SMLR: Q2 Beats Big. Thesis Continues To Play Out. Upward Revision to CF Estimate Moves PT to $55

By Brian Marckx, CFA



Q2 2019 Results: Huge Beat to Our Numbers. Record Revenue, Income, EPS and Cash Flow. Moving PT to $55…

Semler (OTC:SMLR) reported financial results for their second quarter ending June 30th. The company did not hold an earnings call as CEO Doug Murphy-Chutorian continues to recover from the mild stroke he suffered approximately six weeks prior. As a reminder, per SMLR’s press release announcing the event, Doug remained (and remains) at the helm of the organization and involved in day-to-day operations. Encouragingly, the Q2 earnings release notes that Doug continues to make strong progress, that SMLR will host a Q3 earnings call and that additional executives will join him on the call.

As it relates to Q2 results, pretty much the whole income statement was a highlight. Revenue remains very strong, set a new record high (exceeding the prior record of $6.8M set in Q1’19 by 18%) and was 18% ahead of our estimate. Q2’19 marks the ninth consecutive quarter of sequential revenue growth and the eighth consecutive quarter of revenue setting a new record high.

Meanwhile, gross margin was nearly a record best and operating expenses were a record low (on a percentage of revenue basis). The net result of record high revenue, gross margin of almost 90% and record low opex was net income and EPS of $2.6M and $0.32 – which are ahead of their respective prior highs (both from Q1’19) by 41% and 39%.

Cash generation also continues to churn higher and Q2 extended the streak to six consecutive quarters with positive cash flow. Semler generated positive cash flow from operations in every quarter in 2018. For the full year, cash flow from operations was $4.7M (or $6.6M, ex-changes in working capital) in 2018, compared to $621k (or $440k, ex-changes in working capital) in 2017. Cash flow was $1.7M ($2.1M ex-changes in working capital) in Q1’19 and $2.7M ($3.0M ex-changes in w/c) in Q2’19. SMLR generated $5.0M and $4.3M of cash from operations and free cash flow, respectively, representing respective growth of 69% and 53% from 1H 2018. Particularly noteworthy is that these cash flow growth rates are well ahead of that of revenue, which increased by 48% over the same period – which reflects scaling of the business and leveraging the operating base.

As we noted in our Q1 update in May, we were forecasting FY2019 cash flow of approximately $10.5M. Given the big beat (vs our numbers) in Q2, the fact that SMLR is already nearly halfway to our projected FY cash flow estimate (i.e. $5.0M through 1H) and expectations of continued sequential revenue growth (if history is an accurate guide, revenue should grow sequentially through Q4), we think our prior forecast may be too conservative. Updates to our model following Q2 earnings announcement resulted in an increase of projected cash flow from $10.5M to between $11M and $11.5M (despite expectations of continued growth-related investments and incremental expenses).

And while as we have noted in the past, some expected variability in revenue, coupled with periodic additions to personnel and infrastructure aimed at meeting growth in demand, may result in some inconsistent cash flow generation, our confidence of long-term cash flow growth is further bolstered by every passing quarter. And, importantly, the balance sheet remains very healthy with zero debt and cash of $4.2M as of the close of Q2.

While management indicated that operating expenses could increase with further infrastructure-related investments (largely related to personnel additions), these are driven by continued growth in anticipated demand. And while SMLR also noted larger orders could result in short-term volatility (i.e. ‘spurts’) in revenue, that their goal remains to grow the topline faster than that of expenses – the net result of which should be a continuance in growth of EPS and cash flow.

As we have noted in the past, management already has a history of turning these types of ‘investments’ into revenue and profitability growth in short order. We may have underestimated just how quickly that they can make that happen. Fairly significant updates to our model (following reporting of Q2 results) shows SMLR generating revenue and EPS of $31.2M and $1.13 in 2019 (adjusted from $28.5M and $0.92), which implies respective growth of 45% and 72%. If our model proves reasonably accurate, we now think operating cash flow could be in the range of $11.0M – $11.5M, and possibly even higher. As it is now, we model cash flow of approximately $11.0M in 2019.

Growth story remains intact…
The story and our outlook have remained largely intact for the last several quarters – including through Q2’19. As such, we continue to reiterate our comments from our recent earnings updates… the consistency and regularity of revenue growth and flatness of expenses lend credence to the validity of the company’s business model and strategy. Much of that hinges on the supposition that insurers have an economic interest in paying for their capitation-based insured to be tested for PAD. And with these insured tested annually, these are very sticky revenue units (somewhat analogous to an installed base but with much higher margins). Growth comes from adding new customers and additional testing from existing customers – which was the case in throughout 2018 and through the first half of 2019. And with SMLR’s customers (i.e. insurers) consisting of some of the largest Medicare Advantage plans and SMLR’s market penetration still in the low single-digits, this further validation of the company’s business model and insurers’ economic interests as it relates to PAD testing should signal ever-increasing confidence that revenue and profitability will continue to grow. The last several quarters have further bolstered our confidence in that regard.

NASDAQ uplisting is likely on the horizon, which would increase visibility of SMLR and could bolster the ‘investibility’ of the shares, particularly as it relates to institutional interest and ownership. Semler has met the minimum required stockholder’s equity for NASDAQ uplisting. While management has been non-committal in regards to potential plans to uplist, we think it is almost certainly a near-term goal. SMLR will still need to increase the number of independent directors in order to satisfy NASDAQ listing requirements.

Model Updates / Valuation
We think market fundamentals favor long-term growth for Semler. PAD afflicts an estimated 20M Americans yet has been diagnosed in only 25%. Insurers have a financial interest in diagnosing PAD as the potential consequences, including heart attack and stroke, are relatively extremely costly to treat. Physicians are also incentivized to use QuantaFlo as it offers an easier-to-use and (per clinical data) more accurate diagnosis than competing technologies (such as Doppler). The relative operating simplicity of QuantaFlo means a relatively low-level (and low cost) medical aide can administer the test – which frees up physicians and improves profitability. Increasing awareness and recently implemented reimbursement should bode well for increasing testing.

We model 10-year revenue CAGR of ~33%. We show flattish gross margin from the very healthy current level (87% – 88%) and, coupled with expectations of continued improvement in operating leverage from stabilizing R&D and efficiencies in SG&A, has us modeling SMLR to generate significant net income into the foreseeable future. We model 2019 revenue, net income and EPS of $31.2M, $9.7M and $1.13, which are all substantially increased from the $28.5M, $7.7M and $0.92 that we had been forecasting prior to the reporting of Q2 results.

EPS in our out-years is $1.29 and $1.54 in 2020 and 2021, similarly reflecting large upward revisions (from $1.06 and $1.36).

Cash flow multiple puts fair value at $55/share
Given our comfort level with the likelihood of SMLR continuing to generate positive cash flow, we recently moved our valuation methodology from DCF to a Gordon Growth Model-derived cash flow multiple.

SMLR generated ~$7M of cash in 2018 and we estimate ~$11.0M in 2019. Assuming a long-term sustainable cash flow growth rate of 8.5%, at a 11% discount rate (based on CAPM), the Gordon Growth Model implies a ((1/(0.11 – 0.085) = ) 40x cash flow multiple. This values SMLR at ~$55/share today on a fully-diluted basis. Our price target is based on SMLR generating $11.0M of cash in 2019 – if this proves conservative (liberal), we would expect upside (downside) to our price target to materialize. We also note that NASDAQ uplisting, if and when it happens, would likely meaningfully improve liquidity and potentially facilitate accelerated realization of our price target.

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