Senomyx: No Pain, No Multi-Bagger Gain

| About: Senomyx, Inc. (SNMX)
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Senomyx is a food and beverage ingredients producer that has developed and recently received regulatory approval for a product that can reduce sugar usage by 35-50% in carbonated beverages.

The share price has corrected sharply due to a momentum selloff as well as headlines of the chairman selling shares – both are unjustified and have created an attractive entry.

PepsiCo, the company’s strategic partner, will likely imminently announce major plans to revamp its beverage product lineup to address its rapidly declining carbonated beverage volumes.

Projections show PepsiCo alone can contribute roughly $152 million in company gross profits, leading to almost $2-3 billion in value based on PE versus current market capitalization of $358.1 million.

Senomyx (NASDAQ:SNMX) discovers and develops innovative flavor ingredients for the food and beverage industry. One of the company's most promising products, Sweetmyx (formerly S617), can be used to effectively reduce sugar consumption in carbonated drinks while still maintaining a natural sugar taste. The company has a total of 13 flavor enhancing ingredients which have been validated through several partnerships as well as regulatory approvals. Senomyx is in an excellent position to continuously take advantage of the ever-growing global trend towards health and wellness, while saving its customers money by reducing the costs of the raw material inputs.

So why is the chairman selling?

It is always a bit alarming as a shareholder when you see headlines stating that the chairman of the company you hold is selling shares. In my opinion, this is one of the major reasons why shares of Senomyx have been under heavy selling pressure over the past two weeks. I must admit, even I was rattled after seeing the multiple SEC filings that announced Chairman Kent Snyder's repeated sell orders.

However, there is actually a simple explanation to why this is happening: the stock options have an imminent expiration date. Senomyx has used stock options as an important method of compensation to its directors and employees. These stock options have pre-determined dates by which they will expire if not exercised. So unless you had about a million dollars of extra cash lying around to fund this particular exercise without selling, it makes perfect sense why anyone would want to liquidate the position upon exercise. Below is a summary of the options that Kent Snyder was awarded, and their respective expiry dates.

Source: SEC Filings

As you can see, Mr. Snyder had 228,400 options awarded to him on 6/25/2004. This batch of options has an expiration date of June 24, 2014. According to SEC filings, after the company's Q1 2014 earnings announcement, Mr. Snyder adopted a 10B5-1 plan, which pre-determined the date of the exercise and sale of these options. In my opinion, the timing of the sales was chosen to take place around Senomyx's participation in the Needham Healthcare Conference, which took place April 9th. This makes sense from Mr. Snyder's perspective when he fixed this plan on March 14th, as in his mind the healthcare conference could have potentially provided a decent boost in market sentiment as investors would have another fresh opportunity to hear the Senomyx investment story. He probably thought this would be as ideal time as any before the rapidly approaching expiration date of 6/25/2014.

Unfortunately, markets have not been kind to high growth momentum names, with a particularly negative bias towards anything even remotely related to biotech - not good for Senomyx. The chairman's recent "headline" share sales have only added to this negativity. The positive is, this sell-off is entirely explainable and actually makes perfect sense. Most importantly, it has created a very attractive entry opportunity.

Consider the following imminent positive catalyst

If you are familiar with the Senomyx story, you will know that the company has been working with PepsiCo (NYSE:PEP) to create taste enhancers. Their latest breakthrough was receiving Generally Recognized As Safe (GRAS) approval for their fructose flavor enhancer, Sweetmyx (S617). This sweet enhancer is entirely different from traditional sugar substitutes, such as NutraSweet. Sweetmyx itself has no taste, but works as an enhancer by making sweet products taste sweeter. According to the company, this allows producers to reduce sugar in their product (fructose by 35% and sucrose by 50%) while maintaining the original sweetness with no additional flavors.

The backdrop is that PepsiCo should be more or less desperate to turn around its languishing carbonated drink business. Volumes in this business have been declining for nine years straight by around -1% per annum. Last year, in 2013, the rate of decline accelerated to -4.4%, and to an alarming -7% for diet sodas. PepsiCo has been pretty vocal about the possibilities of new and unique products to address these trends. This Thursday, PepsiCo will announce its Q1 results. Not a guarantee, but it might be reasonable to believe that PepsiCo will begin to speak more definitively about their new product pipeline to address the collapse in their diet beverage business, especially now that Sweetmyx has finally received regulatory approval. This should act as a near-term positive catalyst and sentiment boost to Senomyx shares.

Without getting bogged down with minutia and for the sake of simplifying the core investment thesis, the following are some rough estimates of Senomyx's opportunity from the PepsiCo carbonated drink business. I would expect these figures to be reached over a 3-5 year horizon.

  1. PepsiCo's global soda sales roughly equal $15 billion: approximately 75% occurs inside of home, 25% occurs outside of home (retail, commercial).
  2. Outside of home: Assume 50% of this volume will be converted from traditional sweeteners to Sweetmyx, due to its cost savings. 25% x 50% = 12.5%.
  3. Inside of home: Assume 25% conversion. 75% x 25% = 18.75%.
  4. PepsiCo's sales that use Sweetmyx: $15 billion x (12.5% + 18.75%) = $4.69 billion.
  5. Senomyx gross profits: $4.69 billion x 3.5% royalty rate from PepsiCo x 93% gross margin (they pay 7% on technology license) = $152.58 million.

As of yesterday's closing price of $8.60, Senomyx's total market capitalization stands at $358.1 million. Please keep in mind that the above opportunity addresses just one product, with just one customer. Senomyx has recently launched a direct sales campaign that addresses the food market that is many times larger than US carbonated soft drink market. For example, just recently Senomyx also announced plans to work with PepsiCo on developing a salt enhancing product.

Assuming a very conservative 20-30x PE multiple given its growth outlook, $15 million in operating costs associated with the PepsiCo relationship, and a 30% tax rate, I believe we can easily get close to $2-3 billion in potential market value without taking into consideration any of their other products. These assumptions give you a price target of roughly $45-70 per share in 3-5 years. If the market decides to get excited in the nearer term and slaps on a 50-60x PE multiple given the company may be growing earnings in the triple digits, then buckle up and enjoy the ride.

The downside risk is if PepsiCo either completely abandons its partnership with Senomyx, or it decides to be extremely conservative in its rollout of new products despite the alarming declining volume trends it faces. Gross profits could potentially stagnate in the $50-60 million range, which would lead to implicit PE valuations in the 30-40x vicinity. I could hypothetically see up to 50% downside risk in this scenario as valuations reset the lower growth expectations and adjust accordingly.

Over the very long term, Senomyx can potentially attack an incredibly large addressable market. Sugar consumption is a 170 million metric ton annual market, currently worth about $90 billion that is growing annually. Senomyx's products are able to replace 35-50% of sugar consumption while maintaining the same, untainted and natural taste. So, how much is a company with a unique technology that addresses a $35-45 billion market at 80-90% gross margins worth to you? Tough to tell, but I do not imagine the big boys in the food and beverage industry will want this type of story to fall into the "wrong" hands.

Admittedly, the stock has been volatile, as is the case with most early stage, market disrupting firms such as Senomyx. As explained above, the stock has sold off aggressively due to understandable reasons which has created a very attractive entry point. Lastly, the "binary risk" factor is now off the table as the company has already received GRAS approval for its most promising product. It is only a matter of time before PepsiCo announces aggressive plans to totally revamp its product lineup in order to steer its carbonated beverage business back on the right track.

Disclosure: I am long SNMX. 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.

Additional disclosure: This article reflects my personal opinion today, which may change tomorrow or at any other point in the future. Because this investment may not be suitable for all investors, you should contact your investment advisor to determine whether or not it is right for you. Lastly, as compelling as some of the arguments may sound, this investment is meant to be suitable only for a portion within a well-diversified portfolio.