If You Could Design the Perfect Stock...

By Elise Ralph - May 3, 2012 | Tickers: DAVE, JNJ, LTRE, NLS, SLP | 0 Comments

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Back in the late 80’s and early 90’s, I started making my first investments with a very small amount of money. I was in graduate school in the Boston area and Peter Lynch, who had huge success with Fidelity’s Magellan Fund (he averaged a 29.2% annual return), gave the oft-cited advice “invest in what you know.” I was young. What did I know? As someone born in the late 60’s, I’ve always lived in the aftermath of the baby-boomers and so I recognized that health care would become increasingly important as they aged but the details of pharmaceuticals and biotech were just not in my area of expertise.

I shrugged my shoulders and made a small investment in Johnson & Johnson (NYSE: JNJ). I trusted its brand name, its familiar logo, and how it had managed the very public crisis in the early 1980’s involving Tylenol bottles. Its size (its market cap is now roughly $180B) made it seem like a broad play in the healthcare realm. I also liked its dividend reinvestment program. Its dividends are still nicely paid; they’ve increased every year for the past 50 years and are now about 3.75% annually.  It’s a solid blue-chip stock.

However, as it turns out, I didn’t really know Johnson & Johnson and it was not a really great long-term investment for me. I don’t really understand the complications of how an enormous holding company operates. Consequently, I don’t really understand how this trustworthy company has had its recent quality control problems and legal problems and why it hasn’t moved more quickly in response. All I can see is that the share price has only increased by about one percent since the beginning of 2010. That stability, in the face of its recent problems, reflects its stability as a company but still, “things could be worse” is not really a powerful argument for investment.

My graduate work required the numerical simulation of some nonlinear systems and later, as a professor,  I wound up teaching graduate courses in how to do this. This is what I know but I’d never really seen any investment opportunities in companies that focused on this kind of work until I discovered Simulations Plus (NASDAQ: SLP). Although it operates in the pharma sphere, it is about as different from Johnson & Johnson as a company could be. With a market capitalization of roughly $73M, it is a very small microcap. At the outset, I want to be clear how small this is: Johnson & Johnson generates that amount of free cash flow every couple of days. On the other hand, other companies of a similar size such as Famous Dave's (NASDAQ: DAVE) or Learning Tree (NASDAQ: LTRE) or Nautilus (NYSE: NLS) have generated interest amongst individual investors because of their name recognition. Simulations Plus lacks name recognition but has something more valuable: a wide economic moat.

Simulations Plus creates software that simulates drug discovery as well as drug absorption and delivery. The software is licensed annually to virtually all of the major pharma companies, the NIH and the FDA; it has renewal rates in the upper 90%. The company has created a recurring revenue stream that arises from a large and essential industry that spends $50B (and growing) annually in R&D. The cost of a license is a minute fraction of a client's R&D budget. This not only gives them pricing power but also helps protect their moat. Because of the sophistication of their products and their reliability (they are unquestionably the world leader for some of their newer products), it simply would be inefficient for pharma companies to develop in-house software that competes with them.

Their approach to sales is sensible; their scientists also serve as sales people and scientific meetings are the key venues for sales and marketing. Although I am not active in research in my own field right now, I understand how important this is. When you're browsing vendors at a professional meeting, you want to be able to talk to a peer about specifics. Their participation in these meetings underscores their credibility in the field. Within this context, they've recently added a new director with significant marketing experience. By coincidence, he shares my somewhat-unusual last name; as a disclaimer, I want to be clear that we are not connected in any way.

One of the more interesting developments at Simulations Plus, and how they first caught my eye, is that they have been using their molecular design software to propose "new chemical entities" that could potentially be used as inhibitors of drug-sensitive malaria. The software has allowed them to consider a large number of potential molecules, assess their properties, and then select a handful of the most promising for synthesis. They've just announced that one of their molecules is extremely potent compared to existing molecules and thus could provide a therapeutic effect at much smaller dosages.

This result is important to the investor not because it may lead to a cure of malaria, which would be a wonderful boon to humanity, but because it demonstrates the remarkable power that their approach brings to the pharma R&D process. It's well known that it is extraordinarily expensive to bring a new drug to market in terms of time (on the order of a decade) and money (hundreds of millions of dollars). New approaches that allow properties of new molecules to be examined with a computer before they are synthesized allow a greater number of possibilities to be considered and that leads to the potential for discovering more powerful solutions. It also allows scientists to screen out problems in the early stages.

Earlier this year, the CEO, Woltosz, wrote a very readable article for the Journal of Computer-Aided Molecular Design about this sea-change in the industry, "If we designed airplanes like we design drugs ..."  He makes an analogy between how airplanes were designed in their early years with how they are designed now, through the aid of computers. I have heard another investor make an analogy between their work and the role that stock screeners play in an investor's decision-making process. It's actually more exciting than that. A stock-screener examines the properties of existing companies. What Simulations Plus does is akin to constructing artificial companies, simulating their performance, accurately assessing their properties, and then selecting the "perfect" one to put into the real world. That's cool.

An advantage of their business model is, of course, that increased revenue can come without any additional CapEx and instead flows directly into profits. In their last quarter, ending February 29th, revenue has increased for the 18th consecutive quarter and gross profit was up 8.3%; gross margins are roughly 75%. They are on track for another record breaking year. Their balance sheet is very strong. They have no debt and approximately $13M in cash. They've been using that cash wisely for the shareholder: in the recent past they have been repurchasing shares, had some strategic acquisitions and earlier this year they declared their first dividend. At current share prices of about $4.60; the yield is a healthy 4.35%. The CEO and his wife founded the company and still own about 40% of it; his interests are aligned with the shareholders. The board includes outside members for balance. 

As I mentioned at the outset, the company is a microcap and so that presents a risk that is not for everyone.  I have often found it helpful to use one of the Motley Fool's checklists when first considering a stock and so I thought I'd show how they compare to some of the other microcaps I mentioned, as well as JNJ: 

Simulations Plus passes more of the checklist than the other stocks on the list (admittedly chosen only for their market cap and not for any other similarity). It's currently trading with a PE of about 25, so it's not a bargain right now (share prices increased by 50% when the dividend was announced). They also do not yet have the revenue growth that the screening desires. Their growth is consistent though and I suspect it will continue to shine; their opportunities are low-hanging fruit.

For the right investor, it could be the perfect stock.

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