Andaz Private Investments recently released its Q3 2020 Investor Letter, a copy of which you can download here. The fund posted a return of 14.6% in the first nine months of 2020, outperforming the S&P 500 Index which returned 6.5% in the same period. You should check out Andaz Private Investments top 5 stock picks for investors to buy right now, which could be the biggest winners of this year.
In the said letter, Andaz Private Investments highlighted a few stocks and Schrodinger Inc. (NASDAQ:SDGR) is one of them. Schrodinger Inc. (NASDAQ:SDGR) is a life sciences and materials science company. In the last three months, Schrodinger Inc. (NASDAQ:SDGR) stock lost 43.2% and on October 7th it had a closing price of $53.97. Here is what Andaz Private Investments said:
“Schrödinger is a fascinating company but market participants are truly struggling to find a way to think about the business model. To look around the corner in Schrödinger, investors need to find the most important metric.
The investment case with Schrödinger is all about the speed at which the company is covering ground in the drug discovery space. What does this mean and why is this the right way to think about it?
As you may know, all the chemicals in the universe are thought to be around 1060. Schrödinger’s platform is able to explore 237 billion different compounds computationally every six months. This is based on today’s compute power. Obviously, compute power is increasing and accelerating each year, which means that at some point in the future, Schrödinger will be able to explore 237 billion different compounds computationally per day.
Now, compare this to a typical drug discovery program which synthesizes and tests only 1,000 molecules per year. Not only is this snail pace, it is also based on trial-and-error. To test 1,000 molecules costs c.$5 million and consumes considerable time.
That gap between the output from traditional laboratories and the speed at which Schrödinger is able to cover ground is widening at an accelerating pace.
Secondly, people are not accurately taking into account that large pharmaceutical companies are contributing knowledge and intellectual property onto Schrödinger’s computational platform. For example, Schrödinger has a partnership with Takeda Pharmaceutical where Takeda will combine its knowledge of structural biology with Schrödinger’s computational platform. In exchange for exclusive output of any discoveries, Takeda will pay an undisclosed 3-digit $xxx million per program, as well as royalties on future sales. Schrödinger is also collaborating with other companies like ThermoFischer, Bayer, AstraZeneca and Sanofi.
Market participants already know that all of the top 20 pharmaceutical companies use Schrödinger’s computational drug discovery platform. It is a huge mistake however to ignore that learnings, discoveries, knowledge, and intellectual property are cumulatively being added to this first-principles physics-based computational platform and the speed at which Schrödinger is covering ground is accelerating.
The output is already impressive. Today, Schrödinger’s computational platform is used for 2 main reasons: 1) to explore vast amounts of chemical space on the computer (as opposed to synthesizing in a lab) to seek ‘hit’ or superior molecules; and 2) to optimize or design-in drug properties required. When a pre-selected molecule is run through Schrödinger’s platform (i.e. reduced biology risk), the industry is noticing that Schrödinger’s platform is increasing the probability of success for a drug to reach ‘development candidate’ stage from 1/8 to above 8/10. Obviously, at a fraction of the time and a fraction of the cost.
Schrödinger’s platform is a no-brainer and must-have, especially because the failure rate in drug discovery is high.
Schrödinger’s software revenue is currently running at an annualised run rate of $100 million. Again, all of the top 20 pharmaceutical companies use Schrödinger’s computational platform. If pharmaceutical companies that are still primarily organised around iterative laboratory programs transition towards computational drug discovery, usage levels will grow by 10-20x. There are only 10 companies with usage levels exceeding $1 million per year. There will be an inflection point when it makes total sense for a large pharma to allocate $10 to $20 million per annum on computational drug discovery.
This applies not only to large pharmaceuticals but a plethora of smaller biotechs interested in using Schrödinger’s computational drug discovery platform to seek out hit molecules or to improve known molecules i.e. patent the second or third derivative.
Also, we now know that there are ~20,000 protein-coding genes in the human body, yet the industry has only created drugs for less than 500 of those.
Because covering ground is crucial, patentable and rewarding, it is not difficult to see a gold rush in the computational drug discovery space, which should last multiple decades and see Schrödinger’s software revenue increase from c.$100 million per annum to over $1.5 billion per annum (excluding any price increases).
INTERNAL DRUG DISCOVERY
Aside from the software platform, Schrödinger also has an internal drug discovery team. Here, market participants also struggle to value the business. Some have attempted to calculate this based on future royalties. It is difficult to be precise on the value, but it is easier to be able to definitively say that the current market cap is not the right one i.e. invert the question.
If you look at companies in the same space, you will find that the revenue divided by the number of employees involved in drug discovery is between US$4 million to US$6 million. Revenue per total number of employees (including admin, sales etc.) is lower between US$300,000 to US$600,000.
Schrödinger has 80 employees dedicated to drug development. On a comparable basis, this unit should be able to generate US$400 million per annum as this business matures. If you search through the caliber, track record, and talent of the team, you could argue that Schrödinger’s output/productivity should be above the midpoint. (Schrödinger’s drug discovery business is still embryonic with revenue <$10 million.)
Unless investors think that the team is unable to be as productive as the industry, the market cap is not in the right ballpark.
The share price is very undervalued and has a 10-bagger potential. In my view the enterprise value is trading on ~1.4x future revenue (based on the current team size).
After the share price pullback, Schrödinger is currently a c.10% position in the portfolio. Schrödinger’s drug discovery team has 12 internal and collaboration programs in late-stage discovery, including three wholly-owned programs; and shareholders can look forward to progress announcements within the next 6 months.
For those interested in Schrödinger’s latest presentation, the link is below:
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