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$SZYM - Solazyme Takes A Short-Term Hit For Its Long-Term Focus

http://seekingalpha.com/article/1810282-solazyme-takes-a-short-term-hit-for-its-long-term-focus?source=email_rt_article_readmore

When it comes to constructing a large industrial fermentation facility that costs more than $150 million, implementing the most up-to-date adjustments can go a long way to optimizing future production. This is especially the case when processes and technology continue to improve over the two years taken to build the facility. The difference made by integrating these additional technologies can ultimately prove to be cost- and time-effective measures to reduce the more burdensome inefficiencies that would otherwise occur further down the road.

For renewable oils producer, Solazyme (SZYM), the choice to optimize production processes at its Moema facility appears to be one of little comfort for short-term traders. Management announced that the company would be setting back the commercial production date of this Brazilian facility. Upon announcing this construction delay on its Q3 2013 earnings call, Solazyme saw its stock fall more than 5% in the after-hours session to $9.80 on November 5. The rare setback consequently lowered Solazyme's year-end revenue guidance which was largely tied to the company's initial commercial activities at Moema.

Focused On The Bigger Picture

But beyond this temporary delay, management continues to show disciplined restraint and prudence when it comes to focusing on its efficient use of capital and capacity resources. CEO Jonathan Wolfson noted that this reduced guidance was also in part due two additional culprits. First, the company willingly walked away from one undisclosed joint development agreement [JDA] possibility. In this case the short-term gains failed to reconcile with the long-term value potential recognized by Solazyme.

Likewise, Solazyme also passed on a fuels project that would have otherwise provided a boost in short-term revenue. However, this project would have also invited a fair amount of distraction that would have hindered other areas of interest. In both of these instances, we see that Solazyme continues to maintain a focus on the long-term business plan. Rather than scrambling to meet the short-sighted desires of investors for near-term profitability, the company continues to establish a sturdy foundation to realize the full potential of its proven technology.

Listening to the conference call, it remains clear that management is disappointed by the delayed production target. Nevertheless, the state of Solazyme's progress continues to improve. Here are several additional observations that investors might wish to consider:

Scaling is becoming a distant concern. As a common problem for other public companies such as Amyris (AMRS) and Gevo (GEVO), shortfalls in technology scaling have notoriously hindered those associated with industrial biotechnology. However, Solazyme has already scaled at least two of its algae strains at its facility in Clinton, Iowa. The achievement at this level allows for the company to address higher volume products that would otherwise carry a lower margin.
Commissioning is underway. Solazyme has already begun the project commissioning process for both of its facilities at Clinton and Moema. Even though the Moema project has yet to finish construction, this testing and inspection process has already been initiated. Product sampling is also being carried out at Clinton.

Regulatory approval has been met. Solazyme has already gained the first regulatory approval for one of its algae strains in Brazil. The government agency that regulates bio-safety in Brazil has approved the strain that will be used to meet the Unilever (UL) supply commitment. According to the supply agreement, the algae strain used will produce one of Solazyme's tailored oils. This approval of a tailored oil algae strain further dampens investor concern over strains which have been genetically modified.

Projects remain on budget. The capital costs for both facilities remain on budget and already commited for the most part. Keeping the costs under control has been another stumbling block for companies in this field. With the costs of Moema exceeding $150 million, Solazyme has only needed to contribute $17 million for a 50% equity stake.
There is a food focus at Moema. One of the enhancements described at Moema called for equipment that allows for different food products to run back and forth. The addition suggests that various food applications will play an important part of the normal workflow. The nutrition market runs on the higher end of Solazyme's target gross margins and it is reassuring to see that such an emphasis is being taken in Moema.
Emphasis on the back half of 2014. There was a high degree of focus on the non-linear ramp of the facility once production starts. The sharpest acceleration in product volume is expected to occur in the second half of 2014. It would be ideal for investors to also remember that target gross margins are not likely to be fully met prior to reaching nameplate capacity. Nameplate capacity should be met in early- to mid-2015.

Expanded JDA agreements. Both Bunge (BG) and Unilever expanded their JDAs with Solazyme. Particularly for Bunge, this additional commitment further suggests that the company remains a committed partner to Solazyme. Most recently, Bunge has suggested that it will be adjusting its sugar milling business. An expansion of its JDA agreement further affirms to investors that the relationship remains strong even as the company explores its options.

Introducing A New Product Line

Solazyme's successful cosmetic line of Algenist helped to prove that the company was capable of penetrating a new market while developing a brand name. Over the last two years, almost all of the company's product revenue was derived from Algenist. In the absence of large commercial manufacturing capability, Solazyme proved capable of generating high amounts of cash flow with limited capacity. Above all, Algenist tapped into Solazyme's highest grossing market.

The announcement of a new product line found in a second cosmetic brand should not be taken lightly. Whereas Algenist targeted the high-end consumer, it appears that EverDeep is geared more for the low- to mid-range audience. The brand's website has already been designed, and commercials have already begun to run on television. The initial test kit (which includes 6 products) currently sells for $40 along with shipping and handling. Where Algenist sold products at $90 for a 1-ounce bottle, EverDeep appears geared for a higher volume distribution at a lower cost in this untapped market.

The addition of EverDeep looks to be an ideal fit for the present. It allows for the company to tangibly increase its cash flow while it ramps up its large scale facilities. As of September 30, the quarterly results show that Algenist continues to hold its high margin figures. Solazyme sold $4.80 million for the quarter at a cost of $1.45 million. This suggests an average gross margin of 69.8%, a figure slightly above the company target for its skincare division.

Final Thoughts:

Because Solazyme stretched its production target date, volatility is likely to exist for the company's stock in the near-term. The extended date has the additional effect of lowering revenue guidance for the rest of 2013, and it should push down analyst guidance for 2014. Nevertheless, the company itself continues to progress while it further lays down the foundation for its long-term growth. Solazyme currently trades with a premium based on the long-term value of its technology's potential.

While other peers in the industry have suffered from setbacks due to technology risk, Solazyme has not shown any such downside to its technology. Instead, the company's prospects continue to brighten. The company's partnerships continue to mature, new product lines are emerging, new oil profiles are being developed, and regulatory approvals appear to be going well. Above all, Solazyme has the cash cushion to progress at its own pace.

Additionally, management remains highly committed to optimizing the long-term potential of Solazyme. This was the team that abandoned the free Sun for a more productive strategy found in sugarcane. It was also the team that pursued higher-margin products when the industry errantly pursued low-margin biofuels prior to scaling its technology. Even now, we see that management is willing to walk away from short-term revenue gains if it comes at the price of jeopardizing long-term market opportunities. Such focus remains a difficult asset to find, and thus far Solazyme appears to be proving that it can translate into future value.