Earnings Call Transcript - SLP Q3 2020

Operator, Operator

Welcome to the webinar. You’ve entered as an attendee in listen-only mode.

Cameron Donahue, Moderator

…CEO, Shawn O’Connor; and the company's CFO, John Kneisel. An opportunity to ask questions will follow today's presentation. Before beginning, I'd like to remind everyone that with the exception of historical information, the matters discussed in this presentation are forward-looking statements that involve a number of risks and uncertainties. The actual results of the company could differ significantly from those statements. Factors that can cause or contribute to such differences include, but are not limited to, continued demand for the company's products, competitive factors, the company's ability to finance future growth, the company's ability to produce and market new products in a timely fashion, the company's ability to continue to attract and retain skilled personnel, and the company's ability to sustain or improve the current levels of productivity. Further information on the company's risk factors is contained in the company’s quarterly and annual reports filed with the Securities and Exchange Commission. With that said, I’d like to turn the call over to CEO, Shawn O’Connor. Shawn?

Shawn O’Connor, CEO

Thank you, Cameron. This was an excellent quarter for Simulations Plus, despite challenging economic conditions resulting from the COVID-19 pandemic. Fortunately, the pandemic's impact on our company has been relatively minimal and in the third quarter of fiscal year 2020, we delivered another strong quarter of results. Our stated goal of delivering organic revenue growth of 15% to 20% was exceeded with 24% revenue growth and a total of 18% organic revenue growth. This was our fourth consecutive quarter with total revenue growth in excess of 20%. Our software revenues represented 56% of our total revenue and grew 18% to $6.8 million, while our service revenue represented 44% of total revenue and grew 32% year-over-year to $5.5 million. Notably, each of our operating divisions delivered double-digit revenue growth ranging from 12% to 39%. Our gross margin improved to 78% overall. Software gross margin was 90% in this seasonally high revenue growth quarter, while service gross margin rose to 63% in the quarter driven by excellent performance by our Cognigen division. Excluding the effect of one-time transaction expenses of $1.1 million from our acquisition of Lixoft, our profitability metrics in the third quarter all showed improvement. SG&A expense was 32%, aligning with our expectations of 35% for the year. Net income before taxes as a percentage of revenue was 40%. Earnings per share excluding the impact of acquisition expenses was $0.20, up 25% over last year. Finally, EBITDA as a percentage of revenue was 46%, again excluding the one-time acquisition expenses. This was an excellent quarter for the company. Thankfully, the impact of the COVID pandemic on us here at Simulations Plus has been relatively minimal. From an operations perspective, we successfully transitioned our workforce to a remote model for most of the quarter, with a small group beginning to return to work on a voluntary basis in June. Fortunately, prior to the start of our stay-at-home orders, approximately 40% of our workforce was already working remotely and nearly everyone was equipped with the tools needed to transition from office to home rather seamlessly. As a result, there was minimal internal disruption to our business and productivity remains high. I anticipate the remote workforce percentage will remain high on an ongoing basis into the future. Our workforce is highly engaged in supporting our clients and pursuing new business. We're advantaged with a portfolio of business that is largely insulated from market cycles and shocks such as the COVID pandemic. Approximately 85% of our software revenue and 47% of total company revenue this quarter were derived from software renewals, which have experienced no impact to date. Our service business operates off a large backlog which we continually review and validate. Our backlog at the end of the third fiscal quarter was more than $12 million representing more than three quarters' worth of average service revenue into the future. At this point in time, we anticipate any impact to our backlog from the COVID virus will be less than 10%. Just as important, our strong balance sheet and cash position are more than adequate to support the ongoing operations of our business initiatives for growth and our track record of consistent quarterly dividends. We ended the quarter with more than $7 million in cash and added an additional $3.5 million credit facility as a backstop, which remains undrawn. That is not to say we haven't seen some impact during these difficult times. As previously communicated, securing new business has been impacted due to the pandemic, which has disrupted our clients' decision-making and spending activities. For most of the third quarter, we experienced a slowdown in new business closures, particularly in terms of new software licenses, especially in Asia, and new service business. However, lead generation, virtual meetings, and presentations are continuing in both our software and services businesses. With the cancellation of most industry conferences, we've been able to conduct training and workshops virtually and have successfully transitioned sales activities from face-to-face meetings to virtual meetings. As a result, our pipeline of new business opportunities is growing, and exiting the fiscal third quarter at the end of May, we began to see an increase in new business closures for software license agreements and consulting contracts. It's too early to assess whether this trend will hold, but I am cautiously optimistic at this time. In addition to having Monolyx from Lixoft in our sales offerings, we've introduced two new service offerings that have initiated bookings in the last quarter. The two new service offerings are Strategies Plus, which provides regulatory guidance to our clients, and our COVID Program, which provides consulting assistance to any organization involved in Coronavirus research. Both are generating new opportunities in bookings. Let me now turn to a brief comment or two specific to each division. At our Lancaster division, revenue was up 12% to $6.7 million for the quarter. Breaking this down, 79% of Lancaster revenue was derived from renewals, 10% from new sales, and 11% from consulting services. In our software business, renewal rates remained high at 88% on an account business and 94% on a fee basis. New licensing units grew by 10% year-over-year. Our new regulatory services offering generated approximately $250,000 in bookings during the third quarter, and we added 11 new commercial companies, including new licenses in the US, Europe, Japan, and Brazil, expanding our presence with nonprofit research groups, academic institutions, and regulatory agencies. We're engaged in Lancaster projects with 28 companies and seven funded collaborations. We ended the quarter with 45 full-time employees at our Lancaster division, up one from 44 in the prior quarter and up 4 from 41 last year. At our Buffalo division, revenue was up 20% to $3 million for the quarter. Just as important, we made significant improvement in our gross margin, which increased to 56% of revenue, up from 52% in the year-ago quarter, as the division focused on internal project process efficiencies. We signed 33 contracts and initiated 18 new projects during the quarter. Overall, we have 64 active projects across 31 companies and 28 proposals outstanding with 24 different companies as of July 1. We ended the third quarter with 45 full-time employees at our Buffalo division, down 7 from 52 in the prior quarter, and level with 45 last year. These comparisons are impacted by a reduction implemented in software development staff, no longer required to support project work efforts. The underlying growth of consulting staff is 41% year-over-year. Our DILIsym revenue increased 39% for the quarter to $1.9 million. Breaking this down, revenue related to DILIsym software and service projects represented approximately 55% of the total, while RENAsym model services represented 5%, IPF model services represented 22%, and RENAsym grant service revenues represented 10%. Finally, the heart failure model contributed revenues totaling about 8%. DILIsym has 13 active consulting projects and seven active consortium contracts at this time. We ended the quarter with 21 full-time employees in our RTP division, up 3 from 18 in the prior quarter and up 4 from 17 during last year. During the quarter, we completed our acquisition of Lixoft, the developer of the highly regarded Monolix suite and modeling platform that covers a wide range of data types and statistical features for population, PK/PD modeling that is widely used by academia, pharma, and regulatory agencies. This acquisition immediately expanded our presence in Europe and rebalanced our mix of software and consulting revenues to be weighted more towards software licensing. Lixoft contributed two months of performance to our results in the third quarter, totaling about $600,000 in revenue which represents a 15% growth over the revenues in the same period last year, while operating independently. The customer accounts rose to 52, a 23% increase over last year, and the software renewal rates are 84% on fees and 98% on accounts. Post-acquisition, integration efforts are going well and are focused on four primary areas: first, the integration of Monolyx into existing direct and distributor sales processes; second, the evaluation of integrated software product development volumes; third, the initiation of Monolyx-based consulting service offerings and the training of our consulting staff on the platform; and finally, the integration of the Lixoft organization into the company's business processes and infrastructure where appropriate. I'm pleased to report that, while just at their beginnings, progress has been made across all these objectives. I'll now turn the call over to John to review the detailed financial results.

John Kneisel, CFO

Thank you, Shawn and good afternoon, everyone. As Shawn indicated, this was an excellent quarter for Simulations Plus. Our consolidated net revenues for the third quarter of our fiscal year 2020 were up 23.8% or $2.4 million to $12.3 million from just under $10 million the prior year. The third quarter represents the fourth consecutive quarter of revenue growth greater than 20%. On an organic basis, which excludes the Lixoft acquisition, our revenue growth was 18%. Organic revenue remained steady in the high teens despite economic conditions triggered by COVID-19. The general sectors we operate in, primarily software and life sciences and pharmaceuticals, have tended to maintain momentum amidst the pandemic. Consolidated software and software-related sales increased by $1.03 million or 17.7% over the prior year quarter. Lixoft software sales accounted for $566,000 or 55% of this increase. Consolidated analytical study revenues increased by $1.33 million or 32.4% over the third quarter of '19. Cost of revenues increased by 14.7% or $341,000 resulting from increases in labor-related costs and direct expenses on contracts. We saw a decrease in travel-related expenses of $154,000 as training was conducted online due to travel restrictions. Additionally, this quarter we reported a benefit of $189,000 from royalties as the royalty agreement reached a final determination and amounts we had accrued were recognized back in the income. Total gross profit increased by 26.5% to $9.6 million representing a 78.3% gross margin in the third quarter, which is historically our highest quarter seasonally, compared to a 76.6% gross margin in the same quarter last year. Overall software margins were 90% and consulting margins were 63%. SG&A expenses, including the one-time M&A charges associated with the Lixoft acquisition of $1.1 million in the quarter, were $5 million or 41% of revenue for the third quarter of the year. This reflects an increase of approximately $1.9 million or 62% compared to the prior year. The increase in SG&A expenses was primarily due to increased selling expenses and commissions, salary and wage increases, labor-related benefits, as well as contract labor for outsourced services in support of company growth. A $195,000 of the increase came from our new subsidiary during the two months since the acquisition, and as I indicated earlier, we incurred approximately $1.1 million of acquisition-related costs in the quarter for legal, accounting, due diligence, and M&A banker-related fees. Without M&A transaction-related costs, SG&A would have been approximately 32% of revenue. We don't expect any substantive additional M&A transaction-related expenses in the fiscal fourth quarter nor do we foresee any material amounts of integration costs at this time. Research and development expenses for the third quarter were approximately $1.36 million, of which $753,000 was expensed and $606,000 was capitalized. This compares to approximately $1.07 million in the prior year, where $643,000 was expensed and $422,000 was capitalized. Income from operations was $3.9 million for the third quarter of fiscal year 2020, consistent with the prior year. This stability was primarily affected by the one-time M&A related expense associated with our acquisition of Lixoft. Our provision for income taxes in the third quarter was $844,000, with an effective tax rate of 22.3% compared to an effective rate of 25% in the prior year. The lower rate in this period was mainly due to stock compensation-related deductions. We expect our tax rate to end up in the 22% to 25% range for this fiscal year. Net income increased 1.6% or approximately $47,000 to $2.9 million in the third quarter of this year, compared to $2.9 million in the prior year. On a per-share basis, net income was $0.16 per diluted share in both this fiscal year and last year. The Lixoft related transaction lowered diluted earnings per share by approximately $0.04 per share. EBITDA was $4.6 million in the third quarter of both the fiscal year and last year. Now turning to the next line is the nine-month year-to-date comparisons. Consolidated net revenues year-to-date were up 23.5% or $6.1 million to $32 million compared to $25.9 million a year ago. Our gross margin for the first nine months of fiscal 2020 was 75.1% compared to 74% in the year-ago quarter period, an improvement of 110 basis points. SG&A expenses, including $1.4 million of one-time M&A-related costs, were $12.6 million or 39.4% of revenue for the first nine months of fiscal 2020 compared to $8.6 million or 33.2% of revenue for the same period last year. R&D expenses were $3.8 million for the first nine months, up about $500,000 from $3.3 million in the prior year. The expense portion increased $130,000 to $2.03 million. Year-to-date R&D expense is at 6.3% of revenue, down from 7.3% in the prior year. Income from operations for the first nine months of fiscal 2020 was $9.4 million compared to $8.7 million in the prior year. Net income increased by approximately $620,000 or 9.5% to $7.1 million. Diluted earnings per share were $0.39 per share compared to $0.36 for the same period last year. The Lixoft-related transactions lowered EPS by approximately $0.06 per share year-to-date. EBITDA was $11.5 million year-to-date, up 7% from the prior year. This quarter's graph shows consolidated quarterly revenues reaching their typical high for the fiscal year, followed by a decrease in revenue in the fourth quarter which coincides with the slowdown in our clients' purchasing during the summer months. Once again, the first through third quarters of fiscal 2020 have followed the same upward trend. The next line represents operating income by quarter, which illustrates a consistent track record of increases both year-over-year and sequentially throughout the first and third quarters. As you can see, the patterns for quarterly revenues and quarterly income from operations have largely held true for many years. As I noted earlier, this quarter's results were impacted by $1.1 million of non-recurring and non-operational costs related to the Lixoft acquisition. The next slide of consolidated net income by quarter shows a similar pattern with the third quarter typically being the strongest. I would also like to mention the patterns held through EBITDA with overall trends moving upward into the right, with a seasonal variation between the quarters. Like many, we are unable to predict the potential future impacts of COVID-19 with certainty. However, based on our current visibility, we expect the seasonal nature of our revenue income and EPS to continue in the coming quarters based on our annual software revenue renewal model, consulting backlog, and pipeline of new business opportunities.

Shawn O’Connor, CEO

Thank you, John. Additionally, today we filed an audit shelf registration on Form S3 with the SEC. The registration statement and prospectus allow the company to register various securities including common or preferred stock as well as warrants and/or depository shares. We have not filed a specific prospectus supplement to initiate an offering at this time, but have put the shelf registration in place for future use in support of working capital, M&A, and other general corporate purposes. Our recent qualification under the well-known seasoned issuer rules made this undertaking timely and efficient. In conclusion, we're well positioned to continue our record of strong financial performance and are encouraged by the prospects for our business despite the lingering uncertainties related to the COVID pandemic. We're off to a strong start with the integration of Lixoft and are encouraged by the opportunities that this business opens for us, particularly in Europe. Demand for our solutions remains strong, although we may experience delays in the timing of customer orders. We're confident that any short-term disruptions in the flow of new license orders will not impact the long-term prospects for our business or the investment thesis in Simulations Plus. We expect double-digit year-over-year revenue growth in the fiscal fourth quarter despite the expected impact of seasonality on a sequential basis. With that, I'd like to turn the call back to the operator, Cameron, and take any questions that you might have.

Operator, Operator

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

Matt Hewitt, Analyst

I guess first off, could you maybe talk a little bit about the cadence? I know there was a little bit of slowdown on new customer bookings in the quarter, but how has that cadence changed as the quarter progressed, and where do things currently sit? Are you seeing a stronger upturn or is there still some hesitancy?

Shawn O’Connor, CEO

Well, I'll describe it this way, Matt. We went into the quarter with reduced expectations regarding new licenses and new consulting contracts. We saw that in the last month of our second quarter and entered the third quarter anticipating a relatively slow pace. That expectation was realized as during the third quarter, our closure of new business was well below what we've historically seen. As we entered the last month of our quarter in May, things picked up a little bit, which I view positively. However, it may not be something we can definitively call a trend change just yet. So we're looking into the fourth quarter cautiously, as we will remain impacted by COVID-related slowdowns. Our customers' responses to the pandemic are varied; generally, we’ve seen activities start to pick up, but they appear to have taken a slight step back as infection rates have increased. I want to be optimistic; we certainly did better than we anticipated on reduced expectations in May, the last month of the third quarter, and I'd like to think that’s a positive trend, but I don’t think it's robust enough to conclude that clients have returned to the marketplace for us. We'll remain cautious into the fourth quarter.

Matt Hewitt, Analyst

Kind of moving down the income statement, the gross margin was at your high watermark going back to Q3 of 2017. How sustainable is this gross margin? I appreciate there’s some seasonality in play, but how should we think about this going forward?

Shawn O’Connor, CEO

I don’t see anything too significant impacting gross margins other than recent improved margins out of our Cognigen consulting operations, where we’ve found efficiencies and are seeing positive results. The third quarter is our highest revenue quarter from a seasonal perspective, so as we have expenses on a more linear basis throughout the year, our peak revenue is reflected here in the third quarter. As seasonality dictates, we expect to step down in the fourth quarter, and you'll see the patterns on an annual basis are consistent. Gross margins will certainly be impacted in the fourth quarter. So, as you model and look forward, keep in mind that there is a seasonality factor at play here. Lixoft’s addition to the mix increases our high-gross margin software business, and we’re getting closer to a balanced 55-45 split between the two revenue sources, which should also help to improve margins. So, overall, slight improvements are expected year-over-year, but I caution about the seasonal impacts.

Matt Hewitt, Analyst

Given the strong performance and the balance sheet, your profitability—have you discussed with the board about perhaps taking on a little more risk with some of your customers? In essence, could you consider a shift in your model to include partnering with customers or perhaps collecting milestones and royalties as your pipeline opportunities materialize?

Shawn O’Connor, CEO

That's a significant shift from our current model, which typically focuses on a traditional mix of software and consulting revenues. We focus on maintaining very strong profitability metrics on a quarterly basis. A move towards a royalty or milestone model involves considerable risks and would represent a significant change in our approach. However, we are open to situations that can alter our services and lead us into areas where we might deliver consulting results that may not pay off for clients until much later, potentially involving royalties in the equation. That said, we are not close to making any significant changes to our business model at this point and continue to provide good value to our clients while delivering returns to us and our shareholders under our current approach.

Operator, Operator

And our next question is from Bill. Kevin, your line is now live.

Unidentified Analyst, Analyst

Hi, good afternoon and congratulations on a strong quarter. I just wanted to bring up the shelf registration. It seems like some of the commentary indicates the timeliness of becoming a seasoned issuer. Is this timely in the sense that you are looking to engage more M&A, and if you do so, would you consider using something other than accumulated cash on your balance sheet?

Shawn O’Connor, CEO

Sure. The shelf registration is something we have considered appropriate for our company’s size and structure for a while. Achieving the seasoned issuer threshold a month ago positioned us well for this registration, facilitating a much faster filing process. In terms of potential use in the future, it doesn’t alter our approach toward acquisition activity. We closed Lixoft a couple of months ago—our third acquisition—and as I’ve said before, we’ve been executing acquisitions roughly every three years and hope to shorten that timeframe. This shelf allows us more flexibility and speed in responding to potential transactions depending on their size and our use of shares or cash. We have usually funded our acquisitions through existing resources, and this could allow us to consider larger targets down the road.

Unidentified Analyst, Analyst

That’s very helpful. Could you briefly discuss the valuation of some of the targets that you’re considering? Are they within your expected range? Perhaps are some intriguing? Lastly, have you secured any product wins related to COVID-19 from Simulation Plus, such as in antivirals or vaccines?

Shawn O’Connor, CEO

In terms of our M&A target list, we typically evaluate from small up to large, historically aiming for acquisitions around $20 million and below. The target list might expand in terms of valuation size as we move forward. With regard to our efforts concerning COVID, we’ve made attempts to contribute our expertise in modeling to assist research efforts. We have seen some small success in that regard, alongside a pipeline of discussions, grant proposals, and ongoing opportunities related to COVID research.

Operator, Operator

While we gather additional questions, I will address some that have already been submitted. The first question is from Howard Halpern with Taglich Brothers. He asks what factors will contribute to improvements and potential growth in operating margins over the next 12 months.

Shawn O’Connor, CEO

The two major factors impacting those percentage results are overall revenue growth and the mix of our software and consulting revenues. As we grow larger, some fixed expenses won’t rise with revenue growth, which we will see a little improvement there. The other major aspect is the mix of consulting revenue, which is currently growing at a rate above 30%, while software revenue is around 15%. This continual shift should favor the software side through internal product development and driving our existing portfolio’s growth faster. Acquisitions like Lixoft should also further expand our software revenues over time.

Operator, Operator

Thank you, Shawn. Next question from Howard is, over the next 12 months, what are the growth prospects for the European subsidiary?

Shawn O’Connor, CEO

Lixoft has consistently grown over the last couple of years with top-line growth rates near 30%. Their size might mean that growth will moderate as they approach $3 to $4 million in annual revenues. Initial monthly results have been promising, but they face the same challenges as the rest of our organization due to COVID. Their growth rate may decrease from that 30%, but in the long run, they should experience growth in line with our expected 15% to 20% organic rate. This should also include contributions tied to our consulting business associated with the Monolix Suite, facilitating further revenue generation.

Operator, Operator

Thank you, Shawn. The next question from Howard is regarding the $5 million five-year KIWI contract. Has KIWI made any inroads as the need for security is increasing during the drug development process?

Shawn O’Connor, CEO

Recently, there has been more emphasis on investing in KIWI and related data repositories, but overall decision-making has been affected more profoundly by analytical tools like GastroPlus and Monolix. No significant uptick has been observed in that area of our business as a result of growing security concerns.

Operator, Operator

Thank you. The final question from Howard Halpern is for modeling purposes, what is the likely quarterly increase in depreciation and amortization expense related to the Lixoft acquisition?

Shawn O’Connor, CEO

I presume that you are discussing D&A as it pertains to SG&A expense. Their model aligns closely with ours, and we expect to operate on an annualized SG&A level of around 35%, so it should comfortably fit within that relatively small operation, incorporating into our numbers with no significant changes. Lixoft will positively impact overall EBITDA since their margins are better than our pre-consolidation EBITDA percentages at Simulations Plus. Therefore, they will contribute to an increase in cash flow and EBITDA moving forward.

Operator, Operator

Thank you, Shawn. We have a few written questions from Brett, but he is on the line live, so we'll allow him to ask his questions first and then follow up with any that he submitted.

Brett Tasakiyo, Analyst

Hello, I'm here.

Operator, Operator

Your line is live. Great.

Brett Tasakiyo, Analyst

Can you hear me?

Shawn O’Connor, CEO

Yeah, go ahead, Brett.

Brett Tasakiyo, Analyst

Yes, you're live. Thank you for taking my question. The first question is, what is your current marketing/sales approach to distributing your software or other pharma companies, chemical companies, etc.? Do you have any plans to expand your proprietary software outside of pharma, bio, chemicals, or to manufacturing and other markets?

Shawn O’Connor, CEO

Our current sales process involves both direct sales and a distributor network, which is utilized in Asian markets. We focus our sales efforts primarily in the pharmaceutical sector and adjacent industries. Regarding potential expansion outside of pharma, we are not planning to enter the generic ERP space or other markets like manufacturing. We are focusing on delivering solutions within the pharmaceutical space and its adjacencies.

Brett Tasakiyo, Analyst

Japan seems like a huge opportunity for you that’s prime for penetration growth. What is your sales and marketing approach there to grow revenue?

Shawn O’Connor, CEO

Japan is indeed one of our larger non-North American markets. In Japan, we utilize a distributor network for software products, and we do some consulting business there as well. A significant portion of our revenue is driven by our Japanese representation through their subsidiaries in North America. Over time, we’re considering the potential to engage with local consulting organizations to bolster our market share in Japan. However, we haven’t acted on that yet.

Unidentified Analyst, Analyst

If you could generally speak to the resilience of the software modeling industry within the pharma space and perhaps share insights on its long-term growth prospects? It seems like where you are in the drug creation space is almost perpetually growing. Could you share some insights on the dynamics that you've observed over the past several months and your outlook for the future?

Shawn O’Connor, CEO

Absolutely. The market is indeed exciting from my perspective, having been involved for over 20 years. An evolution has occurred since those early days of trying to penetrate the pharma market. Currently, modeling and simulation have gained significant acceptance as essential tools throughout the drug development process, affecting everything from molecule prioritization to decision-making and regulatory submissions. The demand for scientists with a unique set of skills in math, statistics, biology, and chemistry supports the growth and adoption of modeling tools. A silver lining of the COVID pandemic has been the increased awareness that drug development takes far too long. We have an opportunity to improve this situation, and the modeling and simulation capabilities we offer can be crucial in enhancing the drug development cycle's efficiency and effectiveness. Looking ahead, I believe the applications of modeling and simulation will continue to expand, benefiting our clients and paving the way for a bright future in this sector.

Operator, Operator

Thank you, Shawn. This concludes the conference call today. Thank you, everyone. If you missed any part of the conference call, the replay will be available on our website. Thank you and we look forward to the next earnings call to further our dialogue.