SEMLER SCIENTIFIC, INC. The following discussion and analysis should be read together with our financial statements and the related notes appearing elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. See "Forward-Looking Statements" for a discussion of the uncertainties, risks and assumptions associated with these statements. Actual results and the timing of events could differ materially from those discussed in our forward-looking statements as a result of many factors, including those set forth under "Risk Factors" and elsewhere in this annual report on Form 10-K. Overview We are a company providing technology solutions to improve the clinical effectiveness and efficiency of healthcare providers. Our mission is to develop, manufacture and market innovative proprietary products and services that assist our customers in evaluating and treating chronic diseases. In 2011, we began commercializing our first patented andU.S. Food and Drug Administration , or FDA, cleared product, which measured arterial blood flow in the extremities to aid in the diagnosis of peripheral arterial disease, or PAD. InMarch 2015 , we received FDA 510(k) clearance for the next generation version of our product, QuantaFlo®, which we began commercializing inAugust 2015 . We believe our products and services position us to provide valuable information to our customer base, which in turn permits them to better guide patient care. In the year endedDecember 31, 2019 , we had total revenues of$32,767,000 and net income of$15,084,000 compared to total revenues of$21,491,000 and net income of$5,014,000 in 2018. We had an income tax benefit of$4,383,000 in 2019, primarily due to the release of a tax valuation allowance in the third quarter, as compared to income tax expense of$26,000 in 2018. Our pre-tax net income was$10,701,000 in 2019 compared to$5,040,000 in 2018. In the three months endedDecember 31, 2019 , we had net income of$2,833,000 compared to net income of$1,387,000 for the three months endedDecember 31, 2018 . Sources of Revenues and Expenses Revenues We generate revenues primarily from the rental or license of our vascular testing product. We recognize revenues from the licensing of our vascular testing product pursuant to agreements that normally automatically renew each month with revenues recognized on a daily convention basis. Our arrangements with customers for our vascular testing product are normally on a month-to-month basis with fees billed at the rates established in our customer agreements, which are either fixed fees, or variable fees based on usage. We also recognize revenue for hardware and supplies sales as of the date of shipment. Cost of revenues Our cost of revenues for our vascular testing product consists primarily of five components: the depreciation expense of our vascular testing product for lease; the write-off of the residual value of our vascular testing products retired from active leasing; manufacturing oversight personnel costs; the cost of hardware and supplies sold; and other miscellaneous items, such as freight, that are not directly related to product production. Each vascular testing product unit has a depreciation schedule based on the cost of the unit. The cost of each unit is depreciated on a straight-line basis over 36 months. Each unit has its own cost of production, which varies from time to time. We believe that the cost of each unit is a function of manufacturing efficiencies, supply costs and fixed overhead expense as affected by volume of units produced, which change from time to time. When cost of production is lower, the new units have a lower monthly depreciation and decrease the average depreciation per unit per month, which means our cost of revenues is lower. Similarly, if cost of production is higher, the new units will have a higher monthly depreciation and increase the average depreciation per unit per month, which means our cost of revenues is higher. We believe growth in the number of monthly depreciation charges is predominately due to our sales and marketing efforts, which add new customers to an established customer base. The retirement of units from active leasing 32
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is primarily a function of the aggregate number of vascular testing units rented and the occurrence from time to time of system upgrades. The cost of hardware or supplies sold are the cost of production for the item sold. The other costs of revenue vary primarily as a function of the aggregate number of vascular testing units rented and changes in operations such as manufacturing, delivery or maintenance. Engineering and product development expense Our engineering and product development expense consists of costs associated with the design, development, testing and enhancement of our vascular testing product and other products in development. We also include salaries and related employee benefits, research-related overhead expenses and fees paid to external service providers in our engineering and product development expense. Sales and marketing expense Our sales and marketing expense consists primarily of sales commissions and support costs, salaries and related employee benefits, travel, education, trade show and marketing costs. General and administrative expense Our general and administrative expense consists primarily of salaries and related employee benefits, professional service fees, associated travel costs and depreciation and amortization expense. Total other expense Our total other income expense primarily reflects other taxes and fees as well as interest income and expense. Critical Accounting Policies and Estimates The preparation of financial statements in conformity withU.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in the financial statements. Critical accounting policies are those accounting policies that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. While we base our estimates and judgments on our experience and on various other factors that we believe to be reasonable under the circumstances, actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies used in the preparation of our financial statements require significant judgments and estimates. For additional information relating to these and other accounting policies, see Note 2 to our audited financial statements, appearing elsewhere in this this annual report on Form 10-K. Revenue Recognition We recognize revenue from the licensing of our vascular testing product pursuant to agreements that automatically renew each month with revenue recognized on a daily convention basis. Our arrangements with customers for our vascular testing product are normally on a month-to-month basis with fees billed at the rates established in the customer agreement, which are either fixed fees or variable fees based on usage. We also recognize revenue for hardware and supplies sales as of the date of shipment. Stock-Based Compensation We recognize compensation expense in an amount equal to the estimated grant-date fair value of each option grant, or stock award over the estimated period of service and vesting. Although we calculate the fair value under the Black Scholes option pricing model, which is a standard option pricing model, this model still requires the use of numerous assumptions, including, among others, the expected life (turnover), volatility of the underlying equity security, a risk-free interest rate and expected dividends. The model and assumptions also attempt to account for changing employee behavior as the stock price changes and capture 33
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the observed pattern of increasing rates of exercise as the stock price increases. The use of different values by management in connection with these assumptions in the Black Scholes option pricing model could produce substantially different results. Accounting for Income Taxes Deferred income taxes result primarily from temporary differences between financial and tax reporting. Deferred tax assets and liabilities are determined based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted tax rates. Future tax benefits are subject to a valuation allowance when management is unable to conclude that our deferred tax assets will more-likely-than-not be realized from the results of operations. Our estimate for the valuation allowance for deferred tax assets requires management to make significant estimates and judgments about projected future operating results. If actual results differ from these projections or if management's expectations of future results change, it may be necessary to adjust the valuation allowance. Factors Affecting Future Results We have not identified any factors that have a recurring effect that are necessary to understand period to period comparisons as appropriate, nor any one-time events that have an effect on the financials. Results of Operations Year EndedDecember 31, 2019 Compared to Year EndedDecember 31, 2018 Revenues We had revenues of$32,767,000 for the year endedDecember 31, 2019 , an increase of$11,276,000 , or 52.5%, compared to$21,491,000 in 2018. Our revenues are primarily from fees charged to customers for use of our vascular testing products and from sale of accessories used with these products. We recognized revenues of$31,840,000 from fees for our vascular testing products in 2019, an increase of$10,735,000 compared to$21,105,000 in 2018. The remainder was from other equipment/supply sales of accessories, which were$927,000 in 2019 as compared to$386,000 in 2018. Revenues from fees for vascular testing products are recognized monthly for each unit installed with a customer, usually billed as a fixed monthly fee or as a variable monthly fee dependent on usage. The primary reason for the increase in revenues was growth in the number of installed units from both new customers and established customers, which we believe is the result of our sales and marketing efforts. Operating expenses We had total operating expenses of$22,059,000 for the year endedDecember 31, 2019 , an increase of$5,910,000 , or 36.6%, compared to$16,149,000 in 2018. The primary reason for this change was overall growth in our business, increased compensation of the sales team and increased headcount of field sales and technical support personnel to service the expanding number of customers. As a percentage of revenues, operating expenses decreased to 67.3% in 2019, as compared to 75.1% in 2018. The changes in the various components of our operating expenses are described below. Cost of revenues We had cost of revenues of$3,661,000 for the year endedDecember 31, 2019 , an increase of$958,000 , or 35.4%, from$2,703,000 for 2018. The primary reason for this change was increased costs due to increased sales volume of, placement of and technical support for installations in the field. These increases were partially offset by lower depreciation per unit per month as a greater percentage of installations were software and sensor only rather than laptop, software and sensor, as well as lower residual value for retired units. As a percentage of revenues, cost of revenues decreased to 11.2% in 2019, as compared to 12.6% in 2018. Engineering and product development expense We had engineering and product development expense of$2,479,000 for the year endedDecember 31, 2019 , an increase of$394,000 , or 18.9%, compared to$2,085,000 in 2018. The increase was primarily due to 34
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timing of consultant costs, personnel and other costs associated with our product development and customization efforts. As a percentage of revenues, engineering and product development expense decreased to 7.6% in 2019, as compared to 9.7% in 2018. Sales and marketing expense We had sales and marketing expense of$8,965,000 for the year endedDecember 31, 2019 , an increase of$1,763,000 , or 24.5%, compared to$7,202,000 in 2018. The increase was primarily due to higher sales compensation and personnel expense and the continued expansion of existing customer orders, marketing activities and increased headcount and associated expense as compared to the prior year period. As a percentage of revenues, sales and marketing expense decreased to 27.4% in 2019, as compared to 33.5% in 2018. General and administrative expense We had general and administrative expense of$6,954,000 for the year endedDecember 31, 2019 , an increase of$2,795,000 , or 67.2%, compared to$4,159,000 in 2018. The increase was primarily due to the growth in our business, higher professional fees and higher expenses for personnel and our board of directors. As a percentage of revenues, general and administrative expense was 21.2% in 2019, as compared to 19.4% in 2018. Other expense We had other expense of$7,000 for 2019, a decrease of$295,000 , or 97.7%, compared to$302,000 in 2018. The decrease was primarily due to lower interest expense associated with retirement of notes payable. Provision for taxes In 2019, we recorded a tax benefit of$4,383,000 , compared to a tax expense of$26,000 in 2018. The decrease in income tax expense was primarily due to an income tax benefit recognized in 2019 relating to the release of the entire valuation allowance against deferred tax assets. The valuation allowance was released in the third quarter of 2019 due to our recent history of eight straight quarters of positive income before income taxes, resulting in an income tax benefit. Due to full release of the valuation allowance in the third quarter of 2019, income in future periods may also result in income tax expense. As ofDecember 31, 2019 , we had federal NOL carryforwards of$10.3 million . Net income For the foregoing reasons, we had a net income of$15,084,000 for the year endedDecember 31, 2019 , an increase of$10,070,000 , or 200.8%, compared to a net income of$5,014,000 for the year endedDecember 31, 2018 . Liquidity and Capital Resources We had cash of$7,741,000 atDecember 31, 2019 , compared to cash of$3,284,000 atDecember 31, 2018 , and total current liabilities of$5,207,000 atDecember 31, 2019 , compared to$3,512,000 atDecember 31, 2018 . As ofDecember 31, 2019 , we had working capital of approximately$6,236,000 . Our cash is held in a variety of non-interest bearing bank accounts and interest-bearing instruments subject to investment guidelines allowing for holdings inU.S. government and agency securities, corporate securities, taxable municipal bonds, commercial paper and money market accounts. In addition, we may also choose to invest some of our cash resources in other entities that may have complementary technologies or product offerings. Operating activities We generated$12,728,000 of net cash from operating activities for the year endedDecember 31, 2019 , compared to$4,697,000 of net cash in operating activities for the year endedDecember 31, 2018 . The improvement was primarily due to changes in net income, as well as both non-cash adjustments and operating 35
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assets and liabilities, which occurred due to growth in our business. Non-cash adjustments to reconcile net income to net cash from operating activities were$3,250,000 in the year endedDecember 31, 2019 . These non-cash adjustments primarily reflect the deferred tax asset of$4,501,000 , partially offset by depreciation of assets for lease of$483,000 , stock-based compensation expense of$365,000 , loss on disposal of assets for lease of$206,000 , fixed assets depreciation and amortization of$149,000 and allowance for doubtful accounts of$48,000 . Changes in operating assets and liabilities provided$894,000 of net cash. These changes in operating assets and liabilities included cash provided by accrued expenses of$1,113,000 , deferred revenue of$520,000 and accounts payable of$58,000 , partially offset by cash used by trade accounts receivable of$734,000 and prepaid expenses of$63,000 . Investing activities We used$1,698,000 of net cash in investing activities for the year endedDecember 31, 2019 , primarily attributable to purchase of assets for lease of$1,524,000 and additions to property and equipment of$174,000 , to support our growing business. We used$843,000 of net cash in investing activities for the year endedDecember 31, 2018 , primarily attributable to purchase of assets for lease of$706,000 and additions to property and equipment of$137,000 , to support our growing business. Financing activities We used$6,573,000 of net cash from financing activities during the year endedDecember 31, 2019 , primarily due to cash used in payments for purchases of warrants of$6,633,000 , partially offset by proceeds from exercise of stock options of$60,000 . We used$2,027,000 of net cash from financing activities during the year endedDecember 31, 2018 , primarily due to cash used in payments of loans payable of$2,897,000 , partially offset by proceeds from issuance of common stock of$870,000 (including$456,000 from exercise of stock options and$414,000 from exercise of warrants). Description of Indebtedness We do not currently have any outstanding material indebtedness. Off-Balance Sheet Arrangements As of each ofDecember 31, 2019 and 2018, we had no off-balance sheet arrangements. Commitments and Contingencies As of each ofDecember 31, 2019 and 2018, other than employment/consulting agreements with our executive officers and our San Jose lease, we had no material commitments other than the liabilities reflected in our financial statements. ITEM 7A.
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