SMLR: Revenue up 55%, cash flow continues to churn, balance sheet cleaned, moving PT to $35/share

By Brian Marckx, CFA



Q3 2018 Results: Revenue up 55%, cash flow continues to churn, balance sheet cleaned, moving PT to $35/share…

Semler (OTC:SMLR) reported financial results for their third quarter ending September 30th. While revenue in Q3 was meaningfully below our estimate, it was nonetheless a new record high, up 55% yoy and 2% better than Q2. Revenue is expected to continue to climb from what we think is a new base level. Meanwhile EPS was largely inline with our estimate and, at $0.19, tied with the record set in Q2 of this year. Net income and EPS through the first nine months of the year was $3.6M and $0.48, compared to a $1.8M net loss and ($0.33) EPS in the comparable prior year period. But, perhaps the most significant highlight (given that we subscribe to ‘cash is king’) is operating cash flow – which was ~$1.9M in Q3 and $5.0M through the first nine months of the year.

Each of the last several consecutive quarters’ financial results has incrementally bolstered the likely long-term viability of Semler’s business model and sustainability of growth of revenue/earnings/cash flow-generation. Q3, which as management mentioned on the call was the best in company history (at least from a financial standpoint), provides additional support to that theme. And with cash flow churning higher, cash balance growing and the balance sheet continuing to clean up, our comfort level with ‘cash flow multiple’ as an appropriate valuation methodology has similarly been bolstered.

Cash flow multiple values SMLR at $35/share…
Given Q3’s strong numbers, including robust cash flow, we think there is now more risk of incorporating a cash flow multiple-based valuation methodology too late than in introducing it too soon. As such, we are moving from a DCF to a Gordon Growth Model-derived cash flow multiple to value SMLR’s equity. SMLR generated ~$5.0M of cash through the first nine months and we estimate $7.0M for the full-year 2018. We expect cash flow to increase into 2019 but also model some offset from additional increase in share count – we estimate our $35/share target to be valid over the next ~6 months and look for potential upside towards a mid-2019 timeframe. 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.

NASDAQ uplisting is in view…
The strong income growth, balance sheet cleansing and rapid increase in shareholders equity gets SMLR closer to meeting NASDAQ eligibility requirements. Stockholders’ equity increased by nearly $2.1M in Q3 to $2.3M and, subsequent to quarter-end, $350k worth of warrants were exercised for the purchase of 1.03M common shares. We think SMLR could meet the $5M minimum stockholder’s equity requirement for uplisting to NASDAQ by the time they report Q4/full-year results (March 2019), or shortly thereafter (they will also need to bring on at least another three independent directors in order to meet that related mandate).

Growth story remains intact…
The story and our outlook remain largely intact. So, we reiterate our comments following Q2 results… 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 Q3 and throughout 2018 as a whole. 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. Q2 may have been somewhat of a milestone period in that regard – and we think Q3 numbers add further and substantive support to that theory.

Management continues to guide for revenue to grow faster than expenses and for profitability and positive cash flow to persist. As Q4 has historically been SMLR’s strongest period in terms of revenue and, coupled with expectations that operating (including cost of revenue) remains largely flattish, we think Semler will finish the year strong. We now look for full-year revenue, net income and EPS of $21.6M, $5.3M and $0.66, compared to $12.5M, ($1.5M) and ($0.27) in the prior year. We also ballpark cash flow from operations of approximately $2.0M in Q4 and $7.0M for the full year.

Q3 numbers…
Revenue was $5.6M, up 55% (+$2.0M) yoy, up 2% (+$95k) sequentially and about 5% (~$300k) lower than our $5.9M estimate. It was also a new record high. Usage and other fees (from the HRA channel) were approximately $1.4M – roughly flat from Q2 but nearly double the $772k from Q3 2017. We had anticipated usage fees to grow sequentially – as they had for the previous ~10 quarters, which explains ~2/3 of the miss on total revenue in Q3. Importantly, comments on the call suggest that the pattern of usage (and other) fees growing sequentially from Q1 through Q4 each year is likely to repeat itself in 2019 (and beyond). Meanwhile, licensing revenue continues to charge higher, albeit slightly less so than we had forecast for Q3. Licensing revenue was approximately $4.2M in Q3, up ~46% yoy (+$1.3M), up ~4% sequentially (+$148k) and about 2% shy of our $4.3M estimate.

As a reminder, SMLR begins generating revenue immediately upon consummation of new licensing agreements. Growth from this licensing channel is expected to remain robust and will likely continue to account for the majority revenue, at least over the near-term. The HRA channel has quickly become a meaningful contributor to revenue – usage fees were approximately $467k in 2016, accounting for just 6% of total revenue in that year, then grew to almost $2.1M in 2017, or 17% of total revenue. Usage fees accounted for 26% and 24% of total revenue in the most recent three and nine-month periods, respectively.

The recent increase in QuantaFlo placements at HRA customer sites means this segment’s proportional contribution to total revenue could continue to grow. As a reminder of the HRA-related revenue model, Semler charges these customers on a per-test basis. And as the HRA customer takes possession of the asset, the equipment is immediately expensed. This differs from the annual/monthly licensing revenue model and asset depreciation (SMLR maintains ownership of the asset) that they employ with the likes of Medicare Advantage plans.

Q3 operating expenses (including cost of revenue) were $4.0M, or 72%, which ties the record low set in Q2 and compares to $3.5M, or 98% of total revenue, in the prior-year period. Through the first nine months of 2018, operating expenses were $11.6M, equal to 75% of revenue, compared to $9.5M and 115% in the prior year. As we noted in the past, OpEx as a percentage of revenue was a key metric to keep an eye on and the consistent improvement is a testament to management’s efforts to keep costs in-check. It is also, in our opinion, further validation of the long-term viability of SMLR’s business model. The combination of ramping revenue and relatively flat growth in operating expenses has resulted in rapid improvement in operating income/loss.

View Exhibit I

Q3 net income was $1.5M – roughly flat from Q2 but more than double the $706k in Q1 and compares to a $41k net loss in Q3 2017. As the chart above illustrates, the improvement is reflective of both revenue growth and relatively flattish opex. The dramatic improvement in all three metrics (i.e. increasing revenue, flattish opex and growing income) is captured in the ‘OpEx as a % of revenue” line (lower is better).

When operating expenses were rapidly climbing during the early part of 2017 we cautioned that a bloated and growing expense base could be of potentially significant concern, particularly if the sole goal was to chase revenue growth or market share at the expense of mounting operating losses. But, we also noted that we believed management’s explanation for the recent jump in expenses was sound (i.e. related to revenue-generating investments) and, as such, saw no indications for significant concern. Importantly, our confidence is further bolstered by the last few quarters’ results and the rapid pace of absorption of incremental expenses. It is also bolstered by management continuing to guide for the cost base to remain flattish despite continued anticipated revenue growth.

Cash flow churning and debt-free…
Cash flow from operating activities and free cash flow also continue to improve. For some context…

FY 2017: for the full-year 2017, excluding changes in working capital (i.e. eliminating any noise), SMLR generated $440k in cash from operations – an improvement of more than $1.7M as compared to the $1.3M of cash used during 2016. Free cash flow, which accounts for capex, was negative $528k in 2017, compared to negative $2.5M in 2016.

Q4 2017: in Q4 2017, excluding changes in working capital, cash flow from operations was positive $909k. Subtracting 25% of full-year capex, free cash flow was positive $667k in Q4 2017. This compares to Q4 2016 which had $142k in positive operating cash flow (ex-changes in w/c) and $3k of positive free cash flow.

Q1 2018: excluding changes in working capital, cash flow from operations was positive $1.170M. Free cash flow was $1.078M

Q2 2018: excluding changes in working capital, cash flow from operations was positive $1.847M. Free cash flow was $1.696M

Q3 / 9-months 2018: we don’t have all the details as the 10-Q will be filed later this week. But, using the information from the earnings release and on the conference call, it appears cash flow from operations (excluding working capital) was approximately $1.9M in Q3. That would put YTD cash flow from operations at almost $5.0M and YTD free cash flow (which accounts for ~$450k in capex) at around $4.5M

SMLR has also rapidly cleaned up their balance sheet. Including cash payments made during, and subsequent to, Q3, Semler retired $2.2M in debt principal and related interest and is now effectively debt-free. Given expectations of continued strong cash generation, the cash position should rapidly increase.

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