SMLR - Semler Scientific: Value Proposition Still Intact

Summary

• The recent drastic drop in stock price is grossly exaggerated.
• Value proposition of QuantaFlo, Semler's main product, remains intact.
• We believe that stock prices will revalue as the initial HCC code scare dissipates.

Semler Scientific ( SMLR ) is a micro-cap biotechnology company whose product is used to diagnose Peripheral Artery Disease (PAD). Earlier this month, a preliminary notice for an update on the Centers for Medicare and Medicaid Service's ((CMS)) Hierarchical Condition Category ((HCC)) risk adjustment model has caused Semler's stock price has dropped 50%+ within 4 trading days. The drastic drop in stock prices was a reaction to a negative uncertainty in Medicare Advantage payouts to Semler's largest clients, medical insurance companies. Despite this potential change, we believe that Semler's main product, QuantaFlo, remains valuable for PAD testing. We believe that Semler's stock price will appreciate as the initial HCC code scare dissipates and the company continues its solid business performance.

While SMLR has another pilot product for diabetes management, InsulinInsights, we will not be covering it due to lack of substantial revenue as of today. This article will be more substantive and covers the following items, so be prepared for a longer read:

• Introduce readers to PAD and Quantaflo

• Examine HCC & ICD coding

• Compare 2018 vs 2023 value

• DCF Analysis

Part 1: Introduction to Peripheral Artery Disease (PAD)

What is PAD?

Peripheral artery disease is a condition in which narrowed arteries reduce blood flow to the arms or legs. As a result of limbs not receiving enough blood flow, those with the condition experience leg pain when walking (claudication) and other symptoms. This process of fatty buildup in the arteries is also known as atherosclerosis. When this happens, blood cannot get through to organs (usually the legs) and this causes the tissues to die (gangrene). The terms ‘atherosclerosis’ and ‘gangrene’ will be used again in the segment below discussing HCC codes. In several studies conducted, PAD is found in over 10% of the population over 65 years of age. It is also more prevalent in African-Americans and hispanics, men, diabetics, and those with a history of smoking or high blood pressure. However, 3 out of 4 patients who suffer from PAD are left undiagnosed as most patients of the disease are asymptomatic. In any case, asymptomatic patients suffer the same health risks as symptomatic patients. Untested and untreated, PAD can result in limb amputation((s)), or death.

How is it being diagnosed right now?

To be clear, there are a couple of stages of diagnoses for PAD. Semler’s product, QuantaFlo, is used for preliminary diagnostics. That is, to test whether or not a patient may have PAD. This is different from the later stage tests which determine the exact location of the blocked arteries. The list below covers early stage diagnoses that are similar to QuantaFlo. Other more complex methods are available on this page .

• Arterial brachial index ((ABI)) test: The test compares the blood pressure measured at the ankle with the blood pressure measured at the arm. The index number suggests a narrowing or blockage of the arteries in the legs, thus indicating that the patient may have PAD.

• Doppler ultrasound: As the name suggests, doppler ultrasound uses doppler waves to determine whether an area in the leg has blockages. This is done by detecting areas where there is restricted blood flow.

• Vascular ultrasound: This method uses sound waves to create pictures of the arteries to locate blockages. It is similar to an ultrasound scan for pregnancies, but is done on the legs (where PAD is mostly found)

• Duplex ultrasound: A combination of doppler and vascular ultrasound.

How is QuantaFlo different?

The methods of diagnosing PAD listed above require a combination of ((i)) specialized equipment, ((ii)) more extensive training and are ((iii)) mostly unavailable in primary physician offices. What this means is, when a patient goes for a checkup and is predicted to have PAD, they are usually unable to get diagnosed immediately. The patient would typically need to seek a second (vascular) physician who has specialized equipment to get diagnosed for it. In the specialized physician’s office, the diagnoser has to be trained to conduct the diagnosis (with its more sophisticated tools) properly. For the physician, more time is needed to train the diagnosers, and more cost (to obtain those specialized equipment, and for training the healthcare professional). For the patient, this means an extra trip to the doctor (time wasted).

QuantaFlo’s value proposition mitigates these issues. While QuantaFlo is still a specialized equipment, it is much cheaper than the ones used in vascular physicians’ offices. Cost per test is also cheaper, as Semler provides an option for users to pay a monthly fee. They do provide a variable-use fee, also known as fee-per-use, but both options are available for physicians to choose from.

QuantaFlo is also easier to use. As pictured above, one simply needs to clip the device to a toe and a finger on each limb to get diagnosed. This ease of use is one of the reasons management has touted its use for home testing . For physicians, it means less training required for their staff (read: less cost) and it prevents misdiagnosis from incorrect testing. In a comparative study between Doppler ABI (1st test listed above) ABI test, Duplex test (2nd + 3rd test listed above) vs QuantaFlo (then known as FloChec), QuantaFlo is found to have better results in detecting PAD (page 6). While the result of the study is not statistically significant, it sways to the benefit of QuantaFlo. The study results have also been previously studied by Zacks .

The product also takes less time to diagnose, and less physical activity. To be more precise, diagnosing PAD using QuantaFlo’s product takes a total of 6 minutes , with 5 minutes spent on the “patient (being) placed in the supine position, with the arms and legs at the same level as the heart” to stabilize the patient’s blood pressure, prior to a 15-second test per limb where the device is essentially clipped onto a finger/a toe. Compare this with the ABI test which at minimal, requires time equivalent to 4 blood pressure tests, and you will see some time saved for the physician. Thanks to its ease of use, lower cost and small size, QuantaFlo can be made available in a primary physician’s office. This means that patients will save an extra trip they would have spent on getting diagnosed by a vascular physician.

All of these combined sums up QuantaFlo’s value proposition. Restating the benefits: QuantaFlo provides better, more accurate PAD testing, is usable with minimal training, costs less, and can be made easily available at primary physician offices.

Part 2: The Story Thus Far

Semler obtained a 501k FDA clearance for its product in 2010, known then as FloChec. Subsequently, the company began commercialization in 2011, targeting third party payers (i.e. insurance companies) while outsourcing physician distribution to a third party. Production of QuantaFlo is also outsourced, enabling the company to earn ~80% margins on product and software sales. Software sales now follow an SaaS model, where payers select between a fixed monthly fee or a variable fee per-use.

Subsequently, the company IPOed in 2014. While the initial prospectus targeted a sale of $15M of stock at $12-$14, it was then reduced to $7.50-$9.50, before the company eventually sold $10M worth of shares at $7 apiece. Fast forward a few years, the company grew its revenues nearly 6-fold from ~$3.6M in 2014 to $21.5M in 2018, when they were delisted from NASDAQ for failure to meet market cap requirements (Nov 2018). Since then, revenue has increased by another ~2.5x from 21.5M in 2018 to 53M in 2021.

SMLR’s most recent filing shows that 22 revenue through 3Q is 42.9M. If one extrapolates 3Q22 to cover FY 22, and applies a 4% haircut to account for seasonably lower revenues in 4Q, we obtain a revenue of 56.6M, which is within management’s guidance (per 3Q earnings call) of 55M - 58M. Taking management’s mid-point in operating expenses from its most recent earnings call ($38.8M - $40.3M), we get EBIT of ~17.05M. Comparing its valuation in the year they were delisted (2018) to our FY 22 estimates, the company was valued much higher than where it is now.

Source: SEC Filings

As it stands today, the company is valued less than it was soon after its delisting, and much less compared to its peak (at one point in 2021, the company’s value was over $1BN). While a part of this drop in value has to do with the stock market valuation decreasing as a result of a return-to-sanity, it’s most recent drop is related to the preliminary report on CMS HCC code changes announced earlier this month that will be applicable for payment year 2024.

Part 3: ICD-10, CMS, HCC, MA - What’s all this?

The healthcare system is complex and filled with many acronyms. This can be confusing and frustrating for readers. Below, we simplify as much as possible the relevant acronyms and explain how they relate to one another.

ICD-10 refers to the International Classification of Diseases published by the World Health Organization. As its name suggests, it is a method of categorizing diseases internationally which makes comparing diseases internationally better. ICD-10 provides specific codes based on the disease and its severity. ICD-10 code for PAD is I-73.9 , and the code for the severe version of PAD is I-70.209 .

CMS refers to the Center of Medicare and Medicaid Services. It is a US federal agency which essentially manages Medicare, Medicaid and the Children’s Health Insurance Program.

Medicare is a national health insurance policy. It is free for most people, and covers much of the diseases one would experience. There are co-pays, but in general, it costs much lower since it is a public health insurance. On the other hand, Medicare Advantage ((MA)) is essentially an insurance service provided by private companies. It provides greater coverage than Medicare and its costs are partially covered by Medicare. To read more of their differences, go to this link and read Page 5 onwards.

HCC refers to Hierarchical Condition Categories, which are a set of medical codes linked to diagnoses. HCC codes are assigned by CMS to adjust Medicare payments through a risk model. The higher the risk of a disease, the higher “value” is assigned on the HCC code. The higher the “value” assigned, the more money Medicare pays insurance providers. To read more, follow this link or this link . HCC code readjustments are regularly done as CMS modifies their model to reflect the most current information.

HCC Code change - how does this affect SMLR?

In Feb 1, 2023, CMS published the preliminary version of HCC codes (version 28), which will come into effect in 2024. In short, the new version does not contain the HCC code that SMLR has been using, HCC-108. We say “may” because it is not finalized yet. It will become final on April 3rd, 2023. This has caused investors to freak out and dump shares, leading to a 50%+ drop in share prices within 4 trading days (Feb 3 high: $42.36, Feb 8 low: $20.54). Let’s examine this a little closer.

HCC 106 and HCC 107 have been renamed as HCC 263 and HCC 264. HCC 108 was changed to HCC 267. While the change was not missed by investors, what was missed is the fact that PAD, also colloquially known as Peripheral Vascular Disorders, is still covered by all 2 of the HCC codes in the new version. The difference is in the severity. HCC 108 covers all other HCCs (106, 107, 263, 264, 267) since it is the least severe of the rest. It is the all-encompassing “catch-all” with the lowest risk model.

PAD testing is still applicable for HCC 263 and 264. HCC 267 does not cover PAD essentially because it covers “vein-related diseases”, while PAD is an “artery-related disease”. As mentioned early on in the article, PAD is caused by atherosclerosis, and in severe cases, it may result in ulceration or gangrene, both of which are covered in HCC 263. This means that QuantaFlo isn’t going away; it will continue to be used. In digging an old company filing from 2014, the company had highlighted that their product could meet what currently is HCC 264. There has also been no change on this front.

Another point to make, is that insurance companies such as UnitedHealth (SMLR’s largest customer) still benefit from using QuantaFlo even when HCC 108 no longer exists. In general, insurance companies are more willing to pay for cheaper early diagnoses testing and treatment because it costs more when PAD manifests itself in more severe conditions (even with Medicare claims). So rather than potentially paying for loss of limb due to chronic PAD, insurance companies would better serve themselves by covering for early PAD testing. In addition, if PAD testing is truly not covered by Medicare Advantage, then other competitors selling would be affected similarly. In this scenario, the value of Quantaflo could increase in comparison to its competitors. This could reduce the loss of revenues from MA claims as physicians opt for QuantaFlo products for its ease of use, better accuracy and cheaper testing costs.

To summarize this segment, we feel that there was a gross overreaction in recent days to the news of a HCC code change. While QuantaFlo’s usage may decrease and some drop in stock prices is understandable, the drastic drop we have seen is unwarranted. The company’s products will continue to be used, and the HCC codes in the new version are still applicable to PAD testing. It is our view that QuantaFlo’s customer base will continue to expand due to its value proposition: it is much easier to use, more accurate, and costs less.

Part 4: Valuation

For our analysis, we created 3 scenarios applied DCF analysis on each scenario, while providing our assumptions below. Since QuantaFlo’s patent ends at the end of 2026, we assume just one additional year of growth before applying terminal value considerations. We also assume that EBIAT is equal to FCF although historically, D&A has been higher than Capex. This is done for simplicity; otherwise, FCF would be higher than EBIAT and this will result in a higher terminal value ((TV)).

The basis of assumption in growth and decline in these scenarios will be in comparison to historical rates. Use these figures to compare "how good" or "how bad" the scenarios are in comparison to past figures. All figures except share count is in ('000s).

Worst Case

The basis of the worst case scenario is that we were completely wrong in our analysis of the impact of HCC code changes, and management badly fails their cost controls.

Assumptions:

1. Revenue drops in 2023 in anticipation for HCC code change, and again drops precipitously in 2024 due to HCC code removal.

2. Company spends disproportionately higher on marketing in hopes of pursuing new customers.

3. But revenue growth in 2025-2027 remains tepid and continues to decrease as compared to historical figures

4. Cost of sales increases to a 5-year high of 13%

5. Management rewards themselves proportionately more even when company isn't doing well, while decreasing headcount in 2025 onwards.

6. Terminal value based on 2% growth and 7% discount rate (S&P500 historical CAGR)

Base Case

The basis of our base case is in our expectations of is an initial drop in revenues due to HCC code change, and management remains stringent in their cost controls.

Assumptions:

1. Revenue in 2023 is equal 2022 since HCC code is still available, and new revenue gains from customers who recently purchased equipment replace revenues lost from old customers.

2. Revenue drops due to HCC change in 2024. Subsequently, SMLR revenue growth increases slowly, at 10% per year, as the company gains revenue from product extensions and new / expanded customers.

3. Cost of sales sees a modest increase to 12% of revenue (vs L5Y average of ~10%).

4. R&D increases in proportion of revenue as the company invests in product extensions and other products.

5. Company spends disproportionately higher on marketing in hopes of pursuing new customers (but at a lower rate than worst case scenario)

6. G&A costs increase as a percentage of revenue, but cost controls remain, with historical dollar value growth.

7. Terminal value based on 3% growth and 7% discount rate.

Best Case

The basis of our best case is that the clinicians largely ignore the effects of HCC code change (on a net basis), which translates to revenue growth, though it will be lower than prior to the HCC code change. This scenario also assumes increases in operational efficiencies.

1. QuantaFlo integrates with new HCC code system seamlessly

2. Revenue grows modestly from a combination of product extensions, greater volume usage and new customer wins (L3Y CAGR = 20%, L5Y CAGR = 36%)

3. QuantaFlo equipment manufactured at larger amounts gain volume discounts

4. R&D increases in proportion of revenue as the company invests in product extensions and other products.

5. Sales efficiency increases, cost controls in place

6. Terminal value based on 4% growth and 7% discount rate.

Scenario Commentary

Comparing our three scenarios side by side, we view that the company's value lie between $50.8M in its worst case to $953M in a best case scenario, which translates to a downside of 63% to an upside of 585%, with a base case of 132% price appreciation. Given this information, we believe that the current prices provide a good opportunity for entry.

Part 5: Catalysts & Risks

Catalysts

The list below outlines catalysts that we will be closely watching as it will provide us some sense of how management and customers view the business.

1. Stock buybacks

The company initiated a $20M stock buyback program in March 2022. Through 3Q22, $5M has been used to repurchase 148,500 shares (equivalent to ~$33.67/share). If management believes HCC coding issue will be resolved and/or business will not be greatly disrupted, they will repurchase shares at current depressed prices in anticipation of stock price recovery.

2. Equipment sales:

Equipment sales signals buyer’s confidence. If sales are lower, it signals that buyers do not have confidence in the HCC coding for Quantaflo for insurance reimbursement (Medicare Advantage)

3. HCC Code Update / Management Statement:

If management provides clear/positive guidance on HCC code applicability, then it’s an obvious plus and stock prices may rise. An unclear/negative guidance would lead to the opposite effect.

Risks

1. SMLR is a micro-cap stock

Micro-caps are considered to be risky investments with both great upside and downside potential. Investors should be aware of the pros and cons of investing in micro-caps. While the stock trades in NASDAQ and has ~8 million shares outstanding, it is extremely illiquid, with very thin trading volumes. As such, any single investor may be able to cause large swings in the prices in their attempt to accumulate or exit the stock.

2. Impact of new HCC codes

There is no guarantee that the new HCC codes will be available for QuantaFlo. If the HCC codes are unavailable for QuantaFlo, SMLR may experience a significant drop in revenues and this may translate to lower stock prices.

3. Highly concentrated customer base

SMLR’s Top 2 customers, assumed to be UnitedHealth and Signify Health (acquired by CVS, pending shareholder vote estimated to be in 1H2023) account for 70% of 2022 revenues through 3Q. This customer concentration has been the way it is since the company began commercializing QuantaFlo. If any or both customers decide to discourage the usage of QuantaFlo, SMLR will quickly face a material drop in revenue.

Closing

Semler Scientific is a medium/high-risk, high-reward investment. As it currently stands, they have a great product but are bound by external risks - CMS HCC codes and top-2 customers. However, we believe that the company’s drastic drop in stock price has been a gross exaggeration by investors who have not dug deep enough into the weeds to appropriately understand the impact in the business. We believe that SMLR should be valued much higher than it is today as business performance proves to have significantly less impact than the drop in stock prices suggests.

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