Codexis Benefits From Rise in Biofuel Interest

| About: Codexis, Inc. (CDXS)

By Brendan Coffey

Today I want to talk about the growing importance of green fuels. Last week, the average cost of a gallon of gasoline in the U.S. was $3.52, according to the Department of Energy. That’s up a whopping 76 cents from a year ago. Five years ago, a gallon was $2.70; 10 years ago, it was $1.60.

It’s to the point that the other day, I drove an extra few miles to BJs Warehouse Club (NYSE:BJ) because its gas was 10 cents a gallon cheaper. Given that demand rises in the summer (leading to the industry nickname for summer, driving season), it’s a good bet that $4 a gallon gasoline will be on tap by Memorial Day.

The uncertainty of the world’s energy flow promises to continue to roil markets too. Between Libya and other Middle East unrest and the effect that Japan’s disasters will have on its increased demand to import energy to make up for the destroyed nuclear plants, the pressure is bound to continue. Plus there are the fundamental supply and demand pressures that exist anyway, as world economic activity rebounds from the recession.

All of that means biofuels are likely here to stay as a part of the world's energy supply. Today, biofuels are just 3% of the world's supply (in terms of refining capacity), but last autumn, when gasoline prices were under control, they were projected to grow at least at a 7% clip for the foreseeable future. But there is a problem with biofuels.

Here in the U.S., for instance, 40% of the latest corn crop went to ethanol. That’s a stunning figure, especially considering that world grain markets are under intense pressure because of poor wheat crops in Russia and Ukraine, poor corn crops in China and disappointing harvests here in the U.S. in both corn and soy.

The ability to get more from each bit of corn, whether extracting more energy from it or using less energy to extract the same amount of energy, is a key hurdle to overcome. So is creating the ability to produce suitable ethanol or other biofuels from other, non-food sources.

My stock recommendation for this issue is making great strides in those areas. It’s a California company called Codexis (NASDAQ:CDXS). Specifically, Codexis produces biocatalysts, which make the creation of ethanol faster and cleaner than traditional methods.

In the past, biocatalysts have been too unstable to use reliably, but because they can be utilized at room temperature and without the creation of hazardous byproducts — as in chemistry-based catalytic actions — stable, reliable biocatalysts have long been sought after. Codexis identifies and isolates the microorganisms that produce the best enzymes, then performs a series of intricate processes, including gene-shuffling and mutation-identification, to breed proprietary “superenzymes” that can be used more cheaply and efficiently in the creation of biofuels. The benefits include being able to use water as a solvent at normal atmospheric pressure, eliminating the need for purification actions later on and using less energy overall.

With biodiesel, which is chemically different from bioethanol (the latter is an alcohol, the former an oil), Codexis believes it has discovered a process that makes its creation both faster and cheaper.

Right now, biodiesel requires intricate steps from start to finish, including halting the production process at one point to chemically modify the intermediate product, as well as other costly side steps. Codexis believes its process eliminates the need to chemically modify the intermediate product, allowing the process to run continually and slash expenses. Because biodiesel is chemically identical to fossil fuel diesel, this may in fact be the more promising of the two biofuel areas. Ethanol, being chemically different from gasoline, requires additional infrastructure “drop in” fuels that biodiesel does not.

There are plenty of other companies pursuing advances in biofuels and catalysts, such as Gevo (NASDAQ:GEVO), Verenium (NASDAQ:VRNM) and PetroAlgae (PALG), but Codexis has two characteristics that give it an edge. One is that Codexis also has a market for its superenzymes in the pharmaceutical industry. If you take Lipitor, you’ve experienced the end result that includes Codexis. The company’s superenzymes are also sold to Dr. Reddy’s Labs (NYSE:RDY), Teva Phamaceuticals (NYSE:TEVA) and Arch Chemicals (NYSE:ARJ), among others. That gives the company a solid revenue stream while it looks to ramp up its biofuels business.

And the biofuels business is looking good. Codexis has been tied to Shell Oil (NYSE:RDS.A) since 2006, when the pair teamed up to produce biocatalysts for fuel production. For much of that time, Shell has provided payments to Codexis to support development (Shell will pay royalties if it uses Codexis’ technology in fuel production).

A big uncertainty has been whether Shell will stick with Codexis, having earned the right as of November to terminate the relationship with nine months' notice (an option Codexis does not have). That uncertainty is waning, with the pair announcing in early February they will use Codexis technology to produce biofuels directly from straw and sugarcane waste by year’s end. This is potentially important because Shell has also teamed with Cosan (NYSE:CZZ), Brazil’s largest ethanol producer, which uses sugarcane as its raw material.

A potential long-term bonus with shares: Codexis recently announced it has made progress in a carbon sequestration technique using custom enzymes that can be deployed in coal-fired power plants.

In its most recent year, ended December 31, Codexis made $107 million (up 77%) and shrunk its net loss to $8.5 million (35 cents per share) from $20.3 million. Shares in the Cabot Green Investor portfolio are up just 8% so far from our buy price, but they look like they are in the midst of building a rock-solid base around these levels to work higher in coming months. The higher gas prices go, certainly the better outlook for Codexis.