Simulations Plus (NASDAQ: SLP) is a small-cap healthcare technology company with a value of about $800 million. The firm has vastly underperformed the market and its sector over the last 12 months, with a total return of -7%. The S&P 500 is up 26% in the same period, and XLV, which represents the healthcare sector, is up 11%. The firm released earnings after market close on July 2, 2024. Despite beating estimates on both earnings per share (EPS) and revenue, the share price fell nearly 15% on July 3. Let's take a look at some context around what Simulations Plus’s business does, dive deeper into the earnings report to understand the price drop, and close with some outlook on the firm.

Simulations Plus develops modeling and simulation software used in drug discovery and development. This software is largely based on predicting the molecular properties of a potential drug, such as how a drug's molecular structure will interact with biological molecules. This helps determine how a drug can achieve the desired effect on the body and helps identify and stop undesired effects. The software uses AI and machine learning.

The business operates as two reportable segments: software and services. The company offers 12 different software products for pharmaceutical research and development. Its flagship product and largest single source of revenue is GastroPlus. GastroPlus simulates drug absorption and interaction on compounds given to both humans and animals. It is one of the most widely used commercial software products of its kind. The software segment represented 61% of the firm's total revenue during the 2023 fiscal year.

The services segment performs studies for a fee, helping solve drug development problems in which it has expertise. This segment makes up 39% of total revenue. Total revenue grew by 14%, with 12% growth from software and 18% from services from the previous year. Competitors to Simulations Plus include Certara (NASDAQ: CERT) and Schrödinger (NASDAQ: SDGR).

Financial Results: Lower Margins and Other Factors Send Shares Tumbling

In its fiscal Q3 2024 earnings release, the firm’s EPS came in at $0.19, 3 cents above the expected figure of $0.16. So why did the firm lose nearly 15% of its value the next day? One culprit is an alarming contraction in margins. Gross margin fell 400 basis points from the previous quarter and is down 11% from the previous year. This was predominantly due to a massive drop in gross margin for the services segment, which is down to 41% from 63% in Q3 2023. The gross margin for software also declined slightly. This contraction was not limited to gross margin. In total, research & development, selling, general, and administrative expenses were up by $2.2 million. This contributed to the operating margin falling to 10% compared to 25% last year.

The next source of this drop in share price? A hefty reduction in EPS guidance despite an increase in revenue guidance. The firm currently expects midpoint adjusted diluted EPS of $0.55 on revenue of $70.5 million for fiscal 2024. Before, it expected EPS of $0.67 on $67.5 million in revenue. So, the firm is raising its revenue estimate while lowering its EPS estimate by 18%. This can mean only one thing: it expects margins to contract further. Dramatically contracting margins is one of the worst obstacles a business can face. Margins are important indicators of sustainable profitability. Lowering margins often indicates increased competition in an industry, causing prices across the board to come down.

Another troubling sign for Simulations Plus is that the firm is suspending its dividend. Suspending dividends is a sign that a firm is under financial pressure. It can indicate it needs to preserve cash to reinvest in the business or meet its obligations. The company’s balance sheet looks good. It has current assets of $136 million compared to only $11.3 million in current liabilities. This gives it a current ratio of 12x. The firm is likely using the extra cash to reinvest in the business, a much better sign than needing it to fund its liabilities.

Outlook: Relative Valuation and Analyst Price Target

All these factors led to the significant decline in share price. This happened despite Simulations Plus beating earnings estimates. One could argue that the firm is overvalued based on its forward price-to-earnings (P/E) ratio. Its 68x forward P/E is in the 94th percentile for global healthcare companies. However, healthcare analyst Matthew Hewitt at Craig Hallum Capital Group reiterated his buy rating on the company after the release. His price target of $56 implies a 40% upside.