EcoSynthetix: An Excellent Option For The Savvy Investor

| About: Ecosynthetix, Inc. (ECSNF)
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Unknown to many US investors, EcoSynthetix (OTCPK:ECSNF) is the only pure-play biomaterial producer, shipping large commercial quantities into a $6 billion paper and paperboard coatings market. Its primary competitors are petroleum-based specialty chemical producers that have a cost structure 60% higher than the EcoSynthetix EcoSphere® biolatex® polymers. EcoSynthetix has proven its products with global tier-1 customers.

By expanding annualized production from the current name plate capacity of 75 million pounds to 235 million pounds in 2012, EcoSynthetix will not only disrupt and capture market share from traditional petroleum-based producers, but it will create a dominant position that will be hard to displace with no near-term viable competitor. Already paper mills have begun switching to the more economic biolatex binders and existing users are increasing usage rates. For the savvy investor looking to generate alpha in the renewable or biomaterial space, EcoSynthetix is an excellent option.

A total of five US biofuels/biomaterial companies have successfully completed IPOs in the past 16 months. Because many of these firms are net income negative, they are trading on multiples that reflect potential sales growth. Using the 2012 Price/Sales multiple as a guide, Codexis (NASDAQ:CDXS) is trading at 1.36x, Amyris (NASDAQ:AMRS) at 2.18x, Gevo (NASDAQ:GEVO) at 3.55x, Solazyme (SZYM) at 12.66x and KiOR (NASDAQ:KIOR) at 45.67x, while ECO is at 2.24x. Removing the outliers such as CDXS and KIOR, the average price/sales multiple for this group is 6.13x.

ECO is currently trading at a discount to this peer group because it is not well known yet to US investors; however, this is bound to change as ECO executes on its business plan. ECO should be trading at a higher multiple, since it is near profitable today and well-positioned for revenue growth; whereas the other five names will not be profitable until 2013 and beyond. Based on this peer group, ECO could be trading at C$13 to C$14 per share or approximately 55% premium to current share price. Considering that its EcoSphere offering is a superior product in terms of cost and the size of the available market and is essentially unchallenged, the stock could be trading even higher.

EcoSynthetix completed the largest clean technology initial public offering on the Toronto Stock Exchange and began trading on August 4, 2011. The disruptive nature of the EcoSphere biolatex polymer is so compelling that the IPO was well oversubscribed. EcoSynthetix is a renewable chemicals company, deploying biomaterials based on technology for application in the paper and packaging industries. EcoSynthetix develops commercial bio-based products from natural feedstocks such as corn, potato, tapioca and dextrose from cornstarch.

Its flagship product is the EcoSphere biolatex polymer that can be used in a variety of industries as a direct and economical substitute for petroleum-based latex (i.e. styrene-butadiene latex). In fact, Ecosphere is a drop-in replacement for Styrene Butadiene {SB} and Styrene Acrylic {SA} latex with current equipment and processes; only minor alterations and minimal capital expenditures are normally required for the conversion.

Unlike most bio or green companies, ECO does not require government subsidies or support to make the economics work. In fact, as the company ramps up production to be a dominant supplier of latex binders, it will be one of few “green” companies that will be profitable. Its US and Netherland manufacturing facilities currently provide approximately 75 million pounds of annualized production. With the proceeds from the IPO, two new 80 million pound production lines with be installed by the end of 2011, bringing the total production capacity to approximately 235 million pounds of annualized production. Because the new process lines are duplicates of existing manufacturing lines, albeit larger, the ramp up process is expected to be efficient and painless.

Assuming ECO runs at 235 million pounds of production (slated for 2H2012), unit cost of production is estimated to be approximately $0.60/lb (using today’s corn prices) and with potential pricing of $1.20/lb (ASP of SB latex), the full year gross profit could be $141M compared to approximate gross profits of $1.4M achieved the first three months of 2011. Although CEO John van Leeuwen indicated biolatex polymers will be priced below SB and SA latex to incentivize mills to migrate to the more cost-effective option, gross profits will be significantly higher next year compared to this year.

Already in its most recent filings, its gross margin was approximately 24%. The gross margins will expand in the near future as it ramps up production and builds economies of scale. From the Long Form Prospectus filings, EcoSynthetix’s competitive advantage can be summarized as follows:

The only commercial supplier of bio-based latex – EcoSynthetix, to the best of my knowledge, is the only commercially viable supplier of bio-based latex. Its patented protected technology that expires in approximately 13 years will provide it a significant head start against potential entrants. In the paper and paperboard coating business, there are only traditional SB latex suppliers. The production of biolatex binders provide a lower carbon footprint as compared with petroleum-based latex. These products are derived from renewable resources, enabling customers to reduce the environmental impact and potentially increase customer loyalty. Although “green” co-marketing with end-customers for paper and paperboard products is not in the current strategy, this could potentially add value and help improve customer lifetime value.

Incredible upside and large global markets – The bio-based products are tailored to broadly substitute petroleum-based chemicals used in polymers market. Although not a core focus at the moment, ECO’s bio-based technology platforms can be further tailored for various markets that include applications of paints, coatings, adhesives, personal care products and many other things. As mentioned in its IPO filings, the addressable markets for emulsion and non-emulsion products combined are worth approximately $60 billion per year.

However, the principal current focus is to be the dominant supplier of binders to roughly $6 billion coated paper and paperboard market. Below is the total available market for the emulsion polymer space. Being the dominant substitute to SB latex is enough to grow the valuation of the company to enviable levels. If EcoSynthetix’s value proposition is as competitive as it asserts, it may achieve a high probability of success in areas such as paintings, adhesives and carpets.

Figure 1: Global Emulsion Polymer Market

Source: Long form prospectus

Lowest cost provider with equal or superior quality – Per the Long Form Prospectus filing and based on current corn and oil pricing, EcoSynthetix is the lowest cost provider as long as the price of oil is above $20 per barrel (taken from the price of SB Latex when oil was last at $20 per barrel (bbl) in 2002). After speaking with management, they indicated that the cost of SB Latex would be around $0.60 to $0.65/lb at oil prices at around $20/bbl. At today’s oil price of $85/bbl, the approximate cost of production for SB latex is $1.00 to $1.10/lb (estimated).

The cost competitiveness of biolatex polymers exceeds that of SB latex and customers are beginning to recognize this value and switch over. After several channel checks with customers using EcoSphere biolatex binders, the customers were satisfied with the quality of biolatex products as a suitable substitute for SB latex. Although commodity pricing is a main concern with any mass production process, performance and reliability are just as important. In an increasing oil price environment, biolatex binders will become even more compelling for paper mills.

Figure 2: EcoSphere biolatex binders versus SB Latex

Source: Long form prospectus

Feedstock agnostic - EcoSynthetix can produce its products using a variety of feedstock sources that include natural starches such as corn, potatoes, tapioca and dextrose from cornstarch. Feedstock flexibility allows to EcoSynthetix to reduce supplier risk and specific commodity price risks. Natural feedstocks can be used via the standard manufacturing process with minimal alteration to equipment and process.

The choice of feedstock will depend on pricing and regional availability. Nevertheless, the current feedstock of choice is corn, and it takes approximately three bushels of corn to produce about 100 pounds of EcoSphere biolatex binders. Below is a price chart of SB latex, oil and corn. SB latex is highly correlated to the price of oil. In a world with increasing demand for fossil fuels and decreasing resource base, I believe that higher oil prices are inevitable.

Figure 3: Price chart of SB Latex, oil and corn

Source: Long form prospectus

In contrast, the company’s biolatex products are less susceptible to fluctuation in the price of corn as compared to SB latex relative to oil prices. After conducting channel checks and speaking to several mills, increases in oil prices are one of their chief concerns when producing coated paper and paperboard products.

High customer conversion rates - The superior value proposition of EcoSphere biolatex binders is apparent due to the increasing usage rates at existing customers. When ECO started commercial operations in 2008, the EcoSphere biolatex content averaged roughly 25% substitution versus petroleum based competitors. Fast forward to current times, the substitution rate now averages near 50% and with some mills going higher to 80% or 90%.

Conversion rates should increase as more mills become comfortable with applying biolatex products into their coating processes. Given that the majority of market share is concentrated with the top 20 global players controlling close to 70% of the volume, winning a few mills within each client, can easily cascade to multiple mill wins once the process is qualified and tested.

Figure 4: Top 20 Paper and Paperboard Manufacturers

Source: Long form prospectus

At the time of the IPO road show, EcoSynthetix was operating with 11 customers and 20 mills, including 3 of the top 5 global manufacturers in the coated paper and paperboard industry. Already, 50 mill trials were completed in just the first six months of 2011. After participating in the recent earnings call, momentum is definitely picking up.

Discussions about expanding to new regions indicate that there is significant market share to win. EcoSythetix seems to have the most compelling product that sells into a binary segment, where it could be a “winner-take-all” scenario. As with SB latex, which has been so dominant for the past several decades, the revenues tend to be very sticky unless another disruptive product comes to fruition. But at this moment, EcoSphere biolatex polymers are doing all the shaking and rumbling.

Drawing from parallels in the past, nylon was astonishingly disruptive during its market inception in 1939. Analogous to the petroleum market today, during the 1930s and 1940s, silk became increasing expensive due to supply constraints. Nylon was developed to address the limited availability and high cost of certain natural fibers. In 1939, natural fibers accounted for 100% of all fibers used; and within, 5 years, manufactured fibers had captured 25% of the market. Like nylon, EcoSphere biolatex has a superior cost structure and beneficial properties. There is a high probability that history can repeat itself in the emulsion polymer market, with biolatex dominating the space.

Disclosure: My firm is long ECO.TO or ECO.CN, a Toronto-listed stock that has greater liquidity than ECSNF.PK.