Spok Holdings Had A Great Q2, But Risks Remain

I am revisiting my Q1 thesis on Spok Holdings (NASDAQ:SPOK) in light of Q2 earnings.

Looking back on my Q1 analysis, I rated Spok a hold and felt inflation could risk the dividend. Two key factors played into my recommendation. First and foremost, Spok's healthcare customers were struggling coming out of the pandemic, squeezing budgets for services like what Spok provides. Second, Spok had been digging into the balance sheet to fund its dividend, and inflationary pressure put cash flow further at risk.

I saw upside potential in the software licensing business if Spok could come through on customer contracts faster than expected if the wireless business slowed its decline or inflation slowed quickly.

Since my last analysis, Spok is up more than 16%, largely driven by the earnings guidance revision as part of the Q2 earnings presentation. Digging through the results, I feel I got this one wrong, as Spok was able to deliver on customer contracts faster than I expected while also making significant changes to its cost structure.

Spok has found success signing customers by positioning their top-tier service as a cost savings, driving efficiency and allowing large healthcare systems to reduce vendors. In addition to success on the revenue side, Spok has restructured the cost base and expanded margins in a sustainable way. This has driven my price target to $15.40, up from $8.90.

All of that said, risks remain. Cash flow is still extremely tight to cover the dividend. Spok must continue driving growth at a similar rate while maintaining the wireless business base. In addition, given inflation, their pricing growth is not all that strong.

While my price target suggests 8% upside, I believe the risks are substantial enough to warrant caution, especially as one-quarter of success does not make a trend. I rate SPOK a hold at the current price, potentially moving to a Buy if Q3 continues the favorable trend.

Sales Strategy Meeting Industry Need

The healthcare industry is struggling as payers demand lower rates, and inflation raises the cost of everything from nursing staff to basic supplies. In their 2023 study, McKinsey expects EBITDA to contract for most healthcare providers and emphasizes the importance of cost optimization.

In 2022, this cost pressure was squeezing Spok and led to their decision to decommission Spok Go. Healthcare providers were looking for every opportunity to reduce costs, which played into my Q1 hold recommendation that Spok was exposed as an overhead cost.

Despite the cost pressure, Spok has found a sales story that resonates with their market. Check out this quote from the Q2 earnings call:

First, as a multimillion-dollar deal, we secured with one of the largest health systems in the nation. The cell system post 140 hospitals across 21 states and is committed to achieving cost savings through vendor consolidation and enterprise standardization.

They identified our Spok Care Connect platform as the national standard solution for their hospitals paving the way for our partnership. Our engagement with this health system includes the medical operator console spoke Messenger, managed professional services, premium maintenance and support, and value-added services at 37 of their locations. They asserted that our single communications platform allows them to achieve enterprise-wide efficiency and improve patient care while supporting their national standards.

Spok has positioned its service as a cost-savings to rationalize vendors and streamline processes. This strategy seems poised to work across the industry in a sustainable fashion. The same McKinsey survey suggests that the fastest growth in Healthcare costs will be software, platforms, and technology used to offset cost pressures in other parts of the business.

I believe Spok seems well-positioned to continue signing new customers into 2024.

Sustainable Margin Expansion

Spok has been focused on margin expansion and made great strides from Q1 to Q2. First and foremost, their revenue growth versus prior year has been almost entirely in the high-margin software business.

Growth in the software business has come through longer-term contracts, often with maintenance agreements, that provide sustainability to the top line. In an example from the Q2 earnings call, a $3.9 million software contract is worth $5.1 million over three years when you include maintenance.

On the cost side, I was very impressed by the progress in restructuring. Operating expenses decreased for the cost of revenue, Tech, and G&A. Operating expenses as a % of revenue fell nearly 10 percentage points, giving profitability a notable boost.

To illustrate just how impactful this margin expansion has been, here is a DCF with and without margin expansion built in. With margin expansion, as it has played out so far, the share price is $15.40, up from today's price.

Without margin expansion, the share price is only $8.90, down from today's price and more in line with my Q1 thesis.

Given the cost reset, I am comfortable with the DCF's price target of $15.40. Wall Street Analysts have a similar recommendation at $15.50.

Risks Remain

Despite the price target of $15.40, three downside risks give me pause.

First and foremost, cash flow is still tight and just barely covers the dividend. Spok currently has a payout ratio of 133.13% and a coverage ratio of 1.37%. While they have no debt, I don't like to see a company digging into the balance sheet for dividends. Based on my FCF estimates, the dividend won't be fully covered until 2025, and management will need to stay laser-focused on cash flow.

On the revenue side, pricing attainment isn't looking all that strong.

I am concerned that Spok is giving up more on the pricing side than they are letting on to keep customers around. It's worth noting that units are also down over the last two years as well, so rate and volume are on shaky ground.

Lastly, inflation continues to be a risk to Spok's customers and to Spok's bottom line. Sales skills and expense management are critical to covering dividends over the next few years.

Verdict

Despite price targets in the mid-15s from both myself and Wall Street, I rate Spok Holdings a hold.

On the upside, Management has pulled off impressive sales growth, locking major players to long-term contracts. In addition, aggressive cost management has transformed margins, and the margin improvement seems very sustainable.

Despite the strong P&L, risks remain. Cash flow is tight and barely covers the dividend, KPIs for the business don't look all that strong, and inflation continues to be a major risk.

I do not believe that the 8% upside potential in share price offsets the risks to the business, especially after only one-quarter of strong performance. I recommend investors hold their positions, and I will continue to track performance in Q3 and Q4 to look for a change in the risk profile.