Description

Stocks generally go up for three reasons: numbers are going up, the stock is going up (chart momentum), and/or the stock is cheap. Stocks go down for the inverse: numbers are going down, the chart is broken, and there is no valuation support.

Good shorts check at least two boxes. Simulations Plus finally checks all three.

Background

SLP provides simulation modeling software to the pharma and biotech industry. The company is profitable and has seen accelerating top-line growth in the past year. Software, biotech, growth and profitability equates to an easy thematic long and SLP is up 3x in the past two years.

But SLP is not a sexy high-growth software company that is helping biotech save the world.  It is a sleepy, niche software and consulting provider with a small team, minimal R&D, and a long history of promotion. SLP is not really SaaS, competes in a saturated TAM, and is not even a leader in its key software or consulting categories. Moreover, a majority of the company’s growth has come from lower margin consulting and true software growth is minimal.

This thesis is not new though. Lukai highlighted SLP as a short last December on VIC and this past July Lakewood Capital spotlighted SLP as a short in their 2Q20 investor letter. I encourage everyone interested to go read both great write ups. They are a nice summary of SLP’s ascent from small cap obscurity to billion dollar land (27x sales multiple). And just yesterday SLP was featured on SeekingAlpha as a short by Contrarian PM. Today’s write up will focus on being additive and why I believe SLP is a timely short.

SLP is a timely short because growth is slowing, numbers are unachievable, and the company remains extremely overvalued. At a 10x revenue multiple for software and 5x sales multiple for consulting, SLP is worth $18/share representing ~65% downside. This is a 35x NTM earnings multiple for a mature low-earnings growth business.

Company agrees it is overvalued

This past August SLP took advantage of its high stock price to raise $108mm in a secondary offering. The deal was announced at $72/share and priced two days later at $55, down 24%. Talk about hitting the bid. And as of today, those 2.1mm shares are underwater. SLP did not need the cash. SLP had over $7mm of cash - a normal cash balance vs. historical levels despite a recent drawdown for an acquisition - plenty of working capital, no debt, and untapped credit lines. $108mm is a ton of cash considering SLP has spent only $30mm in total on acquisitions over time and SLP uses cash and stock for their deals.

Conversations with the company suggest SLP is in no rush to deploy this capital and that they will continue to evaluate small and mid-size deals consistent with their historical approach (i.e. no transformative deals in the pipe, etc.). The reality is management was just capitalizing on the market gift of their overvalued stock. The secondary offering also provided another benefit – the bankers that assisted, Raymond James and Oppenheimer, picked up coverage with buy ratings.

Recent results show decelerating growth

SLP reported 4Q20 results last week (FYE August) and while the company modestly beat on headline sales and earnings, the numbers beneath the surface were concerning. Organic software revenue growth decelerated to zero. This is well below the high single digit organic growth averaged over the past several years.

Follow up conversations with the company indicated that some revenue from the recent Lixoft acquisition was pulled forward in Q4 which was not discussed on the call (albeit this was likely small 6 figures).  The company also mentioned that their second largest consulting segment, and fastest growing segment, DILIsym, was going to decline in 1Q21. In order for SLP to hit their 25-30% consulting growth target, they’ll need to hire aggressively. Meanwhile, SLP’s consulting backlog has plateaued and now declined as shown on the right.

Estimates appear unachievable

SLP saw accelerating growth in 2020 as a result of the acquisition of a European software company called Lixoft and strong growth in the company’s consulting pipeline. Recall that ~50% of the company’s sales come from consulting and that roughly half of today’s revenue comes from SLP’s cumulative $30mm of M&A. Despite the assist from inorganic growth, SLP’s total company growth decelerated 490bps in its most recent quarter (to 18.9%) and management talked down the Street for another 300bps of deceleration in the upcoming quarter (to 15.9% growth). This is not a function of tough comps – SLP doesn’t lap the Lixoft acquisition until April.

Despite the recent slowdown, the Street is modeling a strong rebound in growth in 2Q21 and beyond. Given the trends in the business and conversations with management regarding plans to accelerate growth (or their honesty in the lack thereof), I believe these numbers are too high and will also need to come down. As you can see below, this is the first time some analysts have ever taken down their revenue estimates for SLP (below is full year 2021 – FYE August, and 1Q21). Of course Raymond James and Oppenheimer can’t throw in the towel on numbers (or their rating) so shortly after an offering and a bullish initiation.

Competition

Until recently, there was very limited public information available on SLP’s core markets or the competitive landscape. SLP claimed to have the #1 physiologically based pharmacokinetic (PBPK) modeling and simulation offering on the market and there were no competitors listed in the 10K. My diligence has shown that while GastroPlus is considered a strong PBPK modeling platform, it is actually smaller from a revenue standpoint than Simcyp, which is the competing software from PE backed Certara.

This information is now publicly available thanks to Certara’s recently filed S-1 on November 18th. Certara dwarfs SLP in revenue (~6x bigger), R&D investment (~4x) and team size. SLP only has 137 employees in total and only 39 focused on software (56 consultants, 8 sales and marketing, 34 other). Certara has 899 employees and 100 people in software development alone, not to mention 302 PhDs and 220 regulatory experts.

Certara appears to throw some shade at SLP in their filing – “In biosimulation software, we primarily compete with companies smaller than ourselves, such as Simulations Plus and NONMEM, a division of ICON.”  SLP also appears to have just recently backed off some claims. They previously stated in their 2019 10K that their “flagship product, GastroPlus, is the most widely used commercial PBPK modeling platform”. SLP’s most recent 10K from last week changed to “our flagship product, GastroPlus, is a leading commercial PBPK modeling platform and has one significant competitor.” While Certara’s valuation is unknown for now, Certara is unlikely to garner SLP’s 20-30x sales multiple which will make it a concerning contrast agent for SLP bulls when Certara starts trading.

Total Addressable Market

Bulls believe that simulation software modeling for drug development is an attractive and fast growing market, but conversations with market participants point to a TAM that is niche and saturated. Large pharmaceutical companies that can afford the expensive software already have it - the largest tend to use a combination of SLP, Certara’s Simcyp, and home grown systems - and for most smaller pharma / biotech companies the simulation software is too expensive and too complex to be needed. The company already claims 19 out of the top 20 pharma companies as GastroPlus customers, but an ex-employee and current industry participant told me that the other top 50 are using them too. “Once you get out of the top 50 and your R&D budget is $4-5mm, you don’t worry about GastroPlus.”

As a result, consolidation in large cap pharma is a risk for SLP. The company said organic software growth decelerated to zero in the most recent quarter because “four software clients reduced their licenses by about 25% from prior year levels because of acquisition, site consolidations and/or layoffs in their organizations.” This is a trend that is likely to continue.

SLP’s spending does not suggest an open ended TAM. The company has a very meager R&D budget (~$5mm in 2020, ~40% of which is capitalized), pays out ~50% of its net income as a dividend (0.4% yield), and has only grown its sales team from 6 to 8 over the past three years. Despite the equity raise there are no plans to hire additional sales personnel at a greater pace.

And while GastroPlus is a relatively sticky and entrenched modeling software, SLP has historically struggled with pricing power. This is not from lack of effort. The company tries to push through 3% price increases each year, but historically has only netted about 1% pricing growth. Big pharma is not the easiest to negotiate with apparently. SLP has plans to push price increases more this coming year, but management has suggested this likely results in 2-3% pricing growth if successful, which is not a meaningful tailwind to total company sales growth.

Conclusion

At $52/share, SLP trades at ~$1.1b market cap and ~$1.0b EV. This is ~56x 2021 EBITDA, ~95x 2021 EPS, ~20x 2021 sales, and a ~1% FCF Yield. This is a premium valuation for a company that has limited software growth, a saturated TAM, and is not even the leader in their respective software categories. While this valuation/TAM/niche software short thesis is not new, I believe the short thesis is now timely since growth is slowing and numbers appear unachievable. With numbers going down, the stock going down, and valuation still sky-high, SLP checks all three boxes of a great short and I believe the stock will unravel back towards a long-term target of $18/share, representing ~70% downside.

Catalyst

Earnings misses and numbers coming down

Certara road show / IPO with large valuation discrepancy

Potential technical selling pressure now that SLP broke its $55 secondary offering price