Simulations Plus, Inc. Q3 FY2022 Earnings Call

Greetings, and welcome to the Simulations Plus Third Quarter Fiscal 2022 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce Brian Siegel from Hayden IR. Thank you, Mr. Siegel, you may now begin.

Good afternoon, everyone. Welcome to our third quarter fiscal 2022 financial results conference call. With me today is our CEO, Shawn O’Connor; and CFO, Will Frederick. After their portion of the call, we will open the floor to questions. Before we begin, I would like to remind everyone that except for historical information, the matters discussed in this presentation are forward-looking statements that involve a number of risks and uncertainties. Words like believe, expect and anticipate mean that these are our best estimates as of this recording, but that there can be no assurances that expected or anticipated results or events will actually take place. Our actual future results could differ significantly from those statements. Factors that contribute to such differences include, but are not limited to, our ability to maintain our competitive advantages, acceptance of new software and improved versions of our existing software by our customers, general economics of the pharmaceutical industry, our ability to finance growth, our ability to continue to attract and retain highly qualified technical staff, and our ability to identify and close acquisitions on terms favorable to the company in the sustainable markets. Further information on the company’s risk factors is contained in the Company’s quarterly and annual reports filed with the United States SEC. With that said, I would like to turn the call over to Shawn O’Connor. Shawn?

Thank you, Brian. We had another strong quarter with growth across both our software and service businesses and encouraging underlying data supporting our long-term view for sustainable top and bottom line growth. The 17% revenue growth was purely organic. Our software business grew 16% year-over-year and accelerated growth rate compared to last year. We experienced growth across all our client segments, but saw improving penetration into smaller customer accounts. This is an indicator of deeper adoption of modeling and simulation throughout the industry. In addition, initiatives to grow our geographic presence and expand cross-selling are benefiting our software business. As I said last quarter, we expected our services backlog to support increased revenue growth during the second half of our fiscal year. In this quarter, we experienced this with service revenue increasing 19%. We maintained strong operating leverage during the quarter, generating significant profitability and free cash flow. EPS grew to $0.20 per share, and our adjusted EBITDA margin was 42%. Moving to our third quarter software highlights. GastroPlus revenue increased 19%. We signed 6 new commercial clients and made 14 upsells. Additionally, we saw good growth from Asia despite significant foreign currency exchange rate impacts. I’d also note that GastroPlus was referenced in 16 peer-reviewed journals during the quarter, supporting our progress in making simulation and modeling mainstream in drug development. In April, we announced a new funded collaboration with a large pharmaceutical company to expand and validate the mechanistic in vitro dissolution models using DDDPlus software. Recent enhancements to the tool are focused on improvements to in vitro analysis. Through this new collaboration, we will expand into the injectable product space and apply our novel approaches to capture dissolution kinetics within in vitro systems designed by our industry partner. This funded collaboration is specific to DDDPlus, but the results will benefit users and developers of GastroPlus. MonolixSuite revenue increased 8% for the quarter and is up 31% year-to-date. Growth rates declined in the quarter due to the timing of renewals. We signed 10 new commercial clients, and the pattern of significant upsell upon renewal of existing customers continued. We continue to believe that MonolixSuite is taking market share in established markets and expanding its addressable market geographically in China and Japan. ADMET Predictor delivered 7% revenue growth in the quarter, but is still up 14% year-to-date. We added 6 new commercial customers and had 9 upsells in this quarter. We released version 10.4 of ADMET in the quarter, allowing users to create 3D chemical structures within the software to access property prediction models derived from our cutting-edge 3D descriptors. Turning to services. PK/PD revenue increased 29%, reversing recent trends and increasing our year-to-date growth in this area to 4%. Our good bookings result in the first half of the year contributed to a 69% year-over-year increase in the number of projects worked in the third quarter. Encouraging trends include increased consultant utilization, normal volume of project disruptions, and higher project pricing yields, which contributed to margin expansion. With improved bookings and a higher backlog, we are optimistic about the prospects for our PK/PD services business overall. During the quarter, Lixoft and Cognigen completed a newly funded project from the U.S. Food and Drug Administration and the Center for Research on Complex Generics to establish the suitability of model-integrated evidence to demonstrate bioequivalence for long-acting injectable and implantable drug products. We proposed a novel delivery design to alleviate bioequivalence trial’s lower power or long duration for long-acting injectables. The results were presented at an FDA-sponsored workshop. This project was a great opportunity to leverage our scientists and developers across the organization to show the need and relevance of the population modeling approach for LAI products and bioequivalence calculations. QSP/QST revenue increased 1% for the quarter and has grown 4% year-to-date. As you recall, this segment saw significant bookings acceleration in Q2 that allows the QSP and QST team to commence planning and initiate many of these projects in Q3. Revenue from these projects will more fully impact future quarters. PBPK revenue increased 83% this quarter and is now up 37% for the year, and the number of projects is up 152%. The performance reflects the deeper implementation of PBPK modeling into new use cases and an increase in the perceived value of these projects and the impact on drug development cycles. Overall, our services backlog continued to grow, increasing 34% during the quarter, providing further evidence that the challenges and disruptions in the second half of last year are behind us. On the heels of our robust performance year-to-date, heading into the fourth quarter, we are currently at the high end of our 10% to 15% revenue guidance for the full year. Given that we are nearly halfway through the quarter, we’re comfortable narrowing our guidance range to $52 million to $53 million or 12% to 15% growth. Within these ranges, we expect software to be approximately 60% of total revenue. Note that the fourth quarter is typically our seasonally slowest quarter. On the software side, the seasonal impact is especially prominent for Lixoft, where buying decisions are typically made early in our fiscal year, driving higher revenue growth rates in the first half of the year. On the services side, it is common for projects to be pulled forward into our third quarter or pushed out of our fourth quarter into our fiscal first quarter. This is due to our customers taking vacation time during the summer months especially in Europe. Concerning M&A, we continue to evaluate opportunities, and we are seeing some levels of valuation rationalization. We will update you when there is something to announce.

Thank you, Shawn. Total revenue growth rate was 17% in the quarter, comprised of 16% software growth and 19% services growth. Software represented 64% of revenue during the quarter, which continues to be above our 55% to 60% fiscal year guidance. Our total revenue growth rate was 15% year-to-date, with software growing 20% and services growing 8%. Software accounted for 63% of total revenue and services contributed 37%. Software gross margin was 92% for the quarter, up from 90% last fiscal year due to higher revenue and leverage from the cost of revenue line. Service margin was 66%, up from 63% last fiscal year due to improved consultant utilization and an increase in higher-margin services projects. Total gross margin increased year-over-year to 83% due to the higher software mix. Software gross margin was 92% year-to-date, up from 89% last fiscal year. Services margin was 62%, essentially flat to last year. Total gross margin increased slightly to 81% due to the higher software revenue mix. For the quarter, GastroPlus represented 67% of software revenue, MonolixSuite was 11%, ADMET Predictor was 17% and other software was 6%. Year-to-date, GastroPlus represented 59% of our software revenue, MonolixSuite was 18%, ADMET Predictor was 17% and other software was 6%. For the quarter, our renewal rate for commercial customers was 92% based on fees and 87% based on accounts. As a reminder, our quarterly renewal rates fluctuate year-to-year when customers renew before their license term ends in the following quarter or the following quarter after their license terms ends in the current quarter. The decrease in the renewal rate based on fees this quarter was also impacted by foreign currency exchange rates. Average revenue per customer dipped slightly this quarter, but remains relatively in line with historical trends. This reflects our normal price increases and ongoing upselling efforts, offset by changes to our discount structure for multiyear deals. Year-to-date, our renewal rate for commercial customers was 96% based on fees and 89% based on accounts, which continue to be in line with historical rates. Average revenue per customer is down slightly year-to-date, but remains relatively in line with historical trends. We also now have 190 University+ customers in 49 countries. As previously mentioned, this program offers free use of our software for students and educators to help prepare the next generation of scientists and contribute to the rapid development of safer, lower-cost treatments for patients worldwide. Shifting to our services business. Our third quarter services revenue breakdown was as follows: 47% from PK/PD services, 23% from QSP/QST services, 25% from PBPK services and 5% from other services. Our year-to-date service revenue breakdown was as follows: 46% from PK/PD services, 27% from QSP/QST services, 20% from PBPK services and 7% from other services. Regarding key service metrics, total service projects increased a robust 50% this quarter compared to last year, and backlog increased by approximately $5 million from last year to $17 million. Now turning to our consolidated income statement for the quarter. Total R&D costs for the quarter were $1.4 million or 9% of revenue compared to $1.5 million or 12% revenue last fiscal year. R&D expenses were $0.7 million or 4% of revenue compared to $0.7 million or 5% of revenue in the same period last year. Capitalized R&D was $0.7 million or 5% of revenue compared to $0.8 million or 7% of revenue in the same period last year. SG&A expense for the quarter was $6.8 million or 45% of revenue compared to $5.1 million or 40% of revenue last year. As we mentioned last fiscal year, Q3 SG&A was lower by approximately $700,000 due to salary expense that shifted to Q4 when we switched from a semimonthly payroll to a biweekly payroll during the fiscal year. The increase in SG&A expense was primarily due to increases in personnel costs driven by increased headcount and salary increases due to competitive wage pressure and a tight labor market, increases in trial costs as COVID-19 restrictions have been removed, allowing for more in-person conference attendance, and increases in the cost of cyber and D&O insurance. Income from operations increased 9% to $4.9 million, and operating margin was 33% compared to 36% last year, reflecting the quarterly timing and increase in operating expenses. Income tax expense was flat from last year at $0.7 million while the effective tax rate decreased from 16% to 15%. This quarter, we recognized the benefit of R&D tax credits from prior year’s tax return amendments that we filed recently. This benefit also reduced our effective tax rate for the quarter compared to the rate for the first two quarters. Net income increased modestly to $4.1 million compared to $3.8 million last year. Diluted earnings per share increased 11% to $0.20 compared to $0.18. Keep in mind that the lower growth rates for net income and EPS relative to last year were due to the impact of the payroll expense shift from Q3 to Q4, previously mentioned. Adjusted EBITDA and adjusted EBITDA margin was $6.3 million or 42% compared to $5.9 million or 46% last year. Similar to net income and EPS, the decline was primarily due to the payroll expense timing last year. As a reminder, we calculate adjusted EBITDA by adding back stock-based compensation expenses, and when applicable, any expenses related to M&A or other noncash non-operating expenses. We provide a reconciliation of this non-GAAP metric to net income to relevant GAAP metric in our earnings release and on our website. For our year-to-date income statement, total R&D costs year-to-date were $4.7 million or 11% of revenue compared to $5.1 million or 14% of revenue last fiscal year. R&D expenses were $2.4 million or 6% of revenue compared to $2.8 million or 8% of revenue in the same period last year. Capitalized R&D was $2.3 million or 5% of revenue compared to $2.3 million or 6% of revenue in the same period last year. SG&A expense year-to-date was $17.4 million or 41% of revenue compared to $15 million, also 41% of revenue last year. Similar to the quarterly variance, the increase in year-to-date expenses was primarily due to increases in personnel costs, travel costs, cyber and D&O insurance costs as well as increases in stock compensation and software licenses due to the implementation of Microsoft Dynamics 365, ERP and CRM. Income from operations was $14.2 million, an increase of 28%. And operating margin expanded to 34% from 30% last year, reflecting increased revenue, expense management and the leverage inherent in our software and services mix. Income tax expense was $2.7 million versus $1.4 million last year with our effective tax rate increasing from 13% to 19%. Last year, we saw a lower effective tax rate, primarily driven by the tax benefit associated with disqualifying dispositions. Net income is up 22% to $11.5 million, and diluted EPS is up 22% to $0.56. Adjusted EBITDA increased by 23% to $18.7 million this year, while adjusted EBITDA margin expanded to 44%. We ended the quarter with cash and short-term investments of $122.5 million and no debt. Cash decreased slightly due to the payment this quarter of the holdback and final earnout amounts with the Lixoft acquisition. We remain well capitalized with sufficient cash to support our continued expansion through internal investment and potential M&A activity.

Thank you, Will. Through three quarters, the year is unfolding as expected with continued strength in our software business and a noteworthy rebound for our service business. New versions of our software, expansion into new geographies and improved cross-selling give us confidence in our software revenue growth, while an increasing backlog with significant increases in the number of projects in our service business give us confidence that we are well positioned headed into fiscal ‘23. Longer term, the use of modeling and simulation solutions as a way to bring in silico-based efficiency to the drug development market continues to expand. Increasingly, our solutions are core parts of a robust drug development program, and the use of our solution by regulators and our University+ program validate our place in this ecosystem. In addition, the increased use of our software by smaller biotechs is a positive leading indicator demonstrating that a growing number of clients are adopting our modeling and simulation solutions. In February, we conducted our second annual Model-Informed Drug Development, or MIDD conference, featuring speakers from the FDA; the Brazilian regulatory agency, Anvisa; Health Canada; and MHRA UK. This event provided attendees with case studies, global regulatory perspectives on the development and validation of MIDD. We also had sessions covering the building and validating and machine learning models and using population PK/PD approaches to support late-phase dose selection. I’m particularly proud of the Women in Science roundtable, led by Cognigen’s Divisional President, Jill Fiedler-Kelly. This event highlighted meaningful topics for women within the scientific pharmaceutical industry, including the power of mentorships, closing the STEM gap and bringing your authentic self to the workplace. All talks are available for replay in the Simulations Plus resource center and on our YouTube channel. With that, I’ll be happy to take your questions. Operator?

Our first question comes from Matt Hewitt with Craig-Hallum.

Good afternoon, and congratulations on the strong quarter. Maybe just a few questions. First one, high level, Shawn, what are you seeing in the market? Obviously, there’s been a lot of concern over the past quarter or so regarding pharma, biotech, funding, given what’s happened in those markets. Anything that you’re seeing, I think, would be helpful.

Yes, Matt, thanks. Our visibility is actually quite positive in terms of both small pharma and small biotech. Their investments in modeling and simulation, which has historically lagged the larger players in the industry, has really picked up, not just in the sense of consulting acquisition, but also in the movement of modeling people into their organization, hiring earlier. I think that’s reflective of the recognition of modeling and simulation, the impact it can have, and commitment to it from top to bottom in the industry. Certainly, the funding challenges are out there, especially in the biotech segment. And we’re cautious in terms of counting on that business in the long haul. But we’ve seen a pickup in terms of number of customers there, albeit small footprints in terms of small projects, single seat licenses and whatnot. And so, I see the positive in terms of it being endorsement in terms of modeling and simulation and its penetration of adoption, and yet cautious in terms of those organizations that are on a tighter budget today because of the funding situation.

That’s helpful. Thank you. Maybe a question regarding the income statement. How should we be thinking about gross margins here in the fourth quarter? You provided some revenue guidance. Should we anticipate that maybe the software gross margins kind of stay in that low-90s range? But, I’m not quite sure what we should anticipate from a service margin as you kind of see a slowdown here as you typically do in the fourth quarter.

I believe our service margin has remained relatively stable over the past few quarters, with some efficiencies coming into play. However, we are facing significant pressure regarding compensation for our scientific staff. The largest impact on our blended gross margin will stem from the balance of software revenue and consulting revenues. We have been experiencing a higher proportion of software revenue, exceeding the usual 60-40 split, which has positively influenced our overall margins this year. We expect this trend to continue. In the fourth quarter, we typically see slower performance in both areas of our business. This is especially true for the software side, as there are fewer decisions made during the summer months due to our clients' fiscal cycles, coupled with the usual slowdown during vacation season affecting the consulting side of the business.

Got it. One last question before I return to the Q&A. Will, could you help me out with this? I’m curious if you calculated a constant currency renewal rate for the software business you mentioned, given that currency or foreign exchange was a factor in the decline you observed. What was the constant currency renewal rate?

Yes. It would have upticked a couple of percent. I mean, we had about a $200,000 impact on currency exchange this quarter.

Our next question comes from the line of François Brisebois with Oppenheimer.

Hi. Congrats on the quarter. Just a couple of questions here. In terms of guidance for next year, can you just remind us maybe historically what gives you the confidence to start looking at that kind of guidance?

Yes, thanks, Frank. We will discuss next year's guidance at the end of the quarter. This year, we provided guidance of 10% to 15%, which reflects the strong momentum in our software business as we entered this quarter, along with the service business that has ramped up from fiscal year '21 to fiscal year '22. As we look ahead to '23, we will continue to benefit from strong performance across our three main product areas: GastroPlus, Monolix, and ADMET Predictor. On the service side, we have successfully built up our backlog in the first half of this year, leading to a positive growth trend in the second half. Going into next year, both sides of our business are expected to operate from a position of strength compared to how we started this year. Thus, when we close out the year and issue next year's guidance in a few months, I am optimistic that we will see continued strength in the business.

Great. If you expect software to be greater than 60%, should we interpret that to mean that there will be a slight reduction in the services side compared to what you initially anticipated? Were the service bookings a bit softer than you expected? Any insights on that?

In terms of the fourth quarter specifically, Frank, or longer term?

Yes. The 60% growth in the final year is notable. Given the service bookings you've observed and the expectation of growth exceeding 60%, does that suggest that there might be some weakness in the services segment compared to previous expectations, or is that not the case?

Yes. Historically, the fourth quarter is relatively soft on the services side. So, that’s what that mix between the two businesses, also on both sides of our business, it’s more dramatic on the service side.

Okay, great. I know you mentioned that you'll address it when there's something to share. But regarding the valuations making more sense in terms of M&A, are you referring to discussions happening? Are people starting to realize that their previous valuations might have been too high? Any insight you can provide would be helpful.

Yes. I mean, it’s multiple discussions ongoing and some new discussions out there. Clearly, the market impact in terms of the people view their alternatives are perhaps going public, getting private funding or partnership through acquisition. Certainly, the opportunity that is presented to them from either of the other two directions in terms of IPO or funding is a little bit more challenging now. And therefore, the discussions in which the acquisition alternative is being looked at on the part of potential partners out there is certainly picked up of late. So, valuation is always a negotiated item, not something that is simple, but certainly compared to a year and a half ago, when both factors were a little different, funding alternatives existed with a little bit more opportunity and the IPO opportunity was also a little stronger. Discussions today are certainly much better in terms of valuation.

Okay. That’s helpful. Thank you very much, and congrats again on the quarter.

Yes. Take care.

Our next question comes from Dane Leone with Raymond James.

Hi. Thank you for the opportunity to ask questions, and congratulations on your progress. I have a specific question regarding the services sector. It seems there may have been higher expectations for growth in services this quarter, but the actual number is still lower than the comparison from Q3 2020. There’s also a slight decline in backlog, which is now at $16.7 million compared to $17 million last quarter. I’m interested to know if there are any updated expectations for the fourth quarter and if you've observed any trends that indicate potential softness in services compared to your earlier forecasts. The motivation behind my question is that many biotech companies I work with are currently facing increased funding challenges and are reevaluating their spending as we progress through this year. Thank you.

Yes, I understand, Dane. The decline we’re seeing in the service side of the business is related to vacations. After a couple of years heavily impacted by COVID, people are now taking vacations they previously skipped due to being homebound. This situation highlights seasonal trends rather than indicating cancellations or slow bookings. We actually grew our service backlog by over 30 percent in the last quarter. Our small biotech clients represent just a minor part of our customer base, so their funding fluctuations have limited effects on our overall business. Although we have seen an uptick in the number of customers in that segment, it still constitutes a small fraction of our total service and software businesses. While there is some softness, our service performance has improved since the start of the year and will likely continue to do so, reflecting typical summertime seasonality.

And maybe one follow-up, if I could. In terms of conducting potential business development deals or right acquisitions, are you getting more positive on the ability to execute transactions on the services side or on the software side? Thank you.

I wouldn’t say my view is shifting there at all. Opportunities exist on both sides of the ledger there. Software in terms of products that would be good tuck-ins and extensions of our portfolio of data analytical tools. On the service side, we’re always looking for opportunities, a to bring in a good skill set of scientific consultants and the book of business, expand our service offerings there, and especially looking to extend our geographical coverage, which is primarily focused in the North America region. So, has there been any change in terms of either our target population out there or our preference? The answer would be no. And in terms of valuation discussions, I would say, the change in evolution in terms of valuation discussions are very similar on both sides of the ledger there.

Thanks. And maybe a final question for me. Could you just update us in terms of the business strategy in Asia to get exposure? And any hiring you’ve done over there or just kind of plans for the remainder of the year? Thanks.

Yes, certainly. Asia is a distributor-covered marketplace for us. We have distributors in China, South Korea, Japan, and India. The Japanese market has historically been our highest performer. We’re seeing good growth and opportunities in each of those regions. In the last quarter, we hired a direct employee in the Indian market to assist our distributor there in a more timely manner and to take on some consulting service opportunities we identified in that marketplace. I believe this will continue to evolve as we look to allocate more resources to support our distributors in that region moving forward.

It appears there are no further questions at this time. I will now turn the floor back over to Mr. Shawn O’Connor for closing comments.

Thanks, operator, and thanks, everyone, for your interest in the company and joining the call today. I look forward to reporting again in a short interval of time next quarter at the end of our fiscal year. Take care.

And this concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.