Earnings Call Transcript - SDGR Q2 2021

Operator, Operator

Thank you for standing by and welcome to the Schrodinger Conference Call to review the Company's Second Quarter Financial Results. My name is Kevin and I will be your operator for today's call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Please be advised this call is being recorded at the Company's request. And now I would like to introduce your host for today's conference, Tracy Lessor, Executive Director of Corporate Communications. Please go ahead.

Tracy Lessor, Executive Director of Corporate Communications

Thank you. And good morning, everyone. Welcome to today's call, during which we'll provide an update on the Company and review our financial results for the second quarter of 2021. Earlier this morning, we issued a press release summarizing our financial results and progress across the Company, which is available on our website at www.schrodinger.com. Here with me today are Ramy Farid, President and Chief Executive Officer, Karen Akinsanya, Executive Vice President, Chief Biomedical Scientist, and Head of Discovery R&D, and Joel Lebowitz, Executive Vice President and Chief Financial Officer. Following our prepared remarks, we'll open the call for Q&A. I'll remind you that during today's call, management will make statements related to our business that are forward-looking and are made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995, including without limitation, statements related to our future financial performance, including our outlook for the full year 2021; the potential advantages of our platform, our strategic plans to accelerate the growth of our software business and advance our collaborative and internal drug discovery programs, risks relating to the COVID-19 pandemic, our expectations related to the use of our cash, cash equivalents, and marketable securities, as well as our future operating expenses. These forward-looking statements reflect our current views about our plans, intentions, expectations, strategies, and prospects, which are based on the information currently available to us and on the assumptions we have made. Actual results may differ materially from those described in the forward-looking statements and are subject to a variety of assumptions, uncertainties, risks, and factors that are beyond our control, including the demand for our software solutions, our ability to further develop our computational platform, our reliance upon our drug discovery collaborators, and other risks detailed under the caption Risk Factors and elsewhere in our most recent Securities and Exchange Commission filings and reports. Except as required by law, we undertake no duty or obligation to update any forward-looking statements discussed in this call as a result of new information, future events, changes in expectations, or otherwise. These forward-looking statements should not be relied upon as representing our views as of any date subsequent to today. With that, I'd like to turn the call over to Ramy.

Ramy Farid, President and CEO

Thanks, Tracy. And thank you, everyone, for joining us today. At Schrodinger, we have developed a computational platform that is transforming the way therapeutics and materials are discovered. The platform is enabling our customers and our internal teams to discover high-quality molecules for drug development and materials applications faster, at lower cost, and with what we believe is a higher probability of success compared to traditional methods. We license our platform to pharmaceutical, biotech, and materials companies, as well as universities and government labs worldwide. As Karen will review shortly, we are also advancing an internal drug discovery pipeline and leveraging our platform in a number of drug discovery programs in collaboration with pharmaceutical and biotech companies. We announced a new drug discovery collaboration this month with Zai Lab. The collaboration marks the first time we have the opportunity to co-develop and co-commercialize a therapeutic. Zai Lab has a deep pipeline in oncology with multiple approved products that we are excited to be working with them. The collaboration with Zai will focus on a target in the area of DNA damage response, an important therapeutic strategy for a broad range of cancers, and builds on the knowledge we have gained working on our own programs in this area. Under the terms of the agreement, Zai will make an upfront payment to help fund our share of research costs. We have co-development and co-commercialization rights, which will allow us to share equally in the profits of the future marketed product in the U.S. if we choose to co-fund U.S. development. We are also eligible to receive up to approximately $338 million in preclinical development, regulatory, and sales-based milestone payments, as well as royalties on net sales outside the U.S. This collaboration provides us with the opportunity to gain expertise in late-stage clinical development and commercialization, as well as the ability to participate more significantly in the downstream value of a program. As you will hear shortly from Joel, we reported a strong second quarter with 29% revenue growth compared to the same period last year. And we ended the quarter with cash resources of $617 million. Our financial strength allows us to continue to invest in advancing our science, growing our software business, advancing our internal pipeline, and adding new talent to support our strategic initiatives. We are excited by the progress we've made as we continue to transform the way therapeutics and materials are discovered. I'll now turn the call over to Karen for an update on our drug discovery programs.

Karen Akinsanya, Executive Vice President, Chief Biomedical Scientist, and Head of Discovery R&D

Thank you, Ramy, and good morning everyone. We are continuing to make important advances on many fronts across our internal pipeline and portfolio with collaborative programs. We have collaborations with both biotech and large pharmaceutical companies, spanning a broad range of target classes. In these collaborations, we are leveraging our platform at the same scale we do internally. We believe this level of large-scale deployment enables us to more rapidly identify high-quality development candidates. We expect several collaborative programs to continue to advance in the clinic and new programs to enter the clinic this year. We are excited to begin working with our new partner, Zai Lab, on a program targeting DNA repair vulnerabilities in cancer that we anticipate will be synergistic with PARP inhibitors. Marketed PARP inhibitors have demonstrated efficacy in multiple cancers, but new regimens and combinations that result in durable responses are needed, especially in patients who relapse or become resistant to treatment. We are also continuing to build early-stage clinical experience to support the advancement of our internal program. Today, I will highlight our three most advanced programs, MALT1, CDC7, and WEE1. We have initiated IND-enabling studies for our development candidate targeting MALT1, and we are working towards the nomination of development candidates for CDC7 and WEE1. Subject to completion of the preclinical data packages, we expect to submit up to three IND applications in 2022, with our first submission expected in the first half of next year. Starting with our MALT1 inhibitor program, MALT1 inhibition is gaining increasing attention as a therapeutic strategy to treat certain relapsed or resistant B-cell lymphomas and chronic lymphocytic leukemia. The MALT1 enzyme is downstream of BTK in the NF kappa B signaling pathway. Constant activation of NF kappa B is a hallmark of several types of lymphoma. Preclinical data previously presented from our MALT1 program showed potent in vitro inhibition of MALT1 enzymatic activity and in vivo anti-tumor activity in mouse xenograft models of diffuse large B-cell lymphoma. Additionally, in vivo patient-derived tumor mouse models, our MALT1 inhibitors demonstrated dose-dependent anti-proliferative effects as monotherapy and in combination with Ibrutinib and Venetoclax, which are approved BTK and BCL-2 inhibitors, respectively. In the second quarter, we selected a development candidate for this program and have since initiated GLP-tox studies required for IND submission. All our IND enabling activities are on track, and we expect to submit the IND and begin Phase 1 studies in patients with hematological malignancies next year. Now, I will turn to CDC7 and WEE1, two programs that target cancer through replication stress and DNA repair mechanisms. CDC7 is thought to be linked to cancer cells' proliferative capacity and ability to bypass normal DNA damage responses. Targeting proteins that play important roles in DNA replication is gaining momentum as a therapeutic approach for cancer. Earlier this year, we presented preclinical data from our CDC7 inhibitor program, which showed that compounds are synergistic with several approved and investigational cancer therapies that modulate apoptosis, DNA repair mechanisms, and DNA checkpoints. These compounds significantly inhibited tumor growth in mouse models of both acute myeloid leukemia and colorectal cancer. The data we have generated to date suggests that we have an opportunity to develop a best-in-class inhibitor with a very favorable pharmacokinetic profile. Our other DNA damage repair program targets WEE1, a tyrosine kinase regulator of the G2/M cell cycle checkpoint, which when inhibited reduces cell viability by inducing apoptosis of cancer cells. WEE1 inhibitors from other companies have shown clinical proof of concept as monotherapy in uterine serous carcinoma. Combinations with chemotherapy, PARP inhibitors, and PD-1 antibodies are being pursued by others in the clinic. We have identified multiple WEE1 inhibitors that are highly selective for WEE1 and show strong pharmacodynamic responses and anti-tumor activity in vivo. Our molecules also have optimized drug-like properties, including no observable inactivation of CYP3A4, a key liver enzyme. We believe this profile limits the potential for accumulation and the need for dose adjustments with combination products. In summary, we have multiple programs advancing towards the clinic to enable up to three IND submissions in 2022. As these programs advance and transition into development, we are initiating new programs. We have begun drug discovery on an undisclosed target in immunology and have prioritized several additional program opportunities with human genetic support and emerging pharmacology data in oncology and immunology that we expect to advance this year. We are excited about the progress that we and our collaborators are making, and look forward to updating you on our R&D activities throughout the year. I will now turn the call over to Joel to review our financial results.

Joel Lebowitz, Executive Vice President and CFO

Thank you, Karen, and hello, everyone. This morning, I'm pleased to discuss our financial results for the second quarter of 2021, and I'll also review our outlook for the year. We reported total revenue of $29.8 million for the second quarter, up 29% compared to the second quarter of 2020. Software revenue was $24.1 million, representing 15% growth compared to the second quarter of 2020. The growth in software continues to reflect increased adoption of our platform by existing customers and the addition of new customers. Drug discovery revenue was $5.7 million for the second quarter, compared to $2.2 million in the second quarter of 2020. Second quarter drug discovery revenue included $3.3 million recognized from our collaboration with Bristol Myers Squibb. Discovery revenue also included a payment from a collaborator associated with the acquisition of intellectual property following the achievement of a lead optimization milestone. Gross profit was $12 million in the second quarter of 2021, compared to $13.6 million in the second quarter of 2020. Software gross margin was 77% in the second quarter of 2021 compared to 82% for the same period in the prior year, reflecting our planned investment to drive and support long-term large-scale adoption of our platform. Operating expenses were $42.3 million compared to $30.7 million in the second quarter of 2020, reflecting our investment in R&D to advance our pipeline and our technology, the addition of staff to drive long-term software sales growth, and expenses required to build a public company infrastructure and support the Company's growth as we scale globally. Another expense, which includes changes in the value of equity investments, was $4.6 million in the second quarter of 2021, driven primarily by a loss of $4.9 million from the mark-to-market of our shares in Morphic Therapeutic. This compared to $13.1 million in income for the second quarter of 2020. As we revalue our shares each quarter, we can experience significant fluctuations in the value of our holdings depending on stock price movements. The value of our shares in Morphic recorded on our balance sheet as of the end of the second quarter was $48 million, demonstrating the value we have helped create through this collaboration so far. We recorded a net loss after adjusting for a non-controlling interest of $34.6 million for the second quarter of 2021 compared to a net loss of $3.4 million for the same period last year. This year-over-year change is driven by quarterly fluctuations in the value of our collaboration equity, particularly our shares in Morphic, as well as planned investment in our business to drive long-term growth. We ended the second quarter with cash resources of $617 million, compared to $649 million at the end of the first quarter of 2021. In March, we provided our financial outlook for the full year and today, we are reaffirming that guidance. We expect total annual revenue in 2021 to be in the range of $124 million to $142 million, which includes software revenue of $102 million to $110 million and discovery revenue of $22 million to $32 million. Also, we expect the majority of our second-half growth in software revenue to occur in the fourth quarter. Drug discovery revenue can be highly variable based on the timing of potential milestones related to collaboration agreements. As we've said before, we anticipate that full-year operating expense growth will be higher than the 42% annual growth rate we saw in 2020, primarily driven by our commitment to fund R&D to advance our technology and our internal drug discovery pipeline. We also anticipate that software gross margin will be lower than the 81% reported in 2020, reflecting investment to drive and support large-scale adoption by our customers. We continue to execute on our strategy across our business. Our new collaboration with Zai Lab enables us to more significantly participate in the downstream value of the programs. Our collaboration programs and internal pipeline are progressing, and we are continuing to make scientific advances in our software to drive large-scale utilization, both in drug discovery and material science. And finally, we have the resources to invest in our long-term growth strategy. I will now turn the call back over to Ramy.

Ramy Farid, President and CEO

Thanks, Joel. As we pass the halfway point in the year, we're very pleased with the progress we're making across our business. We continue to innovate and our technology is having a significant impact on our collaborative and internal drug discovery programs. Our internal programs are advancing toward the clinic. Our software customers are increasingly recognizing the benefits of deploying our solutions at scale. And we are growing our team of exceptional scientists and professionals to deliver on our mission of transforming drug discovery and materials design. At this time, we'd be happy to take your questions. Operator?

Operator, Operator

Our first question comes from Michael Yee with Jefferies.

Michael Yee, Analyst

Hi, good morning, and thanks for the update. Thanks for the question. We wanted to ask around the confidence around your guidance and reflecting the confidence in your business. Specifically, you're maintaining the guidance halfway through the year of $102 to $110 million for software. But it feels like the low end of that would be a pretty big deceleration not only year-over-year but also just from the first half of what is going on this year. Two parts, one, can you just comment on the lower half of your guidance and why you're maintaining the overall guidance, your confidence in hitting the higher end. And then secondly, if COVID may or may not be picking up, is that actually a headwind or tailwind for your business? Maybe just talk about how COVID, if at all, impacts things. Thank you so much.

Ramy Farid, President and CEO

Sure. Joel, you want to take the first part of that question, and I can answer the next one?

Joel Lebowitz, Executive Vice President and CFO

Sure, thank you, Ramy. I appreciate your question. We are maintaining our overall guidance as well as our software guidance. This annual guidance reflects our expectations for the latter half of the year. We have good visibility into our business due to our historically high customer renewal rates. However, there is some inherent variability, especially related to the new customers added each quarter and decisions from our larger clients regarding significant deployments of our solutions, which is a crucial growth strategy for us. Individual decisions can be substantial and significantly impact our growth rate for that quarter. As we look towards the remainder of the year, we believe that the guidance we have provided adequately addresses this inherent short-term variability, which is why we have reaffirmed it.

Ramy Farid, President and CEO

Regarding COVID, as we mentioned in 2020, many software companies experienced similar trends. There seemed to be an interesting increase in interest in computational methods because scientists were mostly unable to access their labs. At this point, and based on feedback from several other companies, we believe that the prolonged lack of travel and face-to-face interaction is not beneficial. It makes it more challenging to start strategic discussions, although it's not impossible. This has been particularly difficult considering it's been about a year and a half of essentially no travel.

Michael Yee, Analyst

Yeah. That's very helpful. Thank you, guys.

Operator, Operator

Our next question comes from Michael Ryskin with Bank of America.

Michael Ryskin, Analyst

Thank you for taking my question. I have a quick follow-up regarding what Mike just asked. You talked about strong renewal rates and a softer business environment. Can you provide some quantification on that? How has it trended in the first half of the year? Are you still in the high 90s? Has there been any impact as we compare to last year?

Joel Lebowitz, Executive Vice President and CFO

Sure. Thanks, Mike, for the question. So that's one of our annual key performance indicators, and we don't provide specific guidance or reporting on the mid-year numbers as they can be affected by timing. But what I'd say is that last year we came in at 99% renewal and of those contracts over $100,000. And over the last seven years, it has never dipped below 96%. So we're pretty confident in our ability to continue to achieve a very high customer renewal rate.

Michael Ryskin, Analyst

Okay, I'll take that. And then on the Zai Lab collaboration you announced recently. You mentioned, first of all, the upfront payment. Could you give us a sense of how sizable it would be? We saw some details there in terms of the potential milestones, but specifically about the upfront and when it will be recognized. And then a bigger picture question on that. Should we expect more deals like that? You have a couple of different ways of working with BioPharm or between the software business, the JVs, the partnerships. And now this is again something a little bit new. Is this another avenue we expect you to explore more going forward?

Joel Lebowitz, Executive Vice President and CFO

Sure. I'll answer the first part and maybe Ramy, you might want to add to the third.

Ramy Farid, President and CEO

Yeah.

Joel Lebowitz, Executive Vice President and CFO

With regard to the size of the upfront payment, we didn't disclose that. It is to help us fund some of our research activities. And we are still evaluating the accounting around this deal, but we expect that a number of these types of deals, that the upfront payment will be recognized over a period of time. And I think if you think about typical deals, where there's upfront payments that we've discussed in the past, that has been the case, and in many cases, it's been over several years.

Ramy Farid, President and CEO

And with regard to this kind of deal, we're very excited about this kind of deal. We are in discussions with a number of companies around innovative types of deals. This is the kind of thing as we've talked about before. We're not only innovating in the science, we're definitely being creative in the types of deals we've done, as you can see from the history of the Company going all the way back to Nimbus. And we're very pleased with the nature of those interactions now, and certainly expect to do other collaborations in the future.

Michael Ryskin, Analyst

Okay. Thanks so much.

Operator, Operator

Our next question comes from Gary Nashman with BMO Capital Markets.

Gary Nashman, Analyst

Hi, good morning. First, for MALT1, what's involved in the IND-enabling studies? What will be included in the preclinical package that you plan to file next year? And I think you'll be presenting some preclinical data for one of your programs in the second half. In what form do you think that's going to be? And then last one. It seems like you're looking to expand your platforms to other areas in materials, like aerospace and electronics. How much of an initiative will you have behind those efforts? And how aggressively will you be finding partnerships in those areas relative to the life sciences that you've been doing more often? Thanks more of. Thanks.

Ramy Farid, President and CEO

Karen, do you want to take the first two and I'll cover the last one?

Karen Akinsanya, Executive Vice President, Chief Biomedical Scientist, and Head of Discovery R&D

Yeah, sure. So with respect to the MALT1 program, we will be presenting the IND-enabling package to the FDA, which will include the results of GLP-tox studies, all of the CMC support that we've got for our clinical product, and really the typical package that you would expect to see going into the FDA to support approval of the IND and initiation of clinical studies. With respect to the science, we've continued to make great progress there. We've characterized MALT1 inhibitors in a number of different models and have new data with respect to how MALT1 performs, both alone as monotherapy and in combination with other products. As you can imagine, we've been putting together abstracts and sending them out to the regular scientific forums. And so we expect to be able to share some of that in one of those scientific meetings later on this year. So looking forward to that.

Ramy Farid, President and CEO

We are very excited about the progress in material science, particularly the growing adoption of our technology across various industries. While we haven't utilized much of the existing technology so far, we are identifying opportunities to build upon it and make new advancements as we delve deeper into this field. We are actively investing in these opportunities due to the strong interest in computation across several domains. It is crucial to emphasize that our work is based on existing technology, and we are building on that foundation. Regarding collaborations, we are actively pursuing them and are pleased with the progress in discussions. You can expect to hear more about these collaborations in the future, following a path similar to our past experiences in Life Sciences. As I mentioned, collaborations like those with Nimbus and Morphic have taught us valuable lessons and generated significant value for Schrodinger, which we plan to replicate in the material science sector.

Gary Nashman, Analyst

Okay, great. Thank you.

Operator, Operator

Our next question comes from David Lebowitz with Morgan Stanley.

David Lebowitz, Analyst

Thank you very much for taking my question. When you look back at 2020, there was a huge step-up in ACV, I believe 10 companies went from 10 to over 16 companies with ACV. What quarters did you see the bulk of that shift? And I guess when do renegotiations with those particular companies; when are they on tap?

Joel Lebowitz, Executive Vice President and CFO

Sure, I can discuss that. Thank you, David. As we've mentioned this year, we anticipate that the fourth quarter will be a significant driver of growth in the latter half of the year. This is primarily due to the seasonal nature of our business in software, where many contracts, especially large ones, are renewed and decisions about renewal sizes are typically made in the fourth quarter. While we observe this trend throughout the year, the fourth quarter tends to have a higher concentration of such activities. I'm sorry, could you please remind me of the second part of your question?

David Lebowitz, Analyst

When do negotiations for those specific contracts begin? Does it start this early, or do discussions typically occur closer to the actual renewal date?

Ramy Farid, President and CEO

Negotiations actually take place throughout the year. We maintain regular communication with the companies and do not just send the software and wait until weeks before the renewal to engage. We are continuously learning about how the software affects their technology and discussing new advancements. We have four releases a year, which provide opportunities to connect, discuss new technologies, and share insights from our collaborations. These discussions occur all year but become more intense as the renewal date approaches. I hope that addresses your question. What was the second part?

David Lebowitz, Analyst

Are they the ones that typically go to a higher level?

Ramy Farid, President and CEO

When you observe our retention rate in the high 90s, that speaks for itself. We wouldn’t achieve such a retention rate if it weren’t significant.

Joel Lebowitz, Executive Vice President and CFO

And one thing I can add to that, David, is that we're very pleased that in this quarter we are experiencing the continued momentum and trends that we observed in previous quarters, which is driving growth on the software side. This growth is not solely due to acquiring new customers, but also because existing customers are increasing their adoption of our solution. We have noted this as an ongoing trend for several quarters. Therefore, we believe that we can continue to encourage customers to adopt the solutions at higher levels in the future.

David Lebowitz, Analyst

And one additional question on the drug discovery side, is it possible you could run through the drugs from partners that we could expect to see data from before year-end and which drugs might actually step into the clinic?

Ramy Farid, President and CEO

I'm considering who should respond. Joel mentioned that it's quite challenging for us to foresee when those events will occur, largely due to the nature of the agreements and confidentiality involved. It's really up to the collaborators to share that information. Some have been quite transparent about their programs and clinical plans, and one is a public company. There's accessible information from the collaborations where they have more developed programs. However, some of the newer collaborations are still in early stages and remain discreet, so it will take more time before we can provide updates on those. I hope this addresses your question. If it doesn’t, please feel free to rephrase it.

David Lebowitz, Analyst

Thank you very much for taking my questions.

Ramy Farid, President and CEO

Okay. Great.

Operator, Operator

Our next question comes from Matt Hewitt with Craig-Hallum.

Matt Hewitt, Analyst

Good morning. And thank you for taking the questions. A couple on utilization, then I've got one regarding the new collaboration. But regarding utilization, can you give us a sense for how many of your customers are coming back multiple times during the year to increase their capacity, as opposed to just coming in once a year and adding what they believe they will need for the upcoming year?

Ramy Farid, President and CEO

Sure, that's a good question. We can't really quantify that. However, we can say that the vast majority of deals are annual. There are a few customers who purchased the software in a way that requires adjustments during the year as the number of compounds they are running calculations on reaches the limits of their purchase, but that's uncommon. Most are annual licenses. Additionally, we currently have six collaborative programs that are in IND enabling studies and four in Phase 1, just to give you an idea of where our focus lies. Did you have another question or did that answer yours? Go ahead.

Matt Hewitt, Analyst

Yeah, I did. And that's fine. Regarding visibility, how much insight do you have into your current customers' utilization trends? Given where we are at this point in the year and understanding the customer's utilization perspective and seeing the growth, does that inform your projections on what that customer is likely to renew at?

Ramy Farid, President and CEO

No, we do not have insight into their usage, as that information is closely held by the customers. We are unable to quantitatively analyze it. However, we do know some important factors, like how their licenses are managed. We are aware of the number of licenses they possess, but we cannot determine if they are fully utilizing them. What we do know is that for nearly all of our customers, including our largest ones, the maximum number of calculations they can perform is significantly lower than what we conduct in our collaborations and internally. We engage in discussions about this despite not having access to daily usage specifics. These discussions typically highlight this fact and also explore how we can achieve higher usage levels, which often necessitates training and expertise on the technical side. For instance, to run many calculations, users need access to numerous computers, typically provided through the cloud, which requires training for large-scale cloud utilization, as well as technological deployment from a scientific perspective.

Matt Hewitt, Analyst

That's really helpful. Thank you. One last question from me, shifting topics a bit. Regarding the collaboration with Zai Lab, were there any existing customers involved? How did that relationship develop? And as you consider adding more partnerships like this, do you typically find that these customers are new to the platform, or are existing customers requesting assistance to navigate these calculations and the associated work?

Ramy Farid, President and CEO

Thinking back on all the collaborations we've undertaken, many involved newly established companies. While we didn't have prior knowledge of them, there were usually individuals in the venture capital firms that funded them or among the founders who were familiar with Schrodinger from past interactions. We have a strong reputation in the field, and it's rare to find someone who isn't aware of Schrodinger or has not had some experience with our software, either in their current role or from a previous position. This was also true with Zai Lab, as we have known them and their board members for quite a while. Therefore, there typically isn't an element of surprise or an interaction without some previous connection to a key person at the company. I hope this addresses your question.

Matt Hewitt, Analyst

Yeah. That helps. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes the Q&A portion of today's conference. It also concludes the conference call for today. You may all disconnect, and have a wonderful day.

Ramy Farid, President and CEO

Thank you.

Joel Lebowitz, Executive Vice President and CFO

Thank you, everybody.