Schrodinger Stock: Upgrading My Rating Post The Nimbus Deal (NASDAQ:SDGR)

Schrödinger’s (NASDAQ:SDGR) stock price has declined ~80% since my bearish article in early 2021. At the time of writing that article, the stock was trading north of $100 and investors were overly bullish on the company’s prospects. However, with the stock trading at 40x FY21 revenues at that time, it appeared to me that investors were pricing in that the company can continue to significantly increase its software sales for the foreseeable future which appeared unlikely. So, I took a contrarian bet at that time. The software sales growth has since moderated and the valuation has contracted meaningfully. The stock is currently trading at ~5.5x Price/Sales on FY23 consensus revenue estimates.

Since then, SDGR has also shifted its focus towards growing revenues from drug discovery collaborations and has made good progress in this regard. The company’s efforts in this regard are now bearing fruits and a very interesting development in this regard took place recently.

Nimbus-TAK Deal and Impact on SGDR

Takeda (TAK), a Japanese pharmaceutical company, announced the acquisition of Nimbus Lakshmi, a wholly-owned subsidiary of Nimbus Therapeutics LLC, last week. SDGR collaborates with Nimbus Therapeutics on different drug discovery projects. Nimbus Lakshmi is involved in the development of an oral TYK2 inhibitor NDI-034858. Takeda will pay $4 bn upfront and two milestone payments of $1 bn each upon achieving annual net sales of $4 bn and $5 bn. After this transaction, the inhibitor will be known as TAK-279.

This acquisition should benefit SDGR in multiple ways. First, SDGR has a 5.5% equity investment in Nimbus Therapeutics LLC. SDGR accounts for the investment in Nimbus as an equity investment and uses the Hypothetical Liquidation at Book Value (HLBV) method to value its contractual rights for substantive profits from Nimbus. HLBV method is a balance sheet approach that calculates the share of the investee’s earnings/losses based on the change in the investor’s claim on the investee’s net assets (the difference between the claim on book value at the beginning and end of the reporting period). The claim is calculated as the amount that the company would receive if the investee were to liquidate all of its assets. The carrying value of the Nimbus investment was zero as of September 2022. This indicates that Nimbus had a negative book value. With Nimbus receiving $4 bn plus potential milestone payments from this deal, its Book Value and Balance Sheet are likely to meaningfully improve and so should be the value of SDGR’s 5.5% stake in Nimbus. The exact number is difficult to quantify as we don’t know the current state of Nimbus Therapeutics’ balance sheet (given it is a private company), but $4 bn plus a potential $2 bn of milestone payments is a really big amount and can transform balance sheet of Nimbus meaningfully in my opinion.

Second, a part of the capital received by Nimbus should likely be used to further several of Nimbus’ existing drug discovery programs and fund new drug discovery programs. It means more business for SDGR as it is a close partner of Nimbus on many of these programs and should be involved in many future projects as well. A well-capitalized client/partner usually means more business.

Third, Nimbus Therapeutics developed the clinical compound NDI-034858, which was acquired, in collaboration with SDGR. Its success creates a positive perception of the value SDGR brings to drug discovery collaborations. This should lead to more acceptability of the company’s offerings resulting in more future wins.

Fourth, the company may also benefit if there is any acquisition-related milestone payment in its collaboration deal with Nimbus Lakshmi. There is not much information available on the specifics of SDGR’s terms of the deal with Nimbus Lakshmi. So, we don’t know if this will be the case here. But, in the past, when Nimbus received $601 mn in payments for licensing firsocostat to Gilead (GILD), $46 mn of that amount went to Schrodinger.

Schrodinger Collaborative Drug Discovery Business Prospects

The interesting thing about SDGR collaborative drug discovery business is even if the drug is not finally successful in getting FDA approval, the effort is not completely wasted for SDGR as it does usually receive an upfront payment and multiple milestone-related payments (Phase 1, Phase 2, etc.) For e.g., Firsocostat was unable to advance from phase 2 to phase 3 but SDGR was still able to make a good amount out of it. So, unlike a biotech company for which a drug’s success is a hit-or-miss kind of event, Schrodinger’s collaborative platform has less downside risk as it gets paid for multiple milestones even before the drug gets FDA approval.

If we think about SDGR’s collaborative business, it somewhat acts like a functional consultant helping a drug discovery company effectively utilize computational chemistry resources. This business is scalable and in my opinion, this partnership model can expand to a significantly large number of drug discovery efforts in the future.

How SDGR’s collaboration efforts play out in terms of achieving partnership milestones and how it prices its services for bringing its computational expertise should be a major factor in deciding the company’s long-term profitability and stock price. There is still a good deal of uncertainty attached to it. However, given the initial success with Nimbus Lakshmi, I feel optimistic about it.

Besides Nimbus, SDGR has seen several notable partnerships in recent years. This includes a deal with Bristol-Meyer Squibb (BMY) in late 2020 that includes a $55 mn upfront payment and up to $2.7 bn in milestone payments. Another interesting third-party collaboration with Eli Lilly (LLY) was announced this year, which in addition to upfront payments can generate $425 mn in milestone payments.

In addition to third-party collaborations, the company is also developing some drugs on its own. However, they are still in the initial phases. So, I am not counting on any success from them.

Conclusion

SDGR’s shares have rallied ~25% since the Nimbus Takeda deal announcement. However, if we look at FY23 consensus revenue estimates of $266 mn and the current EV of slightly less than $1bn, the EV/Sales valuation is much lower compared to when I previously recommended selling it. I believe investors’ expectation about its software business is much more modest now and while some investors have started understanding the prospects of the drug discovery collaboration business, the valuations are still reasonable. Given the potential for growth from its drug discovery collaboration business, I believe the stock is a good buy for long-term investors.