My not so profound valuations and observations on Markets
My not so profound valuations and observations on Markets
Schrodinger develops a platform for drug discovery, either collaborates or services with all top 20 pharmaceutical company, while also developing their own internal drug programs. They generate revenue through two streams, “software” and “drug discovery”.
Before diving into the specifics one need to understand the process of drug discovery. The illustration below does a good job explaining.
Drug discovery is a length process and one that takes a long time and mostly ends with failure. 66% of all programs never succeed in delivering an IND (Investigational New Drug, when FDA gives permission to start human trials). An average of 13.8% succession rate in the clinical trials, while oncology succession rate is 3.4%. Here we are going to do a crash course for the Drug Discovery part of the illustration above since this is the major differentiator with Schrodinger.
In the Target Discovery known also as “Hit Discovery”, is to find the biological origin of a disease, and finding a target (ex a protein) that is “drugable”. Then one need to demonstrate that the “drugable” effects on the target can actually be a therapeutic. Then Lead Discovery also known as “Hit to Lead”, where the target is gone through processes to identify molecules that can interact with the target to produce desired biological effects. Then lastly with Lead Optimization, the leads previously found are synthesized and improve potency, reduced off target variables… Then voila you have a drug development candidate. This typical process using traditional drug design takes around 4 to 6 years, with each step taking from 2 to 3 years.
A very misleading fact got me very excited at first, it was the spending of R&D in pharmaceutical industry is 188 billion in 2020 and forecasted to be 233 billion in 2026, CAGR of 3%1. Seeing this huge market potential with their current revenue of around 80 million, I thought there was going to be huge growth potential. I was wrong. Upon researching I found this site https://www.baybridgebio.com/drug_pricing_calc.html which uses average R&D cost to determine price of a drug. He uses , Paul et al Nature Reviews Drug Discovery 2010 and DiMasi et al, Journal of Health Economics 2016 to calculate average cost of R&D, then adjusting difference from 2010 to 2019. Using his averages, the average cost of Drug Discovery is just 28.4 Million, where the total average cost of Discovery and Development is 562 Million, since later in the R&D process the more labour and capital intensive it is. This would effectively mean that the drug discovery part of total R&D spending is just 5%. However, I have also found an industry overview by Dr Gerhard Goldbeck, titled “The scientific software industry: a general overview” which he states that the scientific software industry only gets to 0.001% of all R&D spending. This overview was published in 2017, and stating the current condition, as he said the total market is 100M but the fact is Schrodinger just had 80M in software revenue, and they don’t not have 80% of the market, so I think it is safe to say that his doesn’t reflect the future. I don’t believe that 0.001% is the TAM, so I decided to take the average of the two and the revised percentage being 2.5%.
Starting with the software part of Schrodinger’s business. It is a platform that help pharmaceutical companies do drug discovery. Compared to manual drug discovery this method is cheaper and faster.
Due to this technology not employed long enough, there isn’t enough data to show statistical significance that the drug discovery has a higher chance of success. But I do believe with the nature of ML and a progressively larger library of data that there is indeed a higher chance of success. That is why all top 20 pharmaceutical companies all use Schrodinger and contract growth rate is increasing since 2013 at CAGR of 16%. I believe, conservatively, as this technology gets proven over time Schrodinger can mange to have a 1B revenue in in the software segment alone. Which translate to a total market share of just 15% percent of the market. I prefer to have a conservative estimate, as I am not in this field and I am uncertain of the market size. Another interesting thing to note of this software segment, is that there are more then 1350 academic institution that uses them to do research. This can cause graduate and PhD student to be familiar with the software and if they enter the work force they would have a bias towards this software. Schrodinger also uses its software in material design, but this is only small portion of revenues so I am not going to focus on them too much.
Considering that the software is the bread and butter of Schrodinger, then Drug Discovery is the growth engine. This is where Schrodinger uses their own software, to discover their own preclinical drug and collaborate with other pharmaceutical companies. For collaborations Schrodinger gets paid single digit royalty for every drug that gets to commercialization and gets paid if reaches certain milestones. As an average cancer drug would produce 12.3B over its lifetime, and they have already 20 collaborative pipeline with other drug manufactures. Which I can take the expected value of this transaction, using the probability of success given the stage at the drug development process and using 5% as the amount of royalties. Over these 20 collaborative pipeline the expected value of the royalties discounted back at the cost of capital, I get a 536M. This method is not the cleanest, but this is a way to estimate royalties. Note that if Schrodinger’s method actually improves the success rate of these drugs, then it would also increase this expected value. For the 5 pipeline that are wholly owned by Schrodinger, will either produce it themselves, or out licencing it. This drug discovery part starts to become a flywheel, where internal pipeline will help them refine the software, and the more success in the internal and collaborative pipeline will attract more customers, and with more customer the more data and feedback so the software gets better. This signals the asymmetric upside.
Other things to note, Bill gates and David Shaw is one of the original investors in this company. Everyone knows Bill Gates but might not know David Shaw. David Shaw was a computer scientist, got a PhD in AI from Stanford, started one of the first quant hedge fund ever, and now turned to full-time scientific research in computational biochemistry. This is the definition of smart money. Another point more then half of their employees have a PhD. All the mean while Schrodinger has a Glassdoor rating of 4.6, while the average rating for a company on the Glassdoor “Best Places to Work” is 4.3. The average overall rating for Glassdoor companies is 3.3. This shows that the company has a good culture.
Finally, this brings us to the valuation. Where I used valuation by parts breaking down the software and drug discovery segment. Where I projected that by 2030 the software business would generate close to 1B in revenue, and would have an operating margin of 20%, with a cost of capital 6.34% and a sales to capital ratio of 1.1.
For the drug discovery segment, I found the expected value of the 20 collaborative pipeline, totalling to 536M. With the five internally-owned pipeline, I did the same expected value discounted back at cost of capital, and subtracting the cost of development, resulting in 1.3B. Adding all this up we get to a price of 62 USD.
Couple important note on this valuation. First, the only “forecast” I did was for the software side, so this valuation doesn’t incorporate future growth in the drug discovery segment. This can be considered as a call option. Especially with the flywheel effect that Schrodinger has, I believe the true intrinsic value to be much higher. Second, I do realize that this is a very rough valuation, with multiple short cuts with expected value, but as the saying go, you don’t have to be right, you just have to be less wrong. I entered in the position at 56 USD.
1 https://www.statista.com/statistics/309466/global-r-and-d-expenditure-for-pharmaceuticals/