Codexis Continues To Struggle With Little Relief In Sight

| About: Codexis, Inc. (CDXS)
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Executive Summary:

Codexis is a producer of cellulase and other enzymes used for the production of biofuels, detergent alcohols, and pharmaceutical ingredients. It's share price has fallen by 86% since its 2010 IPO and recently set a new low. The end of a R&D agreement with Shell, the possible end to an important licensing agreement with Dyadic, and faltering cellulosic ethanol production in the U.S. all raise serious concerns regarding the company's future growth prospects that investors should not overlook.

When I first began working in the biofuels sector back in 2008, a small company called Codexis (NASDAQ:CDXS) was attracting quite a bit of attention. The company was (and still is) a leading developer of a genetically-engineered enzyme (cellulase) capable of converting cellulose from plants into fermentable sugar, or glucose. The process, known as enzymatic hydrolysis or saccharification, was at the time considered to represent the future of cellulosic ethanol production, which was in turn believed to be just around the corner. President George W. Bush announced in his 2006 State of the Union speech the federal government's goal of achieving cellulosic ethanol commercialization by early 2012. The revised Renewable Fuel Standard [RFS2], which was created by Congress in 2007, went so far as to use the term "cellulosic ethanol" in place of today's "cellulosic biofuels" category. At the time, ethanol was the only cellulosic biofuel in sight.

As a producer of the enzymes required to produce cellulosic ethanol via enzymatic hydrolysis, Codexis was favorably compared to the general store owners who made their fortunes during the California Gold Rush by selling equipment to the amateur miners who ultimately went bust in droves. Unlike the cellulosic ethanol producers who would be required to build untested facilities costing several hundred millions of dollars each, Codexis simply needed to develop and produce superior enzymes to be successful in the market. The company managed to attract significant financial support even in the aftermath of the 2008 financial crisis, developing a partnership with Royal Dutch Shell (NYSE:RDS.A) that ultimately generated $300 million in investment and raising $78 million in a 2010 IPO. Codexis, which at the time was also engineering enzymes capable of sequestering carbon and producing pharmaceutical building blocks, initially expected to achieve commercial-scale production of its enzymes sometime this year.

The company's fortunes have fallen sharply since those early days along with its share price, which is currently trading at an all-time low that is 86% below its IPO price (see figure). 2012 was a particularly tough year for the company, during which time:

  • President and CEO Alan Shaw, who had been with the company since its founding and overseen its IPO, left to "pursue other interests";
  • Shell withdrew $60 million in cellulase R&D funding from Codexis, forcing the latter to lay off 1/3 of its staff as a cost-cutting measure; and
  • Codexis and Shell reached a new agreement, under which Codexis gained the rights to its proprietary cellulase ("CodeXyme" enzymes developed with Shell outside of Brazil. In exchange Codexis agreed to pay Shell royalties on its sales of CodeXyme as well as grant it preferential pricing.

While the new relationship with Shell was portrayed as an essential step toward eventual commercialization, investors disagreed and Codexis shares ended the year near its historical lows.

CDXS Chart

CDXS data by YCharts

Codexis at a glance

Shell's decision to pull its R&D funding from Codexis has had a very negative impact on the latter's quarterly returns (see table). The company's Q3 2012 earnings report was its second best on record, with a diluted EPS of -$0.06 and EBITDA of -$2.2 million. The funding withdrawal caused the company's Q4 2012 numbers to fall sharply despite its cost-cutting efforts. The company's H1 2013 revenue of $18.5 million was much lower than the figure of $54.0 million that it reported for H1 2012, and most of the difference was attributable to a $26.1 million fall in the value of collaborative R&D. Quarterly product revenues have held up better, although they still fell from $6.8 million in Q2 2012 to $4.9 million in Q2 2013.

Codexis financials

  Q2 2013 Q1 2013 Q4 2012 Q3 2012 Q2 2012
Revenue ($MM) 7.0 11.5 7.9 26.3 22.9
Gross Profit ($MM) 3.3 5.8 2.1 20.0 17.1
Net Income ($MM) -12.6 -9.6 -15.5 -2.3 -5.5
Diluted EPS ($) -0.33 -0.25 -0.41 -0.06 -0.15
EBITDA ($MM) -12.5 -8.8 -12.9 -2.2 -5.4

Source: Morningstar

Codexis has also seen its cash reserve fall from its post-IPO of $100 million in 2010 to only $38 million at the end of Q2 2013 (see figure). Its current liabilities have fallen sharply as well during the same period, however, and it has maintained a healthy current ratio.

CDXS Cash and ST Investments Chart

CDXS Cash and ST Investments data by YCharts

Shareholder equity has also held up relatively well in light of the company's deteriorating income statements since Q2 2012 (see figure). While shareholder equity has fallen in value by 40% since the beginning of 2012, the company's share price has fallen at an even faster rate, causing its P/B ratio to also decline by 40%.

CDXS Price / Book Value Chart

CDXS Price / Book Value data by YCharts

Product portfolio

Codexis has focused on the development of three different products. The first, which arguably has the largest potential market, is its CodeXyme cellulase enzymes. These enzymes are used for saccharification (aka hydrolysis), as the process of depolymerizing the plant polysaccharide cellulose into glucose is known. It is the most important step in the cellulosic ethanol pathway as the pathway closely resembles the corn ethanol pathway after saccharification; conventional yeast strains can easily ferment glucose to alcohol that is then distilled to fuel ethanol, whether that glucose is derived from corn starch (another polysaccharide that is easily converted to glucose) or cellulose. Cellulosic ethanol's economic feasibility ultimately rides on the ability of the enzymes to quickly and inexpensively convert cellulose to glucose. The advantage of being a cellulase enzyme producer is that relatively high amounts of cellulase are required for saccharification (generally at 2-3% loading rates, although Codexis claims that its CodeXyme product can achieve a loading rate of as low as 0.8% [pdf]). Furthermore, lignocellulose is incredibly plentiful even when sustainably harvested, which is of increasing importance to consumers and policymakers due to concerns over the use of relatively scarce food crops such as corn and soybeans as biofuel feedstocks.

The cellulosic ethanol via enzymatic hydrolysis pathway

Codexis has also partnered with Chemtex to produce CodeXol, which is its brand of cellulosic detergent alcohols. This product utilizes the CodeXyme cellulase enzyme to convert cellulose to glucose, which is then fermented to detergent alcohols rather than ethanol. While not as large as the fuel ethanol market, the company expects the detergent alcohol market to grow in size to $8 billion over the next decade. Much of current global detergent alcohol market is sourced from palm oil, the production of which has been linked to rainforest destruction in Indonesia and severe air pollution in Southeast Asia. Codexis has used its ability to produce detergent alcohols from sustainably-harvested lignocellulosic feedstock as a selling point, although the large decline in palm oil prices over the last year has made it harder for CodeXol to gain traction in the market. While Codexis recently reported the successful production of CodeXol at a demonstration-scale facility, it will need to bring CodeXol's production costs down substantially if it is to compete with palm oil.

Finally, Codexis also develops and produces enzymes and intermediates that are used by pharmaceutical manufacturers to increase product yields. Its customers include Merck (NYSE:MRK) and Pfizer (NYSE:PFE), and the company reported that its sales to the former doubled YoY in Q2 2013 (although management was unwilling to quantify this value).

Future constraints on growth

While Codexis appears to have a diversified product portfolio, its future success is ultimately very dependent on increased sales of its CodeXyme cellulase enzymes. Such sales growth is not guaranteed over the next few years due to reasons related to both contractual disputes and shifts in technology. On the contractual front, Codexis reported earlier this month that Dyadic International (OTCQX:DYAI) was accusing it of breaching the licensing agreement between the two companies. This licensing agreement, which dates back to late 2008, allows for Codexis to use Dyadic's proprietary fungal expression technology as part of its production of CodeXyme. Furthermore, Dyadic intends to terminate the licensing agreement by the end of September if the breach is not resolved to its satisfaction. This has the potential to carry large ramifications for Codexis. As Codexis President and CEO John Nicols stated in the company's Q2 2013 conference call while addressing the feasibility of obtaining a similar licensing agreement from another company:

"[C]ompanies like Novozymes and DuPont are highly unlikely to license to a company like Codexis because their core -- their business has this area as a core area for their companies as well. It would be very difficult for Codexis to rebuild its technology position for CodeXyme, should we lose the Dyadic license."

While the company has also stated that any termination of the licensing agreement would not affect its CodeXol business, the fact that CodeXyme is used in the CodeXol pathway makes the development worrisome for the future production of both products.

Even assuming that Codexis is able to continue its production of CodeXyme in the future, the potential market for the cellulase enzyme is much smaller than it was in 2008, let alone 2010. While construction on the first commercial-scale facility (capacities in excess of 10 million gallons per year [MGY] are considered to be "commercial scale" in the biofuels industry due to the logistics of biomass feedstock supply) for converting lignocellulose to biofuels was completed in 2012, the facility produces cellulosic hydrocarbons rather than ethanol. Furthermore, it relies on the thermochemical platform rather than the biochemical platform to do so and, as such, does not require enzymes as a production input (instead using heat to perform the same role). Roughly half of cellulosic biofuel capacity at the end of 2014 is now expected to be in the form of thermochemical rather than biochemical production. Furthermore, only a quarter of total capacity in that year is expected to require cellulase enzymes and, as stated in the aforementioned Codexis conference call, the companies behind those projects have either contracted with other enzyme producers or developed their own enzymes to meet their needs.

Finally, the ethanol blend wall, as the point at which the U.S. transportation fuel infrastructure cannot handle additional ethanol consumption is known, is expected to be reached sometime in 2013 or 2014. Ethanol consumption is effectively limited in the U.S. to 10 vol% of gasoline consumption. Furthermore, U.S. gasoline consumption is expected to decline over the next several years due to changing driving habits and increased vehicle fuel economy, meaning that the size of the U.S. ethanol market will decline as well so long as the 10 vol% blend wall remains in place. This is important for Codexis because the ethanol blend wall does not differentiate between corn ethanol, which is responsible for virtually all U.S. ethanol consumption at present, and cellulosic ethanol. While the volumetric mandates under the RFS2 should incentivize consumption of the latter over the former, cellulosic ethanol will need to outcompete an entrenched corn ethanol industry in a shrinking U.S. gasoline market if cellulase enzyme demand is to increase substantially in the future. Whether Codexis will benefit will in turn depend on the ability of CodeXyme to outperform the other cellulase enzymes available on the market.

Conclusion

Codexis has struggled to replace the revenues that it received from Shell when the latter decided to end the R&D collaboration between the two companies. While the new arrangement between them has been cast as an essential step toward commercial-scale enzyme production, Codexis faces significant technical and contractual challenges if it is to experience major growth in the market for its CodeXyme product. Falling palm oil prices will also limit the ability of its CodeXol product to compete with lipid-based detergent alcohols. Finally, the company's contractual dispute with Dyadic threatens the licensing agreement that supports its production of CodeXyme. Investors should avoid Codexis shares until the company's growth prospects improve and this may not happen for a year or more (if at all).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.