Diversa Corp: T. Rowe Price Opposes Celunol Merger Agreement

In a 13D filing on Diversa Corp. (DVSA), 7.9% shareholder T. Rowe Price Associates said they oppose the merger with agreement Celunol.

T.Rowe Price said, "the proposed merger is an unwarranted change to Diversa's sound business model." They also said, "the merger would give Celunol's management and shareholders a disproportionate share of the combined company", and they "consider the industry to be insufficiently mature". T.Rowe thinks "Diversa's technology may be applied throughout the cellulosic ethanol industry, generating potentially higher returns and lower risk than would come from tying its fate to a single, small, unproven company like Celunol."

T.Rowe Price plans to vote against the merger.

A Copy of the Letter:

Dear Mr. Shonsey, Dr. Cavanaugh, and Members of the Board of Directors:

We are writing on behalf of our advisory clients, who are shareholders of Diversa Corporation, to express our opposition to the proposed merger with Celunol. T. Rowe Price Associates,Inc. ("T. Rowe Price") is a registered investment adviser with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940, with discretionary authority over the securities holdings of our clients, including the T. Rowe Price mutual funds. As of December 31, 2006, our mutual funds and other clients held over 3.8 million shares, representing approximately 7.9% of Diversa's outstanding common stock. From the investment perspective of our advisory clients, we oppose the merger and wish to share with you the reasons we intend to vote against it:

1. Over the past year, Diversa has successfully reorganized and focused its efforts. We believe the improved stock performance of the company reflects the market's appreciation of the revenue and profit potential of the new strategy. In our view, the proposed merger is an unwarranted change to Diversa's sound business model.

2. We believe the merger would give Celunol's management and shareholders a disproportionate share of the combined company.

3. We consider the industry to be insufficiently mature to merit the decision to make a binary bet on becoming a vertically integrated cellulosic ethanol company. Furthermore, we are unconvinced that Celunol will prove to be a winning player in this market. Abandoning a well-functioning business plan in favor of the financial, technological, and execution risk that could result from a merger with Celunol, in our view, would not be in the best interests of Diversa shareholders.

4. As a leading enzyme discovery and optimization company,Diversa's technology may be applied throughout the cellulosic ethanol industry, generating potentially higher returns and lower risk than would come from tying its fate to a single, small,unproven company like Celunol.

As the chart below reflects, Diversa's management created shareholder value by reorganizing and focusing the company's efforts on alternative energy, specialized industrial processes,and health and nutrition. Progress in these efforts has supported management's guidance of profitability in 2008, driven by $80-$100 million in product revenue. Subsequent to announcing the proposed merger with Celunol, Diversa's stock has declined materially.

We believe the merger would create unacceptable and unjustifiable financial, technological, and execution risk for Diversa shareholders. Just as its reorganization and reprioritization was creating shareholder value, the merger has the potential to change Diversa from a company on the verge of profitability to one that would require a substantial cash infusion to finance operations. Celunol is a small company with limited resources;it has yet to prove it can scale its manufacturing and produce ethanol from biomass in a manner that is economically viable.Celunol's CEO and CFO, who would assume leadership of the merged entity, have no apparent experience in biomass conversion,ethanol production, or industrial biotechnology. Yet they are assuming management responsibility - and Celunol shareholder swill receive 24% of the equity - of a company that has used over$320 million of its shareholder capital to create an intellectual property estate of over 250 issued patents, over 500 patent spending, and over 100 in-licensed patents and patent applications.

The proposed merger, in our opinion, is premature, unnecessary,and speculative in its reliance on unproven technology and a management team with minimal experience with Diversa's science.As a leader in enzyme discovery and optimization, Diversa's technology has the potential for widespread application throughout the fledgling cellulosic ethanol industry. Diversa has no need to tie its fate to a single company, let alone one with the risk characteristics of Celunol. In our view, it would be in its shareholders' better interests for Diversa to remain diversified and work with multiple parties attempting to convert biomass into ethanol. As opposed to potentially increasing its cash burn to $75 million, selling equity or debt to finance operations, and assuming $125 million of capital expense for each25 million gallon ethanol plant, we believe Diversa should utilize a strategy of licensing and partnership, not vertical integration.

For the reasons outlined and explained above we oppose Diversa's proposed merger with Celunol and we intend vote against it. We urge the board to reconsider its decision.

We would welcome the opportunity to meet with you to discuss our concerns.

Respectfully submitted,

Preston G. Athey
Hugh M. Evans III
John H. Laporte
Jay S. Markowitz

Comments

[Dave Huntsman:]

Interesting. I think they have some good points; and some wrong points.

Clearly, they prefer the safe (or, safer) approach DVSA was previously on. There is definitely something to be said for that (one of the reasons I liked it when the company changed direction under a new CEO in 2005). There is no question, in my mind, it was finally on a path to be profitable sooner, rather than later; and was in a position to be an industrial enzyme supplier to everyone: corn-based ethanol producers; waste-based ethanol producers; cellulosic ethanol producers; as well as the other industries they were supplying (feedstocks, nutrition, industrial processing, etc).

The T.Rowe assessment is wrong to imply that going the Celunol route automatically means lower returns. It could, if the whole thing failed. But, in focusing on cellulosic ethanol, they were/are aiming for a long-term home run. Back in the early days of Microsoft, for example, only an idiot believed it was 'safe' to focus solely on providing software for such a stupid thing as desktop computers. But there were people at the time who went further to say that there would be no returns in it, even if it succeeded. That was going to far; it was wrong by a few light years, in fact, since that single-minded focus on a new future yielded the greatest fortune in human history.

So for T.Rowe to go the next step - beyond safety, into also implying automatic lower returns - is just a dumb thing to say; since if the DVSA transfer to Celunol were successful, it would hardly be true.

While I understand why accountants would consider cellulosic ethanol 'immature' - or too immature to bet on - I disagree. Going away from oil is a given; increased biofuels is a given. Corn-based biofuels - just using the grain - simply can't go beyond providing 15% of current USA fuel use, even if every single grain of corn in the US were to go into the gas tank (which can't and won't happen). Also, cellulosic ethanol is one of the few areas where even this Administration is serious; putting several hundred million dollars into it just in the past two weeks alone. (Though the question remains unanswered: why didn't DVSA/Celunol get one of these awards, as well, if they were so advanced? I've written the company asking for clarification; they've refused to answer this shareholder, something that disturbs me greatly).

I do agree that the terms of the deal are rich, in Celunol's favor; something current management hasn't explained. It gives the impression - I hope falsely - that there's something else going on behind the scenes. An investigation might be called for unless the company is more forthcoming. The deal appears to have the aspect of paying Celunol to take over a company that has been years, hundreds of millions of $$, and hundreds of patents in the making. In fact, they want to borrow money to pay Celunol to take the very real asset that is DVSA. The question is, why?

I do agree with DVSA management that, if the company is to become a vertically integrated celulosic operations company, they current DVSA management aren't the ones to run it. T.Rowe says the Celunol guys aren't the ones to run it, either. Yet the only two serious cellulosic pilot plants in the world - in Japan, and the US - are Celunol's. So again, T. Rowe may - may - be overstating this part, just to make a point.

One thing that did bother me in terms of the 'merger' of the two (or, more correctly, the handover of DVSA to Celunol), was the price; which was not determined by an honest assessment of value, but through 'negotiation'. Maybe that should have tipped me that something is funny; that there was more going on behind the scenes than meets the eye.

T.Rowe is technically wrong in their assessment of cellulosic ethanol. They are right in what is the 'safer' approach; they are wrong in what has at least the potential for truly out-sized returns in the future; and they are right in questioning the terms of the agreement, whereby DVSA goes into debt to give itself to someone else.

I'm glad this discussion is happening, though.

Dave Huntsman
DVSA shareowner

2007 Mar 13 10:38 AM