Only two and a half weeks have passed since the launch of the model portfolio, so it is still too early to assess its performance, nevertheless, even after a sharp decline in two stocks, the portfolio seems more robust than the general market. Since inception, the biotech portfolio, co-managed by Ran Nussbaum and myself is down “only” 3.6%, compared to the Nasdaq and S&P which are down 8.5% and 6.7%, respectively for the same period.
Based on recent market action and the unprecedented level of anxiety, it seems that the bottom is getting closer and hopefully, the markets will stabilize towards the end of 2008. Therefore, the coming weeks may be a good opportunity for increasing exposure to the stock market, which is why we intend to end 2008 with 90-95% of the portfolio in stocks.
More specifically, the biotech industry may enjoy a meaningful catalyst in the coming months: The acquisition of Genentech (DNA) by Roche, which just recently reaffirmed its commitment to buy the 44 percent stake it does not already own. Unlike companies in other industries that are paralyzed by recession fears, pharmaceutical companies have both the willingness and the stability in order to get the funding necessary for large scale mergers and acquisitions because they are hardly affected by the economic downturn. In fact, the drug industry is probably one of the few places large financial institutions might feel comfortable putting their money at the moment. In the case of Roche and Genentech, the cash generating portfolios of both companies, which will not be facing substantial generic competition in the coming years, coupled with their focus on serious illnesses such as cancer and inflammatory diseases, will encourage stakeholders to achieve a deal already in the coming months. From the banking industry’s viewpoint, such a high profile deal could serve as the ultimate proof that the credit markets are starting their gradual recovery. We therefore decided to increase our position in Genentech, which now accounts for almost a fifth of the portfolio’s value.
Exelixis in the post-GSK era
We also decided to add more Exelixis (EXEL), which is in the process of transforming into a “leaner and meaner” company, according to the company’s CEO, George Scangos on today’s conference call. Exelixis lost 22% of its value on Thursday after announcing that GlaxoSmithKline (GSK) had decided not to license additional candidates included in the joint development collaboration between the two companies. This is certainly not a positive development for Exelixis, but it was somewhat expected after GSK’s decision earlier this year not to extend the agreement for another year. Looking at the half-full part of the glass, this decision provided the much needed clarity with regard to the ownership of Exelixis’ compounds, and now, Exelixis can start the long-anticipated monetization process.
Thursday’s announcement got investors worrying for two reasons. First was the issue of the quality of the compounds GSK decided to abandon, as it can be wrongly concluded that these compounds are not attractive for further development. Second were the implications this decision had on Exelixis’ financial stability, as any selection by GSK would have triggered a substantial milestone payment, which is extremely valuable in this turbulent financial environment. These milestone payments would have been used to repay a loan Exelixis had received from GSK.
With respect to the quality of the compounds, it is really too early to tell, as the majority of compounds are either in early clinical or in late pre-clinical stages, but judging by the preliminary data Exelixis has just published, there is more than a reasonable chance that at least one or two of the early stage compounds, XL281, XL228, XL820, and XL844 will generate positive results down the road, not to mention XL184, which is the most advanced c-MET inhibitor in the clinic, currently in phase III trial for a niche indication (medullary thyroid cancer).
This week at the EORTC meeting, Exelixis published a massive amount of clinical data including some data pertaining to the compounds developed under the GSK collaboration. XL281, for example, demonstrated signs of activity, including a partial response in an ocular melanoma patient and a minor response in a colorectal cancer patient. In another phase I trial of XL228, which inhibits quite an unusual combination of cancer related targets, 7 of 16 evaluable patients had experienced prolonged disease stabilization (greater than 3 months), with one metastatic non-small cell lung cancer patient experiencing a 27% reduction in its lesions. Additional compounds which were not part of the GSK collaboration generated interesting data as well, including XL147 and XL765, which demonstrated good safety profiles together with prolonged disease stabilization in several tumor types. Despite the modest clinical activity, it is important to note that the majority of the data is derived from dose escalation studies in very diverse and unselected patient populations, many of whom were at a very advanced disease stage, so in the right patient population given at the maximal dose, these compounds might be more effective alone or in combination with other drugs.
The road ahead will be long and challenging, as statistically, most of these compounds will not make it to market, but the company’s pipeline is still one of the most interesting oncology pipelines in the industry containing all the right ingredients: Compounds that inhibit the hottest targets in cancer, great translational research, benign safety profiles which will facilitate many combination trials and most importantly, preliminary signs of activity, including very wise utilization of biomarkers.
The financial situation appeared to be challenging since raising capital in the stock market is out of the question in the foreseeable future. In its previous guidance, the company expected to have ~$300 million in operating expenses in 2008, a mind boggling number for a company with a market cap of just over $320 million. The company ended the third quarter with $135M in cash and cash equivalents, excluding a $150 million line of credit it managed to secure this summer from long-time shareholder, Deerfield Management. In addition, Exelixis will have to start paying back the GSK loan ($101 million), starting October of next year, which would decrease its cash position even further.
This delicate situation raised many concerns, which are clearly echoed by the company’s current market cap. Nevertheless, based on management statements in the past and more importantly, the recent quarterly conference call, it is our belief that the likelihood for a liquidity crisis is extremely low.
During the call, the company’s CEO laid down the steps Exelixis is undertaking in order to remain independent of the equity markets in the foreseeable future. First and foremost, realizing that a company the size of Exelixis cannot support clinical development of the nine (!) wholly owned compounds, the company intends to aggressively monetize its assets, by striking licensing deals for some of the compounds. This step will not only bring a much needed cash infusion, but will also offload the development costs onto the partners. In addition, the company expects to trim expenses by workforce reduction, regardless of the capital brought in by partnership deals.
The company is confident it will be able to complete one or two of the transactions by year end, with additional deals expected to be signed in the first half of 2009. Obviously, only now can Exelixis start negotiating for the GSK compounds, so the compounds to be licensed in 2008 will probably be those which had been independently developed by Exelixis: XL765, XL148 or XL888. These are compounds that hit targets which are implicated in a wide range of cancers, so the resources of a large partner are necessary for optimally developing them. Next year, we should see licensing deals for some of the GSK compounds, probably XL184 and XL281, which are already garnering substantial interest from potential partners, according to the company.
But how much are these compounds worth?
On the call, when asked whether the current market is a “buyers’ market”, Scangos went out of his way to explain that the deal sizes they are seeing is still very high since there is still a large demand for good candidates, let alone, compounds with initial clinical data. Another hint to what the company expects to get for the two imminent licensing deals this year can also be found in the guidance for the expected year end cash position. The company expects to have approximately $200 million in cash, an increase of $65 million, not including the cash to be consumed in the fourth quarter. In other words, Exelixis expects to get almost $100 million in two months, and the majority of this sum (~$70M) will probably come from the two new licensing deals.
On another positive note, the company does not intend to decrease its drug discovery activity, which is very encouraging, given the amount and quality of compounds the company has generated thus far. For a platform company such as Exelixis, generating more candidates is the most cost efficient thing to do, as this enables the company to increase the number of shots on goal and striking early-stage licensing deals at a minimal cost.
In summary, although the market still sees Exelixis as a cash-starved company, by next year, Exelixis may be in a totally different position. The aggressive monetization will leave the company with a handful of wholly owned agents with a well defined route to market in niche indications, while development of compounds with a potentially broader utility will be advancing in the hands of large partners or halted. The cash burn rate will be substantially lower, and if everything goes according to plan, the capital Exelixis obtains via partnership deals will completely offset operational costs. Investors can only hope that in the not so distant future, the fog will clear and the market will see Exelixis for what it truly is – a remarkable platform company with one of the most impressive oncology pipelines in the industry.
In addition to buying more Exelixis, we are also adding more GSK and selling our holdings in Middlebrook (MBRK).
Biotech portfolio as of October 27th,2008.