Senomyx, Inc. (SNMX)

[surf1944]

Taking The Bitter With The Sweet At Senomyx
December 10, 2012 | 2 comments | about: SNMX, includes: IFF, KO, NSRGY.PK, PEP
Disclosure: I am long SNMX. (More...)

http://seekingalpha.com/article/1052981-taking-the-bitter-with-the-sweet-at-senomyx?source=yahoo

It's a fact of the investing life that when you swing for the fences, you will occasionally strike out. Thus far, owning shares of "bioflavor" developer Senomyx (SNMX) has been a frustrating and losing experience for most investors. While there is still considerable potential in this very under-followed stock, investors have to accept a biotech-like risk that Senomyx will ultimately be a bitter experience and a total washout as a stock.

Everybody's Looking For Great Taste

Senomyx is basically taking a biotech-like approach to developing food additives. The company is harnessing high-throughput screening technologies and taste receptor assays to discover compounds that can safely enhance the taste/flavor of the food we eat - whether by enhancing sweetness (and reducing the need for sweeteners), blocking bitterness, or enhancing savory flavors.

In particular, fooling our sweet tooth is a huge market opportunity. Coca-Cola's (KO) Diet Coke has become the second-leading soft drink in America on the basis of soda drinkers' desire to get their sweet fix without packing on pounds; likewise Coke Zero became a billion-dollar product in about four years and has steadily been a volume growth leader for Coca-Cola since its introduction in 2005. All in all diet soda is estimated to be a $30 billion-plus annual market in the U.S., while sugar substitutes in general are seen to be more than a $100 billion opportunity across the food and beverage sector.

Not surprisingly, Senomyx has made the discovery of better sweetness enhancers a top priority. In partnerships with PepsiCo (PEP) and Switzerland's Firmenich, Senomyx has developed more than four compounds targeting sweetness enhancement. One (S2383) can offer upwards of a three-quarters reduction in sucralose (Splenda) use, while the promising S617 has become a priority with PepsiCo for its potential to reduce sugar use by up to 50% and/or high fructose corn syrup by one-third in beverages.

Moving From Lab Bench To Store Shelf Is The Tricky Part

Unfortunately, while Senomyx has announced multiple promising compounds and secured the FDA's Generally Recognized As Safe (GRAS) designation for several of them (roughly equivalent, but much less stringent than a drug approval), commercialization has proven to be very tricky.

Senomyx is still logging less than $1 million per quarter in commercial royalties, despite four marketed compounds licensed to Firmenich and Nestle (NSRGY.PK). Perhaps not surprisingly, packaged food and beverage companies are very reticent to tinker with successful brands and risk alienating customers - new ingredients or recipes are put through rigorous testing and often test-launched in relatively small products in smaller countries. What's more, established flavor companies like International Flavors & Fragrances (IFF) are lucky to get even a 5% or 10% acceptance rate for new compounds.

That leaves Senomyx in a difficult position. Not only are the royalties that the company earns from its compounds relatively low (about 3.5% for most of them), but investors have been frustrated by seeing former partners like Campbell Soup (CPB) walk away and other partners like Nestle and Ajinomoto move so slowly to incorporate these compounds into major products.

There's Still Time, But Not An Indefinite Amount

Senomyx probably has about three years of cash left. That's not terrible, but given the time it takes to craft a new product (or reformulate an old one), test it, refine it, launch it, and support/promote the launch, it's also not an abundance of time. Investors should hear more in early 2013 (February, most likely) about near-term commercialization plans, including Firmenich's plans for that sucralose-reducer in North America and Latin America.

Clearly the biggest development, though, will be the sugar/HCFS-reducer (S617) that Senomyx is developing with PepsiCo. PepsiCo thought enough of it that a prior sucrose modifier (S9632) was released back to Senomyx in favor of this one. This single compound, in a single application (diet soda), could be worth more than $150 million in future revenue to Senomyx - an amount that could make the stock more than a double from here. If development goes to plan, this could be in commercial products on retail store shelves in 2014.

Opportunity Abounds, But What Are The Probabilities?

While 3.5% royalties don't necessarily sound huge, it only takes a few major program wins for the value of Senomyx to add up quickly. As mentioned, a diet soda sweetener (or, more accurately, a sweetness enhancer) could be worth well over $150 million in revenue to Senomyx, while a successful sugar enhancer/substitute in packaged foods could be worth multiples of that. Outside of sweet, there are also multimillion dollar opportunities in savory, bitter blockers, cooling (replicating the taste/sensation of menthol), and salt.

Clearly the catch is just how likely that all is to happen. Against the enormous possibilities, investors also have to consider the probabilities - the probability that a partner will put a Senomyx compound into commercial launch, that they will support that launch, and that the product will capture enough share/sales to be a real contributor to Senomyx. After all, 3.5% of "nothing" is "nothing."

At the same time, companies like Tate & Lyle, Cargill, and Merisant continue to work on a variety of enhancers and substitutes (stevia, or sweetleaf, recently becoming a popular alternative). Not surprisingly, even Senomyx's partners like PepsiCo are hedging their bets and working with multiple partners, so there are no guarantees that Senomyx's compounds will be the ones chosen for new products.

The Bottom Line

While it may seem odd to reduce a company with multiple shots on goal to just one compound and one partner, I do believe a large percentage of Senomyx's future success and value is tied to the success of its current partnership with PepsiCo.

If Senomyx can offer the key to a product that can give PepsiCo 20% of the diet soda market, that alone would be worth around $8 per share. Here are the numbers - 20% share of the U.S. diet soda market ought to be worth about $6 billion. Multiply that by 3.5% and you get $210 million in revenue. Assign a 3.5x multiple to that revenue (60% higher than IFF's, but reasonable given the growth), discount it back 10 years (it takes time to grow a multibillion dollar product) and you get about $8. Assign 50/50 odds and you're looking at a double-and-a-half from today's prices.

On the other hand, if this program fails, it may be difficult for Senomyx to attract enough new partners (or keep the ones it has) to keep funding its R&D activities. Accordingly, this is a high-risk/high-reward proposition for shareholders. I still believe that the science and the model at Senomyx can work, but nobody should consider this stock if they cannot accept the possibility of an abject failure within the next two or three years.