📍 TL;DR

• SMLR has been halved in a week amid key changes surrounding insurance reimbursement.

• There’s a case to buy the dip, given a fortress balance sheet and the possibility that the core QuantaFlo product provides enough value on its own.

• History suggests stepping into these declines can be profitable. But it seems too difficult to jump into SMLR just yet.

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  As we tweeted on Wednesday morning the 18 biggest winners this year (excluding two buyouts) declined 79.8% on average in 2022:

Overlooked Alpha @OverlookedAlpha

7/ Excluding the two buyouts, the 18 biggest winners YTD *on average* declined 79.8% in 2022. The best performer, $THRX, declined "only" 60.7%. These gains represent a bet on mean reversion in a big way.

11:53 AM ∙ Feb 7, 2023

That figure highlights why I’m a little skeptical about this equity market. Set aside debates about inflation and the Fed, and the core risk seems simple: this market feels a little like the 2021 market, and quite obviously that is not a good thing.

It feels like there’s a group of investors who are trying to make up for 2022 losses in a hurry. Positioning and trading, instead of core fundamental analysis, is moving the market and that’s leading to some clearly irrational moves. Personally, my core position hasn’t changed much since we launched this project almost a year ago. Equity valuations are still not attractive on their face and nowhere near what they historically have looked like at a bottom.

That said, I do think opportunities arise when stocks get dislocated by positioning moves. And after a 48% decline in just five trading sessions, diagnostic provider Semler Scientific SMLR 0.00 looks like it fits the bill. So is the fall in SMLR driven by market madness or is there fundamental logic to the decline?

Introducing Semler Scientific

Semler’s sole product is QuantaFlo®, a FDA-approved solution used to diagnose peripheral arterial disease (PAD). PAD is the narrowing of vessels that bring blood from the heart to the legs, usually caused by the buildup of fatty deposits (known as atherosclerosis).

PAD generally afflicts people over 50 — but it’s also usually asymptomatic. Semler itself claims 75% of patients show no signs at all. The problem is that even asymptomatic patients have sharply higher odds of significant cardiovascular events.

As a result, testing for PAD would seem to be an imperative, in terms of both patient outcomes and health care costs. But as Eagle Point Capital detailed in a bullish piece on SMLR 13 months ago, the standard test has some problems. PAD has historically been diagnosed by measuring blood pressure in the arms and legs with a specialized device that requires individualized training. That in turn makes PAD testing unsuitable for most primary care offices, which allows asymptomatic patients to fall through the proverbial cracks.

QuantaFlo fixes this problem. It’s a four-minute test in which a sensor clamp is placed on both hands and both feet. The company’s proprietary algorithm then develops a blood flow waveform, which in turn underpins a report and a potential diagnosis of PAD.

The Attractiveness of QuantaFlo

The ability for QuantaFlo to disrupt the existing diagnostic standard on its own should make the product attractive from an investment standpoint. But in fact there’s a lot more to like.

One of the positive attributes of the business model is underlined by a single sentence from the Semler 10-K. The company writes that [emphasis ours] “we currently market…QuantaFlo to our customers, who include insurance plans, physician groups, and risk assessment groups.”

Eagle Point hit this point repeatedly in its bull case: Semler isn’t marketing to primary care practices. Rather, the fund points out that Semler is aiming at the top of the industry, targeting organizations who should benefit from earlier diagnoses of PAD and the subsequent cost savings created:

Ingeniously, instead of hiring boatloads of sales reps, Semler is utilizing the heft of big health insurance groups to push their product. Their largest customers literally pay doctors to use QuantaFlo while paying Semler for the subscription; talk about efficient marketing!

The other positive attribute is that this is a SaaS (software-as-a-service) business. It’s the software and the algorithm, not the sensor clamps, that are the true product. As a result, gross margins are well past 90%.

Combine 90%-plus gross margins with reasonable sales and marketing (~30% of revenue, not a terrible figure for a still-young, single-product company) and operating margins unsurprisingly are impressive. Relatively early in its growth curve, Semler is already driving operating margins above 30% (31.7% through the first nine quarters of 2022, to be precise).

Thus, there seems a base for real optimism toward Semler, and indeed not that long ago investors were exceptionally excited about this business:

Obviously, a good number of new-ish businesses saw exceptional valuations during 2020-2021. But Semler is a cut above the air taxi stocks and supposed quantum computing pioneers that saw triple-digit returns during that period.

And while the chart certainly looks bubbly, it’s not like SMLR had some insane valuation. At the 2021 peak — at which Semler’s market cap cleared $1 billion — the stock traded for less than 70x that year’s GAAP earnings per share. That valuation isn’t necessarily cheap, certainly, and ensuing performance would suggest that SMLR was overvalued. But in the context of the story here, there was at least some logic to the parabolic returns in the stock.

A Tough 2022

As it turned out, that parabolic rally was far too aggressive. SMLR dropped 64% last year amid a sudden deceleration in growth.

Semler’s revenue increased 37% in full-year 2021 — and 3.4% over the first three quarters of 2022. During that latter period, operating income declined 23% year-over-year. The outlook for 2022 was cut after Q3 results in early November, sending the stock down 35%.

Unsurprisingly given its go-to-market strategy, Semler’s revenue is concentrated among a few key customers. UnitedHealth UNH 0.00 drove 41% of 2021 revenue, and a second insurer another 29%. Revenue from both customers has stagnated, growing ~5% year-to-date based on data from the most recent 10-Q.

But shares gradually recovered — until this week.

What The Heck Happened To SMLR?

On Monday morning, SMLR opened down — and then collapsed. It was exceptionally difficult to understand why. There were no press releases, no SEC filings — no apparent news. Yet the stock closed down 36%. It dropped 5% on Tuesday and 10% on Wednesday, before a 4.5% relief rally on Thursday.

As it turned out, there was some news — and potentially important news. The Centers for Medicare & Medicaid Services (CMS) released their Advance Notice of Methodological Changes for 2024. QuantaFlo previously had been covered under HCC (Hierarchical Condition Category) 108. As of 2024, however, it won’t be:

source: CMS Advance Notice of Methodological Changes for CY24 [pdf]

And that’s a problem:

Guillermo @NeuroStockDoc

@justvalue2 @4drant @PatagoniaValor SMLR's main customers are insurers. Insurers get a huge ROC w/ Quantaflo b/c if it gets someone diagnosed w/ PAD they get an HCC code assigned which increases payout to the insurance from CMS. No HCC code = loss of much of that value proposition.

9:26 PM ∙ Feb 6, 2023

With CMS no longer paying out for PAD diagnoses (presumably), the economics of QuantaFlo for customers changes significantly — and not for the better.

That in turn has the potential to echo down the P&L. Revenue may well get pressured. Marketing expense might have to increase: Semler needs to prove that QuantaFlo can provide return on investment, rather than CMS providing that ROI itself.

In that context, the nearly 50% decline in SMLR over five sessions doesn’t seem like an obvious overreaction. The CMS change seems like a very real problem for Semler.

Buying The Dip

So can an investor consider buying the plunge in SMLR?

There is a case. The sell-off this week seems to conflict with the bull case that existed before the CMS news arose. The argument made by Eagle Point (and others) was that QuantaFlo was worthwhile to customers like UnitedHealth not because of cash coming in from the federal government, but because it had the ability to find a disease that could cause significantly more expensive problems down the line.

After all, it’s not as if PAD is particularly expensive to treat; if the condition is caused by atherosclerosis, statins or other common medications can be prescribed. The value proposition here seems in favor of QuantaFlo, whether or not there’s reimbursement from CMS.

But that might not actually be the case. Semler’s own 10-K (p. 22) notes that “some potential customers have deferred renting our product given the uncertainty regarding reimbursement.” The company adds elsewhere that, under the old coding regime, reimbursement had been denied on occasion.

Right now, however, the most important passage from the 10-K is this one (p. 21):

The existence of coverage and adequate reimbursement for the procedures or patient care performed with our vascular testing product by third-party payors is central to the acceptance of our vascular testing product and any future products.

To some degree, investors ignored that statement, even during the long decline from 2021 highs. Before this week, QuantaFlo was viewed as an innovative product with the potential for putting a small dent in overall U.S. healthcare spending

As always, the truth is probably somewhere in the middle. From a distance (and to be clear, I’m a tourist in this sector), there does seem to be some value to the product. A simpler way to diagnose asymptomatic PAD should be of interest to CMS — and yet this code change seems at odds with that.

However this plays out, it does seem like the business model has to change. That’s one reason why it’s difficult to get too excited even with the stock having halved. Valuation is reasonable, at pretty much 10x trailing twelve-month earnings per share backing out net cash. But, again, there’s a lot of margin to lose here and a business model that probably has to change to some extent. With revenue growth stalling out before the code change, there are real concerns about the top line as well.

Management Concerns

Were this a management team that had garnered investor confidence, it might be easier to take a punt. That doesn’t seem to be the case. Indeed, discussions in the 10-K suggest Semler itself doesn’t know to what extent reimbursement really matters to its insurance customers. (The alternative explanation is that the company didn’t want to say, but that’s little better.) The reaction to both Q1 and Q3 earnings both show that the market didn’t really trust management’s explanations for either disappointment (particularly around the post-Q3 guidance cut, which Semler blamed on a merger).

But all that said…it’s still tempting. Semler now has a fully-diluted enterprise value of ~$130 million. Worst came to worst, couldn’t they just sell out to Medtronic MDT 0.00 or some other medtech giant with a massive sales force and garner a good chunk of that revenue back? Are we sure management is that bad? Are we sure the business is stalling out, or are post-pandemic uncertainty and a tough comparison simply causing growth to pause before inflecting higher?

There’s a scenario where Thursday’s close of $22 proves to have been a fantastic buying opportunity. But amid so much uncertainty, it’s difficult to have much confidence in that scenario playing out. That’s why stocks like SMLR are so appealing — and so terrifying.

As of this writing, Vince Martin has no positions in any securities mentioned.

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