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Shares of Simulations Plus, Inc. (NASDAQ:SLP) have been trading stagnant recently, after the company has been an incredible growth story, certainly in the 2010s. Just a tiny software and consulting business, Simulations Plus operates in a very interesting growth industry, benefiting from rosy long-term prospects.
Amidst margin pressure observed lately, I am cautious given the resulting elevated earnings multiples. This margin pressure and recent M&A activity, which raises some question marks, means that management has to start delivering here.
About The Business
Simulations Plus claims to be a leading provider of software and consulting services in the so-called biosimulation market. AI-powered technology solutions optimize drug discovery, development, research and regulatory submissions processes.
The company has been around for more than 25 years and now counts over 300 clients which trust its solutions in their drug development processes. The company offers nearly 20 different machine learning, modeling, and simulation software solutions across the lifecycle of drug approval processes: ranging from discovery, to pre-clinical, clinical and actual approval processes.
The company touts a huge and growing addressable market, as a current roughly $3 billion biosimulation markets makes up just a fraction of about $200 billion being spent on drug development by pharmaceutical and biotechnology companies. This market is set to grow towards $10 billion in 2020, growing at a compounded annual growth rates in the mid-teens.
Its software solutions aid clients to make these development steps faster, not just in terms of approvals, but also in discontinuation processes within development.
The company is actually quite small in terms of sales, but that only tells part of the story. Just an $11 million business in 2014, the company has six folded to a trailing revenue base in the sixty millions. The company has seen this rapid growth while only incurring about 25% dilution, although truth be said is that operating margins, which historically have come in >30%, have actually come down to the teens, at least in terms of GAAP metrics.
A Hidden Gem Discovered
Just a $5 stock in 2014, the company commanded a market value of less than $100 million at the time, as a $35 stock pre-pandemic peaked in the $80s in 2021. Ever since, shares have been trading largely range bound, having been glued around the $40 mark in recent years.
In October of last year, Simulations Plus reported an 11% increase in 2023 sales to levels just shy of $60 million. While sales growth continued, GAAP operating profits of $8.7 million were down compared to the year 2022 and 2021, with GAAP earnings of $0.49 per share compared to a $0.60 per share number in 2022. That tells just part of the story, with adjusted earnings of $0.67 per share actually up six cents on the year before, with the discrepancy largely resulting from transaction-related costs incurred during the year.
With 20 million shares trading around the $40 mark, the company commanded an $800 million equity valuation, which included a $57 million net cash position. Adjusted for this, the enterprise valuation came in at less than three-quarter of a billion, valuing the business at around 12 times sales. Including a near $3 per share net cash position, operating assets were valued around 55 times adjusted earnings, high valuations, certainly.
2024 Solid So Far
In January, Simulation Plus reported a 21% increase in first quarter sales to $14.5 million in what is seasonally a softer quarter, with adjusted earnings up three cents to $0.10 per share.
Second quarter sales rose by 16% to $18.3 million, with adjusted earnings actually down a penny to $0.20 per share. This was followed by the third quarter results being released in July, with quarterly sales up 14% to $18.5 million, with adjusted earnings of $0.19 per share trailing last year’s earnings numbers by two pennies. Strong cash flow generation meant that net cash holdings rose to $119 million, surpassing $5 per share.
With a current operating asset valuation of around $700 million, the company trades around 10 times sales here. The company sticks to a $69-$72 million sales guidance, although adjusted earnings were only seen a midpoint $0.55 per share, suggesting a very modest further quarter earnings number, while the earnings multiples jump towards 70 times.
A Big Deal
The softer implied fourth quarter guidance has to do with a recent transaction. In June, Simulations Plus announced a big deal as it acquired Pro-ficiency Holdings, a provider of simulation-enabled performance and intelligence solutions for drug development. The $100 million deal tag has been paid for with existing net cash holdings, which subsequently have been largely depleted.
The deal will double the total addressable market, or TAM, to $8 billion. With few details announced in the press release, the third quarter conference call clarified that near-term earnings accretion would be seen. This was defined as the business contributing a similar earnings number than its forfeited interest income on the $100 million deal.
The deal presentation revealed that the company employs about 40 workers, generating some $15 million in revenues. This suggests a near 7 times sales multiple has been paid, compared to its valuation around 10 times sales. That said, little has been said about the growth of the business, nor its margin profile.
For 2025, the business is set to contribute $15-$18 million in sales, yet with a current revenue number of $15 million, that suggests that the acquired activities will see between 0% and 20% growth in 2025, being a broad range.
What Now?
The truth is that with a current market value of around $800 million, amidst a minimal pro forma net cash position of $19 million, I am leaning cautious. Pro forma sales come in around $80 million, suggesting a valuation at close to 10 times sales. The issue is that as growth slows down, adjusted earnings are coming in flat at best, and there remains quite some uncertainty on the latest deal.
Moreover, the slowdown in third quarter sales growth, but moreover softer margins, took investors by surprise. This meant that shares fell from $47 to $40 in the matter of a few weeks, but right here the unleveraged business trades at roughly 70 times adjusted earnings.
While Simulations Plus seems some kind of hidden gem, its margin progress has not been up to standards to justify the current valuation, let alone create a compelling risk-reward proposition. This, certainly, is the case as the emergence of AI on a net basis might create some risks as well, in my view.
While some of its end clients have seen tougher times and have cut back on spending, the long-term potential of the business and industry remains. That said, I fail to see a very compelling risk-reward here for Simulations Plus, Inc. stock amidst a substantial deal which raises some questions. Moreover, the general margin pressure observed is a concern, something which has been the case for some years now.
