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An Ounce of Prevention is Worth a Pound of Cure ...

A blockbuster drug has the potential to generate enormous profits for the company holding the rights to it. Despite the enormous enthusiasm surrounding new drugs, the road to regulatory approval is littered with dozens of failures for every major success. The recent collapse of Celsion Pharmaceuticals (NASDAQ:CLSN) provides a particularly salient example of the "all or nothing" nature of many biotech companies. Though the right drug has the ability to radically alter the fortunes of a company and the health of many patients the world over, the production and research of the next panacea is always a time consuming and extremely costly endeavor. Any method to mitigate such cost, especially early in the process, is likely to be in constant demand by pharmaceutical companies as they try to maximize the benefit derived from the dollars invested in their R&D efforts.

The Rise of the Machines ...

As computation speed has improved, technology has become an ever more critical element of pharmaceutical research. The use of predictive models and programs designed to test the viability of compounds intended for human or animal consumption provides a significant benefit to the pharmaceutical industry. A short period of rapid computation and virtual modeling has the potential to save millions of hours of labor and, potentially, billions of dollars of R&D expenditure. If the molecule is found to be inefficiently absorbed in vivo or to have an unusual interaction with proteins common in living organisms, research on the compound stops before further economic effort is sunk into the project.

A Solution...

A company that specializes in software for medical research is Simulations Plus (NASDAQ:SLP), a small producer catering to a niche market of products designed for application in the fields of pharmaceutical research and education. As companies race to develop cures to the ailments of mankind, there is a chance that they are using the software produced by this company.

Currently, Simulations Plus produces five software products designed to augment pharmaceutical research. The software is designed to predict the likelihood a molecule designed by research chemists has of being successfully and safely absorbed by the body through the application of numerous predictive statistical methods and models for molecules created by chemical engineers.

I like the company because of the consistently high margins generated by the enterprise, the enormous amount of molecular research that pharmaceutical companies will continue to need to perform and high levels of insider ownership. The company is also a lean and efficient entity, employing 25 people yet able to generate a net profit margin of over 20% and a healthy return on assets. Prior to the sale of its subsidiary, Simulations Plus was also engaged in producing software for disabled individuals, under the Words+ brand, however that portion of the company was sold in 2012, rendering Simulations Plus a pure play in the pharmaceutical software sector.

The stock is currently priced at $4.35 per share against $0.94 of book value and $0.71 of cash per share, with zero debt with a current P/E of 26. Simulations Plus has a market cap just shy of 70M and is listed on the Nasdaq. The company, per its most recent 10-K (which can be found here), has also engaged in share buybacks, with its most recent purchase coming at a price of $3.45 per share in 2011. The company also has recently introduced a dividend in 2012 to yield 4.6%, offering an attractive opportunity for a dividend conscious investor.

Another strength I find in the company is its wide distribution network across the globe in addition to not having to rely upon any single entity for a majority of it's business. In the company's 2011 10-k, the largest customer of Simulations Plus, itself a distributor, accounted for only 11% of the companies total sales.

The Risks

A big reason I often eschew investing in the software technology field is because of the fact that it is a highly competitive industry with innovations coming both rapidly and often reducing competition totally. I believe one of the biggest risks to Simulations Plus in this sphere of technology is the computing architecture utilized by the famous, "Jeopardy!"-winning, IBM (NYSE:IBM) computer Watson which may have the potential to be applied in the field of virtual molecular testing and design in the future. Despite this risk, I also believe that Simulations Plus has the potential to be acquired by a much larger force in the industry and have their technology incorporated into an advanced computing unit oriented towards medical support or pharmaceutical research.

The stock also has a low volume and trades at more than 2.5 times the amount of cash per share plus book value, representing a significant premium paid by the shareholder for future growth and intangible factors including intellectual property and the considerable talents of the staff (of which over half hold PHD's per the companies 10-K)

Trade secrets and intellectual property are critical to maintaining a competitive advantage in this field and if undermined, stolen, or leaked the company could face a significant erosion of profitability.

Despite these risks, I believe that Simulations Plus has potential and provides exposure to a growing niche of the software market, pays a strong dividend and is well situated to take advantage of the future advances in pharmaceutical research.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SLP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Value In Pharmaceutical Research: A Niche Software Producer