Shares of DepoMed (NASDAQ: DEPO) rallied after-hours on Monday after PDL BioPharma (NASDAQ: PDLI) announced that it would buy the company's royalty streams on its type 2 diabetes treatments and experimental drugs for $240.5 million.

The deal represents a fresh source of cash for DepoMed, which only generated $90.8 million in revenue in fiscal 2012, and greatly expands PDL BioPharma's collection of royalty streams.

PDL's business of collecting royalty streams
In 2008, PDL spun off its drug-development business, Facet Biotech, with the intention of purely focusing on building up a portfolio of royalty streams. PDL's new business model is simple -- it offers companies a sizable lump-sum cash payment in exchange for the rights to smaller, recurring payments over a longer period of time. Under this business model, PDL already receives royalties from Roche subsidiary Genentech and several other companies that specialize in the production of monoclonal antibodies.

Last quarter, PDL's earnings and revenue rose 27.5% and 14.1%, respectively, from the prior-year quarter. It also pays a hefty forward annual dividend yield of 7.4%. However, the stock hasn't really moved over the past 12 months, especially in comparison to DepoMed.

DEPO Chart

Source: YCharts.

The majority of DepoMed's revenue is generated from royalties from Glumetza (metformin) and sales of two drugs -- Gralise (for postherpetic neuralgia) and Zipsor (for actinic keratoses).

Glumetza is a diabetes drug manufactured by Santarus (NASDAQ: SNTS). Last quarter, royalties from Glumetza came in at $14.2 million, accounting for 47% of DepoMed's total revenue. Royalties from other products came in at $904,000, accounting for another 3%.

DepoMed's total revenue from Glumetza and other royalty payments rose 58% from the prior-year quarter. This year, DepoMed was scheduled to receive 32% of this year's sales of Glumetza from Santarus and 34.5% in 2015.

Under the terms of the agreement, PDL's payment of $240.5 million grants it the rights to all royalty and milestone payments on sales of Glumetza, as well as two other new diabetes drugs, Janumet XR (Merck) and Invokana (Johnson & Johnson), along with several new versions of metformin.

The deal is retroactive and starts from all royalties starting on Oct. 1, and will end when PDL receives twice its original payment at $481 million. After that condition is met, the two companies will split the payments.

DepoMed, which is now guaranteed stable cash flow without having to worry about fluctuating sales of Glumetza, intends to use the capital to "fund future product acquisitions capable of driving growth into the next decade," according to CEO Jim Schoeneck.

The Foolish takeaway
PDL's $240.5 million payment may seem high, considering that DepoMed's royalties only came in at $44.5 million in 2012. At this rate, it's going to take a few years at least to just break even on the deal, and hitting $481 million looks like a very distant goal. However, royalties from other diabetes treatments, especially Invokana -- which some analysts believe could achieve annual peak sales of $2.5 billion -- could speed things along nicely.

The key for DepoMed investors now is to closely watch where it decides to invest all that cash.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.