Senomyx: What's Going On?

| About: Senomyx, Inc. (SNMX)
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Summary

SNMX shares have once again been sucked into a vortex of irrational panic selling.

Senomyx is currently trading below a highly conservative sum of the parts valuation - even assuming a worst case of PepsiCo ditching S617.

PepsiCo still appears likely to go national with its reformulation of Mug Root Beer, paving the way for much broader usage of S617.

Another quarter, another Senomyx (NASDAQ:SNMX) sell-off. The latest source of a collective freak out: growing worries that PepsiCo (NYSE:PEP) will not give the green light to a national rollout of an S617-infused Mug Root Beer. We are now clocking up to the one-year mark since the trial in the two test markets of Denver and Philadelphia began. And yet radio silence.

Also fueling these worries: Senomyx's new three-year deal with PEP included only natural sweeteners, leading some to conclude that Pepsi was throwing in the towel on S617. Others argued that the deal being non-exclusive somehow suggested a lack of commitment on Pepsi's part. I strongly disagree - and feel even more strongly about this after discussions with a number of other SNMX holders.

One especially sharp analyst - EB DD - sent me a long comment, which he has given me permission to post in edited form. Below is his analysis and framework (which I fully agree with), interspersed with a few thoughts of my own in parts.

The fear of Mug not going national is misguided for a ton of reasons. Here are just two:

1) Most importantly, the Mug trial by all accounts is a success. Keep in mind the test objective for PepsiCo is basically "do no harm" - given the cost advantage S617 gives them (and keeping in mind the sugar price has almost doubled in the last year), it would make sense to go ahead if sales trends in the two test markets were just in line with the national trend. The good news is Nielsen scanner data are not only showing "no harm" - they are actually showing growing market share for Mug in the root beer category, versus nationally, where the Mug share is flat.

2) PepsiCo is not only getting serious about reducing sugar, but it is increasingly talking about using "flavor technology" and "proprietary solutions" to get there (this can only mean SNMX). Check out this recent job posting talking about applying flavor technology to multibillion dollar beverage brands to reduce sugar. Or take a look at this quote from just a couple of days ago: "The science has evolved," Mehmood Khan, PepsiCo's chief scientific officer of research and development, told Reuters in this article. He gave an example of new flavor ingredients that require less sweetening, saying: "It's not just about sweeteners, it's about understanding the flavor ingredients and having proprietary knowledge and access to them."

OK, OK, you say, but maybe Pepsi has cold feet about artificial ingredients and wants to go all natural. A couple of things to keep in mind: a) If Pepsi decided not to give the green light to Mug, it would be a material event and we should have already gotten an 8-K from SNMX informing us of it. No news is good news. 2) The trial period ended on 8/29. If it was a failure and PEP decided not to go ahead, the old formulation would probably be back on the shelves by now. Instead, you can walk into a store in Philly or Denver and find cans (by looking at the date stamp on the bottom) manufactured as recently as 9/30.

There are a bunch of other reasons why PepsiCo is likely to go ahead (and move on to reformulating much larger products in the near future), but let's forget that for now. Instead, let's assume the doomsday scenario and consider what SNMX might be worth if Mug does not go national. We'll assume the decision is so absolute that the market decides the use of S617 and its follow up 618 are considered DOA. And let's do this using a sum of the parts.

Direct sales:

SNMX's direct sales business (synthetic ingredients only) has been slow to take off, but it is producing revenues, and it is actually showing signs of accelerating. Commercial revenues (ex lumpy milestone payments) are up 70% Y/Y, with 87% gross margins. This has to be worth something, right? Yes. In theory, this is small enough to be an easy tuck-in acquisition for a competitor if shareholders forced the company to go find bids (we'll assume they wouldn't be amenable to that suggestion without being forced).

As of Q2, these products are run-rating at $8 million in commercial sales gross profit and Q3 should be higher. Let's be uber conservative though and assume growth slows to 25% from 70% next year to bring in just $10 million in GP. If we apply a low-end 8x GP multiple (the bottom end of where much slower growing but larger comps like Sensient Technologies (NYSE:SXT), International Flavors and Fragrances (NYSE:IFF), Givaudan (OTCPK:GVDNY) or Symrise (OTCPK:SYIEY) trade at, you get $80 million in value for this business. Again, this is likely conservative. In reality, the business would go for much more in an auction because of faster growth, higher margins, zero commodity products and the easily digestible size.

Natural Sweetener Program:

Until recently, SNMX's natural sweetener program was just a call option (just like their salt program which we ignore here) - and basically impossible to value. That has now changed, with PEP paying at least $18 million for limited rights under the new deal. It is also handing over the keys to its own library of natural sweetener candidates (six years in development), but let's assume that's worth nothing for now. PEP is likely just the first player of a consortium SNMX is putting together to commercialize any new natural sweeteners. I am confident 15 other CPGs are in negotiations with SNMX to join the consortium, have tasted the product and are just waiting on the info package from SNMX that will give them the same visibility PEP had when it signed its deal (detailing the plan to get to commercial scale, potentially including a letter from the FDA approving the expedited regulatory route SNMX believes they can pursue, etc).

SNMX seems to think getting another $18 million from a few more guys (in total) is a no brainer. And I think most people would at least grudgingly admit the company has proven to be good at business development. But again, let's forget about any additional deals for now. Let's think about a few different ways to value this thing.

1) PEP is willing to pay $18 million for the non-exclusive beverage rights only. But beverages make up only 35% of the natural sweetener market, using Stevia as a proxy. This would argue for valuing the rights at $18 million/0.35 = $51 million.

2) Think about what PEP is paying for under the new deal: a) Early access to the new natural sweetener ahead of regulatory approval to begin formulation work, plus the right to exclude a certain competitor (Coca-Cola (NYSE:KO)) from using it two years after approval; b) Right to buy below market. A thought experiment: how much more would PEP have been willing to pay if SNMX offered it the ability to shut KO out permanently, not just for two years? 1.5x? Maybe 2x? And then consider how much more it might be worth to PepsiCo to gain permanent exclusivity - i.e. shutting out not just KO but all its competitors for perpetuity from using the new sweetener. Plug in your own numbers. But let's be conservative and say $50 million. (Note this is just Pepsi, and only represents the "pay to play" part of the rights; does not include future royalty potential which is obviously very large).

3) Assume PEP attracts other players to the consortium for an additional $18 million, giving us $36 million. And it offers these CPGs not only a lifetime exclusive in their categories, but also the fact they would never need to pay SNMX a dime in the future for the product. Might they be willing to collectively pay $14 million more for this right, versus now where all their $36 million has bought them is the right to pay SNMX more in the future for delivery of actual product? Again, we reach a very conservative $50 million.

And again, this is just floor value today. If the new sweetener works, this product alone is worth many, many, many times this.

Here's another way to look at it. Let's look at the best comp there could be, Evolva Holding (OTCPK:ELVAF) (OTC:ELVAY). The market is pricing Evolva's "next generation" Stevia product at $200 million (when looking at its EV remember it only has the rights to 45% of it) and sellside guys are in print recently valuing it at >$500 million.

Keep in mind SNMX's product is (supposedly) better tasting, (definitely) more soluble and stable, up to 2x as potent, and should be cheaper to manufacture than Stevia. (Listen to the recent Gateway investor conference for details). And don't just take SNMX's word for it that what it has is better than what Evolva has. Think about what PEP paid it vs. what Cargill paid Evolva (nothing upfront, no ongoing royalty, the potential for $7.5 million in milestones while also buying $5 million of Evolva stock at market, and this was for permanent exclusivity of the product in every category forever).

And while I normally think comp analysis is seriously flawed, here I think it's at least interesting for 3 reasons. 1) If they could, I bet Evolva and Cargill would bid on this product in auction, especially because despite the $200 million valuation the street is putting on their product, they haven't been able to actually produce it yet cost effectively (over a year late to market with no clarity on when it will actually launch). 2) I think it shows people might be underestimating what the market is willing to pay for the natural halo (look at PureCircle as well). 3) I'm not arguing SNMX's product is worth more or even as much, but 75% less, despite the better characteristics which the PEP deal seems to validate as true.

Other:

And there's more. Don't forget SNMX is working on a new and improved/next generation S617 which should have regulatory approval late next year (call it 618). I think 617 and 618 still have value even if Mug doesn't go national. PEP will still be using 617 in Manzanita Sol, these products still save CPGs money, they still cut calories, there are still new nutritional labels coming in the US that will make sodas look like death, and sugar is still being vilified/taxed more every day, everywhere. There are three new sugar taxes on the ballot in California alone next month.

And importantly, I don't think there are better alternatives: Stevia has been a failure in soda, is expensive and impacts taste. Artificial sweeteners have both taste and labeling issues. In other words, I think someone would buy these products from SNMX because some CPG will use them even if Mug is a no go.

But how much are they worth? PEP paid SNMX $1.5 million in a commercial milestone when it launched, is on the hook for future milestones, and in any case is going to have to pay something to keep using S617 in ManSol. Wouldn't it pay at least $5 million to keep 617 and maybe use it again but never have to tell SNMX/have it be announced to the public where it is using? Just as schmuck insurance?

And then in that case, isn't 618 worth at least the same amount? Forget it's supposedly easier to use, doesn't KO need to have an option just in case PEP does use 617 and it needs to play defense? Or might it even want to decide for itself if it would use? So that's $10 million pretty conservatively for these two combined, $5 million for 617 and $5 million for 618.

And keep in mind, there might be Mug-specific reasons as to why the decision was no that don't apply to other products or to other geographies with different labeling laws. There could even be positive reasons (the test did so well in stealth mode the company now wants to try advertising the sugar reduction in the same product to see if actually gets a bigger lift versus just "no harm," and wants to do this comparison of different methods in the same product).

For this exercise, I'm assuming "no" means "never anywhere." As another sanity check on how low this price is, it costs up to $1.5 million just to get GRAS approval, and that's only one regulatory body.

Platform/technology:

PEP is giving SNMX its whole natural library as part of the new deal and is willing to pay SNMX for the use of a natural if it (SNMX) finds something in what was PEP's own library as well as allowing it to sell anything SNMX finds in what was PEP's library to PEP's competitors. I have to believe this is objective proof it believes SNMX has a better platform to find something. Again, who knows, but let's be conservative. Is $10 million too much to pay for the best available mousetrap to find one of the biggest Holy Grails in the world today, a new, better natural sweetener?

Cash:

I give SNMX's $20 million in cash no value, assuming it either has to pay severance if forced into an auction to sell off the pieces and shut down, or will continue to burn cash if shareholders don't force an auction.

Share count

So the question is then what's the right share count to divide this all by. I think with an extra $500k/q in synthetic gross profit (discussed in the first section above) and another $1.5 million/q from bringing other CPGs into the natural consortium (discussed in the natural section above) today's cash burn of approximately $3.2 million/q goes to $1.2 million/q. A future natural consortium deal with an upfront cash component and cash would no longer be an issue. Or consider if its synthentic direct sales business maintains 70% growth rather than slowing to 25% as we assume, and you get to break even.

Value/share

Total: $150 million/45 (almost no treasury share method option dilution at this price) = $3.33 if Mug doesn't go national.

But let's also assume this is wrong and it sells 15 million shares at whatever price and then let's not even give it value for this new cash either. $150/60= $2.50.

Take-away

I still think Mug is going national, and those odds go up every day we don't hear otherwise. But forget that, another way to look at this is if you believe the upside if it does go is $5 almost immediately, the stock at Friday's close was pricing in just a 10% chance. At $2.65, a 5% chance. At $2.50, 0 chance.

And even this crazy mismatch between what the odds truly are and what the market is pricing in are based on the worst case scenario. Conservative asset value, a stock price so low it would need to sell 33% more shares than are currently outstanding, and not giving it any credit for that cash because we think it will burn every last dime. Tweak anyone of these however you'd like and you'd see the most likely outcome is upside to the stock, potentially significant, even if Mug is a no.

The Pureplay option

Here's another possibility. Let's assume the company sells its current synthetic business (which is the first two parts of the SOTP analysis, the revenue generating component as well as 617 and 618). These should take in at least $90 million. It could even license out its platform to other people for use in synthetics (which would be additional consideration, but let's ignore this for now). It could then right size the business so it's only supporting natural, which should cut down on opex significantly (hard to analyze directly, but let's assume it could take its cash opex from $7 million/q to $5 million/q).

You could then have a pureplay on natural (and maybe rename the company) that has over $110 million of cash on the balance sheet ($90 million from the sales plus the $20 million it currently has), or almost $2.50 a share in cash today. So you're basically getting this first natural product as well as any future product it discovers via its platform for $10 million as of last Friday's close. More conservatively, this newco will be burning $2 million/q (if it can only double what PEP is paying it from however many other people it brings into the consortium). Let's assume a natural product is three years away from being on the market so you ding them even 4 years of cash burn at $8 million/year, or $32 million. You'd be left with a company with $1.75 in cash four years from now, the high likelihood of a natural product that is better than Stevia already on the market, at which point, if the stock were flat for four years, you'd be paying $45 million in enterprise value.

In this scenario, I think either this first product works and it is in process of developing product number two and the stock's a gigantic homerun, or it is again forced to make drastic changes. It can sell the platform which would cover severance of a shutdown (using ½ a year of opex as shutdown costs), and you have lost $1/share in order to take a shot at a multi-10 bagger.

Wouldn't you take those odds?

Disclosure: I am/we are 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.