Exelixis: Long-Term Problem Isn't Shareholder Activism - It's Cabo Patent Expiry

Investment Overview

It's been nearly three years since I last covered Exelixis (NASDAQ:EXEL) for Seeking Alpha, and in that time, the share price has moved just 9% - in a downward direction. There have been peaks and troughs, but overall, the stock has not exceeded highs of $27 per share, and not sunk lower than $15 per share - a fairly narrow range for such an extended period.

Exelixis' business is built almost exclusively around a single molecule, cabozantinib - as per the company's Q2 2023 submission:

Cabozantinib is an inhibitor of multiple tyrosine kinases including MET, AXL, VEGF receptors and RET and has been approved by the U.S. Food and Drug Administration ("FDA") and in 69 other countries as of the date of this Quarterly Report, as CABOMETYX tablets for advanced renal cell carcinoma ("RCC") (both alone and in combination with Bristol Myers Squibb Company's (BMY) OPDIVO (nivolumab), for previously treated hepatocellular carcinoma ("HCC") and for previously treated, radioactive iodine ("RAI")-refractory differentiated thyroid cancer ("DTC"); and as COMETRIQ (cabozantinib) capsules for progressive, metastatic medullary thyroid cancer.

Cabozantinib is a member of the tyrosine kinase inhibitor ("TKI") drug class, and it is one of 50 FDA-approved TKIs, according to the National Institutes of Health ("NIH"). The fact that the orally administered drug (all TKIs are orally administered) drug is approved in indications such as kidney and liver cancers, as a first or second-line monotherapy, or in combo with a "megablockbuster" drug like Bristol Myers Squibb's Immune Checkpoint Inhibitor ("ICI") Opdivo, is a testament to the versatility, efficacy and safety of Cabozantinib, although the competition within such lucrative markets is particularly intense.

Exelixis has driven revenues of $1.38bn, $1.1bn, and $719m in 2022, 2021, and 2020, with the vast majority coming from sales of Cabometyx, returning net income of $182m, $231m, and $112m - margins of ~13%, ~21% and 16% respectively. Whilst the rate of revenue growth has been very impressive, profitability has wavered, which may help to explain the flat share price.

At the beginning of 2023, Exelixis stock traded at ~$16 per share, its lowest price since the onset of the pandemic triggered a mass market sell-off in March 2020, but recently a series of developments has provided some strong upside, momentum and sent the stock price to $22 (at the time of writing) - its highest price for over a year.

Upward Momentum Starts With Farallon Challenge

In March, Exelixis shared the bad news that its Phase 3 study of Cabometyx in combo with atezolizumab - Roche's (OTCQX:RHHBY) immune checkpoint inhibitor and Opdivo rival Tecentriq - in second-line RCC had surprisingly failed to meet its main endpoint of Progression Free Survival.

Possibly in a move designed to placate shareholders, Exelixis announced later that month that it had approved a $550m share repurchase program, but despite this gesture, management soon found themselves under attack from one of its largest shareholders, the activist Hedge Fund Farallon, which owns a >7% stake in the company.

Farallon accused Exelixis management of having "neither a coherent R&D strategy nor a disciplined approach to spending" in a letter sent to the Board, which also accuses management of attempting to move studies from Phase 1 to Phase 3 too quickly, resulting in a succession of late stage study failures, and of investing too much in R&D. The letter states:

In 2023, Exelixis plans to spend more money than ever on R&D - more than $1 billion - with much of it going to discovery and pre-clinical projects across a range of modalities and targets, many in scientific and clinical areas in which Exelixis lacks differentiation and a competitive advantage. Instead of becoming more focused and disciplined, Exelixis is doing precisely the opposite, sponsoring nearly 80 trials simultaneously, a total that is far higher than any of the Company's peers.

This undisciplined spending on R&D is not good for patients or investors. We believe zanzalintinib and other ADCs in the Exelixis pipeline can extend thousands of lives and become great commercial successes. But we fear the Company is spread too thin and lacks expertise across its many different trials, mechanisms of action and indications. The result is unproductive efforts and wasted resources, neither of which patients or investors can afford.

Zanzalintinib is a promising "next generation" TKI that looks like it could be a long-term replacement for Cabozantinib, whose patents will likely expire early next decade. Several generic drug makers already have submitted Abbreviated New Drug Applications ("ANDAs") seeking to market and sell generic versions of Exelixis' flagship drug. Exelixis has agreed that generics giant Teva (TEVA) will be permitted to market its generic from 2031 (according to Exelixis' latest quarterly report).

Exelixis issues a robust response to Farallon, but ultimately the hedge fund successfully led a campaign to have three of its nominees elected to the board of directors. As alarming as it may be for management to lose the battle in the boardroom, sometimes such a shake up can help to address issues that have been stifling growth, and more specifically, share price growth.

Q2 2023 Earnings Show Cabozantinib Revenues Growing - But Bottom Line Needs Attention

Under pressure to show its guiding Exelixis in the right direction, management was able to deliver a respectable set of Q2 2023 earnings.

Total revenues for the quarter were $469.8m - up 12% year-on-year - which included $60m of collaboration revenues - French pharma Ipsen owns the rights to market and sell Cabozantinib overseas.

Total R&D expenses were $232.6m, which represented a second straight sequential decline - in Q422, R&D expense had hit $337m - albeit a year-on-year increase of ~17%. SG&A expenses increased for the third straight quarter and were up 16% year-on-year, but net income came in at $81.2m on a GAAP basis, and $100.3m on a non-GAAP basis - not an improvement on the prior year quarter, but a strong comeback after the company recorded a net loss in Q422 and only $40m of GAAP net income in Q123, and $52.8m on a non-GAAP basis.

The company also provided guidance for the full year 2023 for $1.775bn - $1.875bn, R&D expenses of $1bn - $1.05bn - a bone of contention with Farallon - SG&A expenses of $475m - $525m, and an effective tax rate of 22%. Do the math, and the EPS implied is ~$0.6 - more or less the same as last year, and implying a forward price to earnings ratio of ~36x. For a company marketing and selling a blockbuster (>$1bn revenue per annum), that is a high figure. Perhaps Farallon is right when insisting Exelixis is neglecting its bottom line - large commercial stage pharmas tend to drive profit margins >20%, with PE ratios in the 20s.

A New Chief Medical Officer And More Good News For Cabo

Exelixis management may well have taken extra satisfaction from the success of Cabo in its Phase 3 CONTACT-02 study of the drug in combo with Tecentriq in patients with metastatic castration-resistant prostate cancer ("mCRPC") given it seemingly validates the "fast track to Phase 3" approach on this occasion, and opens up a new market opportunity.

Cabo demonstrated a "a statistically significant reduction in the risk of disease progression or death" according to Exelixis' press release, which also pointed out that "In 2020, there were more than 1.4 million new cases of prostate cancer and about 375,300 deaths worldwide, highlighting the scale of the unmet need in this indication."

After a series of failures, the Tecentriq / Cabo combo is now beginning to show some promise, perhaps finding its niche in prostate cancer - and there was more good news for Exelixis management to announce yesterday, this time in relation to Cabo as a monotherapy. According to a press release, the:

Alliance for Clinical Trials in Oncology independent Data and Safety Monitoring Board (DSMB) unanimously recommended to unblind and stop the phase 3 CABINET pivotal trial early due to a dramatic improvement in efficacy that was observed at an interim analysis.

CABINET is investigating Cabo as a monotherapy in patients with advanced pancreatic cancer, another underserved indication, and the fact that the trial was halted early is likely very encouraging for Exelixis.

Looking Ahead - Will The Uneasy Marriage Of Management and Activist Investor Bear Fruit?

Cabo is clearly an important and effective drug capable of holding its own against the very best the industry has to offer - for example, the Opdivo / Cabo kidney cancer combo is the number 1 prescribed combo in first-line therapy, beating out the combo of Merck's (MRK) >$20bn selling ICI Keytruda and Pfizer's (PFE) Inlyta.

When, as a company, you almost double revenues within a three-year period, but your net income shrinks, then arguably it's right for shareholders to begin asking questions, as Farallon has done.

With that said, although management may have been guilty of attempting to force the issue with some of its late-stage trials, they also will be well aware of the need to invest in R&D in order to find the sources of revenue to offset sharply falling sales of Cabo once generic competitors enter the market early in the next decade. Typically, a patent-expired drug's revenues decline at a rate of 25-35% per annum - which spells real trouble for Exelixis unless it can find alternative sources of revenues.

Clearly, Zanzalintinib is the "next Cabo off the rank," f you'll excuse the pun, and the drug is showing promising signs in indications such as kidney cancer, where it has achieved a 34% overall response rate ("ORR") of 34% as a second line therapy - likely good enough for an approval shot.

The remainder of the pipeline is very early stage - an antibody-drug conjugate ("ADC"), XB002 has progressed into Phase 1 studies - ADC is an exciting new field of therapy that much is expected of - but there are four preclinical assets whose fate may be more uncertain give the pressure on management to ease R&D spending.

Exelixis President and CEO Michael Morrissey spoke on the Q2 2023 earnings call about M&A - the company is carrying >$1.2bn on its balance sheet after all - the CEO told analysts that:

Business development activities remain a priority as we continue to seek opportunities to access clinical assets with the potential to generate differentiating clinical data in solid tumor indications.

We have several late-stage discussions ongoing and while there is no guarantee of success in closing these transactions, we look to continue using this approach to fortify our product portfolio.

The company also announced yesterday that it had appointed a new chief medical officer, who joined from CytomX, previously serving as president and chief operating officer.

It's interesting to speculate about who may be behind these changes - long-term CEO Morrissey or Farallon? In my view, a marriage between an activist investor and a more drug development-focused CEO can certainly work, however, my main concern around Exelixis remains the single asset risk, and that is the reason I am not giving Exelixis a "Buy" recommendation.

Drug development is a hit and miss business, and it's quite rare to find a company that follows up a major hit such as Cabo with another blockbuster.

As promising as Zanzalintinib looks, progress ought to be framed in the context of the intense competition within oncology markets - which is growing even more intense as major pharma's increasingly view drug development as the best and most lucrative space to be in - witness the number of major pharmas spinning out their consumer or legacy drugs businesses in order to focus more on drug development - Pfizer, Merck, GSK (GSK), and Johnson & Johnson (JNJ) have all opted to go down this route.

Exelixis has done exceptionally well, in my view, to extract the maximum benefit from Cabo - a drug that was first approved in 2012 - and it certainly looks as though there will be many more years of revenue growth before the patent expiry arrives. Farallon has a share price target of $33 in mind for Exelixis stock, and if it fixes the bottom line while management keeps the trial wins coming, that target may well be achievable.

Longer-term, however, the patent expiry is a looming issue the market will want Exelixis to solve as quickly as possible, but it may be a real challenge for the company. Blockbuster drugs do not grow on trees.

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