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3 Healthcare Stocks to Watch

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In this episode of Industry Focus: Wildcard, Dylan Lewis is joined by Motley Fool contributor Brian Feroldi to discuss three healthcare stocks with great upside potential. Learn about their business models, product offerings, financials, what gives them an edge in the space, and their risk factors. They also talk about how to spot stocks with 10X potential, the opportunities ahead for these three particular stocks, and why you should have them on your watch list.

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 October 21, 2020.

Dylan Lewis: It’s Wednesday, October 21st, and we’re pitching a few 10X healthcare stocks. I’m your host Dylan Lewis, and I’m joined by Fool.com’s, Brian Feroldi.

Brian, I know that you had some elaborate name for me here, but admittedly, I was switching tabs between our outline as I was reading the intro, and unfortunately I didn’t get it in time, I’ll do it now though, just to humor you, because I know you put some time into this. Fool.com’s timely tracer of tremendous trailing 10X talent, Brian Feroldi. There we go.

Brian Feroldi: Okay, Dylan, I was a little concerned [laughs] for a couple of seconds there, that we’re all of a sudden working off of different documents. Yes, I put a lot of time into those titles; still haven’t tripped you up, got more work to do.

Lewis: You got me last week as we were wrapping up, because I got cocky and I did it twice, this time, though, I’ve learned my lesson, I’m not going to try to hit it again at the end of the show, particularly because I think you threw eight Ts into that one, and I don’t think I can hit that one twice. [laughs]

Feroldi: Yeah. You know, I’ve noticed that you are slowing down even more so in the intro than [laughs] usual because I’ve damaged your brain, apparently, to make you want to go extremely slow when we start.

Lewis: [laughs] It’s a fun game, and a fun way to kick things off, it’s kind of a nice little broadcaster exercise. And it means, if I can get through that, we can get through the whole show. Hopefully, I didn’t just jinx us. Brian, you’re on today because we are talking in our Wildcard episode about 10X stocks, specifically, healthcare stocks. You’re one of my favorite people to talk about 10X stocks with, you’re one of my favorite people to talk about healthcare stocks with, it only made sense for you to be on today’s show.

Feroldi: Yeah, this is a topic that I absolutely love, healthcare is a great place to go looking for these stocks, because innovations come along all the time that just did not exist before and have tremendous potential to change the face of healthcare. And companies that can do that successfully, definitely have the potential to provide 10X results for investors, so this sector, just like the technology sector, I think is packed with companies that have 10X potential.

Lewis: Before we get into some of the signs of a 10X stock, I think it’s, kind of, worth double-clicking on that industry profile for a second, because a huge part of the healthcare industry is what could happen. And we see it in the hardware space, we see it in the biotech space, in particular, where if certain things come to fruition, the story for a business gets really big, really fast, but you kind of have to discount probabilities. And so, you wind up with these small businesses that could become massive businesses if things go right.

Feroldi: Yeah, it’s very common for, say, smaller companies, and let’s just call smaller companies those below $1 billion, to raise a lot of funding from investors as they develop their product. It takes a long time to develop these innovative technologies, let alone bring them to market. So, it’s common for companies to come public when they are still, you know, in the $500 million or less range. Some of these companies are pre-revenue, and boy! Can that be risky to invest in. However, it does give us, as investors, the chance to get in, in the first inning. And if the technology proves itself out, the percentage returns for investors could be spectacular.

Lewis: Yeah, the upside and downside is a little bit different in this industry, particularly with the biotech stocks, but also with, I think, some health and med-tech companies as well. They are probably a little bit closer to the binary outcomes that you’ll see in some spaces. And that’s really not something that’s super-familiar to people that are normally investing in consumer goods or retail. You know, if Chipotle has a bad quarter, they’re still selling some burritos; if a drug doesn’t get approved, you’re not really making any money on that drug or that therapy.

Feroldi: Yeah, that is a big risk. That’s why, when I typically invest in these companies, it’s after they’ve been significantly de-risked, after they’ve gotten FDA approval and set up in insurance and getting some healthcare providers or more. I normally like to see some traction in the marketplace before I’m willing to put my capital behind it. I do make exceptions in one of the companies that we’re going to talk about today. It is still pre-revenue with their product, but if you can invest at that point and you’re right, the gains can be huge.

Lewis: And I think that’s the right way to go. You know, you’re reducing your upside a little bit with that, but you’re also dramatically increasing your certainty. And you know, everyone has their own risk-adjusted comfort level with those kinds of things, but you got to be able to sleep at night with the stocks that you’re buying.

Feroldi: Totally. And there’s no reason that you can’t invest in risky companies too. If you are a low-risk investor but you still want a little bit of skin in the game in these companies, I see nothing wrong with taking a tiny piece of your portfolio and putting it into these companies, especially if you’re willing to diversify and buy five, 10 or even 20 of them. Just knowing full well in the beginning, a lot of these are going to flame out and go against you, but if you’re right on just one or two of them, it’ll carry the entire portfolio forward.

Lewis: Let’s talk a little bit about some of the characteristics for a typical 10X business. We’ve done this, I think, with a tech lens before, and a lot of the rules are going to be, kind of, the same here, but it’s worth reemphasizing them.

Feroldi: So, mostly, when I think about 10X stocks, I think small, I generally screen for companies that are below a $5 billion market cap. At that size, the company can 10X and still be below $50 billion. $50 billion is a really big company, but if a technology comes along and it’s successful, it can get there. So, that’s my first screen. It is just the market cap of the company. I also want to see that the company is doing something special, especially in healthcare. It’s not hard to find companies that are taking an innovative approach to the market, so I want to see something that either improves greatly upon what’s already existing or is inventing a whole new market for itself.

The other thing we look for is huge revenue growth. If there’s no established history, we have to believe that revenue growth can grow at, say, 20% or 30% for at least the next +5 years, to do that, they have to have a massive untapped market opportunity ahead of them and they can’t have already captured too big percentage of that.

Finally, I like to look for operating leverage ahead of the company. Operating leverage is just a fancy way of saying, as the business scales, profits can grow faster than revenue. If the company isn’t profitable, [laughs] operating leverage is ahead of you. But I like to look for that, because if a business is already fully at scale, its profits will only grow as fast as revenue, and I want to see profits grow faster.

Lewis: Yeah, that’s generally what we’re looking for here, right, Brian? [laughs] And I think what a lot of those elements highlight is a business that maybe isn’t being fully realized with its valuation or has a very large valuation it could grow into. And very often, when we hear “value investing” we tend to think of, you know, the cigar butt style of looking at low P/E stocks and trying to see what value can be eked out of those businesses. But I think there’s a really good case to be made that you can look at value investing as taking companies whose full present value and, certainly, their future value, is not being fully realized by the market. We aren’t able to really think about how dynamic they are, how innovative they are, how big the market could be and how many adjacent markets they might have with some of their products. And a lot of the things that you laid out there touch on those types of business strengths.

Feroldi: I always like to think that my biggest edge, our biggest edge as investors is just the willingness and ability to buy and hold for a long period of time. The market is a discounting machine, always looking forward. Typically, the typical Wall Street trader is looking forward at most a year. With some of these companies, the thesis that I love best are, this thing, that already exists and is already working, is just going to be much bigger in 10 years, if that’s true, I’m perfectly comfortable paying $2 today for $1 in value so long as that $2 grows into $10 in the next, say, 10 years. We have that luxury, because we can be patient. So, value investors like to look for something that’s worth $1 today and only pay $0.70. There’s different styles, no style is right for everybody.

Lewis: All right, Brian, with all of that, why don’t we talk about the three stocks we’re going to be discussing today? The first one is one that is probably familiar to folks that have been watching Motley Fool Live, our members-only livestream, and that is Trupanion (NASDAQ:TRUP), ticker TRUP. I’m guessing Emily Flippen has also probably talked about this on the Tuesday show, because she has been following the pets trend for a while. But do you want to give a quick rundown of what this business does?

Feroldi: I think most people are familiar or at least heard the name Trupanion before, especially if you are a pet owner. This is a leader in the pet insurance market. Anyone with pets knows that you take them to the vet regularly, and occasionally, you get a huge [laughs] bill thrown your way. I mean, I have plenty of friends that have dogs or cats that have cancer or diabetes or they eat something they shouldn’t have. We used to have a dog and my dog swallowed a sock and had to be surgically removed from the stomach, that was a surprise $600 bill. That wasn’t that bad [laughs] compared to other bills that come your way.

Trupanion’s business model is to — it’s an insurance company. They collect premiums from their owners, from dog and cat owners, and that they cost about, say, $20 to $60 per month, depending on the level of coverage. And it protects you from having a huge, huge surprise vet bill. So, you are trading a subscription revenue fee essentially for lowering your risk down the road that you’re going to have some massive bill.

They have been extremely successful with capturing pet owners to-date, and the company’s revenue has been consistently growing up and to the right. They have a wonderful chart on their investor presentation that just shows every single quarter they add new pets to their platform and grow consistently. No surprise, this has also been a homerun stock for investors.

Lewis: Yeah. And I’m sure that a lot of people have started putting this one on their watchlist, because so many pets have been adopted, so many families have gotten pets during the pandemic as people have been staying at home. I have, I think, four or five friends at this point [laughs] that have adopted dogs, and in talking with them all, yeah, I grew up with dogs, one of the first things they say is, we didn’t get ready for all the vet visits, [laughs] we didn’t get ready for all of the, you know, crazy things that dogs do because they are dogs.

My mom has a story about how one of our dogs decided to eat an avocado pit, which, you know, she didn’t see happen, and all of a sudden that became the $500 avocado, [laughs] because there was nothing wrong with the dog, but still had to go to the pet and go through and get imaging done and all that kind of stuff. So, you know, you can’t anticipate these kinds of things, especially with animals. And what’s fascinating about this space, what’s fascinating about this business is how early on we are, really, in the United States, in particular, with the penetration of pet insurance, because for all the benefits it may seem to offer, it’s not really something a lot of people have.

Feroldi: It’s really not, it’s very similar to almost the way our — Trupanion likes to say, it’s very similar to the way that dental insurance used to work, people didn’t used to have dental insurance, they would just show up to the dentist. Gradually, over time, they became insured and that helped to, kind of, take the bite out of really big surprise bills. They hope that the pet insurance market is going to be going the same way.

If you just look at penetration rates, the reason that I think this stock can 10X potentially in time, is that in the United States only about 1% of pets are covered by pet insurance. Now, if we didn’t have another market to compare it to, you would think, well, that’s going to be stuck there forever. However, if you look at Sweden, 40% of pet owners have insurance for their pet. In the U.K., it’s 25%. In Norway, it’s 14%. Those markets can’t be all that different from the U.S. So, if companies like Trupanion, and Trupanion is the market leader here, can eventually grow that penetration rate anywhere close to those foreign markets, this company has massive upside potential.

Lewis: I think one of the reasons that Trupanion probably is a market leader here is they’ve taken a very simplistic approach to pet insurance. If you are a new pet owner, it doesn’t matter what insurance you’re looking at, insurance is complicated, whether it’s home insurance, whether it’s medical insurance, you’re immediately hit with a bunch of terms that you probably don’t know, you probably don’t understand, Trupanion is really trying to make their coverage and their plans as simple as possible, which I imagine is very appealing to new pet owners.

Feroldi: Yes. That is one of the things that they tout is, there’s no one-size-fit-all, they will write a policy based on your specific budgetary needs. You can go on there and say that I want 50% of my vet bills covered for the life of my pet, and probably pay some bill that’s $20/month or $30/month, that increases from there, all the way up to people that say, I don’t want any surprise vet bills, and Trupanion pays 100% of the cost. That is more along the lines of $50, $60 or even $70/month or up from there depending on the health of the pet and the age and those kinds of factors.

But again, taking a surprise huge bill down the road and turning it into a monthly recurring predictable payment is something that’s very attractive to a lot of people.

Lewis: Very attractive. And with low penetration rates, a huge opportunity — I think what’s, kind of, nice about this business is, while there’s a compelling growth story, and we’ve talked about that a little bit, the financials, in and of themselves, don’t look too bad right now. You know, you’re not betting the farm on what this business could become, it’s a business that’s already in decent shape as is.

Feroldi: Yeah, revenue has grown between 20% and 30% for the last 10 years since this company offered its products to the market. More recently, it started generating free cash flow and it’s very close to achieving non-GAAP profitability. Its balance sheet is packed with cash, very little debt, and it has a very low churn rate. Its monthly churn rate is about 1% to 1.5%, in some markets the company naturally gets more referrals than actually it’s churn rate and the company is trying to increase that over time. So, recurring revenue business, generating cash flow, huge opportunity ahead. There’s a reason I picked this stock first, Dylan. [laughs]

Lewis: [laughs] Are we going in descending order, is that what’s happening here, Brian? [laughs]

Feroldi: Yeah, I wanted to start off with what I think is the lowest risk business of the three. I mean, this company has been operating for such a long time, it is the market leader. To me, the biggest risks here is that the penetration rate stays where it is, and for whatever reason, North American consumers reject the whole idea of pet insurance. If that happens and the penetration rate gets stuck at 1%, this is going to be a terrible investment. However, I think that the odds of that going higher are very high, because people clearly love their pets and people clearly do not like [laughs] huge surprise bills, it’s just a matter of time, I think, that that penetration rate is going to go higher.

Lewis: Yeah. And this is not the only business that is benefiting from, you can call it a couple of different things, the personification of pets, the humidification of pets, I mentioned before, Emily has talked about this plenty on the Tuesday show, but we are seeing higher levels of pet ownership and we’re seeing people spend more money on pets. That’s the thesis with a company like Chewy, which has done very well during the pandemic. And I imagine that with that spending, it’s going to become the awareness that, you know, there are probably ways to spend a little bit less on healthcare and provide some protection. I think a lot of people are going to be very happy about that, particularly some of the newer pet owners, maybe more of that millennial market, a little bit more web savvy, and people that are looking for protection and not having to, you know, pay a huge vet bill.

Feroldi: And let’s not forget, pet insurance benefits the veterinarians too. If a customer has insurance, it’s a lot easier for them to sell the idea of having a surgery or paying for some medication. People are much more willing to consume things when they know that at least a big part of the cost is covered by insurance. By contrast, today, I’m sure there are lots of procedures that are recommended to people, and people just say no, because they don’t want to get that huge bill. So, I could also see this being attractive to consumers and the vets themselves.

Lewis: Do you see the risk here with some of the bigger players, more established players in traditional insurance spaces hopping in here and trying to get a piece of this pie if we start seeing that, you know, 3%, 4%, 10% of pet owners wind up with insurance?

Feroldi: That I think is a risk. They point out that since day one they’ve been competing against 20 other insurance companies, and Trupanion’s advantage is that it is the brand leader. The other thing that this business has done to protect itself that I really like, is that it’s built its software directly integrated into vet offices themselves. That allows claims to be processed in seconds. A vet can submit a claim and have the money in their account literally within a couple of seconds, which makes the reimbursement process painless.

Other insurance companies, the pet owner pays the bill upfront and then later submits for reimbursement, which adds friction. And you can also say that Trupanion has the brand name, it is the No. 1 market share leader by far, as well as the data to price its policies more accurately. I do think there are some competitive advantages at play here, but, to me, the No. 1 risk definitely is competition.

Lewis: I imagine we should also probably touch on valuation here, because given that there are some big growth expectations priced into this business, it is a relatively highly valued insurance business.

Feroldi: Yes. Currently trading at about 23X book value. That is a traditional metric that you can use for insurance companies, although this isn’t exactly a pureplay [laughs] insurance company, nor is it a pureplay tech company. So, 23X book value, trading at about 7.5X sales. If that’s all you knew, and you’re used to investing in SaaS stocks, you’re like, wow! This thing is incredibly cheap. However, the margins profile for this company are dramatically different than they are for a company like, say, Datadog, so not a perfect metric. I don’t think there really is a great metric for judging the value of this company right now, every metric has something wrong with it, other than to say, if the company is successful and can continue growing at a 20% to 30% rate for the next 10 years, the business will be bigger in time.

Lewis: [laughs] And for folks that really want to spend more time understanding the way the insurance industry works and some of the specific metrics there, I highly recommend checking out some of the work from Matt Frankel. He and Jason Moser talk about insurance companies a lot on the Monday show, but Matt also does a lot of writing for Fool.com and has done a lot of primers on that space. So, just definitely someone, if this is interesting to you and we just threw a lot of words out there that you don’t know, that’s a great place to start.

Brian, anything else on Trupanion before we switch to stock No. 2?

Feroldi: No, this is a business that really interests me, and I’m glad we dug into it a little bit more, it’s a fascinating company.

Lewis: Are you a shareholder?

Feroldi: Not yet.

Lewis: Not yet. [laughs] The intrigue. All right. Our stock No. 2 is DermTech (NASDAQ:DMTK), and this is ticker DMTK. Trupanion was a $3 billion company, this one is a bit smaller, Brian.

Feroldi: A bit smaller is one way of putting it, Dylan. Yeah, DermTech, this is a $230 million market cap company, and the size difference is really seen by the risk profile here. I would say that Trupanion is a lower risk 10-bagger potential, this one is as high risk as it gets. So, DermTech is focused on noninvasive skin disease diagnostics, particularly, skin cancer. So, I think most listeners know, the key to fighting cancer is detecting it early. With skin cancer, the five-year survival rate for people that are diagnosed with skin cancer is about 98% when it’s caught in its early stage. That drops to 23% when it’s in its advanced stage. So, early diagnosis is key.

Now, the current standard of care for diagnosing skin cancer is to take a biopsy. So, a surgical biopsy of the lesion is chopped and then sent off to a lab for diagnosis. As you can imagine, that’s a pretty invasive thing, if you’ve ever had that done. Not to mention that only about 1% of the lesion is actually checked, and it’s done by an expert looking at it. There’s some other diagnosis, but there are big problems with this, it’s low accuracy, it’s expensive, but the big thing for patients is, it leaves them a scar.

DermTech is pioneering a brand-new way to do that. Picture a small circle that’s clear, kind of like a band-aid, the idea is you take this band-aid, you put it on top of the lesion and it picks up RNA and DNA from the entire lesion, That’s then peeled off and then sent off to DermTech’s lab who then does genetic analysis on it, that’s far more accurate than the current standard of care, and then a report is sent off to the doctor within a couple of days. The big benefit for the patients here is, no scarring, completely noninvasive. This technology was just recently approved and they are literally launching this to market this quarter, hence why it’s so high-risk, but the potential here is huge.

Lewis: When I see the pitch for this business, Brian, I see it checking a lot of boxes for success in healthcare. You have, generally, a better patient experience using this product than the alternatives, you have better processing and you have lower costs. I think everyone along the value chain of using this product is probably happier that it’s being used.

Feroldi: Yeah. As you said, it checks, really, all the boxes that could make this a blockbuster diagnostic product when compared to the current standard of care. If I was a patient, and I’ve actually had lesions checked out myself, rather than go through that process, I’d just say, just take it off, and I have scars on my back from moles that were taken out.

By contrast, if I could go to the doctor and they put a little band-aid on me, [laughs] take the band-aid off and then send it to the lab and then I know for certain whether or not that could be cancerous or not, wow! Is that attractive. And they say that by using RNA and DNA and their technology, they greatly increase the accuracy rate. And the key thing that you highlighted, Dylan, is this is actually lower cost. The current cost to test per lesion is about $1,000 by using the current standard of care treatment; the cost for this test is going to be about $760. So, still not dirt cheap, but a cost saving nonetheless. And when you combine that with the patient ease-of-use and the accuracy gains, I could see this technology really taking off.

Lewis: I think it’s also important beyond just the individual cost of processing that test, to think about all of the tack-on benefits and likely cost savings that come from making that kind of testing easier. You know, you talked about it before, but survival rates go up dramatically when patients get that testing. So, just from a pure healthcare perspective and wellness perspective, that’s going to be better. But also, if you have early detection, that might put you in a spot where you can go through treatment that is far less costly. And that is something that is hard to capture with some of the numbers that we’re throwing out there, but another major benefit if this winds up panning out.

Feroldi: Yeah. And this company, I think, rightly points out that a number of other diagnostics companies have followed the same playbook to success. One company that they point to is a company called EXACT Sciences which created a revolutionary way to diagnose colon cancer. A little box is sent to your house with a product called Cologuard, you put a stool sample in there, you send it off to the lab and you get an accurate reading. DermTech is essentially trying to do that exact same thing with skincare. And importantly, they also recently got a commercial code from Medicare to reimburse for this technology. The fact that they got that so quickly really says that Medicare is interested in getting this product to its patients. And it’s for the exact reason that you said, not only could they potentially diagnose these diseases much earlier, but it’s going to save them money [laughs] over the current cost of care, that’s really compelling.

Lewis: Brian, when I hear about different innovations in the healthcare space and companies that are investing in different treatments, different therapies, as someone who doesn’t follows this space as closely, it’s very easy for me to be like, well, that sounds awesome, [laughs] I don’t know if they can do it. How do you suss-out the contenders and the pretenders when you’re looking at these types of businesses?

Feroldi: I allocate accordingly, Dylan, I mean, that is the strategy. Whenever you look at a company like this, especially their management presentation, it’s easy to come away and say, wow! This just makes so much sense. However, when it comes to healthcare, the details really, really matter. It’s possible that this technology might turn off doctors that deal with skin cancer for some reason that I can’t detect right now. If I was interested in investing in this technology, I would treat it the exact same way I treat a company like Nano-X, which is, I invest a little bit upfront, and then I wait and I see what is the market reception to this, is revenue growing substantially or is the company outperforming, is the company turning this idea into revenue? That’s the real thing that we want to see. And importantly, along the way, what’s margins looking like? So, I think this company has tremendous potential right now, but the way that I would say this for real is just to watch the financials.

Lewis: Yeah. And on the note of potential, I mean, there are certain therapies, treatments, conditions that immediately, your brain goes, OK, that’s going to be a big figure. You know, if it’s anything related to cancer, if it’s anything related to diabetes, you know that those are going to be big sticker figure markets. So, just thinking about the potential of this business, knowing that this is something that is squarely focused on skin cancer, there’s a pretty decent patient population that they could apply this technology to if it winds up being everything that we expect it to be.

Feroldi: Yeah. They say that one out of every five Americans will develop some type of skin cancer at some point in their lives. There are millions of diagnoses every year and about 20,000 people die from cancer. You add all that up, and based on their current approvals, they believe that their opportunity in the U.S. is about $2.5 billion. I think that might be actually underselling the opportunity, because I could very easily see a patient walking into a doctor’s office and saying, maybe I should have this mole checked out, maybe I shouldn’t, but I don’t want my skin to get cut to get a biopsy here. By comparison, if it’s just, again, putting a band-aid on something, I could see the entire market for diagnosis grow substantially.

The other thing that’s exciting about this is, they believe that it has at-home potential. So, imagine that you’re doing a telehealth visit with somebody and then this kit gets sent to your house. The doctor can walk you through how to use the kit right over the phone and you can mail it back right from the comfort of your own home. If they can get that product to work, I can really see that expanding the market.

Lewis: We talked before, when you first introduced this business about how it is a much smaller company than Trupanion. [laughs] And I think that there are, you know, the risks that are just, kind of, boilerplate risks when you’re investing in businesses of this size, outside of the fact that this is a small company, there’s still lot to be proven, what else do you see as a risk for them?

Feroldi: To me, that is the risk. I mean, right now this is basically an idea that sounds great on paper, but we don’t yet have proof that there’s product market fit, while we wait for that to happen, the company is burning through capital, because it’s in commercialization realm right now, they are hiring sales rep, they are establishing reimbursement, they’re hiring their lab, etc., etc. All those things cost money, how long is it going to take them to ramp up sales fast enough and margins fast enough to kind of offset that, will investors get diluted along the way, we don’t know the answers to a lot of these questions right now, hence why it’s incredibly risky. To me, if the idea works, wow! Is there a lot of upside. What are the chances of that? It’s really hard to say at this point.

Lewis: We’re going to stay in the small cap space for stock No. 3. Our third stock for this discussion is going to be Semler Scientific (OTC:SMLR), and this is ticker SMLR. We probably need to make a specific note about the ticker and where this company trades before we even get into what they do.

Feroldi: Yes, this company is not listed on any major exchanges, it trades over-the-counter. So, it is extremely illiquid, only a few thousand or maybe a few tens of thousands of shares trade every day. Just know that going into this, that this does not trade on a major exchange, which raises the risk profile.

Lewis: And what exactly do they do, Brian?

Feroldi: I’ve highlighted this company on the show before, because I think this is a tremendously exciting business. So, Semler is focused on making diagnostics products for people that are at risk of developing a heart attack or a stroke. The product that they launched in the last couple of years helps to diagnose people with Peripheral Artery Disease, PAD, and that’s when your arteries in your arms and legs narrow due to the progressive buildup of fat. People that have PAD are much more likely to die of a heart attack or of a stroke. So, diagnosing PAD is really, really critical. However, if you have PAD there’s a 75% [laughs] chance that you don’t know it. The company estimates that about 12 million Americans have it and about 75% of those cases are undiagnosed. And the reason is, there’s no symptoms. If you have this disease and your arteries are getting narrow, there’s no way for you to tell until you have a stroke. And the current standard of care for diagnosis is to use a blood pressure cuff to measure blood pressure, which takes up a lot of doctor time, it’s an expensive thing and it has to be done by a vascular technician.

Semler’s innovation was to essentially create a small little clip that looks like an oxygen sensor and it goes on your fingers and your toes. And within five minutes this sensor quickly measures the amount of blood that is flowing to your extremities. If it detects an anomaly, it produces a report that gets sent to the physician, and within five minutes, somebody that has never been — that doesn’t need to be trained on anything, you can quickly tell whether or not one of your patients has PAD. If you do, you can start to take action with drugs or even surgery to prevent heart attacks or strokes.

Lewis: Is the right way to think about this, basically counting cars on the highway, you know, [laughs] kind of a simplification of the technology, basically just having sensors that are watching the flow and counting the flow?

Feroldi: Yes, that’s a great analogy you did there. So, blood pressure detects how much pressure there is, this is detecting flow, how much blood is actually getting to your extremities. And if there’s some kind, if the flow is slowed, that would be a sign that PAD is actually happening. But the big thing here is that it makes something that’s invisible, visible. And importantly, it does so fast and noninvasively. Those two things have really helped this technology to take off.

Lewis: Yeah, we talked about the win-wins earlier and how that’s a huge part of the healthcare market and really, really pushing adoption of some of these more innovative products. When you see that a test could take a third of the time, that’s something that healthcare providers are going to be very happy about.

Feroldi: Definitely. Now, the reason that I brought this company to attention again was because the technology itself is really interesting. And Semler is the only company that’s commercializing this kind of technology in this space. But what really attracts me about this company is the business model, they’re not selling the clips, what they’re selling is the software, the software that actually produces the report. So, if I was a doctor’s office that was interested in this technology, I would pay a recurring monthly fee to Semler for unlimited tests or I would pay a small fee each time a test is performed, selling the software is a much better business than selling the hardware. So, this is a company with 90% gross margin. Incredible.

Lewis: For any of our usual Friday listeners that were worried that Brian was straying from his SaaS tendencies, [laughs] fear not, he finds a way to work it in.

Feroldi: That’s right. SaaS + healthcare, I mean, you got to love it, right?

Lewis: [laughs] And that bears out in the margins. I mean, this company looks way more like a software business than it does a hardware provider or someone who’s, you know, providing anything physical, really, to patients.

Feroldi: Yeah, if you want something that’s really incredible about this company, it’s already highly profitable. Now, these tests are performed in doctor’s offices while a patient is there for a routine visit. As you can imagine, Q2, when everybody was staying at home and avoiding the doctor, results for this company weren’t great, revenue fell 20% last quarter over the prior year, not exactly something you want to see from a growth company. However, even in their most challenging quarter they still produced a gross margin of 90% and made a net income of $1 million. Considering that was the worst operating environment of all-time, that shows you how strong this business is.

Lewis: Yeah. And another position of strength for them, look over at the balance sheet, $14 million in cash, no debt. That’s the kind of thing that puts you in a spot where you can weather a 20% drop in revenue and continue operating just fine.

Feroldi: Yeah. And plus, the 90% gross margin helps to cover that too. But yeah, this company is also in growth mode right now. It’s very small. This year they’ve hired a lot of sales people to really get the word out. And they believe that in the United States that about 300,000 doctor offices are potential customers of theirs. They don’t disclose how many they have thus far, but it’s got to be in the low-thousands at best. I mean, this is a company that’s only doing about $30 million in revenue this year. If this technology takes off, there’s a lot of room for that number to grow.

Lewis: Is it 300,000 doctors’ offices?

Feroldi: 300,000 doctors’ offices in the U.S. Correct.

Lewis: Okay. And the patient population is somewhere around 80 million, is that what they’re saying?

Feroldi: Yes, they believe that as many as 80 million Americans should be screened using this technology each year. And again, if they’re successful there, you know, that about 7 million people that currently have peripheral artery disease, could start to take action to prevent future heart attacks or strokes. It’s again, it’s investing a little bit of money upfront to potentially save a lot of money down the road. That plays right into the healthcare mega push toward health and wellness.

Lewis: So, a lot of the risks for this business are going to be relatively similar to the one that we just talked about, just simply based on size where they are in terms of getting the product into user hands and really collecting money for that, but there are also some kind of business specific risks here based on how they’re currently set up.

Feroldi: Given the company’s size, it has landed a couple of very large customers. And so, customer concentration is a huge issue here. I mean, its top three customers are almost two-thirds of revenue, and one customer alone is about half of revenue. So, if it was to lose that customer, it would be a major blow to the thesis. The good news is, while that is a big risk for investors to watch, these numbers should come down over time as Semler continues to grow and add more doctors’ offices, but for now, I think that that customer concentration is the biggest risk that I’m watching.

Lewis: For folks that may follow you on Twitter, Brian, they might have seen this, you’re @BrianFeroldi and you post a lot of really great content there. But you put up a graphic recently and it was looking at the size of a business and the importance of the leadership team over time. And when a company is this small, the leadership team is far more important.

Feroldi: Definitely. In the early stages of a business, the leadership team matters a tremendous amount because they are hiring the people, they’re hiring engineers, they are developing products, they’re creating the business model. There’s tremendous pressure on them. Over time — I mean, leadership is always important, but it’s especially important in the early, early stages — over time, once the business really starts to take hold and the business model gets put into place and the financials start to come through, the need for a tremendous leadership team diminishes slightly. Again, it’s still important, even for a company like Apple and Amazon, however, leadership teams can have an even more outsized control over the returns of the company when the company is small.

Lewis: So, you mentioned that you talked about this before, and I think, going back into the archives, our conversation about this company was back in February of 2020, so it was before we saw that huge revenue dip due to COVID and all the complications from the pandemic. Looking at it now, about eight months later, is this something that you are more confident in, less confident in, the same, how has time treated this business for you?

Feroldi: Yeah, if anything, I’m more confident. I mean, this is one of the three that I am a shareholder of. And I was incredibly impressed that revenue only fell 20% last quarter. I mean, when you think about the [laughs] macro-operating environment and how many doctors’ offices were closed, to still capture 80% of their previous revenue, that’s pretty incredible. And again, importantly, they were still producing net income during this period. If they can survive that and have a clean balance sheet and produce net income, I’m more confident than I was seven months ago in this company’s future.

Lewis: Makes sense to me. And the valuation isn’t crazy, which I think is kind of interesting for a business that has the opportunity in front of it that it does.

Feroldi: Yeah, if you believe analysts’ estimates, which you know, always take them with a grain of salt, but the company is estimated to only show about 1% revenue growth this year. Hey, I’ll take it given it’s 2020, but rebound that to 60% growth next year. And market watchers believe that the company is going to do about $1.86 in earnings per share. If that’s anywhere close to accurate, then that means that the stock is trading at about 30X forward earnings. That is a [laughs] really compelling valuation, when considering the bottom-line there was earnings, not sales. [laughs]

Lewis: So, Brian, you own Semler, DermTech, and Trupanion, are these stocks that are in your portfolio, on your watchlist, you know, how are you categorizing them?

Feroldi: Of the three, Semler is the one that I own, and I’ve just owned for a long time. I could easily see myself becoming a shareholder of Trupanion and DermTech. DermTech is the highest risk of this group by far, because it’s still pre-revenue, its product hasn’t been proven out, but it also has the highest potential to get 10X returns from here if the technology works.

I think that Trupanion is a company that I have just overlooked, and everything I see about this company suggests it’s a compounding machine. To get that 10X return in the stock could take 10 years or maybe a little more, so it’s not going to 10X overnight, but I think it’s a company that is a pretty low risk market beater.

Lewis: Yeah, and 10X over a decade is still a market-beating return; [laughs] that’s still a very impressive return. And I think that’s worth keeping in mind. When I look at these three, especially because we’re talking about a space that I’m less familiar with, my general approach there is to focus a little bit more on certainty and a little bit less on speculation, just because I have a harder time wrapping my head around the, kind of, wellness, healthcare, and therapy space. And so, if I’m going to power rank these, I think it’s probably, Trupanion, Semler, DermTech. Just because the picture is a little bit clear for those first two.

Feroldi: I think that that’s completely fair; I would probably order them in a similar way. But again, this is more of an idea show. And if you want these companies in your portfolio and you just allocate them accordingly, I think there’s a spot in even conservative investors’ portfolios for companies like these.

Lewis: I think folks are always happy to have an idea show with you, Brian. You are so good at bringing stocks that may be aren’t being talked about too much into the conversation. Thanks so much for joining me today.

Feroldi: Anytime, Dylan.

Lewis: Listeners, that’s going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say “Hey!” shoot us an email at [email protected], or tweet us @MFIndustryFocus. Brian is @BrianFeroldi, I’m @WilyLewis. If you’re looking for more stuff, subscribe in iTunes or wherever you get your podcasts.

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

Thanks to Tim Sparks for all his work behind the glass, and thank you for listening. Until next time, Fool on!

https://www.fool.com/investing/2020/10/26/3-healthcare-stocks-to-watch/
https://www.fool.com/investing/2020/10/26/3-healthcare-stocks-to-watch/

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