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Simulations Plus, Inc. develops and produces software for use in pharmaceutical research and education, as well as provides contract research services to the pharmaceutical industry. Its software products include ADMET Predictor that offers numerical models for predicting absorption, distribution, metabolism, excretion, and toxicity properties of chemical compounds from their molecular structures; MedChem Studio, a tool for medicinal and computational chemists for data mining and designing new drug-like molecules; DDDPlus, a software program that is used by formulation scientists to reduce the number of cut-and-try attempts to design new drug formulations, as well as to design in vitro experiments to mimic in vivo conditions; and GastroPlus that simulates the absorption, pharmacokinetics, and pharmacodynamics of drugs administered to humans and animals. The company also provides contract research and consulting services in the areas oral absorption and pharmacokinetics.

In addition, it develops and sells interactive, educational software programs that simulate science experiments conducted in middle school, high school, and junior college science classes, as well as provides Abbreviate, a productivity software program. Further, the company designs and develops computer software and manufactures augmentative communication devices and computer access products for physically disabled persons. It markets augmentative and alternative communication products to speech pathologists, occupational therapists, rehabilitation engineers, special education teachers, disabled persons, and relatives of disabled persons, through a network of employee representatives, independent dealers, and resellers.

The company operates in North America, South America, Europe, Asia, and Oceania. Simulations Plus, Inc. was founded in 1996 and is headquartered in Lancaster, California.

Source: Yahoo! Finance

Thesis

SLP is an undiscovered, stable-growth company in the promising pharmaceutical software sector. SLP has best-in-class technology that is starting to gain some awareness through independent third-party testing. Its Words+ division is the ugly duckling of the company as it struggles in a highly competitive, capital intensive business. It is interesting to note that Stephen Hawkings has used Words+ software since 1985. The economics of SLP's software simulation business is really starting to take over. This business exhibits high margins with limited capital needs. Subsequently we expect overall company financial metrics to improve going forward.

Here is a brief description of SLP's software capabilities from the company's 10K:

ADMET Predictor is compatible with the popular Pipeline Pilot™ software offered by Accelrys, Inc. (NASDAQ:ACCL). This software serves as a tool to allow chemists to run several different software programs in series to accomplish a set workflow for large numbers of molecules. In early discovery, chemists often work with hundreds of thousands or millions of “virtual” molecules – molecules that exist only in computer files. Chemists need to decide which few molecules from these large “libraries” should be made and tested or taken further in development. Using Pipeline Pilot with ADMET Predictor chemists can create and screen very large libraries faster and more efficiently than by running each program by itself. Perhaps the most important aspect of this process is obtaining accurate property predictions for new molecular structures, so that molecules are not filtered out of the process that would have been successful as medicines, and molecules that cannot become useful medicines are eliminated from wasteful further development activities.

MedChem Studio has become a powerful tool for medicinal and computational chemists for both data mining and for designing new drug-like molecules. Coupled with the accurate property predictions in ADMET Predictor, the two programs provide an unmatched capability for chemists to search through huge libraries of compounds to find the most promising classes and molecules that are active against a particular target. In addition, MedChem Studio with ADMET Predictor can take an interesting (but not acceptable) molecule and very quickly generate high quality analogs (i.e., similar new molecules) using several different algorithms. The result is new molecules that are predicted to be both active against the target as well as acceptable in a variety of ADMET properties.

MedChem Studio’s molecule design capabilities provide a number of ways for chemists to rapidly generate large numbers of novel chemical structures based on intelligence from compounds that have already been synthesized and tested, or from basic chemical reactions selected by the user.

DDDPlus simulates in vitro laboratory experiments that measure the rate of dissolution of the drug contained in tablets and capsules in a variety of experimental conditions. This one-of-a-kind software program is used by formulation scientists to reduce the number of cut-and-try attempts to design new drug formulations, as well as to design in vitro experiments to better mimic in vivo conditions.

GastroPlus simulates the absorption, pharmacokinetics, and pharmacodynamics of drugs administered to humans and animals, and is currently in use at numerous pharmaceutical companies, the U.S. Food and Drug Administration (FDA), and other government agencies in the U.S. and other countries. During the fourth quarter we finalized Version 7.0, which includes three major market-expanding capabilities that have been in development for over a year. This release incorporates a highly sophisticated drug-drug interaction simulation capability funded by Hoffmann La Roche, the ocular drug delivery model from our funded collaboration with Pfizer, and the pulmonary drug delivery model we developed under our funded collaboration with GlaxoSmithKline.

Competition is non-existent for some of its newer products such as GastroPlus and DDDPlus and SLP controls the dominant share of these markets. Competition seems more stiff in their MedChem Studio and ADMET Predictor/ADMET Modeler, however these programs were rated the highest among competitors in almost all categories.

Here is an explanation of testing done on simulation software from SLP's 10K:

At an international conference in Shanghai, China, in May 2008, Pfizer scientists presented a scientific poster describing a two-year study in which all four commercially available PBPK (physiologically based pharmacokinetics) simulation programs were compared for their ability to predict human pharmacokinetics from preclinical (animal and in vitro) data. The study was divided into two arms: intravenous and oral dosing. GastroPlus was ranked first in both arms. No other software was ranked consistently second or third.

SLP's balance sheet is rock solid with almost $9mm in cash ($49MM market cap) and no debt. This in spite of using $2.2mm in cash over the past two years to buyback stock. An additional 184K of shares are left on their share repurchase program.

SLP seems to be in a sweet spot of profitability. Since increased capital expenditures aren't necessarily needed to increase sales, any revenue growth drops right to the bottom-line. A good example is last quarter when revenues increased 15% year-over-year while earning increased 32% over the same time frame. Gross margins run in the mid 70's. If SLP's Words+ business were to be sold, margins would increase further.

Continued revenue gains are likely. SLP made a number of improvements and upgrades to software last quarter, so we only have one quarter to see the new revenue trajectory, which was very positive. There is a fundamental shift in the industry that is leading to pharma's adoption of simulation and modeling tools.

Mergers among pharma companies have actually added to revenue because of the increased need for improved productivity, these companies have typically adopted in silico tools at ever-greater levels. Pharma consolidation was originally a concern of our, but upon speaking with management it is clear that they are unaffected by such corporate actions. License renewal rates have been in the upper 90's over the past couple of years with the most likely cause of losing a license coming from temporary employment shifts of one pharma employee leaving to go to another firm, upon which they re-license SLP's software.

The first thing that came to mind when researching the company was our assumption that pharma companies were already using internally built modeling and predictive software. This isn't necessarily the case. While some pharma companies do have internal products, it is not as sophisticated, accurate, or reliable as SLP's products. As CEO Mr. Woltosz has said, pharma is in the industry of making drugs, not building software.

SLP's predictable and growing sales has been done with no sales team. SLP prefers to have customers interact directly with engineers and developers so they are able to answer questions about every facet of the product. The company already works with the largest 25 pharma companies so its license growth is coming from within different divisions of the organization.

SLP has shown pricing strength as 20% of the revenue growth in 2010 came from price increases on its software. The number of licenses grew despite the price increase. The cost of a license is typically a small portion of the client's budget, which makes for strong pricing power.

Upon speaking with management, it is clear that Words+ is on the market for the right price. There aren't too many synergies between these two businesses. With Words+ sold, the financial metrics will only improve and it would position the company for a takeover. Co-founder and CEO Mr. Woltosz has a passion for flying jets and has a pilots license, so we could see him selling at the right price while he is still relatively young. He sells some shares in the company every month to fund his flying hobby. Our thesis is not predicated upon the sale of Words+. SLP is a highly profitable, growing cash-flow machine with a strong balance sheet.

Management and Stewardship

The firm was founded by Mr. and Mrs. Woltosz in 1981 and was originally the Words+ division. It was started, in part, out of necessity since Mr.. Woltosz's mother was diagnosed with ALS. It was thought that some of the inventions would help his mother better cope with this devastating disease. The software modeling was later developed and expanded with a few acquisitions.

Management has done a good job allocating capital. SLP wouldn't be where it is today without its expansion into the software and modeling business. Pre-tax return-on-invested-capital has averaged 24% over the past four years.

Management has done a good job of returning capital to shareholders through share repurchases. They haven't found any acquisitions to be done at the right price and felt their stock was undervalued so they have purchased almost 10% of shares since 2008. Management and the board have contemplated paying a dividend, but decided their shares were a better value.

Mr. and Mrs. Woltosz own nearly 40% of shares outstanding and clearly think like owner/operators. They try to operate the company as efficiently as possible and believe that every penny that they can squeeze out in operating performance will benefit them since they are such large shareholders.

Valuation

SLP is classified as a micro-cap growth company. Here is how the capital structure looks:

Market Value:
Net Cash = $8.88
Market Cap = $49.4
Enterprise Value= $40.5

Revenue and earnings have been remarkably consistent and resilient, even through the economic recession. Revenue has increased 11.5% and 17.65% annualized over the past ten and five years respectively. Earnings per share have increased 52.4% per year over the past five years.

SLP has generated $2.5mm in free-cash-flow (FCF) over the past twelve months. Which pegs its enterprise value-to- FCF ratio at 16x, reasonable for a multiple for this growing company. We believe FCF could surpass $3mm over the next twelve months which would lower the EV/FCF multiple to 13.5x.

Based on our discounted cash flow analysis (DCF), SLP shares are worth $4.74, 58% more than SLP's current share price.

FCF Growth
LOW MIDDLE HIGH Years

  • 17.0% 22.0% 27.0% - 1

  • 15.0% 20.0% 26.0% - 2

  • 13.0% 18.0% 23.0% - 3

  • 10.0% 15.0% 20.0% - 4

  • 7.0% 12.0% 17.0% - 5

  • 2.0% 5.0% 8.0% - 6-10

  • -1.0% 0.0% 1.0% - 11-20

  • -0.3% 0.0% 0.3% Terminal

  • 10.5% 10.5% 10.5% Discount Rate

  • -2.0% -2.0% -2.0% Dilution

  • $3.58 $4.74 $6.43: Total per share IV

  • 23.4x 31.0x 42.0x: Multiple to Y0 FCF

  • 0.8x 0.6x 0.5x: Price% of IV

To achieve our targeted upside of 30%, we would recommend purchasing the shares at, or below, $3.32.

  • Share Price: $3.00 as of 01.25.2011

  • Intrinsic Value: $5

  • Buy Below: $3.44

Variant View and Risks

Some 43% of revenue was from one customer, however, this customer is a dealer and represents many individual clients. SLP's management is constantly looking for acquisitions to bolster the company's product offering. There is no guarantee that these acquisitions will be profitable. SLP is small and doesn't have the resources of much larger organizations, if a large competitor entered, then SLP may not be able to compete.

Sources: Company web-site, sec.gov, company filings, Yahoo! Finance, Morningstar.com, Data provided by EDGAR Online’s I-Metrix Professional, XBRL-enabled application

Source: Simulations Plus: Flying Under the Radar