Lakewood Capital Management recently released its Q2 2020 Investor Letter, a copy of which you can download here. In the letter, among other things, the fund reported a net profit of 10.7% for Q2 2020. You should check out Lakewood Capital’s top 5 stock picks for investors to buy right now, which could be the biggest winners of the stock market crash.
In the said letter, Lakewood Capital highlighted a few stocks and Simulations Plus Inc (NASDAQ:SLP) is one of them. Simulations Plus Inc (NASDAQ:SLP) is a software company. Year-to-date, Simulations Plus Inc (NASDAQ:SLP) stock gained 125.5% and on August 3rd it had a closing price of $72.09. Here is what Lakewood Capital said:
“In recent months, the valuations for hyper-growth software companies have surged to extraordinary heights. Amidst all this excitement, we have seen some lower-quality companies that have been reporting attractive headline growth mistakenly pulled along for the ride, creating a number of interesting short opportunities. The fund is short Simulations Plus, formerly a small-capitalization software company with limited sell-side coverage. Far from a hot start-up, Simulations Plus is actually a fairly mature 25 year-old company with the majority of its growth coming from a lower-margin consulting business and acquisitions. After getting caught up in the recent software rally, Simulations Plus was added to the S&P SmallCap 600 Index in June, sending its stock price up over 50% in a matter of weeks. Consequently, the company now trades at nearly 30x revenue with just mid-teens organic revenue growth of questionable quality.
Simulations Plus sells license software for pharmaceutical research and development, and its core product, GastroPlus, simulates the mechanics and interactions of drug compounds. While GastroPlus is by all measures a quality, leading product, its addressable market is fairly limited, with revenues growing to just around $20 million since its launch in the mid-90s. Over the past several years, the company began a series of acquisitions which meaningfully accelerated reported growth. In 2014, Simulations Plus acquired a company called Cognigen for $7 million at a valuation multiple of roughly 1x revenue, expanding into consulting services for pharmaceutical companies. Since then, the company acquired two smaller software and consulting competitors, both at low-single digit revenue multiples. In total, Simulations Plus has spent just over $30 million to acquire businesses accounting for nearly half of current revenue, in stark contrast to the company’s current market valuation of $1.2 billion.
The company’s consulting business now accounts for nearly half of its $40 million in annual revenues. In the most recent quarter, consulting revenues grew over 30% while software revenues grew 7% organically. While the consulting business has proven to be a success at the top line, results at the bottom line have been more mixed with margins steadily compressing over the last few years as the company has been forced to add headcount to support growth. Despite adding $10 million of company-wide revenue over the last two years, reported pre-tax income increased by only $2 million (even with an acquisition). While many high-growth companies show limited operating leverage as they aggressively invest in new products, this does not appear to be the case at Simulations Plus with annual R&D expense of just $2.5 million.
While we understand the basis for early-stage, subscription software companies to be valued off of revenue multiples, we believe it is more appropriate for Simulations Plus to be valued off of its earnings levels since, after all, Simulations Plus is not early stage, subscription-based or even entirely software. With the index addition now complete, we expect the stock to converge back toward its historical average multiple of 30x forward earnings (instead of 30x revenue). We forecast that the company will generate just over $0.60 of EPS next fiscal year, and at a multiple of 30x earnings (in line with its historical average despite the higher mix of the lower-quality consulting business today), the stock would trade at $18 per share, representing approximately 70% downside.”
In Q1 2020, the number of bullish hedge fund positions on Simulations Plus Inc (NASDAQ:SLP) stock decreased by about 17% from the previous quarter (see the chart here), so a number of other hedge fund managers seem to agree with Simulations Plus’s downside potential. Our calculations showed that Simulations Plus Inc (NASDAQ:SLP) isn’t ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.