What’s in the box? Schrödinger, Inc. $SDGR

The Revenge of Cathie Wood?

Hello and welcome back to “The Revenge of Cathie Wood” where I am exploring small cap tech companies in the off chance that the commodity supercycle has a few more years of delay before we can all retire on our coal, oil, gold, and copper stocks.

It’s a tough time for big pharma, the Covid vaccine revenue has run out, and their stock prices are suffering.  Peak revenue coincided with peak multiples, and the last few years have been painful.  The earnings calls are mostly discussing cost saving measures, and Pfizer’s stock price is half of their 2021 peak.  One company who is not guiding down is Schrödinger (SDGR), the market leader in using computer simulations to predict which molecules have the potential to become medicines.  

The elevator pitch of Schrödinger is to go after the $100 billion to $150 billion annual pharma R&D budget, and instead of physically generating thousands of molecules in a laboratory setting, generating billions of molecules in a physics simulation, using artificial intelligence to narrow it down to the best few dozen or so, and having the laboratory synthesize and test only the few dozen most likely to succeed molecules.  The potential cost saving of pharma R&D gives Schrödinger an enormous Total Addressable Market (TAM).  Of course all Cathie Wood stocks have big TAMs, but penetrating this market has been slow.  It turns out that big pharma is sclerotic, bureaucratic, and hesitant to change, and the small players are in a bit of a capital drought since 2021.  

Instead of just waiting around for their software sales team to slowly penetrate big pharma, Schrödinger started using their technology themselves and produced a pipeline of drugs and partnerships, one of which, Morphic, is being acquired next quarter by Eli Lilly, generating $48 million in revenue for Schrödinger , and embedding a potential royalty stream into Eli Lilly’s portfolio of drugs.  Even though Schrödinger is developing the drugs, they have no intention of bringing them through FDA stage 3 trials on their limited budget. Their plan is to sell or partner the drugs with big pharma, and in this way, get them exposed to Schrödinger software.  If the sales team can’t penetrate big pharma, create a series of gateway drug trojan horses that big pharma will acquire, bring in through the gates, and become addicted to.

My best understanding, as a generalist and not a biotech specialist, is that Schrödinger is a top five company in this arena.  OpenEye and Cresset are private, while Accelrys was acquired by Dassault Systemes of France (DSY.PA).  The barrier to entry for new competition is the data set of molecules that have been generated by the physics computations over the years.  If compute costs do eventually come down rapidly, that barrier to entry would eventually diminish, although as Peter Thiel recently pointed out, this artificial intelligence revolution is a twenty year process, and right now, only NVIDIA is making money.  At least for the medium term, it is reasonably safe to say that Schrödinger has a very decent head start, and only moderate competition.

The final form of Schrödinger is supposed to look like a company that is half royalty streams, and half recurring software revenue.  But management predicts that it will take about 6 to 7 years for the royalty streams to really start to snowball.  Those pesky FDA approvals are slow moving unless you are an emergency Covid genetic therapy.

Regarding software sales, Schrödinger wants to be judged by their Q4 revenue, as that is when the annual contracts for their big pharma clients are renewed.  In 2023 Q4 revenue was $74 million, a 32% increase over 2022’s $56 million, a 21% increase over 2021’s $46 million, a 39% increase over 2020’s $33 million.  Those are pretty aggressive growth rates for their ultimate goal of being the go to software provider for the big drug companies, and management is sounding pretty optimistic for this upcoming Q4 based on conversations with clients.  Software companies in the 25% to 30% annual growth rate, even with lowered multiples since interest rates rose, can still fetch 8x to 10x price to sales ratios, which is right where Schrödinger is given their $200 million trailing twelve month revenue, and their $1.5 billion market capitalization.

But it is important to note that you could underwrite the purchase price of Schrödinger only on their software business, completely ignoring their own pipeline of 25+ drugs.  That pipeline of drugs, and the joint ventures and sales that they can generate, are expected to provide funding for Schrödinger once their current 18 months worth of cash runs out.  With the $48 million coming in from the sale of Morphic, the idea that they can raise more cash to fund themselves with more phase 1 developed drug sales is reasonable, but never guaranteed.  

It is not entirely clear when Schrödinger would flip to profitability.  They have been growing R&D spend as their revenues increase.  Miraculously, they have not diluted in years, so the continuing sales of their developed phase 1 drugs and collaborations seem to be working.  When the Morphic deal completes next quarter, it will join the ranks of successful past sales such as two drugs developed with Nimbus to Bristol Myers and Takeda.  Schrödinger also has two drugs with full FDA approval from a collaboration with agios.  

This is a tough nut to crack for a generalist investor, it's a combination of software and biotech, but using standard software comparables, the current market cap can be underwritten only with current software revenue streams, the company is not diluting, and can probably fund itself for 2 to 3 years without raising external capital.  And when you add Schrödinger’s stake in all of the following, whatever it is worth, it seems pretty enticing.

When I look at the price chart, I know that Schrödinger was massively overpriced on the zero interest rate Covid stimulus bubble, but I also strongly suspect that it is underpriced now.  The fundamentals have only improved, they haven’t diluted, and the stock is stuck in limbo.  At some point, if the fundamentals continue to improve, it will eventually catch a bid, and momentum will kick in.  Who knows how long that will take, or to what heights it will rise?  Can small cap tech really stay in the penalty box for more than three full years? I might be early, and I am far outside of my competence, so I can only size the position small. But if Q4 2024 revenue is up another 30%+ from last year, and the stock price hasn’t moved too far away from me, I would buy a bit more.