as video conferencing with doctors).

Net Margin

One of the usual knocks against high-growth tech stocks it that they "don't make money." Net margins are often negative as the company invests heavily into growth, and it is true that some companies will fail and never made it to profitability. On the other hand, the most compelling appeal of high growth tech stocks is their ability to scale with minimal capital investment. The cost to add new users to the TDOC platform is minimal; at certain milestones more support staff might need to be hired and more cloud storage need to be purchased, but these costs are infinitesimal compared to the additional revenue each new customer brings in. Once a company like TDOC can cover their (relatively) fixed SG&A costs, revenue from each additional customer will be mostly profit and will beef up the overall net margin. Net margins of successful tech companies at scale (Microsoft, Facebook, Google, etc.) range from 20-35%, and I expect that TDOC can reach similar levels.

Price to Earnings Multiple

A company's price to earnings ratio is driven by investor sentiment and general market conditions, but I operate under the assumption that companies that are growing and have predictable earnings will earn a higher PE ratio than those that have stopped growing and have irregular earnings. In these valuation scenarios I assume that the company has reached its peak market share when the multiple is applied, meaning that growth has slowed to match the general pace of the market. Companies with a subscription model and recurring revenue like TDOC will have steady earnings. Thus despite assuming that growth has stopped, I assume the steadiness of the earnings will warrant a PE of at least 15.

Revenue Growth Rate

In these valuation models I used a compound annual growth rate for revenue to help make the math a little bit easier. I subscribe to the general principal that it is easier for a company to grow revenue when it is smaller and that revenue growth slows as the company becomes larger. For companies with network effects this isn't always a linear progression, but all companies face slowing growth as they get close to their maximum market share. I use a averaged compound annual growth rate in the modeling for each year, but in reality revenue growth rates are more likely to look something like 100% in year one, 80% in year two, 70% in year 3, etc., down to maybe 5 or 10% in the last few years before reaching peak market share. So, when I use a CAGR of revenue of 40% below, I'm not saying I expect TDOC to grow revenue exactly 40% each year, but rather that the average annual growth rate will be 40%. For some reference points, Google has averaged a 20% CAGR of revenue over the last ten years, Amazon has done 28%, Facebook has done a whopping 49%, and Netflix has done 26%.

Valuation Scenarios

Beginning with an optimistic scenario, consider the implications if TDOC is eventually able to capture 40% of the estimated $121 billion addressable market, reaches a net margin of 33%, receives a terminal PE ratio of 20 from the market, and is able to grow revenues at a compound annual rate of 50% until it reaches its peak market share. For comparison, this would mean that TDOC surpasses the earning power of Microsoft (which has the highest net margin of any tech company above a $250 billion market cap) and matches Facebook's phenomenal trailing 10-year revenue growth rate. In this scenario, we can expect TDOC to achieve a market cap just above $300 billion in about 10 years, for an annual return of 33%:

(Source: Author's Spreadsheet)

A more moderate scenario would be to assume a lower market share of 25%, a net margin of 25%, a terminal PE ratio of 15, and an only slightly more moderated 40% CAGR of revenue. In this scenario, TDOC reaches a final market cap around $100 billion over the next 10 years, for an annual return on investment of 20%:

(Source: Author's Spreadsheet)

Finally, let's use a more cautious set of assumptions and say that the total addressable market is a smaller $100 billion, TDOC only captures 20% of this smaller market, the company reaches a net margin of 20%, the terminal PE ratio is 15, and revenue "only" averages 25% compounded annually. In this scenario we get a more modest $60 billion market cap and it takes TDOC 14 years to get there, for an average return of only 9%:

(Source: Author's Spreadsheet)

Conclusion

As I explore growth companies for this series, I continue to be surprised and impressed at how well the market is able to price them. The current valuation for TDOC seems reasonable and acceptable, assuming that the company can continue to grow for an extended period of time. More conservative estimates suggest TDOC will underperform over the next 5-10 years, but optimistic assumptions (that are still grounded in reality) result in an expected compound growth rate of 15-20% on an investment today. As usual, I would invite readers to use their own quantitative estimates and share the resulting outcome, especially if there is an area where you strongly disagree with any of the assumptions I have made.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.