Summary

• XOMA Corporation is a royalty aggregator in the biotech sector, acquiring the economic rights to early phase treatment candidates.
• The wider biotech market has been seeing slumping performance throughout the last year, whereas XOMA has been delivering stellar gains, owing to the sustainability of its business model.
• In FY21, XOMA delivered staggering growth in its revenue and operating income figures, on a year-by-year basis. This was primarily due to a one-off milestone payment that has boosted the company’s liquidity profile and enhanced its position as a royalty aggregator.
• The stock, based on several metrics, suggests a potential undervaluation to a significant degree.

I believe XOMA Corporation (XOMA) is a buy, and quite possibly the best investment option for those looking to gain from the biotech sector, whilst exposing their capital to low risk. XOMA is unique, in the sense that it offers investors the best of both worlds, through its sustainable business model.

Company Overview

XOMA Corporation is a biotech financing player that funds health-oriented biotech companies that are developing viable treatments for a wide variety of health conditions. XOMA categorizes its business model as being one that is a royalty aggregator, which it achieves through the acquisition of the future economic rights of pre-commercial treatment candidates. In return, the seller of these exclusive rights receives non-dilutive funding to finance the development of the candidate. Being in operation since 1981, it was as recent as 2017 whereby the company had decided to make a strategic shift from a conventional biotechnology developer to a royalty aggregator.

Market Overview and the Opportunity for XOMA

From 2020 onwards, the biotech industry has been seeing a rocky performance, with clear signs of stress, given its inability to match the wider market’s performance. In quantitative terms, the S&P 500 index saw a 40% rise in the two years following 1 January 2020. Alternatively, the XBI biotech index saw a 4% drop in the same period, indicating a failure to sustain its pandemic level gains. Similarly, IPOs of biotech firms conducted in the first quarter of 2022 raised a mere $560 million in funding, compared to the prior year’s first-quarter figure of over $15 billion. Venture capital funding for biotech firms also took a severe hit, falling to $5.4 billion in the first 2022 quarter, from the prior year’s $10.8 billion figure.

However, it is important to note that this slump in the biotech industrial standing is significant only in comparison to the stellar performance of 2021. With the Covid-19 vaccine rollout in full swing, investors had been highly confident in the biotech and pharmaceutical realm. Although venture capital funding for biotech private firms did fall from $10.8 billion to $5.4 billion within a year, the figure was still above the five-year average of $5.0 billion per quarter. The slide down seen in the industry throughout the prior year has understandably been sending panic flags across the industry. Companies have increasingly been taking on stringent measures to ensure adequate liquidity profile, with many engaging in wide-scale layoffs since late March 2022.

XOMA, given its business model of being a royalty aggregator within the biotech spaces, holds a strategic advantage over the wider industry. This is due to the diversification approach it can undertake on potential treatment candidates that could see a successful launch, which would deliver substantial value creation for XOMA shareholders, based on its royalty arrangement.

This portfolio diversification, which is the core opportunistic benefit that XOMA holds enables it to enhance its balance sheet without having to incur the cost burden of research and development costs. The overall level of risk is reduced by diversification, and the cost of capital is also minimized significantly. XOMA capitalizes on the cost-benefit by closing deals with early-stage assets, that have a long way to maturity. With a strengthened balance sheet, the likelihood of commercialization increases with time, giving the XOMA financial position a boost in the long term. As of yet, the current status of its assets stands as follows:

Performance and Earnings

2021 had been a stellar financial period for XOMA, having received a substantial amount of milestone payments. NIS793 alone brought in $35 million upon making it to phase 3 in its clinical study. Similarly, over $3 million had been received from four separate milestone payments. As a result of these achievements, the company managed to achieve a second consecutive year of positive operational cashflows. This is reflected in the operational earnings for the company in the graph below:

As can be observed from the trend, the company is in a phase where it has reversed negative operational cash flows and has begun cashing in on its earlier investments, as its assets are arriving towards their maturity phase. This growth momentum is highly advantageous for investors considering jumping in on the XOMA ride after it has crossed its early risk phase.

In 2021, XOMA acquired an economic interest worth $5 million in Roche’s novel bispecific antibody treatment for neovascular macular degeneration. This acquisition is highly significant, given that the candidate has received approval for commercialization by the FDA.

XOMA’s net operating income for FY21 jumped up 41% to $17.5 million from $12.4 million in FY20. For a company with a strategy targeting early phase biotech assets, a jump of this magnitude is highly significant. Even though it is a result of a one-time milestone payment, it enhances the company’s portfolio of assets, bringing NIS793 closer to commercialization, in its move up to phase 3 clinical trials. Moreover, the operating income could strengthen the company’s growth prospects through reinvestment.

Similarly, the company’s liquidity profile had further enhanced dramatically across the year, with current assets climbing up from $88 million in 2020 to $96 million in 2021. During this period, the company’s long-term debt of $12.7 million was fully paid off, leaving the figure at nil as of the year-end of FY21. Overall the company’s final balance sheet figures report a 33% rise in total assets and a 36% fall in total liabilities.

This improvement in earnings due to the $35 million milestone payment has significantly enhanced the company’s liquidity profile. Although it is unlikely for the company to maintain a revenue stream with improvements of such magnitudes, it does lower credit risk by enhancing its position as a royalty aggregator.

In effect, the stock allows investors to gain from the exposure of successful candidates in the biotech realm, whilst effectively reducing the level of risk from high to moderate through diversification and strategic acquisitions.

I believe that taking a forward look into the XOMA financial prospects, there is much investors could appreciate with regards to the stock. Holistically, the stock is a good performer, and prone to receive occasional ‘boosts’ every other quarter or so, each of which enhances its overall financial profile, and pushes its assets closer to commercialization. As in its recent $35 million milestone payment, the candidate, NIS793 was pushed up to phase 3 in its clinical trial, significantly enhancing the probability of market success.

The candidate is a monoclonal antibody that plays a critical role in the treatment of pancreatic cancer. Pancreatic cancer impacts over 60,000 Americans on an annual basis, and half a million worldwide. The rate of increase is 1% per year, which indicates the market need for the drug, as well as its sustainability. Upon commercialization, which is far more probable now with the push up to phase 3, the drug will continue to treat patients with pancreatic cancer, and deliver royalty income to XOMA.

The profitability boost enables XOMA to strategically enhance its portfolio of assets by the inclusion of high-profile early-stage treatment candidates. This entire model, therefore, promises exponential growth, as statistically the probability of assets being pushed up to more mature phases of their clinical lifecycle. This, in turn, increases the frequency of the ‘profitability boosts’ with a higher number of candidates progressing, and thus getting closer to commercialization.

Although the risk of failure does exist within this industry, the company ensures diversification by the inclusion of a wide array of candidates, with only a few needed to succeed to deliver significant value to XOMA’s shareholders. This is a big reason why I believe XOMA offers a brilliant opportunity for market participants, as it is structured in a manner that with time, its business continues to become more sustainable, and a potential giant in the bio-tech realm in the future.

Valuation

To further assess the attractiveness of XOMA, it would be useful to take a look at the stock’s valuation figures. For one, a fair value assessment by Simply Wall St demonstrates a significant undervaluation exceeding 42%:

This gap is significant, indicating that XOMA is presently undervalued, and could see a climb in the future, reinforcing its buy status.

Similarly, XOMA holds impressive valuation figures on multiple metrics, as of 1 May 2022:

Despite an average C+ valuation grade, XOMA is trading at a relative discount. With a P/B ratio of 1.53x, this stock is trading nearly 27% below the sector median. In addition, its Price/Cash Flow ratio is solid and comes in way below the sector average. This indicates that XOMA, in comparison to other low-cap biotech firms has a much lower cost to its free cash flows, making it an efficient and heavily undervalued investment. XOMA has both one of the lowest PFCF levels in comparison to that market, as well as one of the highest sales growth rates of the last 5 years. This position, although heavily impacted by its current revenue boost due to the $35 million milestone payment, indicates a valuation boost the company has received, with its assets maturing, and its position as a royalty aggregator being enhanced.

• Where the wider biotech industry of similarly sized stocks holds an average long-term debt to equity ratio of 0.24, XOMA has an equivalent figure amounting to nil, given its payoff of long-term debt in its recent earnings report. This enhances the stock’s value by reducing its credit risk.
• Given that early-phase biotech firms hardly deliver revenue, only 36 firms out of 111 delivered revenues in the last 5 years, which had an average sales growth of 33.67%. Upon inclusion of non-revenue generating biotech stocks, this average figure falls down to 10.36%. Alternatively, XOMA’s revenue figures climbed by over 47% in the last 5 years, showcasing its growth over the years, and the sustainability of its business model.

• Taking a more prospective look at the stock, projecting its revenue growth, analysts on average expect the company’s revenues to rise by an average figure of 14.1% per annum, which is higher than the US market growth of 8.5% per year. This growth rate projected is substantially lower than the 30.8% revenue climb delivered in 2021, given that it was based primarily off a one-time payment. However, this still remains impressive in comparison to the wider market, and the biotech industry.

• The early phase biotech sector collectively holds an average relative strength index figure of 36.1, in comparison to XOMA’s 27.92, emphasizing the degree to which it is undervalued, and positioned to embark on a price climb in the future. The stock is merely 0.79% from its 52-week low, highlighting the potential of the climb it could be likely to take.
• The stock has impressive profitability metrics in comparison to the wider biotech market of similarly sized stocks, with an operating margin of 45%. The market average figure stands at 25.4%, indicating a substantial gap, reinforcing the view of the stock being undervalued. Although it must be emphasized, that this 45% jump is primarily a result of a substantial one-off milestone payment, the boost in profitability enhances the company’s profitability position, which it could use to accelerate its growth through reinvestment. This could assist the company in turning around its regular operating margin figures stand at negative values.

The various indicators do show that, on the basis of the stock’s current pricing and earnings, there is a clear reason to buy the stock, given a potentially significant undervaluation. I believe that this undervaluation is significant due to the unique position that XOMA holds in the biotech realm. It has, through its royalty aggregating business model, maximized the potential gain it can acquire through developments in the biotech industry. Without allocating funds to research and development of treatments, but by acquiring economic rights to high potential early phase drug candidates, XOMA is building up a stellar asset portfolio that is likely to deliver its long-term economic benefit.

The model ensures an uphill trajectory with the company’s prospects only improving with time. It holds greater investment potential in comparison to other players in the biotech realm given its risk minimization through diversification.

Risks

The biotech and pharmaceutical sectors of the healthcare industry are typically perceived as high-risk areas. Although XOMA manages to reduce its exposure to such risk through diversification of its portfolio, it is still subject to sales risk, even with the successful launch of drug candidates it holds royalty rights on.

Due to pricing pressures and fluctuations in demand, a stream of royalty income may be subject to uncertainty and volatility for XOMA shareholders. This issue is further exacerbated by product competition, which makes it extremely difficult to predict the commercial life of a given product. For this reason, for XOMA Inc to maintain its financial sustainability, it would need to ensure none of its royalty streams become obsolete, due to market failure. This would be achieved through a strategy of continuously investing in worthwhile candidates to enhance the company’s portfolio.

Conclusion

The biotech industry has always been characterized by the high degree of risk it holds, which turns away risk-averse investors. XOMA, however, through its financially sustainable business model offers a low-risk position for investors looking to capitalize on the gains made within the industry. It achieves this through its diversified portfolio of assets, to which it holds royalty rights. The company’s financial performance has steadily been seeing a climb, amidst a broader slump hitting the biotech and pharmaceutical markets after the surge in 2021. Multiple valuation metrics indicate that the stock is potentially undervalued by a significant margin, especially in comparison to similarly-sized early phase biotech companies.