Biotechnology analyst at Cantor Fitzgerald. My pleasure to welcome our next company, XOMA Corporation. We're delighted to have with us today, Owen Hughes, who's the company's Chief Executive Officer, as well as Brad Sitko, the company's CIO, and they're going to walk us through the story. But maybe, Owen, for those a little bit less familiar with what you're up to, give us the 30,000-foot view on XOMA.
Sure. Sure thing. Well, two things before we start. First is thank you very much for the invitation. Certainly appreciate it. Second is that there's one thing in life that I want to do before I passed away. And that was actually being interviewed by the Three Musketeers, you, P hil, Josh, and Phil.
There you go.
Now I am complete.
Is that right?
Absolutely.
The last of the bunch.
The last and the best.
My honor.
Very happy, and we're now sharing haircuts. It's even better. So as relates-
We've known each other a long time, guys. So sorry.
As it relates to XOMA, this is actually a business. It happens to be in biotech, which frankly, as Eric and I know. I don't think most biotech companies are businesses, but this is a business. This is a business that should generate significant free cash flow, tremendous margins, and great opportunities, and then from a background perspective, XOMA actually was the original phage display company, and for many, many years, they developed CDRs for antibodies, so Lucentis, Humira, Tremfya, all come from our technology. In the mid-2000s, the company took a slightly different view, and they started going off and actually doing drug development themselves, so still had the phage display technology, but tried to actually take more risks to try to generate returns, and unfortunately, that endeavor failed time and time again for the company.
So in 2017, on the verge of bankruptcy, a fund named BVF came in and said, "Stop all development, bring back all the licenses and milestones, aggregate them to a portfolio, and become a royalty company." So since 2017, that's what the company's been doing, and myself and Brad joined roughly two years ago to try to take what is the framework that has been established by the prior management team and BVF and really just actually grow the company so that we're self-sustainable in the near future.
I mean, not only did you kind of make that transition in 2017 to aggregating backward royalties, but you're now doubling down on this kind of vision and, and strategy going forward, buying into future royalties. Why, why is that generally a good business? Why is, why is that something we should care about?
I'll just give an example, and this is the power of the royalty business. In 2021, early 2022 time period, we bought the Vabysmo royalty. We bought it from a company called Affitech. We bought fifty basis points of what we thought was, at that point in time, a maybe $2 billion drug. So it happens that Roche has given guidance for peak sales of $6 to $10 billion, and we still paid $14 million for that asset, and if you think about the longevity of that asset and the total cash flows from that $14 million, we'll probably make greater than 20 times our capital, and we have no costs associated with that. Now, don't get me wrong, that's the good side.
The bad side is that just subsequent to that, we made an investment in some IP for an asset that was partnered with Organon. It's for preterm labor. The drug had been in Phase II in Europe. We bought that for $15 million. Very nice package from Organon perspective in terms of milestones and royalties that were coming back to us. And Organon made the decision, about a year and a half after we licensed that molecule or bought that asset, to no longer pursue the development of the asset, and we lost $15 million.
That's the nature of this business. So when you win, you need to win big, and when you lose, you have to minimize the zeros. It's no different than what we always talked about in portfolio management and a normal attribution for a traditional hedge fund or a mutual fund. It's very, very similar to that. It just so happens that our costs are quite minimal. So on an annual basis, it costs us about $15 million to run the company, and we have about $5 million of preferred dividends that we pay out. So we have three financial instruments that one can invest in. There's common stock and then two preferreds. Those preferreds are the brainchild of Tom, our CFO. There's about $64 million outstanding, and they're perpetual in nature, and they're not recourse to the company. It is a tremendous financial instrument.
Personally, I bought a ton of these things because if we're actually not profitable in a given year, they're tax-free. So that's the type of creativity that we bring to the financial structure, and having been an investor for so long and an operator, I'm very cognizant of dilution, and that's just a manifestation of our creativity to actually make sure that we don't dilute our shareholders.
I think others who have gotten into the royalty business aggregation model have sort of claimed that their cost of capital is lower than, you know, publicly traded funds or others. I mean, what's your view there as whether there is some benefit—
Yeah
Financial theory-wise from that structure?
I think that's true. I mean, certainly as you look at royalties as an asset class, it really derived from being a credit-backed instrument, right? It was an alternative to yield. Where we approach it and our underlying cost of capital, like we're a public company, so we function as a permanent capital vehicle. As we think about our part of the space, which is earlier, being willing to take on the development risk and generally smaller check size than most of the well-known royalty funds like DRI and HealthCare Royalty and Royalty Pharma, we have a differentiated space in the universe where our competition is around the cost of equity and as an alternative to raising equity to it. So our relative cost of capital may be higher than, say, Royalty Pharma's, but that being said, we play in a different slice of the royalty universe.
Maybe higher, or is it?
It is definitely higher than Royalty Pharma.
So there's always a counterparty on the other side of your transaction, right?
Yeah.
Typically, a biotech company or an academic group, or someone who just happened to have these third-party royalties lying around. And why should they monetize through you? It seems like you're always making a margin on that transaction. You hope on a risk-adjusted basis, that you're getting the better end of the deal.
Yeah.
What's in it for that?
So, so typically, the situation that we see is a company has already out-licensed one of their, say, lead assets, or has a platform and has out-licensed a couple of assets. And they're trying to turn over the next data card and reach their next value inflection point, generally, which the public equity investors in their cap table care about, right? That's what they get valued on. So the royalties end up being a bit of a surprise for the investors. It's a non-dilutive way for them to bring forward at-risk capital. No one knows if those milestones or those royalties will ever be achieved if they're in a clinical stage. So this ends up being a win-win. We take on, you know, the risk and reward of those at-risk milestones and royalties, and they get the benefit of capital on their balance sheet today, which is incredibly important in the biotech universe that we're existing in right now.
Don't get me wrong, the Abivax example is, you know—
Understand
It's not the traditional example.
Yeah.
They do happen, but it's every now and then. But I would say most companies, whether they're investors or management teams, because of the duration of a royalty, don't really understand the value of them. And so if an ability to monetize that, bring forward that capital, so they can continue on their way from a development perspective, is very well received, especially in relation to, and you guys have seen it today, the haves and have-nots, and the dispersion between those just continues to grow. The haves, they have clinical data, and they can raise capital very quickly.
Mm.
The have-nots, maybe the data is in a gray area. There's still a suggestion that the data could work, but they just need more time, more patients, et cetera. That's where we come in, simply because to do an equity deal at that point in time is so punishing, not only to the management team, but also to the existing shareholders. This is an alternative to that.
Okay, so maybe you're playing in a different sandbox than others in the royalty business with these have-nots. Maybe, again, looking at smaller royalties, smaller deals earlier, riskier transactions, potentially.
Yeah.
Who else, if anyone, is playing in that space?
I mean, for the most part, everyone's trying to migrate up. We're actually trying to stay in our little moat. So our direct competition is probably Ligand, but even in the last several months, since under new management, they're kind of migrating up. Their check sizes are escalating. Their stage of development is actually getting a little bit further to the right, meaning more progressed, and you know, we kind of like our little moat.
Sure.
The benefit is that we have patience, and the permanent capital vehicle is the key defender to our competitive moat because you have to wait. If you're buying a phase II royalty stream, it literally could be 10 years before you start to recognize any of the capital associated with that. Most funds don't have a shelf life of that nature, and frankly, most royalty funds have much more capital than we do, and 25 million or 30 million is not relevant to their assets under management.
So when you're engaging with a counterparty, Owen and Brad, is it, is it most of the time that you are the only potential buyer of that asset, that there is no competition or a counter bid?
Yeah. I think that's generally the case. Usually, the decision in the boardroom at that point is either raise equity or think about a non-dilutive financing.
Yeah.
So you don't even need to have a competitive edge. You just need to be the only guy in the room. I like that model.
What I say is like, this to me is a math problem. Right? It's not science. Because the one thing I've learned with you know, Brad, has a lot more experience in this business than I do, is that you can solve most things from a structural perspective. Our goal is if we can actually make back our capital before we even turn over the binary card, that's a huge win for us. Anything above and beyond that, it's gravy. If we can aggregate enough of those, then we're actually in good standing. We can cover our costs, we can start generating free cash. But, you know, as I was just reading something the other day about the number of companies that have been bought by large pharma, either in Phase II or Phase III, that go on to be commercially successful products. Three out of four fail. Why are we gonna sit here, having been investors ourselves, and assume that we're gonna be so much better than everyone else?
I mean, how can we be better than a pharma company when they have more resources, they have more time, they have people that are actually experienced in drug development? And don't get me wrong, there are funds that do very well at this, and we try to mimic some of their tendencies. But to sit here and say that we can pick out a Phase I or Phase II asset and know the actual probability of success, it's just not gonna happen. We don't kid ourselves. So therefore, then it's strength in numbers. And the way you lose in this business is if you overpay for an asset. So as long as we pay the correct amount, and what do I mean by that, is that if we make a mistake, it's not detrimental to the company. That's how I qualify a bad investment.
And if we don't make those mistakes, just given the portfolio that we have, what we generated initially from XOMA's libraries, which is around 40 assets, 45, 50 assets, and then what we've acquired over the last 3 or 4 years, which is in the areas of, you know, call it 15 assets or so, and we're starting to actually generate free cash at this point in time, then we're in a pretty good position. We're at the inflection point. We just don't screw it up.
What is your diligence process like? You're not just throwing money out there or anything.
No, not at all.
How deep will you go, or what, what requirements are you looking for when you think about buying a royalty?
Sure. So I've been an investor, and I've been an operating company that's acquired assets, and I would say that our diligence process is no different than those two. We have 13 people inside the company, of which, call it six or so, are part of the deal team, which is no different than what you'd have for a small fund. But the benefit of actually having no hair on our heads is that we know a lot of people, and so we have a tremendous amount of outside consultants. The benefit is that, XOMA has been around for so long, and there's been so many people that have actually gone through XOMA, especially in the antibody space, that, I don't know, 25%, 30% of those people are still on retainer with us, and so we can just call him.
So for example, the former head of R&D at Nektar was actually the original head of R&D at XOMA, and he is actually on our payroll. One of our consultants help us examine all these different opportunities. I would say this, you know, the scientific diligence today is actually, it's, it's always difficult, but it's actually the less difficult of the two. The more difficult aspect is actually the commercial side.
Mm-hmm.
Developing a drug today is very similar to what we did in the past, at least in my view. What's different, though, is the commercial side. The managed care, the PBMs, the rebating, the gross to nets, the different contractual relationships, that's actually where it's very obtuse and getting more obtuse and opaque, I'd say. It's just. It's very difficult for us to do some of that. So that's where we're generally relying on outside folks in order to get a better sense for how the commercial landscape could evolve.
Okay. So given our upbringing, you seem to be just more comfortable with clinical regulatory risk. You know the rules of the game, you know what you're getting into there, and it's commercial that's maybe changed. Are you therefore putting a greater emphasis on commercial risk reduction when you get into these deals? Are you putting a higher discount rate on commercial than you would otherwise? Or how are you thinking about—
I'll say one thing and then Brad can start. It's like, you gotta remember, where are we buying these assets? We're buying these assets, generally speaking, in Phase I and Phase II. So we don't necessarily know what the standard of care is gonna be 5 or 7 years from now. Our portfolio historically has been over indexed in oncology, and we're trying to move away from that. So that's one of the reasons why I'm very hesitant about the commercial prospects i s that standards of care are changing so quickly in oncology. Remember, as from a business perspective, oncology is generally not a great business.
These patients are on therapy for a year or two or three, and then they're off. So you're on a hamster wheel the entire time. Compare that to immunology, where these patients are on therapy for a decade or more. It's a totally different, different type of business. And so because of the nature of our portfolio, that's the reason why I was suggesting that it's more difficult to ascertain what the probability of success is for those particular assets. There are other places, like in rare diseases, where we have a bunch of rare disease assets that are in the portfolio. Hopefully, one of them actually gets approved here in the next couple of days, which is the drug for Niemann-Pick Type C disease . There's not any competition there. That's much easier to forecast. I think within a relatively good dispersion, confidence dispersion, we actually know what the revenues of that asset are gonna be.
Brad, did you wanna?
Yeah. I think in addition to that, we also don't kid ourselves on the commercial potential, which is we underwrite conservatively. So if you underwrite to a case where we believe might be someone else's downside case and we get an appropriate return, we're comfortable with that. So that means, you know, stretching out the launch curves, being realistic about peak sales, about the potential, price increases, or, you know, realizing that—
Commercial risk.
Right. The duration of the cash flows with the patent life. So we tend to be very pragmatic there and realize that drug development, oftentimes for the royalty seller's point of view, they're very optimistic. And so grounding them in the reality of, you know, what it takes to develop the drug, the realistic timelines of realistic peak sales, I think that's the largest part of our diligence, actually, is educating the counterparty.
So, Owen, you already called out a big success as well as a failure. I'm sure you've had many more of both in your portfolio. What type of overall metrics should we look at to get a sense of your financial performance? With, you know, going even back to 2017, what type of overall financial metrics can you share with us?
Sure. So 7 years, more or less, 2017 to 2024, roughly speaking, we spend $20 million a year, more or less. It's. Some years it's been less, some years it's actually really has been more. So call that $140 million or so. We've brought in $120 million on milestones alone. The number of shares outstanding in 2017 is not significantly different than it is today in 2024. And the reason why I think that's important is that it's very difficult to make a dollar if you have 300,000 shares outstanding relative to 100,000 shares outstanding. In fact, one of the first assets that you and I went back and forth on was Exelixis.
Your memory is better than mine.
Which is, and that time was prostate cancer.
I wanted to forget it.
Listen, cabozantinib was an unbelievably successful drug. In order to get there—
Not in prostate cancer.
Not in prostate cancer, no. But in order to get there, they had to suffer significant amounts of dilution. And it's a $7 billion company today, but that's primarily because of the—
Stock's probably about where it was when we were talking about it.
Shares outstanding, right?
Yeah.
How do I, and how do we, measure success? Can we generate significant shareholder value? The only way to do that is you've got to keep your actual, y ou need leverage in the business. You need growing royalty receipts. Our hope is, and call it, if we're unbelievably lucky, three years, but it's probably more like a five-year timeframe, we're actually generating, call it, you know, hopefully, $200 million plus of royalty receipts in a given year. Given the margin potential of this business, which is essentially 90% plus margins, operating margins, most of that's gonna fall to the bottom line, so the way we look at it, what we just started doing, is how much cash do we spend, and how much cash are we bringing in? It's a pure cash business. And then we should be rewarded from a multiple perspective based on the free cash flow generation of the company.
Okay. And is there a return on investment that you're targeting when you get involved in these transactions, when you get to underwrite a specific transaction?
We generally look for venture-like returns, and that's over the entire duration of the asset. So, to Owen's point earlier, we need to realize that within the asset selection, there's gonna be successes and failures, and we need to account for the failures with the successes, so.
And you've spent about $140 million in the last seven years. Is there a capacity on the dry powder? How much?
How about—
What is your potential appetite for future transactions?
That's strong. I have to give due credit to Brad. In December of last year, we were able to essentially loan our key asset, which is Vabysmo, to the folks at Blue Owl, who are tremendous to work with, and that gave us enough dry powder to go actually complete a couple deals thus far, and hopefully some more in the near future here. Ideally, if we had hundreds of million of capital, I actually think we can actually put it to work, and I think we could put it to work wisely. What I see in the marketplace is, as I mentioned, is this huge dispersion between the haves and the have-nots. Within those have-nots, there are companies with great data but don't have the brand equity. They weren't, you know, they didn't have an RA Capital or Bain Capital, RTW behind them.
It was a more esoteric group of individuals, and I, honestly, I think you need both these days. Ultimately, you get rewarded for the clinical data, but man, oh, man, it's so much easier when you have brand equity behind you to raise capital, and that's kind of where we spend our time.
Is your business then heavily countercyclical, would you say? If you go back two or three years, you just didn't. I think you were at the firm then. Were you just not seeing these types of opportunities that you're seeing in 2017 ?
No, actually, exactly the opposite. The best deals we've done were actually in the boom times.
That was better.
That's when we bought Vabysmo. That's when we bought the Day One royalty. So it's. I, I actually don't believe the external environment is gonna affect us all that much.
Why, why were you able to get such good deals when anything could have been financed?
I honestly, we weren't necessarily here at that point in time, but it comes down to A, relationships. This is a relationship business. So how do we actually get the Day One royalty? Well, that was Sunesis. We also talked about Sunesis and Viracta coming together, and frankly, our largest shareholder, who owns 52% of the company, BVF, is the one that identified that opportunity for us. So relationships. The Aptevo asset, we had a bit of a relationship with them because historically speaking, they use some of our IP, and so we're just made aware of that opportunity. So historical relationships, the fact that we're really good looking, you know, that's nature how we're gonna figure these things out.
Let's talk about the stock, XOMA, the shares it sells. How do investors get paid by owning the stock?
Ultimately, two ways. The first is very similar to any other common stock. We hope to engender growth over the course of time so that there's an increase in the equity valuation. Two, is having run an operating company and been an investor, I'm very cognizant of actually rewarding shareholders. So how many times have we seen a biotech company license their lead molecule to a pharma company? They bring in $500 million of capital, and an investor never sees it. Yes, they save on dilution in the future, but who's to say that I was investing for the pipeline and not the lead asset? And so when we did the Vabysmo deal, we also announced a $50 million share buyback. We could buy back almost 20% of the company at that time, at the prevailing price.
Unfortunately, the price subsequently moved fairly significantly much higher, and we're judicious in terms of actually how we allocate our capital, and we're seeing great opportunities from a BD perspective, but to the extent that we're successful, you would expect to see increases in equity valuation and a return on capital.
So how are analysts looking at your stock from a valuation metric standpoint? What is my old friend, Phil Nadeau, up to when he sees your shares on the screen and says, okay?
Yeah.
You're fairly valued.
I think there's a couple of components. I think the way most royalty businesses are valued is based on a DCF of all of the assets in the portfolio, where the peak sales and then the underlying economics are known. With our portfolio, we have over 70 assets, ranging from preclinical to commercial. So the visibility into, I mean, how many companies do you value their Phase I assets, right? It's a probability—
Yeah
Of success and, you know, economics that aren't publicly disclosed. So what most people do is they look at the most mature, farthest along assets, the commercial and the Phase III, look at where the street is valuing them for peak sales, trying to make assumptions based on what our royalty rates that we can disclose publicly are, and then seeing if that alone can help them make sense of the story. But we,
So it's challenging.
By far, our most challenging aspect.
Yeah.
But ultimately—
I mean, over time, I guess you're just hopeful that with performance and success, you'll get credit for—
Yeah
The business model as opposed to any specific asset, because it's always gonna be challenging to get perform—
A bit of both.
For a Phase I.
A bit of both.
Yeah.
I mean, it's quite clear to me that you can do a DCF—
Yeah
Just taking the top five assets—
Oh, okay
And that's maybe where we trade today. What's less visible at this point in time, but hopefully more visible over time, is actually the emergence and development and maturity of our pipeline. So we're very much like a biotech company. If we own 5% of a royalty, that's essentially owning like 20% of the economics of a drug, right? Just given the nature of a net margin. And if you have positive phase II data on that asset, I would expect over time, not necessarily today, but as we execute and people understand who we are, for that to be actually part of the valuation of the company. So that you take the DCF value and the technology value, and you put those two together, we should trade at a higher multiple over time—
Mm
To a traditional biotech company. We have superior economics, and we have the same growth prospects per se, and we're not like the more established guys, which just have such a huge base that it's very difficult to grow. So it's a combination of a cash flow generating company plus a growth company, and that's the ultimate objective.
You mentioned earlier buying back shares through the Blue, through the Blue Owl transaction.
Yeah.
Yet at the same time, you're also cash constrained in terms of your ability and want to go out and do additional deals. So how do you make that trade-off between returning the capital, which obviously shareholders appreciate, and you're one of the few that's doing it—
Mm.
But continuing to invest in a business where you think there's good future opportunity?
Yeah, it's certainly a balance. We actually have bought back stock. It's when we thought the stock was significantly undervalued, and as it stands today, we're seeing tremendous opportunities from a BD perspective. We're hoping to close a couple by year-end. Fingers crossed. It takes two to tango, so to speak. But it's gonna always be a balance, and that's the benefit of having two finance guys run the company. We have a pretty good sense within some margin of error of what the underlying value of the company should be, and if it's significantly off, we'll try to take advantage of it. People will say, it's crazy that you guys were at that point, like a $300 million company, you're buying back $50 million of stock.
Wouldn't you use it for opportunities? And I say, “Well, of course, we use it for opportunities,” but to the extent that we actually are successful in monetizing an asset and don't return stock back or something back to shareholders, then we're just repeating the same mistake the other biotech company makes, and I'm not quite sure that's actually in the best interest of the shareholders.
So you've done enough deals now where you probably get a little bit of sense for what you're good at and what you're not good at. What have you learned from those transactions? You mentioned one that worked very well, one that didn't work at all. How can you get better at this job?
That's a great question.
We're all getting better, right?
We are. Each and every day, we're trying to get better. I think one piece is f inally stumped you.
Yeah.
You have to be careful not to fall in love with the deal.
That's true.
You have to be fully prepared that when you see something in diligence that raises a yellow or a red flag, you have to be willing to walk away, and it's that discipline.
100% agree with that. And the other thing I would just say is, you know, given the nature of the portfolio, if your underwriting suggests that the return profile is only two or three times, walk away. It's not worth the capital. You've got to be shooting for 10 or 15 baggers, and if you can get a couple of those, just like any other portfolio, those will take care of all the mistakes, and you move on from there.
Owen, Brad, this has been fantastic. Thank you for joining us today.
Thank you. Lots of fun.
Pleasure.
Appreciate it.