Business: Exelixis, an oncology-focused biotechnology company, focuses on the discovery, development, and commercialization of new medicines to treat cancers in the United States. They have produced four marketed pharmaceutical products, including their flagship molecule, cabozantinib.

Stock Market Value: $6.3B ($19.46 per share)

Percentage Ownership:  7.5%

Average Cost: $17.47

Activist Commentary: Farallon Capital is a $36 billion multi-strategy hedge fund founded in 1986. Farallon’s investment strategies include credit investments, long/short equity, merger arbitrage, risk arbitrage, real estate investments and direct investments. Farallon is not an activist investor but will pursue an activist agenda when it feels forced to do so. The firm does not seek a fight but will not back down from one, either.

On April 5, Farallon sent a letter to the company announcing its nomination of the following director nominees for election to the board at the company’s 2023 annual meeting: (i) Tomas Heyman, interim CEO at Interlaken Therapeutics and former president of Johnson & Johnson’s corporate venture capital group, (ii) David Johnson, managing partner of Caligan Partners, and (iii) Robert Oliver, the former CEO of Otsuka America Pharmaceutical and an executive advisor. Farallon also expressed its belief that Exelixis should focus its research and development efforts and spending, communicate a differentiated and coherent strategy, as well as commit to ongoing distributions of excess capital to shareholders.

As the strategy of shareholder activism has become more mainstream, it has been utilized by a larger breadth of investors. For the average investor it is hard to distinguish between shareholders using activism as a short term and opportunistic tool and real long-term investors using shareholder activism because the company is in desperate need of change and the shareholder has exhausted all other amicable options. This situation is the latter. Farallon did not buy the majority of its shares in the last 60 days like we often see from opportunistic investors filing 13Ds. The firm has been a shareholder of Exelixis since 2018 and is just now going public with their concerns. It has given management more than enough time to create shareholder value. Further, Farallon is not using an activist template like we see from novice activists where they criticize everything from board share ownership to executive compensation. Rather, the firm is focusing on glaring company issues and opportunities.  

The firm takes issue with the level of R&D and the lack of discipline and communication with respect to an R&D plan. Every company that spends a material amount on R&D should have a disciplined plan articulated to the market, but that is even more crucial for a company like Exelixis that spends over 50% of its revenue on R&D. In 2022, the company had $1.6 billion in revenue with an R&D budget of nearly $900 million, leading to earnings before interest, taxes, depreciation and amortization of $222 million. This R&D budget is expected to increase to more than $1 billion in 2023. To make matters worse, the company is investing in many projects in scientific and clinical areas where it lacks differentiation and a competitive advantage. Instead of becoming more focused and disciplined, Exelixis is doing the opposite: pursuing 27 indications across 79 trials using at least three very different therapeutic modalities, a total that is much higher than any of their peers. Investors want to see a reasoned, disciplined R&D plan that explains the differentiated approach and competitive advantage the company is exploiting so that they can assess the likelihood of success.

Farallon estimates that the net present value of the company’s cabozantinib cash flows alone (with a modest R&D program) is worth in excess of $33 per share. Farallon would also like to see Exelixis commit to a much larger share repurchase program than the $550 million it has announced. The company has over $2 billion in cash and investments versus virtually no long-term debt and using a portion of this cash to buy back shares ahead of any R&D restructuring would not only create shareholder value but will help add discipline to management by forcing them to run a leaner operation without a cash stockpile on the balance sheet.

While improving margins and buying back stock may seem to be a typical activist play, it is not Farallon’s typical play. In the firm’s 2021 engagement with health-care company Acceleron Pharma, the firm suggested the opposite plan. At Acceleron, Farallon was in favor of increased R&D and opposed Merck’s acquisition of the company, lobbying for a standalone company which had significant prospects following the positive results of the Phase 2 trials of its pulmonary drug. Ultimately, Merck acquired Acceleron in the face of Farallon’s opposition, and the pulmonary drug’s Phase 3 trials have been a success. It’s expected to hit the market later this year, and Merck is slated to make an oversized return on this acquisition.

Farallon is making a very reasonable request to add three board members to Exelixis’s 11-person board. We believe this is reasonable just based on the company’s lack of discipline with respect to R&D and its serial underperformance compared to the market and its peers. However, other than three female directors added to 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 between 13 and 29 years, for an average of over 20 years each. What is worse is that the board dismissed Farallon’s overtures; the firm said it was told that “the Board does its own refreshing.” Three new directors in the past 13 years is the company’s idea of board refreshing. It is one thing to have bad corporate governance; it is quite another to not even recognize bad corporate governance when you see it.

Farallon is nominating only three directors to this board, and it befuddles us as to how Exelixis does not see this as a gift. Assuming Farallon is targeting the three directors who have been on the board for 26 years, 22 years and 19 years, the firm is sparing three directors who have been on the board for 19 years, 18 years and 16 years, not to mention the chair and CEO, who have been on the board for 29 years and 13 years, respectively. All five of them are male. We do not see how Institutional Shareholder Services and the large institutional stockholders who own 25% of the company’s common stock could support these long-tenured directors if presented with a competing slate of qualified, fresh, diverse directors. In our opinion, Farallon could have won six seats on this board and should take three seats in a cake 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 business; and David Johnson is an experienced shareholder investor who is well versed in corporate governance and shareholder activism. Johnson, formerly a Carlyle Group managing director, is the founder of Caligan Partners, a fund that uses activism as a tool to unlock value.

This seems like the type of situation that should settle. Less than a week ago, that was the case when the parties had reached a near-final agreement which included the appointment of two Farallon nominees (Heyman and Oliver), the retirement of two long-standing existing directors and the formation of a new Capital Allocation Committee. However, Exelixis claims that the deal was derailed when Farallon requested too much confidential information related to their R&D strategy, their pipeline, people and clinical trial data.

On April 13, the company announced that two incumbent directors were resigning from the board and it was recommending that shareholders vote for Heyman and Oliver to replace them. This was not done as part of a settlement with Farallon but likely to effectively implement a settlement offer that Farallon had previously rejected. The company may be hoping that this will prevent shareholders from voting for Farallon’s third nominee, David Johnson. This is a tactical move that was made much easier by the implementation of the universal proxy card. The unfortunate part of this is that often the nominee the company resists the most is the one who is most needed. That is true in this case. As a sophisticated shareholder investor with activist experience, we believe David Johnson was the candidate most capable of reining in management’s R&D spending and further refreshing a board that still needs many newer directors. However, if Farallon gets tactical, the firm can orchestrate it so any two of its three nominees who they select will be elected to the board with a free option for the third.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.