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SMLR: No Slowing Down Into 2019. Record Revenue, EPS. Cash Flow Churning. Moving PT to $50/share

By Brian Marckx, CFA



Q1 2019 Results: Record Revenue, EPS. Cash Flow Increasing. Infrastructure Investments Based on Demand

Semler Scientific (SMLR) reported financial results for their first quarter ending March 31, 2019. Revenue was about 2% better than our estimate, up nearly 52% from the prior year and +13% from Q4’18 and a record high. Revenue has now increased on a sequential basis for eight consecutive quarters. Gross margin, at 86.7%, while not a record high was nonetheless relatively healthy and 250 basis points wider than the comparable prior-year period (although down 150 bps from Q4’18 and lower than our 88.4% estimate). Meanwhile, operating expenses (not including cost of revenue) were at an all-time high but inline with our $4.0M estimate and a record low on a percentage of sales basis.

The net result was record highs on net income and EPS. Net income, of $1.85M, was nearly 2.5x that of Q1’18 ($706k), 34% higher than Q4’18 ($1.39M) and 26% higher than the prior best ($1.47M in Q3’18). EPS of $0.23 in Q1’19 compares to $0.10 in Q1’18, $0.17 in Q4’18 and a prior best of $0.19 (Q2 and Q3 2018).

Perhaps just as important as the new records that were set on the top and bottom lines was that significant cash generation continues (Q1 cash flow statement will be available when the 10-Q is filed). Semler generated positive cash flow from operations in every quarter in 2018. For the full year, cash flow from operations was $4.7M (or $6.6M, ex-changes in working capital) in 2018, compared to $621k (or $440k, ex-changes in working capital) in 2017. The balance sheet also remains very healthy, following the cleansing of remaining debt during the latter portion of 2018.

While management indicated that operating expenses could increase with further infrastructure-related investments (largely related to personnel additions), these are driven by continued growth in anticipated demand. And while SMLR also noted larger orders could result in short-term volatility (i.e. ‘spurts’) in revenue, that their goal remains to grow the topline faster than that of expenses – the net result of which should be a continuance in growth of EPS and cash flow.

As we have noted in the past, management already has a history of turning these types of ‘investments’ into revenue and profitability growth in short order. Our updated model (following reporting of Q1 results) shows SMLR generating revenue and EPS of $28.5M and $0.92 in 2019 (adjusted from $28.4M and $0.91), which implies respective growth of 33% and 39%. If our model proves reasonably accurate, we think operating cash flow could be in the range of $10.0M - $11.0M, and possibly even higher. As it is now, we model cash flow of approximately $10.5M in 2019.

Growth story remains intact…
The story and our outlook have remained largely intact for the last several quarters – including through Q1’19. As such, we continue to reiterate our comments from our recent earnings updates… 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 throughout 2018 and through the first quarter of 2019. 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. The last several quarters have further bolstered our confidence in that regard.

NASDAQ uplisting is likely on the horizon, which would increase visibility of SMLR and could bolster the ‘investibility’ of the shares, particularly as it relates to institutional interest and ownership. As we had forecasted, as of the close of Q1’19 Semler met the minimum required stockholder’s equity for NASDAQ uplisting. While management was non-committal on the Q1 call in regards to potential plans to uplist, we think it is almost certainly a near-term goal. SMLR will still need to increase the number of independent directors in order to satisfy NASDAQ listing requirements.

Q1 numbers
Revenue was $6.8M, up 52% (+$2.3M) yoy, up 13% (+797k) sequentially and about 2% (+$158k) higher than our $6.6M estimate. It was also a new record high. As a reminder, with the reporting Q4’18 results (late-February) SMLR announced that, based on a trend of both fixed and variable-type licenses which resulted in less meaningful distinction between their previously-reported revenue categories of licensing (i.e. implied ‘fixed’) and usage (i.e. ‘variable’) fees, they would no longer break these out.

Q1 operating expenses (including cost of revenue) was $4.9M, or 72.6% of revenue – this is nearly a record low on a percentage of revenue basis (only Q2 and Q3 2018, both at 72%, were lower). This compares to $3.7M (81.8%) in Q1’18 and $3.8M (75.7%) in Q4’18. For the full-year 2018, operating expenses averaged 75.2% of revenue, down from 107% in 2017. We currently forecast operating expenses (including cost of revenue) to average 71.5% of revenue throughout 2019.

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

Q1 net income was a record $1.9M – increases of 163% and 34% from Q1’18 and Q4’18, respectively, and 26% greater than the previous high ($1.5M in Q3’18). 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).

As a reminder, 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 several 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 2018: excluding changes in working capital, cash flow from operations was positive $1.87M. Free cash flow was $1.667M

- Q4 2018: excluding changes in working capital, cash flow from operations was positive $1.735M. Free cash flow was $1.345M

- FY2018: excluding changes in working capital, cash flow from operations was $6.617M. Free cash flow was $5.774M

Profitability, ROI Ramping…
SMLR has recently made investments related to product upgrades, such as enhancing cybersecurity features, and certain software and integration customization work - all aimed at facilitating the customer onboarding process as well as the overall customer experience and level of service. This has resulted in an increase in expenses but, based on management’s comments, has been responsible for much of the recent revenue growth.

To meet the increase in demand SMLR has also beefed up manufacturing capacity and incrementally expanded support-related capabilities. These additional expenses have shown up in higher R&D expense and, to a lesser degree, in incremental cost of services. These investments have benefitted revenue growth and improved profitability. Results through Q1’19 indicate that the return on these investments is not only still growing, but it is significantly accelerating. The even better news is that these trends are expected to continue. So, while management is guiding for operating expenses to continue to climb, the positive ROI from these investments means that revenue and gross income will grow even faster which should result in continued improvement in net income and cash burn.

Our price target has moved from $45 to $50/share. See link for free access to our updated report on SMLR which includes our financial model and valuation methodology.

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