Semler Scientific
a medtech monopoly?
By Manuel Maurício
January 14, 2022
Symbol: SMLR (NASDAQ)
Share Price: $82
Market Cap: $554 Million
Would you like to buy a SaaS medical business with 93% gross margin, 40% operating margin, growing at 30% year on year, with 200% return on invested capital, for 30 times earnings?
I would!
Semler Sientific is an American midcap company disrupting the diagnosis of Peripheral Arterial Disease (PAD).
What is PAD?
PAD is a narrowing of the peripheral arteries that causes the patient’s blood flow to reduce (it’s also called Atherosclerosis). Eventually PAD may lead to gangrene, amputation, and ultimately death. People with PAD are 4 times more likely to die from a heart attack and 3 times more likely to die of stroke than the rest of the population.
But as important as it may be to have it diagnosed, it’s estimated that 75% of all cases go undiagnosed. A great part of PAD patients don’t show any symptoms so it’s usually only in an advanced state of the disease that the patients are referred to a vascular specialist to be diagnosed.
According to the SAGE group, approximately 8.5 million people suffer from PAD in the USA. Semler’s management estimates that the evaluable patient population for PAD is closer to 80 million.
How is ABI currently diagnosed?
The current Standard of Care for diagnosing PAD is through a test called ABI (Ankle Brachial Index) using an inflatable cuff and a hand-held ultrasound device.
ABI must be performed by specialized vascular technicians so it cannot be done in primary care offices, and usually involve some manual analysis to interpret results.
How is Semler's product different?
Semler’s diagnosis tool – QuantaFlo – comes to revolutionize how diagnosis of PAD is done.
You just attach a clip to a finger or a toe and the cloud software spits out the results. Any primary care provider can do it in under 5 minutes. The best thing? QuantaFlo can be used without a referral. All of this should make it easier to massively reduce the number of underdiagnosed patients.
Distribution
The way a typical medical device company goes to market is by deploying a big sales force that will visit the doctors in hospitals and clinics. This takes a lot of time and money to reach scale.
Semler did it in a different way. Although its users are health professionals, its customers are big insurance providers and At-Home-Risk Assessment (HRA) companies.
These entities stand to benefit massively from knowing early on which of its clients have a predisposition to suffer from a disease that will likely get them killed.
So it’s the clients who will deploy the “salesmen” on behalf of Semler. Semler just needs to give them training and support. By doing this, Semler doesn’t need a big Sales & Marketing team.
But there’s a downside to this as well. Because there only a handful of big players in this industry, Semler has very high customer concentration. The two largest customers account for 40% and 30% of revenues. It’s speculated that these 2 largest customers are United Healthcare and Humana.
Just like Prodex, this a risk that investors must bear in mind because these clients can (and will) exert a lot of pressure on Semler to lower costs (thus lowering margins).
I’ve read somewhere that some of the big players pay both Semler and the doctors to use QuantaFlo. If this information is accurate, it serves to illustrate the enormous value that QuantaFlo delivers to the insurers.
Revenue model
Also unlike most medical devices companies, Semler’s management chose not to sell QuantaFlo as a one-off device with a high upfront cost. Instead it chose to sell it as a subscription.
Although the reader (or the clip) that attaches to the finger or toes is still needed, what’s really important and differentiated is the software that reads and interprets the signal. So, a Software-as-a-Service model (SaaS) was the best way to market QuantaFlo.
But some of Semler’s customers don’t want to be paying a fixed fee subscription when they’re not using Quanta-Flo. These customers are usually the At-Home Risk assessment companies. They prefer to pay on a per-test, or variable basis. Right now, the subscription business accounts for 56% or revenues while the variable business accounts for 41% of revenue. The sale of devices represents 2% of revenues and I suspect that the company sells the devices at or close to cost.
Just like the best software businesses, Semler has a super high gross margin above 90%.
SaaS businesses are highly rated by investors due to the predictability of their revenues and scalability and operating leverage (as revenue goes up and costs don’t go up as much, every new dollar of revenue is more profitable than the previous).
You see, because software is often very sticky, these companies spend huge amounts of money in Sales & Marketing to grab the most market share early on.
This makes it so that, as they’re in the growth phase, they’re usually unprofitable (although in a steady-state – if they would pause their growth – they would be massively profitable).
But the fact that it’s Semler’s customers who take care of the distribution makes Semler a little different (for the better) than most money losing SaaS businesses.
Its operating margin is astonishing.
And, because Semler outsources the manufacturing (and R&D) of the devices, it doesn’t need any manufacturing facilities, so the capital that is invested in the business is very low.
And what do we get when we have high margins and very low capital needs?
Amazing Returns on Invested Capital. I have never seen a company with 249% returns before!
Of course, margins and ROIC will come down as competition understands how good this business is.
So how has this translated into revenue growth?
Well, take a look at the chart below and tell me if you don’t find it B-E-A-U-T-I-F-U-L?
Recent weakness
I have actually found Semler Scientific a few months back, but because of its dependency on one single product, I was quick to dismiss it. In the meantime, as the company uplisted to the NASDAQ, the stock price went through the roof and I never again worried about looking at it.
…until recently.
The third quarter of 2021 was the first quarter since the beginning of 2017 when revenue declined sequentially (not taking into account the second quarter of 2020 for obvious reasons).
This, together with a recent generalized weakness in the share price of growth and medtech stocks, has led the stock price to go down 44% since its All-Time-High of $150 back in October 2020 to the current $82.
The slowing down of revenue growth (still at a very sound 30% growth from the prior year), happened in the Variable Fee segment.
When asked about the reason behind this weakness, the management team didn’t have a good answer. They mentioned that they believed it could be tied to the At Home Risk assessment companies performing their exams earlier in the year, leading to a new seasonality in the business.
I’ve taken a look at Signify, one of Semler’s largest HRA clients and they seem to confirm this:
“the typical seasonality is for the HCS business, you’re typically going to have a stronger first half. And in the back half of the year, it’s going to be a little bit softer because as you go through the list, the member list, and get the in-home engagements, that starts to trickle down in the back half of the year, Q4.
As we’ve said since we had the IPO and the road show, it’s always our softest quarter. And there’s a variety of reasons for that. We’re winding down the list, there’s holidays, the weather, typically, and then we start again for the following year. So that’s the biggest thing.” Signify Health, Q3 2021 Conference Call
From the above, I think it would be reasonable to believe that the share price will languish, or even drop, in the near future.
Strategy going forward
The “problem” with companies with such high returns on invested capital is the reinvestment rate. Without the ability to reinvest the profits at high returns on capital, the cash just piles up on the balance sheet. At the end of the third quarter Semler had $36 million in cash and zero debt.
I know this is a good problem to have. The company might issue special dividends or buy back shares. But I would prefer if the cash was reinvested back into the business. One way that the management is doing this is by buying minority stakes in other companies with complementary products.
Recently Semler invested in 3 different companies and it’s also ramping up its internal R&D efforts. Now, we don’t know what these other companies do, the management is tight lipped about it. We just know that two of them target metabolic disorders and that Semler is already working with its largest customers on the new products. We should expect management to talk about them when they become material to the revenue.
Going forward, I think we’ll be seeing more small investments in other companies (like a venture capital fund). If any of those new products becomes a hit, we could see Semler buying out that particulat company.
Management and Ownership
The management is careful in keeping things to themselves and not disclosing any material information that could attract competition. They don’t issue guidance, and they don’t talk about the new products.
The CEO owns 11.9% of the company and, collectively, insiders own 13.5%. Eric Semler, the founder’s son, and another long term shareholder, Will Chang, own approximately 25.2% of the company.
The management’s compensation doesn’t seem too high, but unfortunately I haven’t been able to find the incentives for the variable compensation.
Competitive environment
QuantaFlo’s biggest competitor is the traditional ABI tests. I’m sure there are a few start-ups looking to come out with new, better products, but so far I’ve found only two relevant threats: Flow-met by the giant Medtronic, and Smart ABI by Hyperion Medical.
Flow-met also has a “thingy” that is clipped onto a patients toe that transmits a signal to a tablet with a proprietary software that will decode and interpret the signal. But as Quantaflo is based on radio frequency, Flow-met uses laser technology.
By using a different technology, Flow-met can monitor the blood flow in real time. This is especially important in surgeries where vascular surgeons need to understand how the stents, balloons, and other techniques that they use affect the blood flow as they perform the surgery.
I do not know if QuantaFlo could be used in a similar way, but right now I don’t think it can because Semler recommends the doctor performing the examination to warm the patients toes and the patient doing back calves (likely to draw blood to the extremities). This is unpractical in a surgery.
So far, Flow-Met has been marketed to surgical settings and I suspect it will remain so in the near future, but I guess they could easily adapt it to become usable by any primary care provider.
The other potential competitor, Smart ABI, is based on the old ABI technology of inflatable cuffs. I’m still doing work on this competitor, but I suspect their biggest asset is their relationship with the insurance companies.
Patent Expiration...
The two major risks I see for Semler are the patent expiration in 2027, and the changing of the regulatory environment.
I would expect other players to come into the market right after the patent expires so Semler has 5 years to make QuantaFlo very sticky (maybe by integrating its software deeply with its customer’s software), and also to launch complementary products.
None will stop competitors from coming into this space, but that shouldn’t mean that Semler should rest on its laurels.
Also, as Quantaflo has an estimated market share in the single digits, I would say that there’s room for more than one competitor to thrive.
... and Regulatory Risk
Regarding the regulatory risk, this one is actually a bit more difficult to assess which is the reimbursement by Medicare Advantage, the public health insurance program in the USA. Although Medicare is a public program, it’s sold by private insurance companies.
The Medicare Advantage pays the insurance companies (Semler’s customers) a fixed fee per patient per month. It works with a multitude of specific codes that are used by the doctors and insurers to claim reimbursement for the treatment. Each code corresponds to one or more medical conditions and procedures.
As Semler has never pursued specific codes for QuantaFlo, its customers have been applying for reimbursement under generic codes. Now, if CMS – the organization running Medicare – changes anything to those codes leading to a change in how diagnosis made with QuantaFlo is paid for, there’s a strong likelihood that Semler’s customers would stop recommending the use of QuantaFlo to their doctor’s network.
Also, with more people turning 65 every year, Medicare has been reducing the fee it pays per patient. As the doctors are usually paid the same regardless of how long they take to see the patient and what type of exams they perform, at some point, some procedures will be discarded due to economic reasons. One of those procedures could be PAD diagnosis with QuantaFlo.
The issue with this regulatory environment is that CMS updates the coverage of its codes every year, so the ground is shaky for QuantaFlo since it has been paid for under codes that aren’t specific to it. I believe that the management is pursuing specific codes for the QuantaFlo to reduce this risk.
A couple of things that I don't like
Having made the case for an investment in Semler Scientific, there’s still 2 things on the back of my mind that I would like to lay out here for future tracking.
The first one is the stagnation of inventory on the balance sheet:
The assets held for sale are the devices and the tablets used for testing. I think it’s reasonable to think that this should be a leading indicator for revenue.
But the management mentioned recently that they’re selling more devices and software and less tablets. The doctors and nurses working for the At-Home Risk Assessment Companies will carry with them a backpack with only one tablet and several diagnosis devices. I think it’s fair to believe that they use their own tablet with all the software that they license instead of Semler’s tablet.
The second thing that bothers me is that, on the press release for the third quarter, the management chose to highlight the financial performance for the first 9 months of the year instead of the performance for the third quarter. They had never done this before.
But now that the numbers weren’t great, I guess that they felt the need to hide it. I don’t like this. It doesn’t constitute a deal-breaker for me, but it doesn’t sit nicely.
Risks
- Changes to Medicare Advantage
- Customer concentration
- Supplier concentration
- Single product
- Technological obsolescence
- Product liability issues
Conclusion
Semler Scientific, with its single product QuantaFlo, is disrupting the diagnosis of Peripheral Arterial Disease (PAD).
Right now, they’re the only show in town which has allowed the company to see exponential growth all the while enjoying amazing margins and returns on capital.
Its distribution, performed by its clients, is highly effective, but investors must understand that the customer concentration is a double edged sword.
So is the Medicare Advantage reimbursement environment.
Having said that, Semler has a huge runway in front of it. Even if a competitor comes up with a better/cheaper/faster test, I believe that it will have to be materially better to displace QuantaFlo.
And how much better can it be? Well, instead of a device that you clip onto a finger, maybe it could be performed with a smartphone or smartwatch. That’s definitely something to keep an eye on.
For now, as QuantaFlo has single digit market share and the rest of the market is dominated by an inferior product, there’s still plenty of room for growth – even if competition comes in.
I believe that the weakness in the variable fee segment is only temporary. The company keeps winning new clients and developing new products. Now, I don’t know for how long it will continue, but the fact that investors got spooked has created a buying opportunity throwing the share price down 45% from its All-Time-Highs.
The company is estimated to be making around $2.7 in Earnings-per-Share in 2022. At today’s price of $82, that means investors are currently paying 30 times earnings (or an earnings yield of 3.3%).
Through a deep-value investor’s eyes, this might seem like a lot. But the odds of Semler doubling its revenue (and profits) in the next 5 years are very high.
That’s why I’m buying a €5.000 starters position in Semler Scientific. The stock will enter the Portfolio on Monday and it will go directly to the “Long Term” basket.
I will consider adding to my position if the stock price comes down or, on the opposite side of the spectrum, if the new products show good market potential.
I would like to hear your anonymous opinion!
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