Business model

Semler: Unique Business Model Fueling Profitable Growth (SMLR)

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Scientist Semler (SMLR) is a small capitalization company. Since 2010, small caps have underperformed large caps, due to the growing importance of agglomeration effects in the United States. Semler operates in a unique market with favorable industry conditions that will allow it to grow and outperform the market, despite its small cap status. Market pessimism is high and last year the company lost a third of its market cap. The company’s distribution model, differentiated products and growth opportunities suggest that the company’s undervaluation is an opportunity for investors to buy a company with a large moat.

Are small cap stocks investable?

Since 2010, small cap stocks have significantly underperformed large cap stocks and the broader market.

Source: Google Finance

Source: Google Finance

Although intuition tells us that smaller companies should be able to grow faster than larger ones, and that in the decade leading up to 2010 small cap stocks outperformed large cap stocks, 2010 was a turning point. The disparity is greatest in North America and Asia excluding Japan. In Europe, Japan, the Middle East, Africa and Latin America, small cap stocks always outperform large cap stocks. Many reasons have been suggested for this, the most compelling of which is the rise of Big Tech and the importance of companies whose ability to grow increases as they grow. However, the underperformance extends beyond the technology sector.

The most likely explanation for the underperformance of small caps lies in agglomeration effects, including intellectual capital and labor pooling, which have allowed industry leaders to to emerge and achieve dominance unimaginable before 2010. Once a company becomes a market leader in the United States, it quickly takes on that role globally, killing all competition. In order to win with small caps, it is essential to look in niche markets where industry conditions are favorable and where it is less important to be a big company. Semler Scientific meets these criteria.

A niche market

Semler Scientific provides technology that helps healthcare providers assess and treat chronic disease. The company has received a US Food and Drug Administration (FDA) patent in 2011 for its sole product, QuantFlo, and in March 2015 the company received an FDA 510(k) authorization for the product. In 2017, the company had started selling the product. QuantFlo is used to measure arterial blood flow in the extremities to help diagnose peripheral arterial disease (BUFFER). QuantFlo’s patent is valid until 2027.

PAD has comorbidities such as heart failure, diabetes, and kidney failure. The PAD test is essential for the early detection of potential heart attacks and strokes. The typical patient is often unaware of the risk they run. The worst case scenario is of course death. Therefore, patients need a quick and accurate way to test for any underlying risk so they can begin preventive care and avoid higher acute care costs in the future. According to the company’s November 2021 investor presentation, there are 80 million people in the United States who could be treated by AHA/ACC criteria and of this group, the company estimates that 20 million could have PAD. Yet only 1-2 million of these PAD patients are diagnosed conventionally.

Despite the importance of PAD testing, PAD remains a vastly underdiagnosed condition. Semler estimates that 75% of patients with PAD are asymptomatic and therefore GPs frequently miss the diagnosis.

The cost of asymptomatic PAD and comorbidity are similar to those of symptomatic PAD. Patients with PAD typically have a 21% higher risk of heart attack, stroke, hospitalization, or death within one year of getting PAD. 20% of people with PAD are over 60 and half of patients over 85 have PAD.

QuantFlo is a vast improvement over the traditional PAD test using the ankle-arm index (ABI) method. It is faster, cheaper and does not need to be done in specialized laboratories, but can be done by the patient’s doctor.

To reduce upfront costs for healthcare providers and drive growth, the company uses a SaaS model to generate revenue. Customers pay subscription fees to use their technology, rather than purchasing the product directly.

Unique distribution model

Rather than targeting healthcare providers, one provider at a time, or with road shows and other presentations, the company realized that its ultimate customer was the one who wrote the checks: insurance companies. . Insurers are incentivized to reduce future acute care costs. Early detection with preventative care saves insurers money. Yen Liow, managing partner at Aravt Global, estimates that insurers enjoy a 100% to 150% return on investment in the first year when they deploy QuantFlo.

So insurers are happy to pay healthcare providers to use QuantFlo to test the PDA. Insurers have a clear incentive to pay for the product and physicians have an incentive to use the product. The consequence is that Semler is able to grow rapidly while achieving profitability. Semler has an added advantage in that it uses subcontractors to manufacture QuantFlo, which greatly reduces its need for large investments.

Growth with profitability

The company increased its revenue from $21.5 million in 2018 to $38.6 million in 2020. In the last twelve months (TTM), the company had revenue of $53.6 million. Given the company’s lean business model and the way it shifted marketing expenses for its products to insurers, its cost of revenue during this period was negligible. In 2018 it was $2.7 million and in 2020 it had risen to around $3.4 million. In the TTM period, the revenue cost is nearly $5 million. Gross margins are therefore absurdly high, starting at 80% in 2018 and reaching 91%. During this period, the company increased its net income from $5 million in 2018 to over $21 million during the TTM period. Since the start of sales of its only product, the company has never made a loss. The company’s operating cash flow decreased from $4.7 million in 2018 to $20.2 million during the TTM period.

Source: November 2021 investor presentation

Source: November 2021 investor presentation

The company’s profitability has enabled it to generate significant and growing free cash flow (FCF), which grew from nearly $3.9 million in 2018 to nearly $18.9 million during the year. TTM period. The company has generated approximately 10% of its market capitalization in the form of FCF since its IPO. Semler’s FCF yield is 3.96. Thus, the market set an attractive price for a growing FCF.

Currently, the company has a return on invested capital (ROIC) of 116.28%. This type of ROI is top-notch and reflects the company’s asset-light business model and immense profitability. Crucially, it also reflects the moat the company has built, providing valuable service while shifting most of the costs to its customers. The company has retained almost all of its profits since 2017 and achieved an additional return on investment of around 35%. This speaks perhaps even more strongly than the company’s return on investment: a company can have a high return on investment with a gradually declining or low return on investment, leading to a decline in shareholder value. Instead, Semler has increased shareholder value by about 35% since launching QuantFlo.

Risks for the thesis

The possibility of making attractive economic profits inevitably invites competition. The biggest threat to Semler’s position is that market entrants depress yields. Currently, QuantFlo is the only non-traditional PAD test on the market. It is many years ahead of any potential competition. So while the threat of competition is real, Semler has the opportunity to up the score and set the standard for the industry, so that by the time a viable alternative presents itself, Semler’s position will be closed.

Evaluation

We have already discussed the first buy signal, which is the company’s attractively priced and growing FCF. Second, on a relative basis, the company has a price/earnings ratio of 27.96. Compared to the 24.8 multiple of the S&P 500. Given that Semler operates in a niche market in which simply pursuing historical performance equates to immense success with rapidly growing revenue, earnings and FCF, I think the market has priced the company conservatively. If its incremental return on investment were halved, the company would continue to increase its intrinsic value to very attractive levels. The underlying economics of the company support a larger valuation and I expect Semler to experience multiple expansion going forward.

Conclusion

Although small caps in general have struggled to outperform large cap stocks, small caps that operate in niche markets and have enduring competitive advantages have been able to outperform the market. Semler’s revolutionary PAD test kit, QuantFlo and the company’s unique distribution model have given it a platform to grow profitably. While there is a risk of new market entrants hurting returns, the company has a big head start and can close the market before a challenger comes along. Given the company’s attractively priced FCF and its conservative relative prices, the company is a solid buy.