Can Changes To The Beverage Industry Affect Solazyme?

| About: TerraVia Holdings, (TVIA)

There is an ongoing transition now at work in the leading companies that influence the beverage industry. Both PepsiCo (PEP) and The Coca-Cola Company (KO) are actively attempting to reduce the amount of sugars in their soft-drinks. The new formulations could potentially serve as the basis for future advertising efforts as each company expects to face off in the new battleground for a midcalorie soda.

At the heart of the matter is a growing trend away from soda consumption itself. Soda consumption fell to a 26-year low in 2012 as consumption declined 1.2%. This built upon the 1% drop experienced in 2011 and the 0.5% decline in 2010. Such momentum finds itself amid the growing awareness of obesity and the widening epidemic it has become.

For soda companies, the trend is coercing a push towards healthier alternatives made possible in the reduction of sugars in their formulations. As such, while demand for soft drinks may diminish the consumption of sugar, it is also the companies themselves that are looking to reduce their reliance on the sweetening ingredient.

The beverage industry accounts for a significant portion of sugar consumption around the world. For The Coca-Cola Company alone, the company serves beverages at a rate of 1.9 billion servings a day. With the typical can of soda carrying approximately 36 grams of sugar, this would suggest that this one company can go through roughly 25 million metric tons [MT] of sugars per year. This is an impressive feat considering that there was less than 170 million MT of raw sugar consumed around the globe in 2013. While a good portion of Coca-Cola's sugars may be based on high-fructose corn syrup, the sheer size of this beverage company illustrates the large amount of sugars used by the industry itself.

It's for this reason that changes to the industry could soon be affecting the markets of other sugar consumers. One often neglected industry that could feel the impact is the growing list of companies specializing in industrial biotechnology. These companies typically rely on large amounts of sugar consumption (from cane, corn, etc.) in order to conduct large-scale commercial fermentation. For them, the slight changes in sugar prices can often result in significant shifts in profit margin spreads. One such company poised to lead in this space is a renewable oil company named Solazyme (SZYM).

A Look At Solazyme

As a leader in the emerging field of industrial biotechnology, Solazyme is a producer of custom-designed oils and bioproducts. The company is able to use sugars to create tailored oil profiles capable of replacing oils derived from petroleum, plants, and animal fats. Because of its ability to customize these oil profiles within a microalgae cell, Solazyme is able to create higher-valued products which impart improved characteristics over that which is found in the natural world. As oils are used in a wide spectrum of industries, Solazyme will initially be addressing the target markets of personal care, nutrition, and fuels and chemicals.

Solazyme now trades with a market capitalization of $766 million based on the last price of $11.24 as of February 21, 2014. The company is currently in the process of ramping its first large-scale facilities which will increase manufacturing capacity by more than 6,500% to more than 120,000 MT per year. The company expects gross margins to range between 30% to more than 60% depending on product mix. While these margins are dependent upon average selling prices, they are also reliant upon the stability of feedstock costs.

The Reliance On Sugar Feedstocks

One of the ongoing factors for Solazyme's investors to consider is the type of feedstock required by this advanced technology. While the company's process can utilize a wide range of sugars including those derived from cellulose and other waste materials, the reality is that conventional crops (such as sugar cane, corn, sugar beets, and etc.) remain the only feasible pathway to sugars in the present. Next-generation industrial sugar technologies are still in the development phase, thereby leaving Solazyme's cost structure potentially vulnerable to volatile swings in feedstock prices.

The location of Solazyme's first commercial facilities will place the company's reliance on the stability of sugar cane and corn prices. While Solazyme has taken numerous measures to help mitigate the effects of shifting feedstock costs, lower prices for corn or sugar cane can only help improve the company's margins. Thus far, a declining trend in commodity prices have been beneficial as the company enters into large scale commercial production. Over the past two years, sugar prices have largely declined as production outpaced consumption. This can be seen in the chart below, which was created by the US Department of Agriculture.

Falling prices for sugar have helped play a significant role in curbing production as the curve begins to drop down towards the level of consumption. However, a reduction to the consumption curve would help to extend these falling prices. For Solazyme, such drops in sugar prices can only translate into improving margins. At the very least, a progressive reduction in consumption could have the benefit of maintaining price stability over the next few years.

An Interesting Hypothetical

One interesting hypothetical scenario could also place Solazyme itself in the field of expediting this trend. Artificial flavors are made by the fractional distillation and various chemical processes of naturally found chemicals, tar, and crude oil. Solazyme's ability to manipulate its microalgae allows it control the make-up and placement of linear fatty acids and esters within its oils. Additionally, Solazyme could use the genetic make-up of naturally occurring products for the design of its resulting oils. This potentially suggests that the company could have increased flexibility and control over the production of unique flavors were it to pursue a high-end market found in flavors and fragrances.

To date, Solazyme has stayed away from these niche markets - opting rather to become the commodity supplier of designer oils used in large volume markets. Part of this decision-making process is likely due to the fact that the Solazyme is only beginning to launch its first commercial lines. Its ability explore additional projects remains constrained in the present. Yet if this health trend in the beverage industry begins to gain momentum, the need for new and large volume flavors could become relevant market for Solazyme as well.

One interesting aspect of the beverage industry's race to replace sugar lies in its pursuit of flavors that can offset the sweetness of sugar through the use of something that is even sweeter. Take for example, the case of Stevia First which is pursuing the production of steviol glycosides. One such glycoside can be 300 to 400 times sweeter than an equal weight of sugar. The Coca-Cola Company is looking to introduce a new healthier beverage named Coca-Cola Life mixed with sugar and a stevia-based substitute. The brand carries two times less calories than regular Coke and supports more eco-friendly packaging.

Another case involves that of Senomyx's (SNMX) "S617" which is vying to be a part of PepsiCo's transition to include a sugar-reducing alternative. The company estimated that adoption of its S617 would allow for as much as a 35% reduction in high-fructose corn syrup and up to 50% reduction in sucrose. In each case, the adoption of these new alternatives to sugar can result in a healthier product by limiting the amount of sugar used.

In an interesting twist, Stevia First has also begun to explore the use of fermentation in order to create its product while lowering its total costs by 70% or more. As fermentation remains the cornerstone of Solazyme's platform, it remains feasible to think that Solazyme itself could also have a role in this sugar transition. With its technology platform, it is plausible that Solazyme could increase a naturally-occurring ingredient that helps reduce the need for sugars.

After all, Solazyme already has plans to improve the health profiles of foods within the nutritionals market. The company's platform can also use the natural genes of existing plant profiles and possibly increased their capabilities. Above all, the growing flavors market would also demand a much larger volume of production than what is currently in existence. Such reasons could support the exploration of this market in the future in light of having a technology platform capable of contributing.

Final Thoughts

Whether or not Solazyme ever ends up playing an active role in this beverage industry transition, the growing trend to reduce sugar out of the consumer diet could affect the rate of raw sugar demand around the globe. While soft drink companies appear to be leading the way towards a healthier beverage profile, the potential impact this transition can eventually have on the consumption market could lead to extended periods of low sugar prices. The push for reduced-sugar recipes could also spill over into other industries such as the those found in chocolates and candies.

This bodes well for industrial biotechnology companies like Solazyme which prospers from the low cost of sugars in relation to the higher margins of their output product. It also provides a potential market opportunity for fermentation-based companies like Solazyme. Due to its flexible technology platform, the company may be able to contribute to the development of these flavoring alternatives.

In the most likely scenario, a slower growth in the demand for sugar or high-fructose corn syrup can lead to increases in price stability for both of Solazyme's current feedstocks. This may be helpful as the company awaits the development of cheaper industrial sugars which will help to provide even greater stability in feedstock costs. Overall, the ongoing health trend stands as a potential de-risking development for Solazyme. Ironically, it is also one that is now at work in the background of another industry altogether.

Disclosure: I am long SZYM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.