Snapshot

Schrodinger (SDGR) is offering 10m shares at $14-16 for a $1B market cap. We expect the shares to perform well in part given that they are backed by two notable investors, David Shaw and Bill Gates, and they have a strong position in enabling new drug discovery and the development of new materials. It also helps that they have multiple revenue streams to leverage their substantial platform investment.

Their core value proposition is simple enough – we can accelerate your discovery process and provide a higher probability of success at the same time. Here’s their vision in a nutshell.

Their business model is unique in that they have one side of the business that is typical enterprise software and another where they retain an interest in developing the drugs in collaboration or in a few cases with full ownership.

This creates two significant revenue streams. This also will make valuation more difficult to gauge for investors.

Early investors lend tremendous credibility to the story. David Shaw provided the $30M Series A and Bill Gates provided $52M through the Series B, C & D rounds of funding.

There are risks though, including the potential application of quantum computing to this problem area. See Risks & Parting Thoughts section for more on that.

Why is this hard and how does it work?

In the case of a new drug discovery is hard because it is a problem with at least nine anti-correlated properties.

There is no way to “brute force” this with sheer numbers of molecules and arrays of supercomputers. (Maybe Quantum Computing could offer solutions to this but that’s a topic for another post.)

Schrodinger is using a combination of techniques to tackle the problem – apply physics-based modeling but combine it with machine learning and multiple iterations to perform the optimization.

By using these techniques together they can take 1 billion molecules and reduce it to a “top 5000” that in tern can be reduced to 8-10 that are most likely to meet requirements.

The Multi-Faceted Business Model

Schrodinger has a typical enterprise SaaS business which has been a stable grower for over 15 years. It’s a little surprising that the growth is only in the 16% range but it did accelerate a bit to 18% in 2019. I suspect that the sales cycle is long and the company has probably historically under-priced the software.

The other revenue stream comes from “collaboration programs” where Schrodinger retains in interest in many drugs under development. Recently the revenue from this area has increased dramatically from $6.8M in 2018 to $19M in 2019. Management has stated that the increase is reflective of the historical increase in the number of programs. Based on the expansion of those the outlook for this revenue stream would seem to be very good.

In addition to the software and drug discovery revenue the company retains ownership of a few proprietary programs which we are not modeling in terms of valuation but which do represent some real long-term value. As seen in the image below this programs span a number of therapeutic areas with some significant opportunities.

Valuation & Stock Conclusion

Most people viewing the roadshow, listening to the CEO and understanding the investors behind the company will want to own this stock. It’s a great story. Valuation is tricky though. We broke it into two parts. One is the somewhat slow growth enterprise SaaS business and the other is drug discovery revenue.

The software business is fairly easy and we get about $10 in PFV per share from that. (All the PFV models are included below.)

Drug discovery (DD) revenue just increased 177% year-over-year which is very high. These numbers were driven by “collaboration milestones” which by definition will be lumpy. If we look at the number of collaborative programs over time they grow by about 20% per year. 2019 saw a big jump from 20 to 29 but we’ll start with the average which generates a PFV for the DD business of another $12/share.

Combining the two we get to a PFV for the company of $22 but that feels like a “base case” value that doesn’t capture much potential upside from additional milestones or the wholly-owned programs.

However the DD business is hard to forecast so we also did a “stretch” case for the DD business that shows 50% long-term revenue growth that would probably be a level where we’d consider the shares fully valued. This put the DD value at $40-50/share for a total share price of $50-60.

Risks & Parting Thoughts

The stock should get a good reception from investors given the quality of the story and recent growth. However there are some things to consider in the context.

  • We’ve seen this other examples that are somewhat similar to SDGR and they haven’t done that well. BioXL (BTAI) comes to mind. It’s just had a huge move from $5 to $20 but before that spent almost two years declining from the IPO price. See our original post on BioXL.
  • The dynamics of the DD revenue stream mean that this stock will be hard for analysts to model and lead to lots of volatility. Every quarterly report is likely to generate either joy or despair instead of quiet satisfaction.
  • Can other companies catch up in terms of the software? Schrodinger licensed much of their IP from Columbia University and their “secret sauce” of combining the physical modeling with machine learning is now out in the open. That means it could be replicated, possibly with a jump start via a licensing agreement with a different university. I bet MIT has some good stuff in their labs too. There are also some very major players already in this market like Dassault Systemes (DASTY).
  • Finally it may seem “far out” but we did mention this above. One of the strongest use cases for quantum computing systems is what we would call finding optimal solutions to problems with a large number of co-dependent variables. That means that Schrodinger could be “leapfrogged” by another company if they don’t start working on it themselves.

This is the kind of company we love to see entering the public markets and appreciate how their applied science is expanding our universe of knowledge and coverage. Hopefully some of the drugs will work too!

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