Description

Simulations Plus is a $10 Stock Trading for $36

Summary

The incremental buyer of Simulations Plus today likely believes he or she is purchasing shares of a high-growth software business. Simulations Plus is not a high-growth software business. It is instead a decades-old, non-subscription software company that has expanded primarily via bolt-on low margin professional services acquisitions. Unfortunately for unsuspecting investors, its software heritage causes SLP to be bucketed by well-known share services as a software business. Meanwhile its professional services acquisitions are the primary contributor to its headline growth. This confluence of misleading optics has resulted in one of the highest valuations in the software industry, and across all industries. With growth in its software segment decelerating, the absence of a defensible TAM story, and an 18.5x revenue multiple, SLP’s valuation is difficult to justify.

Unless one spends the time to scratch the surface and understand what this business is and where its growth is coming from, he or she will fall into an unintended trap. 

The Company

Founded in 1996, Simulations Plus develops drug discovery and development software. It licenses to pharmaceutical, biotech, agrochemical, and food industry participants worldwide. In recent years The Company has expanded into consulting services for early drug discovery through preclinical and clinical trial data analysis. Clients use SLP’s software and services to enhance their understanding of the properties of potential new medicines and to use emerging data to improve formulations, select dosing 

Software Segment

SLP offers ten (10) software products for pharmaceutical R&D. It’s flagship product, GastroPlus, was originally introduced in 1998. GastroPlus remains the Company’s largest source of software revenue and enjoys dominant market share. GastroPlus is currently on version 9.7. 

Let’s unpack this paragraph:

1. SLP offers 10 software products
   • SLP’s annualized R&D expenditure is $2.5m. At an all-in cost of $150k for an engineer, that implies a 16-person development team. How can a 16-person development team maintain - let alone advance - 10 software products?
   • Medidata Solutions (MDSO), a provider of clinical development software and consulting services, will spend more on R&D this week than SLP will spend all year. In fact, Simulation’s Plus has spent less than $15m of R&D in the last 10 years. 
   • In addition, we searched the Patent and Trademark Office and could not find Simulations Plus on any patents in the Applicant, Assignee, or Inventor names fields.
   • How valuable can SLP’s software be? 
2. SLP’s flagship GastroPlus was introduced in 1998 and commands dominant market share
   • Having dominant market share in a large or potentially large market is generally a positive.
   • SLP’s flagship software has been [literally] shipping for over 20 years. Meanwhile, SLP’s overall software revenue is only $18.5m. It’s core GastroPlus software revenue and has grown by only $6.3m over the last five years. That’s an average of $1.3 m of incremental software revenue per year for a player that is dominating its chosen vertical.
   • How large can this opportunity be?  
3. GastroPlus is currently on version 9.7
   • Having grown up covering technology and software businesses before Benioff founded Salesforce.com, I’m no stranger to software versioning. I just haven’t seen it in about 5 years, and so naturally I was curious.
   • As it turns out, Simulations Plus delivers software that is locally installed on a point-in-time business model. Up until a few years ago, SLP was still shipping software CD-ROMs with paper instruction manuals to customers. The only enhancement is that they now allow the software to be downloaded.

   • We dug in further to find that Simulations Plus generates around $1m of annualized software revenue to be recognized overtime; the vast majority of Company software revenue is from one-time license fees. 
     

   • Finally, SLP has only a mid-80% customer client retention rate for its software, a metric that would cause a PE shop to haircut a private company multiple substantially. 

   • How can a company with locally installed software that has grown to only ~$18.5m of software revenue in the last 23 years command a multiple in the 99th percentile of software companies? 

      

Services

SLP’s acquisitions of Cognigen in 2015 and DILIsym in 2017 have introduced a meaningful consulting component through the establishment of a Contract Research Organization (CRO) segment. Since 2015, consulting revenue has gone from a negligible contribution to nearly 50% of revenue.

2/3 of SLP’s growth over the last five years is from acquiring services businesses that generate a fraction of its software margin. 

While the acquisitions and growth in this area have continued to drive SLP’s topline growth optics, profitability is struggling to follow suit. As an example, in SLP’s fiscal 2019, its overall topline grew by $4.3m while its operating income grew by only $400k. The implication is a 9% incremental operating margin vs. a mid-30% headline metric. This is in-line with the CRO space with operating margins in the 10% range.

The CRO outsourcing industry is mature and roughly half of biopharmaceutical R&D in 2020 will be outsourced to independent service providers according to Credit Suisse. In order to grow, CROs must hire more humans and then lease them out to clients to conduct research. This runs counter to the promise of scalability that underpins the lofty valuations of subscription software companies. As a result, CROs tend to trade at more reasonable multiples. As illustrated in the chart below, SLP trades at a significant premium to the CRO space. 

Valuation and Conclusion

SLP has a $639.1m market value and net cash of $9.7m for an enterprise value of $629.4m. We model $36.7m of revenue, $13.0m of EBITDA, and 47¢ of EPS. The resulting multiples are 17.2x forward sales, 48.3x EBITDA, and 75.8x earnings. 

Few would argue that SLP is outwardly expensive. However, peeling back the layers of this business reveals a number of salient reasons why SLP is grossly overvalued. I find it difficult to envision a scenario where SLP can ever grow into its current valuation, let alone provide any business-driven upside for the incremental buyer of the stock. 

The single brokerage firm that covers SLP, Taglich Brothers, recently increased its 2020 EPS forecast by 7% and its price target by 50% based on ditching its 15-year old P/E valuation methodology to one based on relative earnings growth. I suppose this should be taken with a salt grain anyway given that SLP pays Taglich Brothers for its research. 

It appears that management is beginning to play some games with the bucketing of expenses. In the most recently reported quarter, SLP management considers senior scientific consulting staff with “business development acumen” as part of their investment in sales & marketing.  

Based on our internal sum-of-the-parts analysis, SLP is worth precipitously less than its current price. If we assume that its Perpetual Software model can support a 6.0x EV/S valuation (twice the 3.0x typically assigned to legacy software models) and an inline multiple on its Consulting business the stock is worth 71.5% less than today’s price. 

With perceptions heavily anchored to a 30-handle on the stock, the thought of a $10 share price is gasp-inducing. Insiders have nonetheless taken recent advantage of these high prices to sell, and in some cases the sales represent meaningful portions of their respective holdings. Passing this proverbial hot potato soon could prove to be a prophetic move.

Catalyst

The primary catalyst in our SLP investment thesis is the passage of time. When the fundamentals of the CRO business begin to crowd out the attractive aspects of its highly profitable yet miniscule software business I believe the stock will experience a hard landing. A lower than normal tax-rate in 2019 also implies that EPS will be mechanically pressured by 20% as the effective rate increases from 18.7% to 22.5% in 2020.