Schrödinger, the computational drug discovery and materials science powerhouse, delivered a solid first quarter in 2024, with total revenue of $36.6 million and software revenue reaching $33.4 million. While these figures align with expectations, a deeper dive into the transcript reveals a subtle but potentially groundbreaking trend: the quiet rise of hosted software as a driver of long-term profitability.

The traditional focus on multi-year, multimillion-dollar on-premise software renewals often overshadows the steady, yet powerful, growth of hosted software. In Q1 2024, hosted software revenue accounted for 22% of total revenue, representing a staggering 60% year-over-year growth compared to Q1 2023. This outpaces the overall software revenue growth of 4%, indicating a significant shift in customer preference towards the hosted model.

While Schrödinger executives acknowledge this gradual transition towards hosted software, the full implications of this shift remain largely unexplored by analysts. The emphasis often centers on securing those large, headline-grabbing on-premise renewals, but hosted software may hold the key to unlocking greater profitability and stability in the long run.

The allure of hosted software lies in its inherent predictability. Unlike on-premise software, which generates lumpy revenue recognition depending on the duration and timing of renewals, hosted software operates on a subscription model with recurring, predictable revenue streams. This translates into greater financial stability, allowing for more accurate forecasting and strategic planning.

Beyond stability, hosted software offers compelling advantages from a profitability standpoint. The significantly lower technology and infrastructure costs associated with hosting the license server, as opposed to managing individual installations for each customer, create a high gross margin environment.

Let's delve into the numbers. As highlighted by CFO Geoff Porges, Q1 2024 software gross margin was 76%, slightly lower than the 78% in Q1 2023. This decrease is primarily attributed to the increased proportion of hosted software revenue, which, despite its higher gross margin potential, is still in its early stages of adoption.

To illustrate this, consider a hypothetical scenario. If the hosted software revenue mix were to increase to 50% by 2026, assuming a conservative hosted software gross margin of 85%, the overall software gross margin could potentially reach 80.5%. This represents a significant improvement over the current gross margin, paving the way for greater profitability.

Projected Software Gross Margin Growth

This chart illustrates the potential impact of increased hosted software adoption on Schrödinger's overall software gross margin.

Furthermore, the transition to hosted software aligns perfectly with Schrödinger's vision of making its platform accessible to a wider audience. Emerging biotech companies, often constrained by limited budgets and IT resources, find the hosted model particularly attractive. It eliminates the upfront costs and complexity of managing on-premise installations, allowing them to leverage Schrödinger's platform at a lower cost of entry.

This broadened customer base, coupled with the inherent profitability and predictability of hosted software, has the potential to transform Schrödinger's financial performance. As more customers embrace the hosted model, we could witness a virtuous cycle of increased revenue, improved margins, and enhanced shareholder value.

Schrödinger, known for its groundbreaking scientific breakthroughs, may be on the verge of another paradigm shift, this time in its business model. While the industry eagerly awaits clinical data readouts from its proprietary programs, the silent rise of hosted software may prove to be the unsung hero, propelling Schrödinger towards a future of sustained growth and profitability.

"Fun Fact: Did you know that Schrödinger's software played a role in the development of sofosbuvir, a revolutionary drug that effectively cures Hepatitis C? This breakthrough earned a Nobel Prize in Medicine and underscores the profound impact of Schrödinger's technology on human health."