Wildcard: Three Med-Tech Stocks to Watch

In this episode of Industry Focus: Wildcard, Emily Flippen is joined by Motley Fool analyst Brian Feroldi to discuss three great stocks in the med-tech space. These companies provide cutting-edge technology solutions to solve problems in the medical space in one form or another. They talk about the various solutions they provide to the medical industry, their business models, products, financials, competition, what makes them an attractive investment, and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Sept. 9, 2020.

Emily Flippen: Hello and welcome to Industry Focus. It is Wednesday, September 9th, and for this Wildcard Wednesday, we'll be talking about healthcare. I'm your host Emily Flippen, and I'm joined by Fool.com's prime purveyor of perpetual pollyannaish positivity, Brian Feroldi. Brian, did I get that right?

Brian Feroldi: Emily, it sounds like you nailed it, well done.

Flippen: [laughs] I may have rehearsed beforehand.

Feroldi: Oh, that's cheating a little bit, but that's OK. Yeah, I always try to trip up Dylan. And shout out to The New Investor Book that's @The_New_Investor (sic) [@The_New_Invest] on Twitter for helping me to crowdsource that title.

Flippen: That's great. I need to up my game here, host Emily Flippen, doesn't quite have that same cachet, does it?

Feroldi: No, it doesn't, we can get you a good title, Emily.

Flippen: We'll think about it. [laughs] Without any further ado, we mentioned that this is going to be a healthcare-focused episode, but we're actually going to be discussing three med-tech stocks. So, stocks that are operating in the technology space, but specifically for the purposes of serving the medical industry in one form or another, so really interesting cutting-edge companies here, of which I have no knowledge to add [laughs] for the most part. So, Brian, you are, again, our perpetual pollyannaish positivity purveyor, or something along those lines, but you're also our resident med-tech expert, so I'm excited to talk to you about these three companies today.

But before we get started, I just want to thank our listeners. They sent their feedback in, either through our email or through reviews. And you are the people that made this episode happen; we heard you and you screamed, we want more Feroldi. So, here you go, healthcare and Feroldi on this Wildcard Wednesday.

Feroldi: Awesome! Yeah, love seeing the feedback like that. And tech and healthcare are my two favorite markets to explore for new ideas and med-tech is kind of like a crisscross between the two, so it's like my sweet spot.

Flippen: And I'm really excited about today's episode, because two of the three companies we're going to be talking about are companies I have genuinely never heard of before. And I would imagine that will be the case for plenty of our listeners. And the reason why we're revisiting this topic is because, when you're discussing what we wanted to do, I knew I wanted you on, Brian, [laughs] but when we were discussing what we want to talk about today, you said, well, why not take a look back at 2019 and look at some of the most successful episodes or most downloaded episodes that we have for 2019. And as I went back, one from November that you and Shannon Jones taped regarding healthcare was the med-tech stocks. So, I'm happy that we're going to be revisiting it again today.

And now that I've droned on here for maybe three minutes [laughs] or so, let's not hold the listeners in any more suspense. So, what's the first company you're looking at?

Feroldi: Yeah, so the first med-tech company I want to talk about is called Schrodinger  (SDGR -3.44%). And this is a company that IPO'd earlier this year, in actually February, and they've had a wonderful public debut. So, they're currently up 82% since their February IPO, and this is a company that's worth about $3.7 billion. This is a fascinating business once you dig into the details here, because it's really two businesses in one. And there's reason to be bullish on both of them. So, the moneymaking part of the business right now is Schrodinger's software business. So, they have proprietary software that they've developed over the last couple of decades, this is actually more than 30 years old, that aids in the drug discovery and materials design process. So, they have developed ...

Flippen: That means nothing to me. [laughs]

Feroldi: [laughs] Drug discovery. So, coming up with brand-new compounds and chemicals that are used either in biotechnology or the pharmacology space or for materials design to make chemicals that are the base molecules for products, better, faster, stronger, cheaper, etc. So, Schrodinger's software uses physics, chemistry and predictive modeling to basically test billions of compounds and do all of the R&D for the compound virtually, as opposed to doing them manually. And the idea here is that by using AI to do the drug discovery process, you can get way more reps than you can by doing it manually and you can come up with a list of compounds that have a much higher percent chance of making it through to actually hit the market than if you were just manually creating them yourselves.

Flippen: And you mentioned that this company is a relatively recent IPO. This feels like a really cutting-edge business, have they been successful in implementing this thus far or is this just an idea?

Feroldi: Yes, they have been very successful in helping other companies do this. So, they sell this technology and they sell this software to pharma companies, chemical companies, biotechnology companies, and the reason that you know this works is that they have more than 1,300 paying customers for their software business. And they said that in just the first half of this year their platform analyzed 237 billion compounds for potentially making it to the market. So, this is a thriving business that generates, through the first half of the year, $49 million in high-margin software revenue. So, this business unit alone is really interesting.

Flippen: And you mentioned that this is the cash-generating business unit. I think it's safe to assume [laughs] the other business unit is not generating any cash. What does the future look like for Schrodinger in terms of profitability? Am I safe to assume they're not there yet?

Feroldi: Yes. Well, I think that they could be, if they wanted to. This is very much a company that is purposely not profitable at this point in time. And we'll get into the financials a little bit later. But they've basically developed this software model that brings in predictable, recurring, growing high-margin revenue. And what they're doing with that revenue is they are funding the second half of their business, which is the drug-development business. So, they are a software company that also has a drug-developing business as well, where they own their own proprietary drugs that are in the clinical development process and they have partnership agreements with more than 25 different collaborators, some big pharma companies that are out there, where they use their technology to help finance and get those proprietary drugs through the market. So, not only does their software help with the discovery, that's their primary business, but they're also taking ownership, either wholly or in collaboration, to bring new drugs to the market themselves. It's a fascinating business.

Flippen: I have to be honest, hearing that they're trying to play on both sides of the value spectrum has me a little bit concerned, a little doubtful. Do they not believe in [laughs] one of these businesses? Is there value in combining both sides or do you think one side wins out in the end?

Feroldi: Well, I think it does show that they're eating their own cooking. And if you know anything about the clinical development process, you know that it is long, it's arduous, it's capital intensive, and it's incredibly risky. So, I actually like the strategy here. They're saying that our software works and we're going to sell access to that, and that is a dependable recurring revenue, a business that's growing up pretty quickly, 25% revenue growth through the first half of the year. So, that's their stable core business. And then they're funneling some of the profits from that, and the know-how from that business into this more high-risk program. And what gives me confidence in this strategy is that they've already gotten two drugs through the FDA approval process with their collaboration partner. So, not only does that bring in revenue from milestone payments and drug development costs, but it also gives them the potential to earn royalties on sales down the road.

So, this is a two-sided strategy that I think is, when combined, really lowers the risk of having the clinical development business, but also provides for tremendous upside if they can develop the next big drug.

Flippen: That's really interesting, because when we talk about pure biopharma companies, we tend to talk about them as really binary. They are as binary as companies come. Oftentimes they have prospects for a single drug or maybe a collection of drugs that uses the same active ingredients, and if that gets FDA approval, the market opportunity is infinite, but if it doesn't, the company essentially goes to nothing. In this case, it seems like that software business is always going to be there for Schrodinger, right? The need for biopharma software doesn't go away just because a single drug does. At the same time, it offers a lot of that really explosive upside that I think investors who are looking at biopharma companies specifically look for.

Feroldi: Yeah, I like that barbell strategy. There's the dependable part and then there's the high-risk part. And, again, what's nice here is that they've already proven out that the high-risk part does have value. And one thing that Schrodinger has done in the past, it has actually created brand-new companies, pharmaceutical companies, from itself and spun them out. One it did just that called Nimbus, which it founded in 2009 and it developed a drug for that. That drug actually went on to be bought by Gilead Sciences for $1.2 billion. So, Schrodinger maintained an equity position in Nimbus at the time and it was able to cash in on that. So, they are really doing a great job of building a drug development process while minimizing investor risk.

Flippen: Yeah, I was skeptical when you started talking, but I think you have me sold here. For the sake of playing devil's advocate, what kills this company? What comes out and what causes Schrodinger to just be the worst med-tech stock of 2020? [laughs]

Feroldi: Well, I actually think it's a fairly low-risk business, again, because its revenue is primarily generated from recurring revenue software sales. And when you have +1,300 customers and growing, that makes your business pretty resilient. But make no mistake, they are a risky business. And for them to grow into -- and them to be a multibagger returner for investors from here, they're going to have to develop a hit drug or two through their clinical side of the business. I like that they have a ton of shots on goals. Like I said, 25 drugs in collaboration as well as five wholly owned compounds. So, if any of those pay off it could be a financial windfall for the company.

But another thing to keep in mind here is, because of the nature of this business model, they are losing money. So, that is something to keep an eye on. They haven't officially crossed into the black yet. But if you are interested in drug development and potential for big upside, but don't want to take a lot of risk, this is definitely a company to check out.

Flippen: And if you thought Schrodinger was a weird name for a company, I think the second company we're going to talk about today may have them beat, depending on how you feel maybe about cats. [laughs] What's the second company, Brian?

Feroldi: This is a company that I've highlighted on the show before, but it's had a monster great year, this is called Simulations Plus (SLP -1.76%), the ticker symbol here is SLP. This stock is up 114% year to date. And despite the tremendous run, not only year to date but if you look at any time period, this has been a huge winner. Even despite being a monster performer for investors already, it's only a $1.25 billion company, so it still qualifies as a small cap.

And this company is actually, again, a similar business as Schrodinger. So, they also have two primary businesses, one is software that aids in the drug discovery and development process. Now, you might be thinking, well, [laughs] wouldn't that be a direct competitor to Schrodinger? And the answer is, yes, these two companies do compete against each other, but whereas Schrodinger is on the drug-discovery side, Simulations Plus is really on the drug-development side.

And they have 12 different software products that they sell. And what they excel at is really finding drugs that have systemic toxicity issues, so that they can be eliminated from contention before a company has to invest millions of dollars in the clinical development process. That vastly oversimplifies things, but in essence this is a software company at its heart that helps companies to get the most out of their R&D dollars and develop better drugs.

Flippen: [laughs] Your vast oversimplification is still above my head, but that last sentence there really cleared it up for me. Is there a lot of competition in this space, because it feels like a massive opportunity? And all of the businesses we're talking about right now are really, really small.

Feroldi: Yeah, I don't think this is a massive market. And one of the things that these companies do have is competition, but because of its relatively niche applications, the competition between these companies is fairly limited. There's always competition to worry about, but each of them seems to dominate their specific niche. And it wouldn't surprise me, one day, if these two companies tied up in some ways, that would be OK, in my opinion.

The other thing that Simulations Plus does. So, software is a big part of the business; more than half of sales. And again, it's software, so it's really high-margin sales. But Simulations Plus also has a thriving consulting business where not only do they help companies implement the software itself, but they can help with like, drug filings, clinical trial design, registration, population sampling, etc. That's about 44% of the business, so it's a nice balancing act with this company as well.

Flippen: When you look at growth for a company like Simulations Plus, is the growth coming from the service or is it coming from the software? And which one, in an ideal world, would you want it to be coming from?

Feroldi: It's coming from both, thankfully. There's reasons to be bullish on both of these businesses. And when I found out that the consulting made up such a big component of revenue, I was actually expecting to see that the margins here wouldn't be that good, because if you look at a company like Accenture, their gross margins tend to be in, like, the 30-percentile range. With Simulations Plus, their consolidated gross margin is 78%. And again, that's with half of their revenue, almost half of their revenue, coming from the consulting business. So, not only is the consulting business pretty high margin, they've also got a really high-margin software business, too. So, that's a nice balancing act.

Flippen: And I see that in our notes you've highlighted something really maybe special about a company this small in the med-tech space that I'm not sure I can think of any other companies off the top of my head that provides this service to shareholders. Do you know what I'm talking about?

Feroldi: Would it be the profitability?

Flippen: Profitability in the form of dividends, right?

Feroldi: Yes, this company actually does have a dividend. It has been paying one for many years. This used to be a primarily family-owned business. And that is something you see sometimes with family-owned businesses that have been around for years. They sometimes do pay a dividend as a way to get the initial families some capital without having to sell off their stake. But what's interesting about Simulations Plus to me is that, as you mentioned, not a huge amount of revenue here. Last quarter, revenue was about $12 million, so that's about a $50 million run rate. But despite that small number, they cranked out $2.9 million in net income last quarter; that's a net margin of 23%, that's incredible.

Flippen: [laughs] It is incredible. And I don't think it occurred to me how small of a company this is. So, at $50 million in yearly revenue for the run rate right now, still making money off of that. I know cannabis companies that are making maybe triple that, right, quadruple that, and are nowhere near the profitability that this company is showing, so definitely goes to the power of the software business model here.

Feroldi: Definitely. Recurring revenue, of course. And again, when you have a consolidated gross margin of 70%, 80% it really makes it much easier to generate net income. And this company has been doing that for a long time. That's how they can afford to pay that dividend. Another thing worth noting here, is that they actually have a pretty sizable backlog, at least compared to the size of this company. So, they do have a service backlog, very similar to the contract research organizations that we see. So, they do have $12 million in service backlog. So, both sides of the business here, the software and the consulting, both benefit from recurring, predictable revenue.

Flippen: And before we move on to our last company, I'm kind of curious. Earlier on you mentioned that the opportunity wasn't huge for either of these companies. They play in an important niche, but it's not the opportunity that exists for a company like salesforce.com, let's say. Maybe that's a bad example. [laughs] But the opportunity is a bit smaller. What is the potential for a company like this, like Simulations Plus to really quadruple in size, is that something that you think is possible?

Feroldi: Yeah, they have a history of not only creating new products organically, but also making use of acquisitions to kind of build out their products. Most of the acquisitions that they've made are relatively small; a few million or a few tens of million dollars. But when you're the company the size of this is, that actually is enough to move the top and bottom line for the company. So, if you look back at their history, they have done exactly that. Plus, on the consulting side, they do have the ability to land new customers and sell those customers more services. And both Schrodinger and Simulations Plus have expressed interest in taking their software and using it in industries beyond the biopharma and pharmaceutical space. They both have agreements now with, like, chemical makers, for example. But they believe that there is use for this technology far beyond than what exists today.

Flippen: And I like that you ended that note on, both of these companies believe that they can expand their business beyond just the biopharma life sciences space, because the last company we're going to talk about today is also a company that has hinged a lot of its growth contingent upon the idea that they could be more than a life sciences play, and that's Veeva Systems (VEEV -2.48%).

Feroldi: Yeah, Veeva Systems should be no surprise to regular listeners of the show. This has been a Fool favorite for many, many years. And this is another med-tech stock that is just on fire in 2020, and for good reason. This stock is up 87% year to date. And this is a $41 billion business. I hope at this point our listeners are somewhat familiar with this company, it was started by a former salesforce.com executive named Peter Gassner. When he was working at Salesforce, he noticed that Salesforce did a great job of servicing a large swath of the economy, however the needs of life sciences companies, because of the heavy regulatory components, Salesforce.com software didn't exactly fit their needs. So, he saw a market niche to create basically the Salesforce of life sciences and that is exactly what Veeva has become.

Flippen: It's funny because we saw all these former Salesforce executives pop off and create their own companies. I think Okta was also founded by a former salesforce executive. Veeva is in the same boat. Gassner still owns, not a majority of shares, but I think he still owns a sizable number of shares, something around 9% or 10% of the company he still owns. So, it's been a huge winner for investors who have held Veeva Systems but also for Gassner himself.

Feroldi: Yeah, he's become a billionaire due to his entrepreneurial vision to create the company that is today. And they have just done a phenomenal job at becoming the CRM platform of the life sciences industry. And one of the reasons that this company has grown well beyond even what I expected them to grow initially was they have a history of continually rolling out new products and expanding within just their existing base of customers. So not only have they become really the standard in software products for life sciences companies, but they also develop products to help for data management, regulatory submission, quality verification, etc. That land-and-expand model is really paid off for this business.

Flippen: I think it's easy to understate just how hard it is to operate as a company in a highly regulated industry. I didn't, before researching Veeva Systems, understand all the different processes that go into getting a drug approved by the FDA. The data, the records, the customer relationship, all of that stuff needs to be tracked, maintained and delivered if regulatory authorities ask for it. It's not as simple as rolling out a customer relationship management, a CRM platform for any other business. So, Veeva definitely found its niche, but as you alluded to, they really dominated in life science or really pharmaceuticals, which is, I don't know why they just don't run with pharmaceuticals; we'll say life sciences, because that's what they say. But ultimately that is their industry right now and it's been great, they've dominated the space. But so much of that growth has just depended on them either upselling to their current customers or entering new markets. And while they've been successful at that in the past, I think it's understandable to be a little bit skeptical of their ability to continue to recreate that success into the future.

Feroldi: Yeah. And that was my big question for this company a few years ago when it came across my radar. I said, wow! They've done great things in the life sciences industry, but is that a big enough market for the company to justify its valuation and growth potential. And from the beginning Gassner has basically said, we see ourselves as more than just a life sciences company, we believe that our technology can be applied to numerous other industries, and we've seen them enter the cosmetics industry and the consumer goods industry and the chemical industry, all of which have a regulatory component. I mean, the "F" in FDA stands for food, right? So, there are more applications for its core technologies than the life sciences industry, and they seem to have successfully made that leap. That was a question that I had, but they've really proven that they can do it.

Flippen: Yeah. And if you don't mind indulging me, Brian. I know this is an industry you hate, and I know that our listeners who have listened to me talk have probably heard this before. But as an analyst who runs our Marijuana Masters cannabis service, I like to look at companies in the context of new opportunities. And I actually was a little bit shocked when I was researching Veeva for the first time a while back, because I saw the opportunities that existed in other highly regulated industries as well, cannabis just being one of them. So, they look at cosmetics, consumer packaged goods and chemicals as being other highly regulated industries, industries where it's really hard to implement some sort of platform for relationship management, because so much of those records need to be retained and stored in certain manners. I think that cannabis, once we have some sort of regulations here in the U.S., could be another opportunity for them, even though management has never talked about it. There are third parties that have partnered with them to serve this industry.

So, while they've done a great job in pulling in, especially CPG, those consumer packaged goods customers, as well as some chemical customers, I think that the opportunity for them is still maybe understated.

Feroldi: Yeah, I think that that's fair. And to be clear, Emily, I don't hate the cannabis industry, [laughs] I think it's just a market that has received a tremendous amount of hype. And for me, it's just too hard for me to pick the winner there. And you know, as you've dug into these companies, there's a lot of junk companies in this space. So, I do think there will be winners, I do think the market is going to grow, it's just not a market that has interested me personally. But when you can find companies like Veeva Systems that can sell into that market and essentially be a software supplier, that is a great way to benefit from the booming of an industry.

Flippen: Exactly. So, while they've expanded into these industries, there have been headwinds. And throughout this entire show, we've managed to make it without mentioning [laughs] the pandemic, I guess this is where that ends. The CPG and the cosmetics industry really have been impacted by the pandemic. I thought it was really interesting, in the most recent quarter, Veeva didn't really dig into the progress on their other fronts, they focused a lot on this product that they launched called MyVeeva, which is going out to current life sciences customers. But they didn't talk very much about the other industries they're getting into. And I just assume this is because there are significant headwinds against expanding new products during a pandemic. I can't imagine there are a lot of consumer goods companies that are looking to upgrade their software systems right now.

Feroldi: Yeah, that's definitely a headwind for them, and for all three of these companies, really. They all play in the FDA approval process and in the drug-discovery process, they all play a role there. So, COVID has obviously thrown a wrench into that entire thing. Some clinical trials had to be paused, others had to be scrapped completely. I mean, it's really hard to run one when you can't actually get patients enrolled and to come to the offices. So, 2020 is going to be a difficult year for all three of these companies, although, if you looked at their Q2 results, all three of them posted really strong growth. So, that just speaks to me to the volume of how high quality all three of these companies are.

Flippen: Definitely. When you look at Veeva's future, do you see any big risks here is it safer than other three or does it have something that could potentially really make it falter?

Feroldi: Veeva, to me, is probably the lowest risk of the three of them. From a business perspective it has a bazillion customers, it gets great reviews, it has really sticky relationships with them, and it's very highly profitable and continues to grow. Really, with all three of these, the biggest risk that I see would be mostly valuation. All three of these companies trade at nosebleed numbers. I mean, even Simulations Plus, the smallest one, trades at over 120 times trailing earnings; that is an insanely high number, and it's not artificially boosted because profitability is down. Again, that's a company with a 23% net margin, so that's a real P/E ratio.

I still think investors should take a look at these companies and get to know them, but the biggest risk that I see, at least on the investor front, is that these businesses are priced for huge growth.

Flippen: And I'm going to steal again from Mac Greer here and give you the false dichotomy of the desert island question. If you're looking at these three companies; Schrodinger, Veeva Systems and Simulations Plus, and I have a gun to your head, I'm saying, you have to buy one of these companies and you can't buy more than one, you had to buy one, which one are you buying and why?

Feroldi: I'll mix it up and I'll say Schrodinger. I think that there's reason to own all three of these companies, but I really like that that company is still relatively small and unknown, I mean, even after the tremendous run, it's still a sub-$4 billion company. And I really like that they essentially could be profitable if they chose to, from the software business, but they're still choosing to plow a lot of their profits into their potentially high growth and extremely lucrative drug development platform. So, if I'm forced to choose, Emily, I'm picking that one. How about you?

Flippen: [laughs] Yeah, I hate that question, because again, you can own all of these companies, you can own none of these companies, that choice is entirely yours, but if asked the same question, I think Veeva maybe gets my vote here. Partly because I did not know about Schrodinger until maybe [laughs] 20 minutes ago. So, learned everything about it from you, from listening to this episode. But also just because, I like Veeva's business, I like the fact that when you look at it from a valuation perspective, and I don't do that very often, but I still think at today's prices, with the cash that Veeva generates, it looks pretty attractive even after it's run-up. So, I think, for me, Veeva gets the nod. But these all seem to be really interesting companies.

Feroldi: Yeah. I think they're all really high-quality businesses. And not to knock Simulations Plus at all. Again, I think it's a tremendous business, but if it says anything, management just raised $150 million through a secondary offering. So, this is a company that was debt-free prior to that and had no need for capital. So, the fact that they did that does tell me that's probably short-term overvalued, but, yeah, I don't think investors can go wrong with any of these businesses so long as they hold with a long-term mindset.

Flippen: That's great, and that's exactly what we do here at The Fool. Brian, thank you so much for joining me and I expect I'll see you back soon.

Feroldi: Sounds good, Emily.

Flippen: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the screen today. For Brian Feroldi, I'm Emily Flippen, thanks for listening and Fool on!