Revisiting Solazyme, Part II: Where The Technology Is Leading

| About: TerraVia Holdings, (TVIAQ)
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(On Friday, January 10, 2014, I returned to Solazyme's research headquarters in San Francisco to converse with key staff members in a follow-up session nearly 2 years after my last visit found here. The articles of this series are based on my own conclusions as an individual investor in the company. Part 1 can be found here.)

"We continue to improve upon the base strain... the parent strain. So we always have activities going on in terms of yield improvement, productivity improvement and general robustness. Let's say we put in a certain set of genes to make a high stability, high oleic oil. If we get a new base strain, we can put those genes into the new strain and potentially see better yield and productivities."

- Peter Licari, CTO of Solazyme

Through vigorous screening and a touch of serendipity, Solazyme (SZYM) has managed to build its technology platform upon a highly productive and robust strain of heterotrophic algae. Since my first interview with CEO Jonathan Wolfson, the importance of the parent algal strain discovery has always been emphasized. Nearly two years later, the parent strain continues to be highlighted to this day.

When asked what stands out most about the platform, CTO Peter Licari thoughtfully referred to the strain's pH tolerance, temperature range and nutrient limitation. It is this general robustness in order to stay productive and the ability to effectively control the microorganism that continues to be some of the platform's greatest strengths. For Solazyme, the ability to harness a very productive strain of algae has allowed the company to excel where few have yet to explore.

Solazyme designs and manufactures renewable oils. The industrial biotechnology company has developed a microalgae-based platform capable of creating a wide variety of customized oil profiles. Like a vehicle chassis, each base strain can be outfitted with the genetic code needed to produce a particular oil profile. It is through the ongoing improvements to the base strain and the development of unique oil profiles that Solazyme now finds itself equipped with such a versatile technology.

(Sample oils ranging from C12 to C18:1, all derived from descendants of the same parent strain.)

Within the profile itself, the company can control the carbon chain length, degree of saturation and position of the fatty acid on the glycerol backbone. By conducting such alterations inside the cell, this unique capability can cost-effectively replace expensive processing steps now utilized throughout the industry. Consider for example the processes of hydrogenation, fractionation and inter-esterification. Such additional processing steps and costs are traditionally endured in order to further shape the oil into an ideal product based on its physical and functional properties.

Part of the need to resort to these techniques inherently comes down to using what is both available and affordable. Industry may be well aware of what oils it would like to use, but it too must comply with basic agronomics. Economically speaking, there are only a small number of oils in this world, which can be efficiently produced and made in large enough supply to become reasonably priced for most products. There is an overall lack of characteristic diversity amongst this pool of well-known oils. Wolfson expanded on this concept with the following thought:

"Because there's such a limited number of oils that you can get at reasonable volume and cost, there's not a huge array of solid fat curve opportunities," Wolfson explained at the whiteboard. "Could you theoretically (without what we do) figure out a way to get thick oils that would have all kinds of different solid fat curves and the answer is 'Yes.' But to do it in an economically viable way for most of the applications you'd use them in, and the answer is 'No.'"

Inherent in his statement, Wolfson states that one of Solazyme's advantages is its ability to manipulate the solid fat curve for a wide range of oils. As a single property of the oil to consider, solid fat curves describe the way a solid turns into a liquid based on temperature. Consider lipstick or chocolate, which are both ideal when solid at room temperature. Yet when applied to the lips or placed in the mouth, the sharp rate at which they turn to liquid due to a small increase in temperature is important when it comes to product development. Solazyme's low-cost control over this property can increase functionality for products in a way that may not have made economic sense before.

It is through these value-adding advantages that Solazyme's technology continues to open doors for future partnerships. Over the last two years, the company's platform has begun to be more understood by larger companies. Yet it's still very early in the game. I sat down with Senior Vice President of Emerging Business, Walter Rakitsky. When asking how aware he thought corporations are right now of Solazyme's capabilities, Rakitsky had the following to say:

"I think it just depends on the industry. We're a small company and we have limited resources, but we have big aspirations obviously. I would say there's a process that goes on at every major customer and partner that we approach. (There is) the process of the lights going on, the process of them seeing that this is real, (and) that we can hand them oil that is not imaginary. I would say that we're still at the beginning stages of this process (of being understood)."

It appears that one of the concepts that must be repeatedly impressed upon these potential customers is the differentiating value, which is possible through the platform. Prior to a more in-depth relationship, it seems as if some companies appear more intrigued in replacing their existing supply lines rather than pursuing the ideal oil characteristics that they actually want. Rakitsky added the following thought:

"A lot of people ask me: 'Can you make a palm oil? Can you make a soy oil? Can you make a palm kernel oil?" And the answer is 'Yes, we can do all that'. But why would we? (To do so would be missing) our unique differential value in terms of creating compositions that have enhanced performance. All in all, what we do is look at the properties of the oils and fats and try to figure out how we can, through our technology, either make these specialty oils and fat more available, improve their performance, or create performance that is not achievable with plant-derived oils."

Herein lies a part of the business that has thus far been overlooked by investors. To date, much of Solazyme's progress has been made at increasing target compounds within an oil rather than pursuing improvements to characteristic performance. A look at my article found here shows how the company has significantly increased the amount of C8-C10 within one of its latest oil profiles. But apart from merely easing the supply restraints of existing markets, Solazyme's creative front has yet to be truly explored. Rakitsky added the following thought:

"On the one hand, what we're trying to do is augment an oil - increase the amount of the valuable component. That's part of the story. The other part of the story is how do you change the oil composition to affect the properties that are really valuable to an end user."

Solazyme is starting to get customers that understand the company can create products that begin to fall into the category of specialty materials. Part of this process is about changing the mentality away from "what is this oil made up of?" to "what is it that this oil can do?" In doing so, this will likely to become the future direction when we look at Solazyme's tailored oils.

It is in this realm where properties such as oxidative stability, hydrolytic stability, thermolytic stability, viscosity, cloud points, plug points, solid fat curve and etc. begin to take greater meaning in the overall functionality of the product. Over time, Solazyme expects to be comparing these attributes to what is currently being used in the market place. In a separate conversation with Wolfson, the CEO had the following to say in regards to the ongoing science at Solazyme:

"You have a range of physical properties and one of the interesting things we're finding now is that we're making oils that don't exist in nature. We're seeing properties that you don't see in any existing triglyceride. Sometimes we don't know what that means, (and store it away for future research). But sometimes (the thought is) if it does 'that', then the thesis is: 'If it is used in this kind of application, then it should outperform something used in that application today."

Market implications

As of January 20, Solazyme now trades with a market capitalization of $706 million based on the ending share price of $10.36. In early 2014, Solazyme expects to emerge from its development phase and finally begin full commercial operations as its large production facilities in Brazil and the United States come online. This is the case after nearly two years of construction and planning. With another 12 - 18 months for an expected capacity ramp-up to nameplate capacity at each facility, investors can expect the revenue to gradually increase in the coming quarters.

Over this time period, margins are anticipated to improve to the stated expectations of the company as seen in the chart above. It is important to consider that even upon reaching nameplate capacity, Solazyme's full potential remains far from tapped. As portrayed in what was written above, Solazyme has only begun to introduce products that represent the base level of their value-added creativity. For now, the company is comfortable in increasing the yields of well-known molecules within established markets.

The ability to meaningfully augment a target molecule within an oil profile carries enhanced value in itself. For example, Solazyme can already increase the amount of myristic acid in an oil profile by nearly four times the next largest source. But forward-looking investors should also be considering the added value made possible in developing materials specialized in specific physical properties. More so, investors should be considering the potential value not yet realized in the intellectual property being claimed behind the creation of these potential applications.

Concluding Thought

For investors, there appears to be a large disconnect between what's really going on at the company and what is portrayed on the market. A brief look at Solazyme's income statement seemingly shows stagnant growth for multiple years when one looks at the revenue or net loss. Yet it's important to realize that the company has yet to emerge from its development phase and enter into commercial production. Indeed, a more accurate measure of how the company has been growing ultimately comes down to a look at the technology.

In the nearly two years since my previous visit to the company HQ, Solazyme has significantly increased the number of oil profiles it is able to produce. The technology has scaled up to the 500,000-L level and management now openly conveys its confidence in the ability to produce at the large commercial scale. The number of issued US patents to Solazyme has increased from a mere 3 to the current count of 20. More so, the number of filed patent applications worldwide continues to grow as Solazyme gains ground in this uncharted territory.

With $194 million in cash and short-term investments, Solazyme continues to remain well-capitalized as it introduces its 120,000 MT of new manufacturing capacity along with partners Bunge (BG) and Archer Daniels Midland Company (ADM). While Solazyme will ultimately remain a speculative investment until it has shown it can consistently operate out of these two facilities, the company appears more than prepared for the upcoming challenge.

Disclosure: I am long BG, 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.