Morning, everyone, or good afternoon, everyone. I'm Trevor Allred, one of the biotech analysts here at Oppenheimer. We have with us today CEO Owen Hughes and Brad Sitko, CIO from XOMA Royalty, here with us to discuss the company. So let's kick things off. So you're a royalty company. Can you tell us about how you've designed the business model and where you guys see yourselves as differentiated there?
Sure. I'll start, and Brad can certainly complement what I'm about to say, so I think it's important to understand the history of XOMA. A couple of fun facts about XOMA. XOMA is the longest tenured, publicly traded, I will put in quotes, "Biotech Company" because we are no longer a true biotech company. But we went public in 1984, and the company was started in 1981, and the original business model was antibody drug discovery. And so we had a number of clients over that time frame, in fact, hundreds of clients over that time frame that came to us to make their antibody sequences. And over that time period, XOMA touched a number of multibillion-dollar assets: Rituxan, Lucentis, Tremfya. There's probably about eight to 10 multibillion-dollar assets that came through our hands, many of which we actually had royalties to.
And at that point in time, the management team decided to actually monetize some of those royalties to fund development of their own assets, which we see pretty much every day in this business. Unfortunately, the assets or the indications that were chosen by the prior team were extremely difficult or simply just didn't work, such that on two occasions, XOMA almost went bankrupt. And one of those times, we sold the Rituxan royalty to stay afloat. And another time, we actually sold another royalty to actually fund the phase III development of a sepsis asset. And so I'm bringing all that to you to make it known that we understand the trials and tribulations of drug development. But how did that get us into the royalty business?
In 2017, actually on the brink of bankruptcy, a fund, which is actually our largest shareholder, called the Biotechnology Value Fund, put in front of us a proposition that, frankly, Tom, who is our current CFO and the prior CEO, Jim Neal, had started to contemplate, which is, what happens if we actually just stop clinical development and we downsize the operations such that we have a core group of individuals and we bring back and prosecute all the IP that we've had over the last 20 or 30 years? Can we create a sustainable portfolio of royalties and milestones that would get us to the promised land, the promised land being positive operating cash flow?
So in that 2017 time frame, the company switched from a clinical development drug development company into a true royalty aggregator and started off with roughly 40 assets that were in various stages of clinical development, preclinical all the way up to phase II, and I believe it was early phase III. And what we've been doing since that time frame, since 2017, is trying to augment that portfolio with assets across the drug development spectrum. So Trevor, you asked us, how are we different? So I say, in many respects, we're actually very similar to our competitors, except for maybe one key differentiating factor, which is that we actually are willing to underwrite risk, clinical risk, as early as preclinical development. And we go from preclinical all the way up to commercial. And so we have six assets that are generating royalties for us today.
We have several, more than a handful, that are in phase III development. We're trying to continue to add to that. And then we have hundreds, actually well over 100 assets that are in phase I , phase II, and preclinical. And so we believe it's actually really important to actually have a portfolio that spans the entire spectrum of drug development for the following reason. And for that reason, I'll turn it over to my colleague and partner, Brad.
Yeah, absolutely. So as a public company, we have the unique advantage of being a permanent capital vehicle, which means we can do something that a lot of different funds out there can't, which is be able to arbitrage time and have patience. And coupled with the fact that we have the royalty model, we can acquire new royalties and build that portfolio fully across the spectrum and be patient and wait for assets to mature that we buy at what we believe are a deep value to what could be their intrinsic value. And I've spent about 20 years in the life sciences. 15 of those have touched royalties from different forms and fashion, including analyzing different royalty streams. Others, as an investment banker, where I was running processes to sell royalties and raise capital off of royalties.
You could see that there is a part of the market that gets very crowded and competitive. And we tend to stay differentiated because we are willing to write smaller check sizes that can be meaningful to a broader universe of companies. We can look across all stages and think about a royalty transaction very creatively and embrace the risk that's inherently out there and ultimately use the fact that we're a public company to be more creative in how we structure the transactions.
That makes sense, Trevor?
Yeah, yeah. And on that, I mean, you guys recently joined or somewhat recently. I mean, what kind of sparked your interest in joining this and having that access to the business model here?
Yeah. Brad, you want to start?
Yeah, sure. I think one thing is, having been an investor in doing structured finance for a while, this is a novel approach to a unique asset class. So being able to participate at any stage of clinical development in an asset class that, when you're right, it's sticky and durable and sustainable cash flows. And when much of the market very much views royalties as almost a credit arbitrage, we can look at it as a long-term equity-like return for the types of transactions we did. And for me, it was seeing that there was a base of 70 royalties, potential royalties already established that you could build off of, plus the visibility into an upcoming inflection point, being able to kind of go through that timeline flip book and see what happens year by year as a portfolio progresses.
And then having a business model that is good in the good times and good in the bad times of the biotech equity markets. So whether the equity markets are flying hot or whether they're in a period right now where we're oscillating sideways for equity, this is a very applicable business model. So that was something that was interesting for me. Owen?
Yeah, I'd follow up on those comments, which is that I started my career as an investor, then went to the operating side. And I very quickly realized how difficult it is to actually develop drugs. It is extremely hard. I think it's in fact one of the hardest things to do in humankind because, frankly, we just don't understand biology all that well. And what I learned very quickly is that in drug development, every day is a fire alarm. It's just a question of what stage, one-alarm fire versus five-alarm fire. And every day there's a one-alarm fire. And generally speaking, very few days where there's a five-alarm fire. But when there's a five-alarm fire, it gets very tricky.
You take that and you compound that with what transpired in 2008 and 2009, which is what you realize very quickly is that these uncorrelated assets, gold, precious metals, equities, bonds, senior secured bonds, CLOs, they're supposed to be uncorrelated. But when the you know what hits the fan, in fact, the correlation goes to one. And so what I am intrigued by this business model is that this is actually an economic stream that should truly be uncorrelated from anything in the marketplace. You're talking about providing lifesaving drugs to folks that need them. As long as governments and folks have the ability to pay, those royalty streams, cash flow streams will come to accrue to us over time. And so it's a truly uncorrelated asset.
And in the space of, I would call it, a very competitive marketplace in terms of both funds going after different ideas, you've seen a plethora of capital into the biotech space over the last 10 or 15 years. 20 years ago, there was no biotech funds that were probably greater than a billion or two in assets. Today, there's well over a dozen that have that type of capital. And they're all fighting for a certain position within the equity cap table. Interesting enough is that if you actually take a lot of royalty, there's some elements of royalty that are actually quite unique. The first is you can't dilute a royalty. So when we buy an economic stream, while we care about the overall cost and we also care about the time, in reality, not that important to us, especially in the context of a very large portfolio.
So in essence, the reason I was interested in it is that it's an uncorrelated asset. It has elements that are distinct from equity. It's long-term in nature. Earlier ago, frankly, the difference between the intrinsic value and the stated value. And so at times, you can buy assets for pennies on the dollar, whereas you can do that in the equities too, but you're taking generally a lot more risk to do that just because of dilution over time. And last but not least is that we're on the cusp. The company, when we joined, was just at the cusp of actually an inflection point. That inflection point was actually starting to generate positive operating cash flow.
Over the next couple of quarters, three, four, five quarters or so, depending on kind of how the assets mature that are currently in the commercial portfolio, we should be at a place where we actually are self-sustainable. As a public company that's self-sustainable with, frankly, very little debt on the overall books, while we do have some debt, it's secured against one particular asset, not against the company, I think we're in a pretty good position to actually take this business model to the next level, which is not only underwriting partnered assets, but also underwriting synthetic royalties. You combine those two with the operating cash flow, plus what Brad was talking about before, which is trying to generate this technology value.
The interesting thing about royalty businesses is that typically, they don't really have much terminal value because you're only as good as the last deal you've done. And what we're trying to do and what we're trying to change is to give people insight into our pipeline such that when our pipeline matures, it actually is reflected in the terminal value that people are willing to pay for our equity. And if we're successful in that, then I actually think it's a very unique business model within the royalty space. I'm not going to say it's better or worse than others because obviously, there are people that are much more mature than us in generating cash flow and, frankly, maybe smarter than us and have more resources than us.
But if we can find our little moat in this business, I think we can actually generate significant returns for people and do it in a very risk-adjusted manner.
Yeah, yeah. In terms of that moat, I mean, where can you tell us about the sourcing and diligence process that you guys do? How do you cast that net when you're looking for those deals in the earlier space?
Sure. So I think having data and access to information is part of the value. So we've developed proprietary databases and processes, mapping out all of the partnering agreements that we can find out there that have been disclosed publicly. Because in this type of business, you need to be purposeful with where you spend time and where you allocate any type of capital. I mean, the entire company is 14 people. So any time spent on or misspent on an opportunity is time wasted. So we've built a really exciting database internally that helps us figure out where we want to be, what we like, what we're interested in. And then beyond that, so that's the information layer. And a lot of folks have done similar types of transaction tracking. The other part of it is building an ecosystem around us.
Part of our business is depending on actionability. Is there a transaction to be done at this point in time? And that's knowing board members, management teams, lawyers, bankers, consultants who all build the ecosystem around us and are, quite frankly, an extension of our team with idea generation and creativity. And oftentimes, what we're finding is that as people learn about our model, because it's so unique, because it has a place that's very different than debt or commercial royalty monetization or large-scale monetization, we get a lot of calls because people are intrigued by it. Management teams are intrigued by it. Folks who are struggling to raise equity or hate their share price are intrigued by it. So we do a lot of that type of work.
Plus, for a small team, we have a big presence covering industry conferences, banking conferences, seeing a lot of people shaking a lot of hands.
Great. And how do you determine when to pull the trigger on a deal? What are the internal debates? What resources do you have access to? I think you mentioned a few of those with the lawyers and other things. But what networks do you have and what other things do you have to lean on?
Yeah. So what I'd say is that if you go back to the XOMA history, there have been hundreds of protein engineers that have actually worked at XOMA at one point in time, many of which actually remain consultants to us. So when we look at, and frankly, at this point in time, antibodies are probably 70%-80% of all the assets that we look at. So from that perspective, when you think about molecule design, bispecific , trispecific, all those types of things, we have the requisite knowledge base just sitting within inside XOMA. It's a phone call away. But we like variable expenses instead of fixed expenses. So that's where we keep our headcount. But we stay close in touch with most folks. And then I've had the privilege of working at a couple of different venture funds. I've run a publicly traded company.
I've been involved in many different areas, as has Brad. And so, to Brad's earlier point, is that I'm sure we'll all be replaced by AI robots at some point in time. But up until point in that time, relationships really matter. And calling on the past president of Citi or the former head of EULAR, this business comes down to relationships. So it's consultants, frankly, that do a lot of the actual heavy clinical work for us. We kind of pigeonhole things into kind of small, medium, and large. That's pretty much the precision that we have for some of our earlier stage deals, which is, what's the opportunity for this deal? What's the clinical rationale? Those types of things. So frankly, we look very similar to what a hedge fund would do or a private equity fund or a mutual fund. We're doing the same types of analyses.
We may go to another level or two as it relates to the commercial enterprise doing qual, quant, especially as we do our later stage assets, which is what happens inside of a company as well. But the one thing I do know is that when it comes to clinical and commercial, every time I've looked at something, I've been wrong. It's a question of whether I'm wrong on the upside or downside and the magnitude. And so this gets to kind of how we underwrite the actual specific deals, which is that when you sit inside of a company and you forecast out revenues or you even think about the clinical success of a program, you're assigning odds, 50% odds, 60% odds. And we've all seen these. This is how a lot of people get to their price targets in the Wall Street area.
But the reality is that, frankly, the drug either works or doesn't work. It's either 0% or 100%, at least from a clinical perspective. And then once you get beyond that, frankly, it's a gradient in terms of the commercial, right? But oftentimes, those first six or nine months are going to determine the outcome of the trajectory of your launch. You can look at the Vabysmo, which is obviously our largest asset today. And obviously, we were excited about the launch. Frankly, it was well beyond what we had anticipated. I believe it's one of the fastest launches in Roche's history. But when you have a launch of that nature, you know to a large extent what the trajectory is three, five, and even seven years out, regardless of competition. That's actually what the data would suggest.
And so the reason why I bring all this up is that we're not beholden to any particular criteria when we look at various assets. What we are often concerned about is what type of risk are we taking? In fact, the question that we asked ourselves first is, how much money are we willing to lose on this particular asset? And when I was actually investing, I was an analyst who I believe is actually one of the smartest investors I've ever met. And his number one question whenever we went to go pitch him an idea was, how much money are we going to lose? It wasn't, tell me what your upside is or tell me the actual rationale you're thinking is how much money if we actually make this investment. And it changed my mindset.
And Brad and I are trying to instill that here at XOMA, which is how much money are we willing to lose? How much risk are we willing to take for this particular asset? And that's why you see oftentimes when we do deals, we're trying to underwrite to several different assets because, frankly, it's very difficult. This business is very difficult to ascertain the success or lack thereof of a drug in phase I or phase II. In fact, I would say oftentimes it's nearly impossible. So we like these basket deals. It's not that we all do. We bought an asset in phase III that had legitimate phase II data. It's in the PH base. So we will do those things.
But I go back to what I said before is the reason why I think it's so important to invest across the spectrum is that the risk is different along the way. And the amount of money you need to allocate along the way is much different as well. And so if you have that wide swath, it's kind of what we learned in our CFA days, right? It's just portfolio management and CFA Level III. You start to employ those techniques. It just happens that we're doing it in the royalty business, but people do it in the music business. People do it in clinical development. People do it in AI, wherever it may be. We're just happening to do it in the royalty space.
Yeah. And can you speak to some of the, I guess, ways you mitigate that risk with the structurings you do around milestones and other things?
Yeah. So we talked about the binary risk element of it. And again, capital you're willing to lose. So the way we think about structuring many of our deals is because you're moving into the shoes of a licensing agreement where economics are already negotiated between two parties and you're buying some or all of those economics. As you look at what are the near-term events where if cards turn over positively, can you return capital? Every acquisition we do is coming off of our balance sheet cash. So we think about how does capital recycle within the system.
We can structure around that in terms of buying some or all of the phase I milestone, the phase II milestone, the phase III milestone, approval milestones so that in the odds that are against a drug making it to the market from, say, phase I, where you can not put all of that capital at risk, where you can bring it back into the system. And then by the time you get to producing royalties, can have significant upside. I think that's kind of the unique piece about what we do is structuring what ultimately creates our protection and mitigates the risk of what's otherwise a significant portfolio of lots of binary events.
Now, I'd just point to one specific example there, Brad, which is the transaction that was done prior to our arrival, so our team did it, and kudos to them. They laid out $14 million for the royalty on OJEMDA, the pan-RAF inhibitor going after pediatric low-grade glioma, which was a royalty that emerged when Viracta and Sunesis came together in the reverse merger, and at this point in time, I don't know the exact numbers, but at one point, before the drug even got approved, we had put out $14 million and then we'd already received $22 million, and so that was before we even got to the royalties, so at this point in time, the royalties to us are all upside.
Now, we need that upside, frankly, in order to make up for the mistakes that we make in other places because we have made investments and we've lost the entire investment. The drug didn't work. The asset got reprioritized inside the portfolio. Frankly, it didn't launch very well. So there are all sorts of things that happen. But like I said, this risk component is probably the key thing that we look at when we do deals because it's ultimately our livelihood. It's either the emergence of a new company or the death of a company. And if we don't handle the risk correctly, we'll be in a bad spot.
Yeah. Yeah. And in terms of, I guess, the risk of going through this process, I mean, what are some of the red flags that appear kind of during the diligence process that will give you pause and what factors ultimately make you decide to walk away from a deal?
There's a couple of things. A lot of it is based around intellectual property and do we believe that the end market will be there at the end of the day? Will the asset, if it's successful, have the right type of commercial protection? So that's from where I think most transactions fall apart, when you get conviction around the asset. Until you get conviction around the asset, it's, can it be a long-term sustainable competitive product in markets? I think we're seeing certain markets, like for instance, oncology, where there's incredible therapeutic density and the ability to differentiate as a fourth-line asset in a very specific cancer. It's hard to translate into what would that look like 10 years after a launch.
Or you're seeing some assets, for instance, in different parts of gene therapy where a standard of care is so entrenched that you're ultimately shifting the standard of care so much that it's hard to see how you get durability where, for instance, something that's $20,000 a year turns into a $2 million product and causing the dynamics. So we look to that a lot about physician behavior, payer behavior, the type of data, and then try to see even as early as we're willing to go with royalty acquisitions, what could be the next disruptor or the next wave of technology that's going to cause a space or an existing technology to evaporate. So you've got to be very pragmatic about the different things that could sideswipe any asset that you're looking at.
That said, I think there are a couple of areas. There have been some phenomenal contrarian investors over time, the Baupost folks, and I would even say Peter Lynch to a certain extent. What interests us at this point in time is these rare diseases where you have a fairly high price point that's substantiated by the actual benefit that's provided to the patient, a readily identifiable patient population, probably increasingly so given the nature of sequencing in a lot of these situations, and they're having a very difficult time actually raising capital at this point. Immunology is a new oncology, and so as we saw the oncology capital kind of dry up in the 2022, 2023 timeframe, immunology came on its backside, but there are hundreds of therapeutic indications that don't really receive a lot of attention from mainstream investors.
That's where we spend a lot of our time. These Mendelian diseases that one specific genetic cause, the underlying cause, if you can correct that cause, you can have tremendous impact on patients. We did a deal just about 18 months ago for what is now the first approved drug for Niemann-Pick T ype C disease. Dramatic change for these kids and for the families that are living with these children. And so we're trying to put our money to good use. We try to generate a good return for our investors. And every now and then, we can actually do the same thing for the patients, which is great to see.
Yeah, and on that, I mean, it sounds like the key indications or disease categories you'd really want to pursue are in that rare disease and immunology arenas. I mean, are there other areas that you're looking at? Are you kind of agnostic to what you're looking at? Or do you have a specific focus where you're really aiming to direct capital?
No, I'd say we're relatively agnostic. If you actually look at our portfolio, it's diversified by indication. It's diversified by therapeutic subcategory, modality, stage, preclinical to phase III. With that said, there are certain areas that are starting to pique our interest. Like I said, the rare disease one is for sure, neuro as well. Frankly, many of the issues, many of the areas that most public investors shun, we tend to gravitate to. One, because those companies are having a difficult time raising capital. And two, if we can put that inside of a portfolio, which I believe numbers are around 127 today, what's the risk if we're putting $5 million or $10 million in? Well, the risk is $5 million or $10 million, but the upside can be astronomical.
And so I look at the Vabysmo situation where we put $14 million to work, and that asset over time could generate close to $250 million-$300 million for XOMA. And the only way we're going to get to that type of situation is we have to invest early. Otherwise, it's going to go to our competitors who have a lower cost of capital. And so that is the benefit of us going early is that, frankly, we'll be wrong, but when we're right, we can be super right. And that super right will actually power the returns for the overall portfolio, very similar to any attribution analysis you would look at at a hedge fund or equity fund or whatever it may be, or even a private equity fund. So I think we're dead set on continuing the actual business model, actually continuing to build it out.
One thing that wasn't done significantly prior to our arrival was synthetic royalties. Our hope is that the next year or two, that's probably 20%-30% of all of our deal flow, where these are assets that are not partnered. And so we are taking a slightly more risk, but our belief is that the underlying asset itself will be able to generate enough clinical data, enough good clinical data that the company actually can raise capital and eventually get that drug commercialized or partnered. And so there, I would say the number of opportunities that we've looked at over the last year have probably ballooned by a factor of two or three because that's an opening that we have now created for the company.
It's more difficult for us to ascertain what's going to work and not going to work just because we're overwhelmed and we have a small company, but to your earlier point, Trevor, how do we siphon these things or what's the aperture on these things? Brad's building systems and the team has been building some systems and processes to get a better sense for how do we actually characterize some of these opportunities coming to us, and we need to do a better job there, but I'm actually proud with what we've done to date, and there's a light at the end of the tunnel there.
Yeah. Can you give us some insight into how? I mean, you mentioned some of the recent capital deployments. Can you give us some insight into how the negotiations go with these companies? I mean, you guys are trying to underwrite pretty conservatively, and the counterparties are generally overly enthusiastic about their assets. So how are you kind of coming to an agreement there?
Do you see the black eye that I have right here? I'm just kidding.
I think one thing that's important is to be a credible counterparty and not get too far into a process where you have divergent views. And if you have divergent views, sometimes it's best to park an opportunity and wait for it to come back or watch it walk away. That's okay too. We have to maintain our discipline. I think as long as there's no surprises in the process, we want to be straightforward with our counterparties. We think reputation is everything. Being a good counterparty will carry its weight far longer than retrading on a transaction. When you have divergent views, because oftentimes if a program was invented within a company and then outlicensed, for example, people always wear rose-colored glasses. They don't realize that drug development takes more time and costs more money than anyone will ever think.
They always think that there's the exception rather than the norm. We have to bridge that. Sometimes you could bridge it with structure, and sometimes you can bridge it by just partying as friends.
With that said, I think the one thing that we try to do, which we need to do a better job of, is just be responsive to our potential partners. Generally, within two weeks, we have a sense as to whether this is going to work for us or not. At times, we do a great job of that. Sometimes we procrastinate. It's the nature of human beings, but we try to be responsive to our partners, and to the extent that we are interacting with folks and it's not a fit for XOMA, we do try to put them in touch with other folks that we know. It just goes back to what we said before is that as much as AI, things may change, the nature of drug development, this particular business is still very much relationship-driven.
And at the end of the day, you need a human to sign the actual check. And so we try to be helpful to our partners. We can't always be helpful, but we certainly try.
Yeah. Yeah, it's interesting. We're coming up on time here, but I do want to ask you guys one more question if we can squeeze it in. I mean, can you guys speak to kind of the potential near-term financial leverage of the business model? I mean, how do you see OpEx shifting over the next three to five years? How much top line do you guys kind of expect that you need to get to that 30%-40% net margin number?
Yeah. I think the way we characterize it is that for every revenue dollar over essentially $20 million, it's 100% free cash flow. We have NOLs that will probably go out several years, so we won't be paying taxes anytime soon based on legacy XOMA, and as I mentioned before, we're hopeful that in 2025, sometime in 2026, we'll actually be cash flow neutral to cash flow positive just based on our royalties alone, so not inclusive of the milestones. The milestones are very difficult to forecast. They're extremely lumpy, so what we're more concerned about is actually just growing that revenue base, and our goal is sitting four or five years from now to have a company, hopefully, that's generating $150 million-$200 million in royalty receipts in a given year.
If we're successful in that endeavor and you put a standard royalty multiple on that, you're talking about creating pretty significant value for our shareholders, something along the lines of like a 20%-25% IRR. So the leverage in this business is, I said it before, this is probably the most interesting business I've ever actually analyzed. The expenses are very low. They'll probably grow at inflation plus or minus a little bit, but there's no huge step up. Even if we actually are generating $150 million-$200 million in royalty receipts, I don't see the expense base running commensurate with the actual royalty receipts. It's a fraction of actually the royalty receipts. So we should have, and if you look at some of our larger competitors, more experienced competitors, they've got a margin profile that can approach 90% at times on the operating side.
That's something that is within reach for this business within a couple of years if we do our job and we get a little bit of luck every now and then.
Yeah. Yeah, definitely. Great. Well, yeah, thank you both for joining us, and thank you all for listening in. It's been a great conversation, and we will see you at the next event.
We appreciate your time, Trevor. Really appreciate it.