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Company: Exelixis (EXEL)
Business: exelixis, an oncology-focused biotechnology company, is focused on discovering, developing and commercializing new drugs to treat cancer in the United States. They have manufactured four marketed pharmaceutical products, including their flagship molecule, cabozantinib.
market value: $6.3 billion ($19.46 per share)
Activist: Farallon Capital Management
Percentage ownership: 7.5%
average cost: $17.47
Activist Comment: Farallon Capital is a $36 billion multi-strategy hedge fund founded in 1986. Farallon’s investment strategies include credit investing, equity long/short, merger arbitrage, risk arbitrage, real estate investing and direct investing. Farallon is not an activist investor, but will pursue an activist agenda when it feels compelled to do so. The law firm is not looking for a fight, but will not shy away from it either.
What’s up?
On April 5, Farallon sent a letter to the Company announcing the nomination of the following director candidates for election to the Board of Directors at the Company’s 2023 annual meeting: (i) Tomas Heyman, interim CEO of Interlaken Therapeutics and past President of the Company from Johnson & Johnson venture capital group, (ii) David Johnson, Managing Partner of Caligan Partners, and (iii) Robert Oliver, former CEO of Otsuka America Pharmaceutical and Executive Advisor. Farallon also expressed his belief that Exelixis should focus its research and development efforts and spending, communicate a differentiated and coherent strategy, and commit to continued returns of excess capital to shareholders.
Backstage
As the strategy of shareholder activism has become more mainstream, it has been used by a wider range of investors. It is difficult for the average investor to distinguish between shareholders using activism as a short-term and opportunistic tool and genuine long-term investors using shareholder activism because the company is in dire need of change and the shareholder has exhausted all other options that could be considered acceptable. This situation is the latter. Farallon hasn’t bought a majority of its shares in the past 60 days, as we often see from opportunistic investors filing 13Ds. The company has been a shareholder of Exelixis since 2018 and is currently going public with its concerns. It has given management more than enough time to create shareholder value. Furthermore, Farallon does not use an activist template like the ones we see from inexperienced activists, where they criticize everything from board ownership to executive compensation. Rather, the company focuses on glaring corporate issues and opportunities.
The company objects to the level of R&D and the lack of discipline and communication regarding an R&D plan. Any company that spends a significant amount on research and development should have a disciplined plan in place to face the market, but that’s even more important for a company like Exelixis that spends over 50% of its revenue on research and development. In 2022, the company had sales of $1.6 billion with an R&D budget of nearly $900 million, resulting in earnings before interest, taxes, depreciation and amortization of $222 million. This R&D budget is projected to grow to more than $1 billion by 2023. To make matters worse, the company invests in many projects in scientific and clinical areas that lack differentiation and competitive advantage. Rather than becoming more focused and disciplined, Exelixis is doing the opposite: It’s pursuing 27 indications in 79 studies involving at least three very different therapeutic modalities, a total that’s much higher than any of its competitors. Investors want to see a thoughtful, disciplined R&D plan that explains the differentiated approach and competitive advantage the company is using so they can assess the likelihood of success.
Farallon estimates that the present value of the company’s cabozantinib cash flows alone (with a modest R&D program) is worth over $33 per share. Farallon would also like to see Exelixis commit to a much larger share buyback program than the $550 million announced. The company has more than $2 billion in cash and investments compared to virtually no long-term debt, and using some of that cash to repurchase stock ahead of an R&D reorganization would not only create, but contribute to, shareholder value to discipline management by forcing them to run a leaner operation with no cash on the balance sheet.
While improving margins and buying back stock may seem like a typical activist game, it’s not Farallon’s typical game. In the company’s collaboration with healthcare company Acceleron Pharma in 2021, the company proposed the opposite plan. At Acceleron, Farallon advocated increased research and development and opposed Merck’s acquisition of the company, championing a standalone company that had significant prospects following the positive results of phase 2 trials of its lung drug. Eventually, Merck acquired Acceleron despite opposition from Farallon, and the lung drug’s Phase 3 trials were a success. It’s expected to launch later this year, and Merck is expected to reap an outsize return from this acquisition.
Farallon makes a very reasonable motion to add three directors to Exelixis’ 11-member board. We believe this is appropriate only due to the company’s lack of discipline when it comes to R&D and its serial underperformance relative to the market and its peers. Aside from three female directors who joined the otherwise all-male board since 2016, the company has not added a new director since 2010. Eight of the 11 directors have been on the board for between 13 and 29 years, an average of more than 20 years each. Worse still, the board turned down Farallon’s offers; The company said it was told that “the board is conducting its own refresher.” Three new directors in the last 13 years is the company’s idea to refresh the board. It’s one thing to have bad management; failing to recognize bad corporate governance when you see it is quite another matter.
Farallon is only nominating three directors for this board and we are puzzled that Exelixis does not see this as a gift. Assuming Farallon targets the three directors who have been on the board for 26 years, 22 years and 19 years, the firm spares three directors who have been on the board for 19 years, 18 years and 16 years, not to mention the chairman and CEOs who have been on the board for 29 and 13 years respectively. All five are male. We don’t see how Institutional Shareholder Services and the large institutional shareholders who own 25% of the company’s common stock could support these long-serving directors when presented with a competing roster of qualified, fresh and diverse directors. In our opinion, Farallon could have won six seats on that board and should take three seats in a pie walk. Farallon has nominated three very qualified directors. Tomas Heyman is a venture investor, formerly of Johnson & Johnson; Robert Oliver is the former CEO of a pharmaceutical company; and David Johnson is a seasoned shareholder investor with a background in corporate governance and shareholder activism. Johnson, formerly CEO of the Carlyle Group, is the founder of Caligan Partners, a fund using activism as a vehicle to unlock value.
This seems like the kind of situation that should calm down. That was the case less than a week ago, when the parties reached a near-final agreement that included the appointment of two Farallon nominees (Heyman and Oliver), the retirement of two long-time existing directors, and the creation of a new capital awards committee. However, Exelixis claims the deal fell through when Farallon requested too much confidential information regarding its R&D strategy, pipeline, employees and clinical trial data.
On April 13, the company announced that two acting directors were stepping down from the board and recommended that shareholders vote for Heyman and Oliver to replace them. This was not as part of a settlement with Farallon, but is likely to effectively implement a settlement offer that Farallon had previously rejected. The company may be hoping this will prevent shareholders from voting for Farallon’s third nominee, David Johnson. This is a tactical move made much easier with the implementation of the universal proxy map. The unfortunate part of this is that often the candidate that the company resists the most is the one that is needed the most. That’s true in this case. As a seasoned shareholder investor with activist experience, we believe David Johnson was the candidate best placed to rein in management R&D spending and continue to refresh a board that still needs many newer directors. However, if Farallon gets tactical, the firm can orchestrate it so that two of the three candidates they pick are elected to the board, with a no-cost option for the third.
Ken Squire is Founder and President of 13D Monitor, an institutional research service on shareholder activism, and Founder and Portfolio Manager of 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist assets.