More on Teladoc (TDOC) - Why I Am Not Holding

My previous write-up about Teladoc (TDOC) did not leave a clear conclusion as to what to do with the stock. The answer is I'm planning to exit the small starter position I have.

While Teladoc's revenues will continue to grow at a healthy rate, I'm doubtful that it can ever achieve the margin necessary to justify stock valuation.

Here's some simple math on where margins needs to be in 10 years to call this a buy. Right now TDOC trades at $58/share, or about about $7.9bn enterprise value. Let's say I want 2029 EV/EBIT to be 10x to call it a buy, so by 2029 I need them to have EBIT of $790mm. Annualized revenue are getting close to $500mm. If revenue grow at 30% CAGR for the next 10 years, by 2029 revenue could be $7 billion. This implies an EBIT margin of 790/7000 = ~11%.

Can Teladoc get to this 11% margin? I doubt it. As I illustrated in my previous article, TDOC is less a tech company than a "sub-insurer" that its payer clients outsource to. Insurers like UNH and ANTM operate at 6-8% EBIT margin, and it doesn't make sense that TDOC can capture higher margin than its clients since it has a weak bargaining position relative to them.

Weak Strategic Position Limits Margin Upside

The problem is telehealth itself is not a thing, not if it's just doctors using video chat. What IS a thing, is the creation of a business model that 1) adds value to the overall system, and 2) captures part of that value. 

Teladoc creates value for the overall system - many patients would simply not visit a doctor without TDOC. So they're creating value by competing against non-consumption.

To capture value though, disruptive entrants should have a separate value chain to avoid being co-opted by incumbents. TDOC does the opposite, it contorts itself to fit into the incumbent value chain. 

In order to grow revenue quickly, Teladoc uses health insurers as distribution, so insurers ended up owning the end-customer (patients) relationship and TDOC's leverage is weakened. As I argued in the previous article, TDOC's true value proposition for payers (as opposed to for the overall system) is to control cost by turning a visits based variable cost into a per member per month based fixed cost. This is a nice to have, not a must have for its payer clients. 

TDOC's margins already suffer from this weak position. It is forced to spend on marketing to drive utilization, even as that benefits clients (insurers) directly and hurts TDOC's margins (higher costs of service and marketing costs). 

Nor is Teladoc integrated enough with patients to own that relationship and impose high switching cost on its payer clients. Although Teladoc has a separate registration, it's the insurers that really own the patient relationship. Not only because patients still go first to insurer portals, but also because the current TDOC value proposition simply isn't able to stand alone. Consumer cannot just use TDOC and leave their regular insurance plan - because if conditions get any worse they'll need to physically visit a doctor, which would be outside of what TDOC can offer. The perils of fitting yourself into incumbent value proposition!

Not owning the patient relationship leaves TDOC replaceable. Payer clients can swap TDOC out for another telehealth provider the second TDOC tries to go direct to consumer. 

In this way, the center of gravity is with payer clients. They've managed to keep the most valuable part of the job and outsource what's NOT valuable to TDOC. Not only that they do it in a way with minimal tie-in, making TDOC replaceable.


Conclusion

An inherently flawed business model leaves TDOC at the mercy of its payer clients. This means low pricing power. This means the higher margins needed to justify stock valuation will be hard to achieve. It also means I should exit my position.

Going direct to consumer and owning that relationship would be a good fix, but that requires Teladoc to further differentiate itself in terms of value proposition and value chain. My own recommendation is to achieve that through 1) focus on chronic care, 2) use of nurse practioners, and 3) ideally hire them as employees.

Teladoc's Business Model and Implications

I’ll start with an short hypothesis of how Teladoc (TDOC) could play out to the upside (or else why bother right?) then analyze the business model, implications and options to change that model.

Summary Upside Case

• Continued organic revenue growth at 20-30% CAGR. Growth comes from both membership increases and price increases.
• Government expansion of telehealth coverage for Medicare Advantage plans beginning in 2020 should help membership increases
• Operating leverage kick in as TDOC drives utilization, proving its worth to clients, which in turn justifies price increases. Management expects EBITDA to inflect positive this year.

TDOC trades at 8x EV/revenue while still unprofitable, so buying it requires us to think 10 years+ forward and project sizeable revenue and margin increases. That calls for an understanding of Teladoc’s business model and its place in the healthcare value chain.

Business Model

For the most part, Teladoc gets revenue from payer clients (health insurance plans, self-insured employers), and not directly from patients/consumers. 

These clients pay TDOC recurring "subscription access fees", typically on a per-member-per-month basis.

Costs of revenue are essentially based on volume of visits:

Cost of revenue is driven primarily by the number of general medical visits, expert medical services and other specialty visits completed in each period. Many of the elements of the cost of revenue are relatively variable and semi-variable, and can be reduced in the near-term to offset any decline in our revenue

As far as value proposition and "jobs to be done", here's a line from TDOC's filings:

(Clients) purchase our solutions to reduce their healthcare spending, or to provide market differentiating services as either part of, or a complement to, their core set of consumer service offerings,

Cost savings is the most tangible benefit, and in my opinion the most important one, since telehealth itself will not be much of a differentiator for health plans given the proliferation of video technology. 

TDOC saves money for payers by "capitating" an otherwise fee-for-service cost. The typical health plan pays doctor each time patients visit. More visit means higher costs for the plan/insurer. But with TDOC, the insurer just pays TDOC a fixed fee regardless of how many times patients visits doctors in TDOC’s network.

Here's a very simplified diagram that illustrates how economics flow from payers to doctors through TDOC (right side of picture). Compare that to the world without Teladoc (left side of picture), note that TDOC basically injects another layer of physician network for the original insurer to outsource to, and turn a volume based variable cost into fixed cost.

Implications

TDOC’s business model has several implications:

1) This business model only makes sense in a non-integrated healthcare world where payers still pay doctors on fee-for-service basis. It makes no sense in a vertically integrated healthcare system like Kaiser, where doctors are salaried staff.

As mentioned earlier, in a typical non-integrated healthcare system (for example Blue Cross for example), the more you visit doctors, the higher the costs for Blue Cross. TDOC comes in and fixes that costs at some per-member-per-month, regardless of number of visits. But with Kaiser that cost is already fixed because doctors are employees, so TDOC can add little value there.

This implies an inherent limit to growth. But TDOC has a long way to go before it hits that limit since systems like Kaiser are relatively rare.

2) Ability to raise prices depends on how much payer clients are saving by using TDOC. That saving amount is based on telehealth utilization - and TDOC is incurring marketing costs to drive patient awareness and utilization.

That TDOC couldn’t pass that marketing cost along to payers, even as it directly benefit payers, shows the weak bargaining position that TDOC occupies in the value chain.

Unlike say, Uber, where both sides of the market place – drivers and riders – are both fragmented and politically weak, TDOC is a middleman between 2 powerful groups – payers and doctors.

This is why I would love to see TDOC go more of a direct-to-consumer route, like they’re already doing with behavioral health. Owning the customer relationship would give them more bargaining power vis-a-vis health plans.

3) Where will operating leverage come from in the future?

The problem with driving utilization higher to improve client ROI is that TDOC itself would have lower margins, since revenue is fixed based on number of members while costs goes up when visits are higher. 

TDOC can change its own costs structure though, by hiring doctors (which turns variable costs into fixed cost), or even use algorithms for simple prescriptions. They are in fact already exploring the former.

Having more of a fixed cost structure would further incentivize TDOC to continuously prove and improve ROI for payer clients. This would convince payers to offer Teladoc through more of their health plans (boosting membership), and allow TDOC to argue for higher access fees per member (boosting both revenue and margins)

4) Perhaps Teladoc can carve out a separate product for chronic care and using nurse practioners instead of doctors. This would be a more optimal use of resources from not just cost perspective, but also from coverage perspecdtive (more supply available to cover patients 24-7). It would also let Teladoc cleanly differentiate itself against your typical “health plan with video option”– important if TDOC wants to go direct-to-consumer and build that brand.

More on Video Games, from a Disruptive Innovation Perspective

I have been reading Christensen’s theories on disruption. Some key themes of disruption are: 1) making a technology cheaper and more accessible, and 2) solving a problem that’s previously under-treated, or addresses a slightly different audience. Competing against non-consumption is a key theme as well.

So disruption is about creating value and diffusing it throughout society. You want things to be both cheaper and available to more people.

This also echoes “Crossing the Chasm”, where a technology leaps across the exclusive purview of early adopters and visionaries, and into the mainstream.

Disruption typically requires three things that are internally consistent and reinforce each other:

• An enabling technology
• A new business model
• A new value network (value chain) of disruptive players. Creating this often requires one strong company to vertically integrate the value chain and force industry changes.

From an investment perspective, picking winners means spotting industry trend changes, understanding the technologies and new business models that enable these changes, and then investing in a company that is part of the new value network of disruptors.

For practice, I'm trying to think through the video game landscape and apply these concepts. 

Video games - changes I’m observing

Two changes come to mind immediately:

• First, the value proposition and target audience of video games is changing, from teenage and college dudes in the basement shooting strangers, to a more inclusive (both adults and children, male and female) social experience.
• Second, costs have gone down dramatically. The proliferation of simple, low cost mobile games means people are conditioned to only paying a few dollars for games, if at all.

These fit the themes of disruption – a broader audience, lower cost access, and address problems that were previously unsolved (social needs instead of pure adrenaline rush).

The next questions are "what's technologies and business models fit with these changes", and "who's part of the disrupting value chain?"

(Apologies - the next couple sections are a bit messy because it's a bit of brainstorming)

Enabling Technologies and New Business Models

1. Enabling technologies- 

Internet is an obvious enabler that allows players to go online and shoot at random strangers, or team up with friends and strategize. This increased the social component of video games.

Network technologies continue to evolve. First, with CDNs (Fortnite uses Akamai), and now with full streaming (Google Stadia).

Another one I can think of is Nvidia’s ray-tracing chips. This seems to me a complementary technology for CDNs, where the ray-tracing capability can be done not at huge data centers, not at consumer’s homes, but at more remote (“edge” if you will) locations within CDNs.

2. Business Models

Free to Play (F2P) a revenue model that’s here to stay. This could be F2P with advertising, or F2P with microtransactions (loot boxes, battle passes, skins…etc).

Distribution is another obvious one. We went from buying game at physical retail stores, to downloading games at home, to now full on streaming.

Fortnite is potentially pioneering a whole new business model. With unique in game events like concerts, Fortnite real value could be as a “gamified” online gathering place that monetizes by selling tickets to events.

Value Networks - who’s part of the disruptive chain?

Now it's time to find parts of the value chain that benefits from these enabling technologies and (relatively new) business models. 

Let’s go from upstream to downstream.

• Hardware.  As mentioned earlier NVDA’s ray tracing chips could be used to bring top quality to mass market.
• Consoles are being disrupted by F2P model as well as streaming, so makers like Nintendo, Sony, and Microsoft will have to rely on their game development skills.

• Game Developers and Publishers.  
• Developers that grew up with low cost mobile games will fit well with the F2P paradigm. Zynga and ATVI’s King are examples. 
• Publishers with strong experience in online multi-player games have advantage.

• Streaming networks like Twitch, communication apps like Discord, or even Reddit amplify the social value of playing video games.

How to invest – Tencent and ATVI

Unfortunately much of this is uninvestible. I'd love to invest in Epic Games, or Twitch, but they are owned by Tencent and Amazon, respectively. Both are so big that the impact of Fortnite/Twitch would be negligible. 

I do like Tencent itself though. The company is integrated along games, social, and payments. That’s three competencies that define the future video game world. No wonder they saw the potential of Fortnite before it happened! They also have a stake in Garena’s Free Fire.

Activision Blizzard (ATVI) is one that I have a small position in. Their games like Overwatch will be disrupted by F2P model, but they do have the resources to overcome disruption if management tread wisely.

Fending off disruption requires disrupting yourself, and separate the new business into an autonomous entity. ATVI (like EA) already does that. Activision is a different studio from Blizzard, which is separate from King. King is quite familiar with F2P model. So I do think ATVI has the skills to thrive in the new world. But we’ll see.