Schrödinger: Positive Signs Despite The Share Price Decline

seekingalpha11-21 21:49

Schrödinger's growth was soft in the third quarter, and the company's losses continue to grow due to investments in internal programs.Operating expenses are expected to level out going forward, though...

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The Novartis deal is also material relative to Schrödinger's enterprise value. None of this really matters in the short term, though, as investors only see a cash-burning company that is many years away from bringing a drug to market. Despite this negative sentiment, Schrödinger's operating expenses should begin to level out in the coming quarters and the company will soon return to YoY growth. The last time I wrote about Schrödinger, I suggested that investors would likely need to see more evidence of drug discovery success before the stock moves higher. I continue to think that this is the case, with Schrödinger's stock barely reacting to positives like Lilly's $3.2 billion acquisition of Morphic and Schrödinger's large collaboration with Novartis. Market Conditions Biotech and pharma stocks have been hit by Trump's election and Robert Kennedy Junior's potential role in health regulation. Biden's presidency was already a major blow to the sector due to the Inflation Reduction Act and an aggressive FTC. The reaction to Trump's re-election may be overdone, though. Trump previously proposed a most favored nation drug pricing policy, where Americans would only pay the same amount as other high-income countries. While this suggests a desire to reduce drug pricing, it appears to be driven less by a belief that drug companies are earning too much and more by a desire to force other nations to pay their fair share of R&D costs. Trump may also move to repeal the IRA, although this doesn't appear to be high on the agenda. While uncertainty is elevated, it is difficult to see Trump implementing policies that would hurt American businesses. Figure 1: Schrödinger Performance Relative to the Biotech Sector and the Market (Seeking Alpha) Schrödinger Business Updates Schrödinger has started its predictive tox project, which is partly funded by a grant from the Gates Foundation. The project is using Schrödinger's to predict the interaction of molecules with off-target proteins. This could help to improve the properties of drug development candidates and reduce the risk of development failure associated with binding to off-target proteins. Schrödinger is reportedly making good progress, expanding the number of targets that are part of the virtual panel. While Schrödinger is using the technology extensively in its collaboration programs, the software is not yet widely available to customers. Schrödinger recently received an additional $99.5 million (on top of the initial $10 million grant) from the Bill & Melinda Gates Foundation to further accelerate this initiative. The majority of this funding is expected to be recognized as revenue in 2025. While this program is an incremental source of revenue at the moment, it should also lead to increased software revenue over time and potentially improve the quality of Schrödinger drug candidates entering the clinic in the coming years. Companies co-founded by Schrödinger also continue to progress:  Ajax Therapeutics recently dosed the first patient in its first Phase I study. This comes after the company recently raised $95 million in a Series C financing. Nimbus announced updated Phase I/II clinical data for its HPK1 inhibitor. Schrödinger received $48 million as a result of Lilly's acquisition of Morphic.  Schrödinger's proprietary pipeline is also advancing, with initial data from all three clinical-stage programs expected next year:  SGR-1505 (MALT1 inhibitor) - advancing in a Phase I study in patients with relapsed refractory B-cell lymphomas. SGR-2921 (CDC7 inhibitor) - advancing through a Phase I study in patients with relapsed refractory acute myeloid leukemia. SGR-2921 was recently granted FDA Fast-Track designation. SGR-3515 (Wee1/Myt1 co-inhibitor) - Phase I study in patients with advanced solid tumors. Schrödinger recently presented pre-clinical data demonstrating a favorable pharmacological profile.  While the release of clinical data will be an important step forward for Schrödinger, the current focus is on safety, PK, PD, and early evidence of efficacy. The SGR-1505 study is not powered for a full efficacy analysis, meaning the potential upside from this data is probably somewhat limited. As a result, Schrödinger will likely need positive Phase II data before investors meaningfully reassess its drug discovery business. Schrödinger recently announced a multi-target collaboration and expanded software licensing agreement with Novartis. As part of the arrangement, Schrödinger will receive $150 million upfront and will be eligible to receive up to approximately $2.3 billion in milestone payments and a tiered mid-single-digit to low-single-digit royalty on net sales. Schrödinger and Novartis will jointly advance several of Schrodinger's existing non-oncology discovery programs and collaborate on additional targets. The software licensing agreement will significantly increase Novartis' access to Schrödinger's platform and runs for 3 years. As part of the agreement, Schrödinger will provide support services, ensuring its software is successfully implemented at scale. Prior to Q3 earnings, Schrödinger stated that it was engaged in discussions with customers about significantly scaling up the use of its software, which has been validated by the Novartis agreement. Interestingly, Schrödinger hinted at multiple customers, meaning more of these types of arrangements could be in the works. Financial Analysis Schrödinger generated $35.3 million in revenue in the third quarter, with software revenue up 10% YoY to $31.9 million. Hosted revenue increased to 28% of total software revenue, up from 23% in the prior-year comparable period. The increase in hosted revenue was partially offset by a decline in on-prem revenue, though. The transition to hosted software is creating headwinds, with Schrödinger suggesting that for a one-year on-prem license, up to 80% of the revenue is recognized upfront. Software weakness was attributed to a slower-than-expected ramp in activities for Schrödinger's predictive tox initiative, as well as smaller software opportunities that were deferred or reduced relative to expectations. The shortfall in predictive tox revenue will be made up in coming quarters, though. While software revenue was below expectations, Schrödinger remains confident about customer renewals and scale-ups through the end of the year. Services and maintenance revenue was fairly flat YoY, which is partly the result of more maintenance services being embedded into hosted software contracts. Drug discovery revenue totaled $3.4 million in the third quarter, down from $13.7 million in the prior-year comparable quarter. This decline was due to Schrödinger's ongoing shift away from collaboration projects and a lack of significant milestones in the quarter. Schrödinger is now guiding to 8-13% YoY software revenue growth for the full year, suggesting 6-14% YoY growth in Q4. The Novartis software contract will make a significant contribution in the fourth quarter. There is uncertainty about the scale and timing of other software renewals, though. Schrödinger is also guiding to $20-30 million in drug discovery revenue in 2024, implying $1.5-11.5 million in revenue in the fourth quarter. This represents a modest reduction from prior guidance due to the expected timing of milestones. The Novartis collaboration is expected to drive an increase in drug discovery revenue in 2025, though. This revenue is being recognized over a multi-year period, and it will take several quarters for revenue to ramp. Figure 2: Schrödinger Revenue by Segment (Created by author using data from Schrodinger) Schrödinger's operating expenses continue to rise faster than its revenue, leading to larger losses. Some of this is the result of the company shifting expenses from cost of revenue to R&D expenses, though. Schrödinger's operating cash burn was $33 million in the third quarter, compared to $50 million in the prior-year comparable quarter. Schrödinger is focused on bringing the growth rate of operating expenses down in coming quarters, suggesting a single-digit growth rate going forward. If this is achieved, the company should begin to realize improved margins in 2025. Figure 3: Schrödinger Operating Expenses (Created by author using data from Schrodinger) Schrödinger had $398 million of cash and marketable securities at the end of the third quarter. The cash from the Morphic sale was received subsequent to this, though. Schrödinger's cash balance will be further bolstered by its collaboration with Novartis, which should be received around the end of the year. This will give the company around $600 million cash and at least a 4-year runway. Conclusion While it may be difficult to see at the moment, Schrödinger is deeply undervalued. The software business generated around $168 million in revenue in the last 12 months, and without the company's investments in drug discovery, would likely be highly profitable. Simulation software generally trades on high multiples, meaning Schrödinger's software platform would likely be worth the better part of a billion dollars as a standalone business. The Novartis collaboration could be worth something like $200 million to Schrödinger, compared to an enterprise value of roughly $1.1 billion. The market reaction to the announcement was fairly muted, though. This adds to Schrödinger's roughly $5 billion existing milestone opportunity, along with an additional 15 programs eligible for a royalty on sales. On a risk-weighted and discounted basis, Schrödinger's milestones and equity are probably worth something like $500 million.  Schrödinger's partners have already demonstrated multiple times (Nimbus, Morphic) that its approach to discovery yields high-value drugs. However, until Schrödinger generates its own positive late-stage clinical data, none of this will likely matter.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485494168"}