Semler Scientific Stock pitch

 

Semler Scientific (SMLR:OTCPK) is a small cap medical device company that sells QuantaFlo, an FDA-approved device for diagnosing Peripheral Artery Disease.

Peripheral artery disease (PAD)

PAD is a disease where blood flow is obstructed in blood vessels in the extremities via a buildup of plaque. Due to an uptick in obesity and unhealthy habits, the prevalence of PAD in the population has quadrupled in the last 50 years. It is asymptomatic in 90% of people which makes diagnosis difficult. PAD is a precursor to numerous sever cardiovascular conditions such as heart attacks, strokes, and amputations. People with PAD have a 21% risk of having a heart attack, stroke or other hospitalization due to cardiovascular complications. People with PAD are 2-3x more likely to have a stroke and 4x more likely to have a heart attack. ~50% of all amputees in the USA have had PAD.

Product Overview: QuantaFlo

QuantaFlo uses a clamp attached to both feet and hands to measure blood flow via infrared sensing of blood vessel. A report is then formed classifying flow as either obstructed or not obstructed. The device is FDA approved with 510k clearance and Semler has a patent protection on devices that use infrared sensing to measure blood flow in extremities until 2027. It takes 4 minutes and can be used by any physician. It has been shown in scientific literature to be just as accurate as the current standard of diagnosis.

The current way to diagnose PAD is an Ankle Brachial Index, which places a blood pressure cuff around the patient’s ankle and wrist and compares the pressure between the two to give a positive or negative reading on whether or not a person has PAD. The test takes 15-30 minutes and requires a trained vascular technician, thus is often performed at special clinics. Primary care doctors search for symptoms and recommend patients to be tested.

QuantaFlo	Ankle Brachial Index
Test is ~4 minutes total	Test is >15 minutes
Can be used by any physician	Has to be done by specially trained vascular technician
Can be conducted by any physician when seen fit, making it more accessible	Patients have to get referred to taken an ABI based on a doctor’s judgement
More accurate than ABI on identifying both true positives and negatives.	Traditionally used to test for PAD, less accurate by ~7%

 

The table above sums up the competitive advantages Semler has.

 

Business Overview

Unlike other medical device makers, Semler does not sell their devices for a profit, instead opting for a licensing model where customers pay a fee per month or a fee per test. They lease their device at cost and license out software, thus their gross margins are above 90%. Their current customers are private insurance providers offering Medicare Advantage (which will be discussed later) and Home Risk Assessment companies (HRAs). They market to physicians who code for the product through insurance. The business model is complicated, but a diagram can simplify it a little bit.

 

Semler Scientific

Provides QuantaFlo

Primary Care Providers

QuantaFlo patients directly pay insurance

Insurance Companies

Covers costs for QuantaFlo

Reimburses providers after billing

Semler has two types of contracts, fixed rate and variable rate. Fixed rate is paid monthly while variable rate is paid by the test. 70% of revenue came from fixed rate licensing in 2019, 25% from variable rate, and 5% from direct sale of their devices.

Industry Overview

The American Heart association recommends that anyone over 65 and anyone over 50 with certain risk factors (weight, health conditions, etc.) should be tested, thus recommending 80 million people should be tested. Only a fraction of these people is being tested currently with estimates at approximately 8-20 million people. The issue is that PAD is asymptomatic, thus doctors do not recommend testing for PAD often enough. Diagnosing PAD early greatly assists treatment, because lifestyle changes can be made such as changing diet and quitting smoking before more serious consequences occur. Preventative medicine is the key to improving quality of care in the long term.

The main customers that Semler has are insurance companies that provide Medicare Advantage (MA) plans. MA uses a fee-for-patient rather than fee-for-service, thus encouraging quality care over number of visits. Preventative care is a huge part of this model. According to the Center for Medicare and Medicaid Services (CMS), treatment is moving toward proactive rather than reactive care. By helping diagnosing PAD early, Semler plays into this trend. Currently 35% of Medicare patients are part of MA and the number is growing with some estimates placing it as the major Medicare plan by 2023.

The Numbers

Before addressing some of the concerns, I would like to look at the fantastic numbers the company has. Gross margin is 90%. Revenue growth has been >50% the past three years and the company is GAAP earnings positive with an EPS of 1.88$ per diluted share in 2019. Pre-tax net income grew 100% last year. With a net debt of -11 million$, the company is extremely well capitalized. Despite all these great numbers and potential for growth, Semler only trades at an EV/EBITDA of 19.8x and P/E of 20.7x. This puts their PEG at .4 looking backwards, ridiculously low. You might be concerned about Covid-19 impact, but that will be discussed in the next couple of sections.

Uplisting and OTC status

Currently SMLR trades Over-The-Counter meaning liquidity is very low and buying large amounts of stock is difficult. This prevents large funds from buying the stock which can hurt the share price, but the high quality of business creates value. Finding a good stock and a good business are two different tasks. A potential catalyst is an uplisting to the NASDAQ exchange. Management has fielded lots of questions about this and recently said there were no plans to uplist, because all investing can be financed from current operations and cash balances.

Customer Concentration

One risk that exists is a high level of customer concentration as their top 3 customers make up 75% of revenue. This risk is mitigated if you understand their business model as customer concentration is high because only a select few providers offer MA plans and provide home risk assessments, United Healthcare, Aetna, and Humana. Semler is not selling directly to these insurance companies but rather to thousands of clinics and physicians across the country who then bill insurance providers. The high customer concentration stems from their business model.

Covid-19 Impact and looking forward

Semler’s Q2 results (April 1 – June 30) demonstrated the impact Covid-19 had on the business as they reported a revenue drop of 20% to 6.4 million. The majority of the revenue drop stemmed from a drop in variable rate-licensing fees. Variable rate licenses dropped to 290,000$ while fixed fee license arrangements dropped 8% to 6$ million. Their largest customer comprised an even larger share of quarterly revenues in Q2 at 62.1%.

Although the Q2 numbers look bad, there are some positives to highlight. Preliminary results for July indicate pre-covid levels of revenue returning in variable rate licenses and post-covid management anticipates a return to pre-covid levels or above. The mechanics of home risk assessments also support the thesis of ‘pent-up demand’ returning. HRAs are typically given a list of people to test at the beginning of the year and have to test them by the end of the year. As HRAs are carried out on those who were delayed, demand should bounce back and Semler will recover lost revenue.

The Q2 earnings report also demonstrates the financial strength of Semler’s subscription-based business model. Even with a drop in revenue, gross margins stayed at ~90%, their cash position increased, and they were able to stay net income positive.

DCF

Even though Semler is high growth, it is cash flow positive, thus we can use a DCF to value the company.

After taking into account the impact Covid-19 has and the future avenues for growth, we can model the following income statement assuming all margins stay similar except for R and D, which increases due to investment into a new product.

Using an EV/EBIT approach to the DCF we can generate the following heat-map based on the WACC and Exit multiple. For a high growth company such as Semler, this approach is more appropriate than a growth into perpetuity approach.

 

Using a CAPM approach the WACC would be 9.3% and assuming the EV/EBIT multiple stays constant at 15.1x, the intrinsic value of the shares is 69.83$. This is 37% higher than the 51.00$ it trades at currently indicating Semler is undervalued.

The primary risks to the model are the ongoing effects of Covid-19 and new products entering the market.

The Possibility for Expansion

Semler is already playing into a large and underserved market, but if you look past their current device, there exists an opportunity to leverage their current relationships and network of insurance providers, home-risk assessment companies,  and physicians (over 300,000 doctors’ offices) to deploy diagnostic products for other chronic conditions and even create a platform for helping patients through their PAD and other chronic conditions. Currently, Livongo (Nasdaq: LVGO) is the best-known stock in the chronic care space, but Semler has the opportunity to either collaborate with larger players or build out their own digital health solutions for chronic care. The market opportunity for preventive health is large and growing as healthcare reform is enacted to switch from a fee-per-service to a fee-per-patient model. 

Summary

Semler has a product with a competitive advantage and a long growth runway yet trades at only 20x earnings. The unique licensing model means Semler has recurring revenue and extremely high margins. Customer concentration is an overblown concern and Covid-19 impacts will be minimal in the long term. The company is playing into the preventative care trend leaving a large growth runway. The only major risk is a change in insurance policy and innovation, both of which are unlikely and unpredictable due to trends in healthcare and Semler’s intellectual property. With no debt and a great product, the company is extremely well-positioned for extreme long-term growth. That, combined with a compelling valuation makes Semler a buy at these levels.