SMLR - Semler Scientific: A High-Quality Cash Rich Microcap

2023-07-27 14:57:35 ET

Summary

• SMLR has shown strong financial performance over the past decade, and the company's long-term prospects also look bright.
• Cardiovascular diseases are still the biggest cause of global deaths meaning there is vast room for improvement and investment in this industry.
• A valuation analysis using a discounted cash flow approach suggests that the stock is massively undervalued.

Investment thesis

Semler Scientific ( SMLR ) is a high-quality micro-cap business with stellar financial performance over the past decade. The company delivered a massive profitability metrics expansion while the business scaled up, which is a solid bullish indicator for me. The latest and upcoming quarterly financial performance indicates strong momentum, while profitability metrics are still expanding. My valuation analysis suggests that the stock is significantly undervalued with an upside potential of around 100%. That said, the stock is a "Strong Buy" in my opinion.

Company information

Semler Scientific is a company that provides technology solutions to improve healthcare providers' clinical effectiveness and efficiency. SMLR markets a patented and FDA-approved cardiac and vascular testing product called QuantaFlo. It is a four-minute in-office blood flow test that enables healthcare providers to assess a patient's vascular condition.

SMLR also exclusively distributes the software program called Insulin Insights, working via a SaaS license model with a per-patient monthly fee.

The company's fiscal year ends on December 31. SMLR's revenues are primarily from fees charged to customers for the use of the company's products and from the sale of accessories used with these products.

Financials

Over the past decade, SMLR demonstrated firm financial performance. The top line compounded at about 43% annually, and profitability metrics improved significantly. In the past five years, the gross margin has been dancing around 90%, while the operating margin is consistently above 30%, and the free cash flow [FCF] margin ex-stock-based compensation [SBC] is at double digits.

Expanding profitability metrics while the business scales up is a good signal for potential investors suggesting to me that the management is efficient in managing growth. The R&D to revenue ratio has been in the high single digits over the past decade, indicating to me management's long-term mindset.

Consistently strong financial performance with wide FCF margins enabled SMLR to build a fortress balance sheet. As of the latest reporting date, the company had about $43 million in cash and ST investments with almost no outstanding debt. Besides an above $40 million net cash position, SMLR's liquidity ratios are also in excellent shape.

According to the latest quarterly earnings, revenue growth momentum is still strong. The company announced its Q1 earnings on May 10 , beating consensus estimates on the top and bottom lines. Q1 earned the highest quarterly revenue and pre-tax income ever achieved. Revenue grew almost 30% YoY, and the adjusted EPS expanded from $0.41 to $0.62. The strength in revenue was driven by both fixed-fee and variable-fee streams. The gross margin was about flat YoY at a staggering 93% level. The economies of scale effect on the SG&A line allowed SMLR to expand the operating margin from 28% to 34%.

The upcoming quarter's earnings release is scheduled on August 10, and revenue growth is expected to decelerate to 9% YoY. The EPS is expected to expand from $0.51 to $0.56.

I think that the long-term prospects of the company are strong as well. SMLR's products offer the opportunity for healthcare providers to make early diagnoses of complex diseases. And that gives a big advantage to the ultimate customers, i.e., patients with cardiovascular diseases [CVDs]. That said, SMLR's products deliver great value for the healthcare industry. According to the World Health Organization [WHO], CVDs are the leading cause of death globally. According to WHO, in 2019 [before disruptions to statistics from deaths caused by COVID-19], almost 18 million people died from CVDs. That massive quantity represented about 32% of all global deaths. That said, CVDs are one of the biggest challenges humanity is facing, and there is still enormous room for further improvement and industry growth. Therefore, secular factors are favorable for SMLR, and the company is well-positioned to benefit in the long-term thanks to the high quality of its business model, evidenced by wide profitability metrics.

Valuation

The stock demonstrated a substantial 24% price decline year-to-date, significantly underperforming the broad market. Seeking Alpha Quant assigns the stock a high "A" valuation grade due to low valuation multiples compared to the sector median and five-year averages.

SMLR does not pay dividends, so I continue my valuation analysis by simulating the discounted cash flow [DCF] approach. I use a 10% discount rate, a conservative assumption compared to the WACC suggested by valueinvesting.io . I have earnings consensus estimates for the two upcoming years, and I expect the company to sustain a 10% revenue growth over the long term for the years beyond. For the FCF margin, I implement the last five years' average, which is 17.1%, and expect it to expand by ten basis points yearly.

As you see, the stock looks substantially undervalued and has the upside potential to more than double. Sustaining a 10% revenue CAGR over the long term might be challenging. Therefore, let me simulate a more conservative scenario with an 8% revenue CAGR and no expansion in the FCF margin.

Even under a more conservative scenario, the upside potential remains at about 95%. Considering their substantial net cash of about $43 million, I have a high conviction that the stock is massively undervalued.

Risks to consider

The company faces significant concentration risk. The latest 10-K report shows that the two largest customers represented about 70% of the total sales. Such an intense concentration means that SMLR heavily depends on just two customers. SMLR also does not have power over customers' budgets and decision-making processes, meaning that earnings are very vulnerable to its two largest customers' financial performance and financial health.

Technologies and products offered by SMLR face the substantial risk of obsolescence. As technology evolves rapidly, there is a high risk that the company's offerings might become outdated or inferior to competitors' products. To mitigate this risk, SMLR must continue investing in innovation to stay ahead of competitors.

Also, substantial legal and regulatory risks are inherent to SMLR's business. Medical devices such as QuantaFlo are subject to regulation from FDA. Ensuring compliance with FDA regulations and maintaining the required documentation is essential to avoid problems like fines or market restrictions.

Bottom line

To sum up, SMLR stock looks like a "Strong Buy" for me. I think the business model implemented by the company is of high quality. SMLR has a strong track record of success with consistent revenue growth and profitability metrics expansion. The wide FCF margins allowed SMLR to build a strong balance sheet. The stock is very attractively valued, and the upside potential far outweighs the potential risks.

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