Item 2.
Management's Discussion and
Analysis or Plan of Operations
Forward-Looking Statements
This document and the documents incorporated
in this document by reference contain forward-looking statements that are subject to risks and uncertainties. All statements other
than statements of historical fact contained in this document and the materials accompanying this document are forward-looking
statements.
The forward-looking statements are based
on the beliefs of our management, as well as assumptions made by and information currently available to our management. Frequently,
but not always, forward-looking statements are identified by the use of the future tense and by words such as “believes,”
expects,” “anticipates,” “intends,” “will,” “may,” “could,” “would,”
“projects,” “continues,” “estimates” or similar expressions. Forward-looking statements are
not guarantees of future performance and actual results could differ materially from those indicated by the forward-looking statements.
Forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our or our industry’s
actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of
activity, performance, or achievements expressed or implied by the forward-looking statements.
The forward-looking statements contained
or incorporated by reference in this document are forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended (“Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended
(“Exchange Act”) and are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995.
These statements include declarations regarding our plans, intentions, beliefs, or current expectations.
Among the important factors that could
cause actual results to differ materially from those indicated by forward-looking statements are the risks and uncertainties described
under “Risk Factors” in our Annual Report and elsewhere in this document and in our other filings with the SEC.
Forward-looking statements are expressly
qualified in their entirety by this cautionary statement. The forward-looking statements included in this document are made as
of the date of this document and we do not undertake any obligation to update forward-looking statements to reflect new information,
subsequent events, or otherwise.
General
BUSINESS
OVERVIEW
Simulations Plus, Inc., incorporated in
1996, is a premier developer of groundbreaking drug discovery and development software for mechanistic modeling and simulation,
and for machine-learning-based prediction of properties of molecules solely from their structure, and is exploring the application
of its machine-learning technologies in other industries, including aerospace/military and general healthcare. Our pharmaceutical/chemistry
software is licensed to major pharmaceutical, biotechnology, agrochemical, and food industry companies and to regulatory agencies
worldwide for use in the conduct of industry-based research. We also provide consulting services ranging from early drug discovery
through preclinical and clinical trial data analysis and for submissions to regulatory agencies. As the result of acquiring our
Cognigen division in Buffalo in 2014, we are also a leading provider of population modeling and simulation contract research services
for the pharmaceutical and biotechnology industries. Our clinical-pharmacology-based consulting services include pharmacokinetic
and pharmacodynamic modeling, clinical trial simulations, data programming, and technical writing services in support of regulatory
submissions. In addition, we have developed software for harnessing cloud-based computing in support of modeling and simulation
activities and secure data archiving, and we provide consulting services to improve interdisciplinary collaborations and research
and development productivity. Simulations Plus is headquartered in Southern California, with additional offices in Buffalo, New
York; San Diego, California; Auburn, Alabama; Guerneville, California; and Raleigh-Durham, North Carolina. The Company’s
common stock trades on the NASDAQ Capital Market under the symbol “SLP.”
We are a global leader focused on improving
the ways scientists use knowledge and data to predict the properties and outcomes of pharmaceutical and biotechnology agents, and
are one of only two global companies who provide a wide range of preclinical and clinical consulting services and software from
early discovery all the way through clinical trials and beyond to post-patent support of generic drug companies. Our innovations
in integrating new and existing science in medicinal chemistry, computational chemistry, pharmaceutical science, biology, physiology,
and machine learning into our software have made us the leading software provider for physiologically based pharmacokinetics (PBPK)
modeling and simulation and for prediction of molecular properties from structure.
We generate revenue by delivering relevant,
cost-effective software and creative and insightful consulting services. Pharmaceutical and biotechnology companies use our software
programs and scientific knowledge to guide early drug discovery (molecule design and screening), preclinical development, clinical
development, and generic product development programs. They use it to enhance their understanding of the properties of potential
new medicines and to use emerging data to improve formulations, select and justify dosing regimens, optimize clinical trial design,
and simulate outcomes in special populations, such as the elderly and pediatric patients.
PRODUCTS
General
We currently offer eight software products
for pharmaceutical research and development: three simulation programs that provide time-dependent results based on solving large
sets of differential equations: GastroPlus™; DDDPlus™; and MembranePlus™; three programs that are based on predicting
and analyzing static (not time-dependent) properties of chemicals: ADMET Predictor™; MedChem Designer™; and MedChem
Studio™ (the combination of ADMET Predictor, MedChem Designer, and MedChem Studio is called our ADMET Design Suite™);
our newest program which is designed for rapid clinical trial data analysis and regulatory submissions called PKPlus™; and
one program called KIWI™ from our Cognigen division that provides an integrated platform for data analysis and reporting
through our proprietary secure cloud.
GastroPlus
Our flagship product, and currently
our largest source of revenue, is GastroPlus. GastroPlus simulates the absorption, pharmacokinetics, and pharmacodynamics of
drugs administered to humans and animals, and is currently the most widely used commercial software of its type by
pharmaceutical companies, the U.S. Food and Drug Administration (FDA), the U.S. National Institutes of Health (NIH), and
other government agencies in the U.S. and other countries. The FDA currently has 70 GastroPlus licenses.
Because of the widespread use of GastroPlus,
we were the only non-European company invited to join the European Innovative Medicines Initiative (IMI) program for Oral Bioavailability
Tools (OrBiTo). OrBiTo, begun in 2012, is an international collaboration among 27 industry, academic, and government organizations
working in the area of oral absorption of pharmaceutical products. Because we are outside of the European Union, our participation
in this project has been at our own expense, while other members are compensated for their work; however, we are a full member
with access to all of the data and discussions of all other members. We believe our investment to participate in this initiative
has enabled us to benefit from, and to contribute to, advancing the prediction of human oral bioavailability from preclinical data,
and ensures that we are well-known to member pharmaceutical companies and regulatory agencies.
In September 2016 we announced that Simulations
Plus had been invited to join the European SimInhale Consortium and had been admitted to this prestigious group focused on advancing
the state of the art for simulation of inhaled dosage forms. As one of only two U.S. participants, Simulations Plus is participating
in activities designed to
advance particle designs for improved deposition and interaction with lung
tissue; promote realistic computer simulations of particle aerosolization, delivery, and deposition; promote patient-tailored inhaled
medicines; promote integration of device and formulation design; and promote critical assessment of toxicity issues and related
risks.
In September 2014, we entered into a research
collaboration agreement (RCA) with the FDA to enhance the Ocular Compartmental Absorption and Transit (OCAT™) model within
the Additional Dosing Routes Module of GastroPlus. The objective of this agreement is to provide a tool for generic companies and
the FDA to assess the likely bioequivalence of generic drug formulations dosed to the eye. Under this RCA, we receive up to $200,000
per year. This RCA may be renewed for up to a total of three years based on the progress achieved during the project. After a successful
second year, the RCA was renewed for its third year in September 2016, and will expire in September 2017.
We were awarded another RCA by the FDA
in September 2015, this one to expand the capabilities of GastroPlus to simulate the dosing of long-acting injectable microspheres.
This type of dosage form is usually injected via subcutaneous or intramuscular routes, but can also be used for ocular dosing.
Once again, this RCA provides up to $200,000 per year for up to three years. Under this agreement, we are developing simulation
models to deal with the very slow dissolution/decomposition of the microsphere carrier material that gradually releases the active
drug over periods as long as weeks or months. After a successful first year, the RCA was renewed for the second year in September
2016, and will expire in September 2017 unless further renewed.
In addition to the two funded efforts with
the FDA described above, we also have an unfunded RCA with the FDA’s Office of Generic Drugs (OGD) that began in 2014. The
objective of this RCA, which has a five-year term, is directed toward the FDA’s evaluation of mechanistic IVIVCs (
in vitro-in
vivo
correlations) to determine whether mechanistic absorption modeling (MAM) can relate laboratory (
in vitro
) dissolution
experiment results to the behavior of dosage forms in humans and animals (
in vivo
) better than traditional empirical methods.
In April 2017, we released Version 9.5
of GastroPlus after nearly two years of improvements over version 9.0, which was released in April 2015. Version 9.5 is now the
largest single upgrade we’ve made to the program. New functionalities that we believe provide the most advanced decision-making
tool for preclinical and early clinical trial simulation and modeling analysis available today include:
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ability to simulate the absorption and distribution of antibody-drug conjugates (ADCs), which are antibodies that are used to carry small drug molecules to the intended target tissue
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ability to dose via intramuscular injection and an improved model for subcutaneous injection
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several new physiology models, including Chinese and hepatic impairment populations
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revamped workflows for building
in vitro-in vivo
correlations (IVIVCs) and performing virtual bioequivalence trial simulations
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improved reporting capabilities, making it easier for companies wishing to submit results to regulatory agencies
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Our goal with GastroPlus is to integrate
the most advanced science into user-friendly software to enable pharmaceutical researchers and regulators to perform sophisticated
analyses of complex drug behaviors in humans and laboratory animals. Already the most widely used program in the world for physiologically
based pharmacokinetics (PBPK), the addition of these new capabilities is expected to expand the user base in the early pharmaceutical
research and development process, while also helping us further penetrate the biopharmaceuticals, food, cosmetics, and general
toxicology markets.
DDDPlus
DDDPlus simulates
in vitro
(laboratory)
experiments that measure the rate of dissolution of a drug and, if desired, the additives (excipients) in a particular dosage form
(e.g., powder, tablet, capsule, or injectable solids) under a variety of experimental conditions. This unique software program
is used by formulation scientists in industry and the FDA to (1) understand the physical mechanisms affecting the disintegration
and dissolution rates of various formulations, (2) reduce the number of cut-and-try attempts to design new drug formulations, and
(3) design
in vitro
dissolution experiments to better mimic
in vivo
(animal and human) conditions. Version 5.0 of
DDDPlus, which added a number of significant enhancements, was released in April 2016. This version added new formulation types
(controlled release bilayer tablet, delayed release coated tablet, and immediate release coated beads), expanded formulation specification
options, biorelevant solubilities and surfactant effects on dissolution, tablet compression and disintegration models, links with
GastroPlus, and updated licensing. Current improvements in development and testing include new capabilities to simulate
in vitro
dissolution experiments for long-acting injectable microspheres as part of our work under the FDA-funded grant mentioned above.
MembranePlus™
MembranePlus was released in October 2014.
Similar to DDDPlus, MembranePlus simulates laboratory experiments, but in this case, the experiments are for measuring permeability
of drug-like molecules through various membranes, including several different standard cell cultures (Caco-2, MDCK), as well as
artificially formulated membranes (PAMPA). The value of such simulations derives from the fact that when the permeabilities of
the same molecules are measured in different laboratories using (supposedly) the same experimental conditions, the results are
often significantly different. These differences are caused by a complex interplay of factors in how the experiment was set up
and run. MembranePlus simulates these experiments with their specific experimental details, and this enables scientists to better
interpret how results from specific experimental protocols can be used to predict permeability in human and animals, which is the
ultimate goal.
PKPlus™
On August 25, 2016, we announced the release
of a new standalone software product called PKPlus, based on the internal PKPlus Module in GastroPlus that has been available since
2000. The PKPlus Module in GastroPlus provides quick and easy fitting of compartmental pharmacokinetic (PK) models as well as noncompartmental
analysis (NCA) for intravenous and extravascular (oral, dermal, ocular, pulmonary, etc.) doses; however, the PKPlus Module in GastroPlus
was not designed to meet all of the requirements for performing these analyses for Phase 2 and 3 clinical trials, nor to produce
report-quality output for regulatory submissions. The new standalone PKPlus program has been developed to provide the full level
of functionality needed by pharmaceutical industry scientists to perform the analyses and generate the outputs needed to fully
satisfy regulatory agency requirements for both NCA and compartmental PK modeling. After receiving considerable feedback on version
1.0, we are modifying the program to include a number of additional features requested by our users and potential users and expect
to release the next version later this year. We believe the potential number of eventual users for PKPlus is in the thousands world-wide
and that it has the potential to eventually become one of our leading revenue producers.
ADMET Predictor™
ADMET (Absorption, Distribution, Metabolism,
Excretion, and Toxicity) Predictor is a chemistry-based computer program that takes molecular structures (i.e., drawings of molecules
represented in various formats) as inputs and predicts approximately 150 different properties for them at an average rate of over
100,000 compounds per hour on a modern laptop computer. This capability allows chemists to generate estimates for a large number
of important molecular properties without the need to synthesize and test the molecules, as well as to generate estimates of unknown
properties for molecules that have been synthesized, but for which only a limited number of experimental properties have been measured.
Thus, a chemist can assess the likely success of a large number of existing molecules in a company’s chemical library, as
well as molecules that have never been made, by providing their molecular structures, either by drawing them using a tool such
as our MedChem Designer software, or by automatically generating large numbers of molecules using various computer algorithms,
including those embedded in our MedChem Studio software.
For many years, ADMET Predictor has been
top-ranked for predictive accuracy in multiple peer-reviewed, independent comparison studies, while generating its results at a
high throughput rate. Although the state of the art of this type of software does not enable identifying the best molecule in a
series, it does allow early screening of molecules that are highly likely to fail as potential drug candidates (i.e., the worst
molecules, which is usually the majority of a chemical library) before synthesizing and testing them. Thus, millions of virtual
compounds can be created and screened in a day, compared to potentially months or years of work to actually synthesize and test
a much smaller number of actual compounds.
The most recent release of ADMET Predictor,
version 8.0, was released on August 1, 2016. This new version features a completely redesigned and modernized interface as well
as a number of new capabilities to enhance the performance and user-friendliness of the program. In addition, we have integrated
a number of MedChem Studio features into the new ADMET Predictor, and created a tighter integration between the two programs when
a MedChem Studio license is obtained along with an ADMET Predictor license.
The optional ADMET Modeler Module™
in ADMET Predictor enables scientists to use their own experimental data to quickly create proprietary high-quality predictive
models using the same powerful machine-learning methods we use to build our top-ranked property predictions. Pharmaceutical companies
expend substantial time and money conducting a wide variety of experiments on new molecules each year, generating large databases
of experimental data. Using this proprietary data to build predictive models can provide a second return on their investment; however,
model building has traditionally been a difficult and tedious activity performed by specialists. The automation in ADMET Modeler
makes it easy for a scientist to create very powerful models with minimal training.
We released version 8.1 in January 2017.
This new release includes:
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Both 64-bit and 32-bit executables, making it possible to handle larger data sets
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Optimization of spreadsheet and model-building functions to improve efficiency
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Model-building in ADMET Modeler has been streamlined and made much more efficient
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The MedChem Studio™ Module includes combinatorial substituent and scaffold replacement operations
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New
in silico
Ames tests have been added to produce reliable confidence predictions and are more broadly applicable
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ADMET Risk™ scores are now accessible graphically in histograms
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Version 8.5 is now well along in development
and will add a number of powerful new features, including significant improvements to the ADMET Modeler Module.
Potential new markets for machine
learning
We are currently investigating applications
of our sophisticated machine-learning engine outside of our normal pharmaceutical markets. To date, we have conducted several proof-of-concept
studies including: (1) building predictive models for missile aerodynamic force and moment coefficients as a function of missile
geometry, Mach number, and angle of attack, (2) classifying/identifying missiles and other objects from radar tracking data, (3)
mapping jet engine compressor performance to predict when maintenance might be required, and (4) classifying patients as healthy
or experiencing some disease state or genetic disorder evidenced by magnetic resonance imaging (MRI) of the brain. Other potential
applications for this modeling engine have also been identified; however, our focus to date has been primarily in these areas.
We believe our proprietary machine-learning
software engine has a wide variety of potential applications and we intend to pursue funding to develop customized tools to further
monetize our investment in this technology by expanding our markets beyond the life sciences and chemistry. In addition, we are
examining a variety of expanded capabilities to add to the basic modeling engine to accommodate even larger data sets (“big
data analytics”) and new applications.
MedChem Designer™
MedChem Designer was launched in 2011.
It was initially a molecule-drawing program, or “sketcher”, but now has capabilities exceeding those of other molecule-drawing
programs because of its integration with both MedChem Studio and ADMET Predictor. We provide MedChem Designer for free because
we believe that in the long run it will help to increase demand for ADMET Predictor and MedChem Studio, and because most other
existing molecule-drawing programs are also provided for free. Our free version includes a small set of ADMET Predictor’s
best-in-class property predictions, allowing the chemist to modify molecular structures and then see a few key properties very
quickly. With a paid ADMET Predictor license, the chemist would see the entire approximately 150 predictions that are available.
Over 18,000 copies of MedChem Designer have been downloaded by scientists around the world to date.
When used with a license for ADMET Predictor,
MedChem Designer becomes a
de novo
molecule design tool. With it, a researcher can draw one or more molecular structures,
then click on the ADMET Predictor icon and have approximately 150 properties for each structure calculated in seconds, including
our proprietary ADMET Risk index. Researchers can also click on an icon to generate the likely metabolites of a molecule and then
predict all of the properties of those metabolites from ADMET Predictor, including each of their ADMET Risk scores. This is important
because a metabolite of a molecule can be therapeutically beneficial (or harmful) even though the parent molecule is not.
Our proprietary ADMET Risk score provides
a single number that tells the chemist how many default threshold values for various predicted properties were crossed (or violated)
by each structure. Thus, in a single number, the chemist can instantly compare the effects of different structural changes in many
dimensions. The ideal score is zero; however, a low score greater than zero might be acceptable, depending on what property(s)
caused the points to be assigned. If the number is too high (greater than 5 or 6), the molecule is not likely to be successful
as a drug. The default rules can be modified and new rules can be added by the user to include any desired rule set based on any
combination of calculated descriptors, predicted properties, and user inputs. As chemists attempt to modify structures to improve
one property, they often cause others to become unacceptable. Without ADMET Risk, the chemist would have to individually examine
many key properties for each new molecule (and its metabolites) to determine whether any of them became unacceptable as a result
of changing the structure.
MedChem Studio™
MedChem Studio is a powerful software tool
that is used both for data mining and for
de novo
design of new molecules. In its data-mining role, MedChem Studio facilitates
searching large chemical libraries to find molecules that contain identified substructures, and it enables rapid identification
of clusters (classes) of molecules that share common substructures. MedChem Studio version 4.0 was released during fiscal year
2014. We have now merged MedChem Studio with the refactoring of ADMET Predictor 8.0, so that either program can be entered through
the same interface, and the communication between the two programs is enhanced through the seamless integration of both technologies.
We believe this will enhance the attractiveness of both ADMET Predictor and MedChem Studio to medicinal and computational chemists.
While MedChem Designer can be used to refine
a small number of molecules, MedChem Studio can be used to create and screen (with ADMET Predictor) very large numbers of molecules
down to a few promising lead candidates. MedChem Studio has features that enable it to generate new molecular structures using
a variety of
de novo
design methods. When MedChem Studio is used with ADMET Predictor and MedChem Designer (the combination
of which we refer to as our ADMET Design Suite), we believe the programs provide an unmatched capability for chemists to search
through large libraries of compounds that have undergone high-throughput screening experiments to find the most promising classes
(groups of molecules with a large common part of their structures) and molecules that are active against a particular target. In
addition, MedChem Studio can take an interesting (but not acceptable) molecule and, using a variety of design algorithms, quickly
generate many thousands to millions of high quality analogs (similar new molecules). These molecules can then be screened using
ADMET Predictor to find molecules that are predicted to be both active against the target and acceptable in a variety of ADMET
properties. We demonstrated the power of the ADMET Design Suite during two NCE (new chemical entity) projects wherein we designed
lead molecules to inhibit the growth of the
plasmodium falciparum
malaria parasite in one study and lead molecules that
were combined COX-1 and COX-2 inhibitors. In each case, we announced ahead of time that we were attempting to do this, and we reported
the results when the projects were complete. Every molecule we designed and had synthesized hit their targets in both projects.
KIWI
TM
Drug development programs rely increasingly
on modeling and simulation analyses to support decision-making and submissions to regulatory agencies. To ensure high-quality analyses,
organizations must not only apply high-quality science, but must also be able to support the science by being able to validate
the results. KIWI is a cloud-based web application that was developed to efficiently organize, process, maintain, and communicate
the volume of data and results generated by pharmacologists and scientists over the duration of a drug development program. The
validated workflow and tools within KIWI promote traceability and reproducibility of results.
The pharmaceutical industry has been rapidly
adopting cloud technology as a solution to ever-expanding computer processing needs. Leveraging our 20-plus years of experience
in providing an architecture supporting modeling and simulation efforts, we have developed KIWI as a secure, validated, enterprise-scale
environment, enabling global teams to collaborate on model-based decision making. KIWI has proven to be a valuable platform for
encouraging interdisciplinary discussions about the model development process and interpretation of results. We continue to receive
positive feedback about the functionality implemented in KIWI and the value of the approach we have taken to harness cloud technology.
We continue to improve functionality and collaboration within the KIWI platform, and we expect the licensing fee will be a source
of recurring revenue for further development and growth. KIWI Version 1.3 was released in May 2015. This version of KIWI provides
our user community with access to new features that accelerate completion of modeling projects by decreasing run times and facilitating
the comparison and exporting of results across models. These features include dynamic comparisons of model parameter estimates
and diagnostic plots, export of model run records for regulatory submissions, and accelerated infrastructure with the upgrade to
the latest versions of NONMEM® and Perl-speaks-NONMEM running in a 64-bit Linux environment.
KIWI Version 1.6 was released in September
2016. This new version introduced major enhancements in the functionality of visualization tools offered by the platform. These
enhancements include simplifying the creation of plots and comparing them across multiple models, thus accelerating the model refinement
process. In addition, analysts can now conveniently copy visualization preferences across projects, improving consistency and facilitating
collaboration and communication with clients and colleagues. We are now further enhancing KIWI as part of our five-year, almost-$5
million contract with a leading global research foundation.
Contract Research and Consulting Services
Our scientists and engineers have expertise
in drug absorption via various dosing routes (oral, intravenous, ocular, nasal/pulmonary, and dermal), pharmacokinetics, and pharmacodynamics.
They have attended over 200 scientific meetings worldwide in the past four years, often speaking and presenting. We frequently
conduct contracted consulting studies for large customers (including the five largest pharmaceutical companies) who have particularly
difficult problems and who recognize our expertise in solving them, as well as for smaller customers who prefer to have studies
run by our scientists rather than to license our software and train someone to use it. The demand for our consulting services has
been steadily increasing, and we have expanded our consulting teams to meet the increased workload.
We continue working on a five-year consulting
agreement with a major research foundation to implement a platform for coordinating the data generated by global teams engaged
in model-based drug development.
We currently are working with the FDA on
three different Research Collaboration Agreements (RCAs): two funded efforts for the ocular model and long-acting injectable microspheres
and the unfunded IVIVC effort, all described above under “GastroPlus”. We also successfully completed the fifth year
of our five-year renewable collaboration with the Center for Food Safety and Nutrition of the FDA to develop predictive toxicity
models for food additives and contaminants.
Pharmacometric Modeling
We have a reputation for high-quality analyses
and regulatory reporting of data collected during preclinical experiments as well as clinical trials of new and existing pharmaceutical
products, typically working on 30-40 drug projects per year. The model-based analysis of clinical trial data that we perform is
different from the modeling analysis offered by GastroPlus; the former relies more on statistical and semi-mechanistic models,
whereas the latter relies on very detailed mechanistic models. Statistical models rely on direct observation and mathematical equations
that are used to fit data collected across multiple studies along with describing the variability within and between patients.
Mechanistic models are based on a detailed understanding of the human body and the chemistry of the drug and involve mathematical
and scientific representation of the phenomena involved in drug dissolution/precipitation, absorption, distribution, metabolism,
and elimination. Collectively, the models guide drug formulation design and dose selection.
PRODUCT DEVELOPMENT
Development of our software is focused
on expanding product lines, designing enhancements to our core technologies, and integrating existing and new products into our
principal software architecture and platform technologies. We intend to continue to offer regular updates to our products and to
continue to look for opportunities to expand our existing suite of products and services.
To date, we have developed products internally,
sometimes also licensing or acquiring products, or portions of products, from third parties. These arrangements sometimes require
that we pay royalties to third parties. We intend to continue to license or otherwise acquire technology or products from third
parties when it makes business sense to do so. We currently have one license agreement, with BIOVIA, a San Diego division of Dassault
Systemes in France (formerly known as Accelrys, Inc.), pursuant to which a small royalty is paid to BIOVIA from revenues on each
license for the Metabolite module in ADMET Predictor. This license agreement continues in perpetuity and either party has the right
to terminate it.
In 1997 we entered into an exclusive software
licensing agreement with TSRL, Inc. (aka Therapeutic Systems Research Laboratories) (TSRL), pursuant to which TSRL licensed certain
software technology and databases to us, and we paid royalties to TSRL. On May 15, 2014, we and TSRL entered into a termination
and nonassertion agreement pursuant to which the parties agreed to terminate the 1997 exclusive software licensing agreement. As
a result, the Company obtained a perpetual right to use certain source code and data, and TSRL relinquished any rights and claims
to any GastroPlus products and to any claims to royalties or other payments under that agreement, and we agreed to pay TSRL total
consideration of $6,000,000. All payments have now been made as of April 2017. Our payment obligation is being amortized at a constant
rate of $150,000 per quarter until it is completely amortized, after which no further expense will be incurred. To date, this has
resulted in expense savings over $900,000 compared to the royalty payments that would have been paid to TSRL if paid consistent
with past practices.
MARKETING AND DISTRIBUTION
We distribute our products and offer our
services in North America, South America, Europe, Japan, Australia, New Zealand, India, Singapore, Taiwan, and the People’s
Republic of China.
We market our pharmaceutical software and
consulting services through attendance and presentations at scientific meetings, exhibits at trade shows, seminars at pharmaceutical
companies and government agencies, through our website, and using various communication channels to our database of prospects and
customers. At various scientific meetings around the world each year there are numerous presentations and posters presented in
which the reported research was performed using our software. Many of these presentations are from industry and FDA scientists;
some are from our staff. In addition, more than 50 peer-reviewed scientific journal articles, posters, and podium presentations
are typically published each year using our software, mostly by our customers, further supporting its use in a wide range of preclinical
and clinical studies.
Our sales and marketing efforts are handled
primarily internally with our scientific team and several senior management staff assisting our marketing and sales staff with
trade shows, seminars, and customer trainings both online and on-site. We believe that this is more effective than a completely
separate sales team for several reasons: (1) customers appreciate talking directly with software developers and consulting scientists
who can answer a wide range of in-depth technical questions about methods and features; (2) our scientists and engineers gain an
appreciation for the customer’s environment and problems; and (3) we believe the relationships we build through scientist-to-scientist
contact are stronger than relationships built through salesperson-to-scientist contacts. We also have one independent distributor
in Japan and two independent representatives in China who also sell and market our products with support from our scientists and
engineers.
We provide support to the GastroPlus User
Group in Japan, which was organized by Japanese researchers in 2009. In early 2013, a group of scientists in Europe and North America
organized another group following the example set in Japan. Over 850 members have joined this group to date. We support this group
through coordination of online meetings each month and managing the user group web site for exchange of information among members.
These user groups provide us valuable feedback with respect to desired new features and suggested interface changes.
PRODUCTION
Our pharmaceutical software products are
designed and developed by our development teams in California, North Carolina, and New York, with California locations in Lancaster,
Gureneville, San Jose, and San Diego, and in Buffalo, New York. In addition, our Chief Executive Officer works primarily from Auburn,
Alabama. Our products and services are now delivered electronically – we no longer provide CD-ROMs and printed manuals or
reports.
COMPETITION
In our pharmaceutical software and services
business, we compete against a number of established companies that provide screening, testing and research services, and products
that are not based on simulation software. There are also software companies whose products do not compete directly with, but are
sometimes closely related to, ours. Our competitors in this field include some companies with financial, personnel, research, and
marketing resources that are larger than ours. Our management believes there is currently no significant competitive threat to
GastroPlus; however, in spite of a high barrier to entry, one could be developed over time. Our new PKPlus software product will
compete with one major and a few minor software programs; however, the capabilities and design features of PKPlus, along with more
affordable licensing, are expected to generate significant interest. MedChem Studio, MedChem Designer, and ADMET Predictor/ADMET
Modeler operate in a more competitive environment. Several other companies presently offer simulation or modeling software, or
simulation-software-based services, to the pharmaceutical industry.
Major pharmaceutical companies conduct
drug discovery and development efforts through their internal development staffs and through outsourcing. Smaller companies generally
need to outsource a greater percentage of this research. Thus, we compete not only with other software suppliers, but also with
the in-house development teams at some of the larger pharmaceutical companies.
Although competitive products exist, both
new licenses and license renewals for GastroPlus have continued to grow. We believe that we enjoy a dominant market share in this
segment. We believe our ADMET Predictor/ADMET Modeler, MedChem Studio, MedChem Designer, DDDPlus, MembranePlus, PKPlus, and KIWI
software offerings are each unique in their combination of capabilities and we intend to continue to market them aggressively.
We believe the key factors in our ability
to successfully compete in this field are our ability to: (1) continue to invest in research and development, and develop and support
industry-leading simulation and modeling software and related products and services to effectively predict activities and ADMET-related
behaviors of new drug-like compounds, (2) design new molecules with acceptable activity and ADMET properties, (3) develop and maintain
a proprietary database of results of physical experiments that serve as a basis for simulated studies and empirical models, (4)
attract and retain a highly skilled scientific and engineering team, (5) aggressively our products and services to our global market,
and (6) develop and maintain relationships with research and development departments of pharmaceutical companies, universities,
and government agencies.
In addition, we actively seek strategic
acquisitions to expand the pharmaceutical software and services business and to explore opportunities in aerospace and general
healthcare.
STRATEGY
Our business strategy is to do the things
we need to do to promote growth both organically (i.e., by expanding our current products and services through in-house efforts)
and by acquisition. We believe in the “Built to Last” approach - that the fundamental science and technologies that
underlie our business units are the keys both to improving our existing products and to expanding the product line with new products
that meet our various customers’ needs. We believe the continued growth of our pharmaceutical software and services business
segment is the result of steadily increasing adoption of simulation and modeling software tools across the pharmaceutical industry,
as well as the world-class expertise we offer as consultants to assist companies involved in the research and development of new
medicines. We have received a continuing series of study contracts with pharmaceutical companies ranging from several of the largest
in the world to a number of medium-sized and smaller companies in the U.S. and Europe.
In the fiscal year ended August 31, 2016
we distributed $0.20 per share in dividends to our shareholders. In November 2016, February 2017, and May 2017 we distributed quarterly
dividends of $0.05 per share. We anticipate future dividends to be at least $0.05 per share per quarter; however, there can be
no assurances that such dividends will be distributed, or if so, whether the amounts will be more, less, or the same as expected.
The Board of Directors must approve each quarterly dividend distribution and may decide to increase, decrease, or eliminate dividend
distributions at any time.
Results of Operations
Comparison of Three Months Ended May 31, 2017 and 2016.
The following table sets forth our condensed
statements of operations (in thousands) and the percentages that such items bear to net sales (because of rounding, numbers may
not foot):
|
|
Three Months Ended
|
|
|
|
5/31/17
|
|
|
5/31/16
|
|
Net revenues
|
|
$
|
6,749
|
|
|
|
100.0%
|
|
|
$
|
6,012
|
|
|
|
100.0%
|
|
Cost of revenues
|
|
|
1,445
|
|
|
|
21.4
|
|
|
|
1,195
|
|
|
|
19.9
|
|
Gross profit
|
|
|
5,304
|
|
|
|
78.6
|
|
|
|
4,817
|
|
|
|
80.1
|
|
Selling, general and administrative
|
|
|
1,955
|
|
|
|
29.0
|
|
|
|
1,681
|
|
|
|
28.0
|
|
Research and development
|
|
|
254
|
|
|
|
3.7
|
|
|
|
348
|
|
|
|
5.8
|
|
Total operating expenses
|
|
|
2,209
|
|
|
|
32.7
|
|
|
|
2,029
|
|
|
|
33.8
|
|
Income from operations
|
|
|
3,095
|
|
|
|
45.9
|
|
|
|
2,788
|
|
|
|
46.4
|
|
Other income
|
|
|
(10
|
)
|
|
|
(0.2
|
)
|
|
|
12
|
|
|
|
0.2
|
|
Income from operations before taxes
|
|
|
3,085
|
|
|
|
45.7
|
|
|
|
2,800
|
|
|
|
46.6
|
|
(Provision for) income taxes
|
|
|
(1,005
|
)
|
|
|
(14.9
|
)
|
|
|
(891
|
)
|
|
|
(14.8
|
)
|
Net income
|
|
$
|
2,080
|
|
|
|
30.8%
|
|
|
$
|
1,909
|
|
|
|
31.8%
|
|
Net Revenues
Consolidated net revenues increased by
12.2% or $736,000 to $6.75 million in the third fiscal quarter of Fiscal Year 2017 (“3QFY17”) from $6.01 million in
the third fiscal quarter of Fiscal Year 2016 (“3QFY16”). This net increase was due to a $284,000 increase in revenues
generated by our Lancaster Division, representing a 6.1% increase over 3QFY16, along with an increase of $453,000 or 33.6% in revenues
of our Buffalo Division to $1.80 million in 3QFY17 from $1.35 million in 3QFY16. Consolidated software and software-related sales
increased $223,000 or 4.9%, while consolidated consulting and analytical study revenues increased $513,000 or 34.9% over 3QFY16.
Cost of Revenues
Consolidated cost of revenues increased
by $250,000, or 20.9%, in 3QFY17 to $1.45 million from $1.20 million in 3QFY16. Cost of Revenues as a percentage of revenue increased
by 1.5% in 3QFY17 to 21.4% as compared to 19.9% in 3QFY16. $209,000 of the increased costs are allocated labor related to increased
studies and contracts, and software amortization increase by $50,000.
Gross Profit
Consolidated gross profits increased $486,000
or 10.1%, to $5.30 million in 3QFY17 from $4.82 million in 3QFY16. Our Lancaster Division accounted for a $233,000 increase, which
came from a mix of increased software license sales and analytical study revenues, while our Buffalo Division showed a $253,000
increase mainly from consulting revenues. Consolidated Gross profit as a percentage of revenues decreased 1.5% to 78.6% in 3QFY17
from 80.1% in 3QFY16.
Selling, General and Administrative Expenses
Selling, general, and administrative (SG&A)
expenses increased $274,000, or 16.3%, to $1.95 million in 3QFY17, from $1.68 million in 3QFY16.
The major increases in SG&A expenses
this year compared to last year were:
|
·
|
Commissions increased $94,000 – higher commissionable sales in Asia
|
|
·
|
Salaries and Wages increased $94,000 – increases in wages over the prior year, higher increased non-cash stock compensation costs, and a higher percentage of allocated G&A labor by scientific staff.
|
|
·
|
Recruitment and Hiring increased $34,000 – hiring fees and moving costs for increased staffing
|
|
·
|
Acquisition Costs DILIsym Services, Inc.—costs of acquisition during the quarter were $144,000 which included legal, M&A, accounting and other direct acquisition related costs
|
The major decreases in SG&A expenses
this year compared to last year were:
|
·
|
Selling expenses decreased by $27,000 web and website redevelopment costs were down over the prior year
|
|
·
|
Professional Fees-Accounting–decreased by $55,000 lower compliance cost associated with Sarbanes-Oxley incurred in the current year
|
Research and Development
Total research and development cost decreased
$19,000 in 3QFY17 compared to 3QFY16. In 3QFY17 we incurred approximately $598,000 of research and development costs, of which
$344,000 was capitalized and $254,000 was expensed. In 3QFY16 we incurred approximately $617,000 of research and development costs,
of which $269,000 was capitalized and $348,000 was expensed.
Provision for Income Taxes
The provision for income taxes was $1.00
million for 3QFY17 compared to $891,000 for 3QFY16. Our effective tax rate decreased to 32.57% in 3Q17from 34.4% in 3QFY16. This
decrease is a result of the effect of tax credits and equity based compensation on earnings in 3QFY17.
Net Income
Net income increased by $171,000 or 8.9%,
in 3QFY17 to $2.08 million from $1.91 million in 3QFY16. Net earnings from our Lancaster division were up $36,000 or 2.0% to $1.78
million in 3QFY17. Approximately $144,000 in one-time pretax charges related to the acquisition of DILIsym Services, Inc. were
expensed to the Lancaster division in this reporting period, which lowered net income by approximately $97,000 for 3QFY17. Net
earnings for our Buffalo division increased by $131,000 or 102.3% to $266,000 in 3QFY17.
Comparison of Nine Months Ended May 31, 2017 and 2016
The following table sets forth our condensed statements of operations
(in thousands) and the percentages that such items bear to net sales (because of rounding, numbers may not foot):
|
|
Nine Months Ended
|
|
|
|
5/31/17
|
|
|
5/31/16
|
|
|
|
|
|
|
|
|
Net revenues
|
|
$
|
17,872
|
|
|
|
100.0%
|
|
|
$
|
16,015
|
|
|
|
100.0%
|
|
Cost of revenues
|
|
|
4,335
|
|
|
|
24.2
|
|
|
|
3,542
|
|
|
|
22.1
|
|
Gross profit
|
|
|
13,537
|
|
|
|
75.8
|
|
|
|
12,473
|
|
|
|
77.9
|
|
Selling, general and administrative
|
|
|
5,767
|
|
|
|
32.3
|
|
|
|
5,080
|
|
|
|
31.7
|
|
Research and development
|
|
|
953
|
|
|
|
5.3
|
|
|
|
1,161
|
|
|
|
7.3
|
|
Total operating expenses
|
|
|
6,719
|
|
|
|
37.6
|
|
|
|
6,241
|
|
|
|
39.0
|
|
Income from operations
|
|
|
6,818
|
|
|
|
38.2
|
|
|
|
6,232
|
|
|
|
38.9
|
|
Other income
|
|
|
19
|
|
|
|
0.1
|
|
|
|
(22
|
)
|
|
|
(0.1
|
)
|
Income from operations before taxes
|
|
|
6,837
|
|
|
|
38.3
|
|
|
|
6,210
|
|
|
|
38.8
|
|
(Provision for) income taxes
|
|
|
(2,200
|
)
|
|
|
(12.3
|
)
|
|
|
(2,048
|
)
|
|
|
(12.8
|
)
|
Net income
|
|
$
|
4,637
|
|
|
|
25.9%
|
|
|
$
|
4,161
|
|
|
|
26.0%
|
|
Net Revenues
Consolidated net revenues increased by
11.6% or $1.86 million to $17.87 million in the first nine months of Fiscal Year 2017 (“9moFY17”) from $16.01 million
in the first nine months of Fiscal Year 2016 (“9moFY16). $895,000 of this increase was from revenues generated by our Buffalo
Division, representing a 20.8% increase over 9moFY16. Net revenues of the Lancaster Division increased $963,000, or 8.2%, to $11.72
million for 9moFY17 from $11.72 million in 9moFY16. Consolidated software and software-related sales increased $751,000, or 6.7%,
in 9moFY17, while consolidated consulting and analytical study revenues increased $1.11 million, or 23.2%, over 9moFY16.
Cost of Revenues
Consolidated cost of revenues increased
by 22.4% or $793,000 in 9moFY17 to $4.33 million from $3.54 million in 9moFY16. The increase came mainly from $472,000 of increased
labor related to studies and contracts, $65,000 of increased costs associated with training programs, increased software amortization
of $129,000, and $108,000 of direct contract-related expenses. Consolidated cost of revenues as a percentage of revenue increased
from 22.1% in 9moFY16 to 24.2% in 9moFY17.
Gross Profit
Consolidated gross profit increased $1.06
million or 8.5%, to $13.53 million in 9moFY17 from $12.47 million in 9moFY16. $415,000 of this increase in gross margin is from
our Buffalo Division, which showed a 56.9% gross margin on $5.19 million in revenues for 9moFY17. Our Lancaster Division accounted
for $649,000 of the increase, showing an 83.4% gross margin for the nine-month period.
Selling, General and Administrative Expenses
Selling, general, and administrative (SG&A) expenses increased
$687,000 or 13.5%, to $5.77 million in 9moFY17 from $5.08 million in 9moFY16.
|
·
|
Salaries and Wages increased $183,000 – increases in wages, taxes, and benefits over the prior year, higher annual bonuses paid based on increased profit, increased non-cash stock compensation costs, and a higher percentage of allocated G&A labor by scientific staff
|
|
·
|
Commission expense increased $102,000 – higher commissionable sales in Asia
|
|
·
|
Professional fees increased $316,000 – this increase is the result of the company’s transition to accelerated filer status and the cost of the Company’s Sarbanes-Oxley internal-control-related costs, as well as additional accounting compliance and legal costs associated with reviews of our proxy, 10-K, Equity Incentive Plan, and other corporate documents
|
|
·
|
Acquisition Costs DILIsym Services, Inc.—costs of acquisition during the nine months were $261,000, which included legal, M&A, accounting and other direct acquisition related costs
|
The major decreases in SG&A expenses
this year compared to last year were:
|
·
|
Selling expenses decreased by $53,000 mostly as advertising and website redevelopment costs were down over the prior year
|
|
·
|
Travel and Entertainment decreased by $45,000 – lower cost of conference attendance and foreign travel
|
Research and Development
We incurred approximately $1.89 million
of research and development costs during 9moFY17. Of this amount, $928,000 was capitalized software development costs and $952,000
was expensed. We incurred approximately $1.97 million of research and development costs during 9moFY16. Of this amount, $814,000
was capitalized software development costs and $1.16 million was expensed.
Other income (expense)
Other income increased $41,000 in 9moFY17
and showed income of $19,000 in 9moFY17 compared to an expense of $21,000 in 9MoFY16. Foreign currency exchange gains accounted
for this change due to the dollar strengthening in relation to the Japanese yen.
Provision for Income Taxes
The provision for income taxes was $2.20
million for 9moFY17 compared to $2.05 million for 9moFY16. Our effective tax rate decreased to 32.2% in 9moFY17, down from 33.0%
in 9moFY16 due mainly to the effect of stock-based compensation.
Net Income
Net income increased by $476,000, or 11.4%,
to $4.64 million in 9moFY17 from $4.16 million in 9moFY16. The increase comes from revenue growth in both divisions of the Company.
Net earnings from our Lancaster division were up $260,000 or 7% to $3.95 million in 9moFY17 from $3.69 million in 9moFY16. Approximately
$261,000 in one-time pretax charges related to the acquisition of DILIsym Services, Inc. were expensed to the Lancaster division
in 9moFY17, which lowered net income by approximately $177,000. Net earnings for our Buffalo division increased by $216,000 or
45.9% to $687,000 in 9moFY17 from $471,000 in 9moFY16.
Liquidity and Capital Resources
Our principal sources of capital have been
cash flows from our operations. We have achieved continuous positive operating cash flow over the last nine fiscal years. We believe
that our existing capital and anticipated funds from operations will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures for the foreseeable future. Thereafter, if cash generated from operations is insufficient to satisfy
our capital requirements, we may open a revolving line of credit with a bank, or we may have to sell additional equity or debt
securities or obtain expanded credit facilities. In the event such financing is needed in the future, there can be no assurance
that such financing will be available to us, or, if available, that it will be in amounts and on terms acceptable to us. If cash
flows from operations became insufficient to continue operations at the current level, and if no additional financing was obtained,
then management would restructure the Company in a way to preserve its pharmaceutical business while maintaining expenses within
operating cash flows.