Shattuck: A High RIsk But Worthwhile Bet

Shattuck (ticker: STTK), the clinical-stage life science company treating cancer and other autoimmune diseases, has done right by its early backers. Since listing on the Nasdaq on 9 October, when it raised over $232 million, with an IPO price of $17, it has appreciated to around $28 per share. 

Funding was raised to advance development of its lead product, SL-172154, which is in Phase 1 clinical trial for the treatment of ovarian cancer; and SL-279252 which it is developing in collaboration with Takeda Pharmaceuticals and is in Phase 1 clinical trial in patients with advanced solid tumors and lymphoma. STTK plans to roll out two new clinical trials next year. Initial data from the trial of SL-172154 will only be available in 2021. 

Evaluating a business whose core products are still at the clinical-trial stage is fraught with difficulties. The value of a drug program grows over time, assuming the program is successful at each stage, from the start of the program to Phase 3. Even with a large addressable patient population and the best event space, the business may simply fail to either arrive at the results they need to seek FDA approval, or, that approval may be denied, or a fate somewhere in the middle may happen and the process from clinical trial to drug approval takes longer than expected and costs much more than anticipated. We have witnessed as much with the development of the Covid-19 vaccine where AstraZeneca and Johnson & Johnson had to halt trials. There are non-trivial reasons to believe that STTK may experience complete failure or delays in development and this will affect valuations. 

The probability that a drug program reaches Phase 2 from Phase 1 is 20% and the probability it reaches Phase 3 is 56% (if it fails, the value generally goes back to zero). Even if we assume that STTK is confident it can get to Phase 2 because the data they are getting is impressive, the odds of getting to Phase 3 are not overwhelmingly in their favour from a base case perspective. The period from Phase 1 to Phase 2 and 3 may be elongated by problems in the trials, as we have seen happen with the Covid-19 vaccine. 

Though STTK has revenues, those revenues are not meaningful in terms of the core business. It really does not matter how much it makes from its partnerships and what its return on invested capital is, etc, because the real business is in the future. We do not know how management will allocate capital in a post-Phase 3 world, or how profitable the business will be or how fast revenues will grow. If STTK fails to reach Phase 2 or Phase 3, the value of the business will collapse regardless of revenues from its partnership agreements. Those simply do not reflect what the company is about. 

We can not evaluate STTK using traditional historical measures simply because they have not yet brought to market their core product. The SL-172154 and SL-279252 drugs are of limited value until they reach Phase 2. If STTK reaches Phase 2, investors will reap a huge price appreciation due to the surge in value of those drugs. 

STTK is Derisking and Growing Value

In drug development, derisking, rather than revenue, profits, and other such traditional metrics, drives value creation and STTK has been derisking through its clinical studies. 

Phase 1 clinical trials using the SL-172154 compound have opened. The first clinical trial will explore intravenous administration of SL-172154 in patients with ovarian, fallopian tube, and primary peritoneal cancer. The second clinical trial will enroll patients with squamous cell carcinoma of the skin and head and neck who will receive SL-172154 via intratumoral administration. Phase 1 of its clinical trials of SL-279252 commenced in 2019 and dose escalation is expected to be completed in 2020. This study includes two dose expansion cohorts: one that will enroll patients with non-small cell lung cancer and another “all comers” cohort. 

Remembering our base rates for moving to Phase 2 and Phase 3, we have to understand that these clinical trials offer more than just the ability to test whether the drugs are safe for humans. From the start of the program to Phase 1 clinical trials, STTK have studied both drugs extensively on disease cells in the laboratory and/or in laboratory animals. The advantages of working on cancer in Phase 1 clinical trials have grown mostly due to the Human Genome Project (HGP). The HGP, which was completed in 2003, allows scientists to discover the sequence of all genes found in humans, which allows for medical advances in the diagnosis and treatment of many diseases, including cancer. Before the HGP, Phase 1 drugs existed as a last ditch effort to test the safety of a drug, without any real benefits accruing to the patient.

Now, patients can benefit right off the bat if the drug works. STTK’s methodology further reduces risks by using its Agonist Redirected Checkpoint (ARC) program for advanced cancers to teach the patient’s immune system how to fight off cancerous cells, similar to how it fights off other illnesses. In conjunction with its ARC program, STTK is working on a biotech , Gadlen, that will work on the gamma delta T cells in the body. In plain English, the reduced risk brought about by HGP, coupled with the reduced risk brought about by ARC and Gadlen, not only improve the value of the company but heighten their chances of FDA approval for Phase 2 trials. HGP alone has increased survival rates of patients and STTK is confident that its treatment has the potential to restore anti-tumor immune responses and improve survival in cancer patients.  

So far, positive binary events have catalysed STTK’s value, but as we have said, value creation is tied to derisking through clinical trials, which itself opens a company up to dramatic swings in value when new data from experiments and studies comes in. Investors should then be aware that value creation is prone to extreme levels of volatility. 

Valuations of drug companies at this stage are highly sensitive to the discount rate because each phase of drug development requires fresh and large injections of capital. STTK benefits from an environment of low interests which seem to be in secular decline. STTK then is likely to have a very low long-run natural cost of capital. The pandemic has brought into focus innovative companies that have solutions to different diseases out there and so a lot of generalist investors are very focused on healthcare and biotech and healthcare technology. Furthermore, investors are more willing to invest in high risk projects because of the amount of quantitative easing that has taken place. COnsequently, it is likely STTK will not face an adverse discount rate. If STTK can complete its drug developments program in this low-interest rate environment, it will be able to drastically reduce drug prices to capture market share. 

A Tough Market

The nature of the pharmaceutical industry is that each drug, by definition, has a moat, it is protected by law, even if that moat comes with an expiry date. However, the value of that moat in a post-Phase 3 world is dependent on the competitive landscape, quality of the drug and the size of the addressable patient population. STTK is pursuing a concept that is revolutionary, but they are in this race alone. STTK is in a race with large pharmaceutical and biotechnology companies, such asAstraZeneca/MedImmune, Bristol Myers Squibb, Merck, Novartis, Pfizer, and Roche/Genentech; academic institutions, government agencies and other public and private research organizations that conduct research, seek patent protection and establish collaborative arrangements for the research, development, manufacturing, and commercialization of cancer therapies. 

If STTK can successfully develop its product candidates, they will compete with existing therapies and new therapies that may become available in the future. The competition is fierce and many of their present and future competitors are better funded and have greater expertise in research and development, manufacturing, preclinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved drugs. 

The biggest risk the business has is that one of its competitors gets FDA or foreign approval faster than it does and establishes a lead in the market that it may never relinquish.

A Bet Worth Taking

Much of this study has pointed out unknowns and the fallibility of financial measures when values are pretty much in the future and financial statements are meaningless. Yet the steps STTK has taken lead us to believe that it will achieve Phase 2 approval, even if there are delays, because the nature of the drug program, the advances brought about by HGP and the testing so far have not only derisked the drug program but they limit the chances of negative outcomes for patients. Needcamp and Citigroup have near-term price targets of $34 per share. This should be easily achievable. The question is if derisking will continue to create value for the company. If it can, the gains for shareholders will be astronomical. As a risk/reward question, this is a bet worth taking.