Senomyx: Past, Present And Future

About: Senomyx, Inc. (SNMX)
by: Zen Investor

Senomyx has hired an investment bank and strategic adviser to explore "all available strategic options" up to and including a sale of the company.

The company trades well below even the most conservative sum of the parts valuation. Importantly, there is now a catalyst to unlock this value.

A recent $10 million licensing deal with Firmenich points to significant upside in the company's hidden assets.

Long-suffering Senomyx (NASDAQ:SNMX) shareholders, there is light at the end of the tunnel. After years of missteps and bad fortune, management has said it's open to selling the company. In an irony that only long-term shareholders can appreciate, the share price proceeded to fall back under $1 on this positive news. But the news is a game changer. The company has rehired the strategic adviser that brokered a recent $10 million licensing deal (also totally unappreciated by the market), and in a further sign that it is serious, hired an investment bank (Needham) to look for buyers of the company.

The share price reaction is puzzling to say the least, because even the most conservative imaginable sum of the parts results in a valuation significantly above the current share price. In fact the company's existing commercial revenue stream alone is almost certainly worth the current share price. That means you get the rest of the business for free. More on all this below.

Why does the opportunity exist? First, many long-term shareholders have given up on the name after years of disappointments. And who could blame them? Second, the company's most valuable asset is its IP/platform, which is intangible, underutilized and very difficult to value. This company does not show up on your typical value screen. And third, Senomyx is a tiny, illiquid microcap that has been kicked out of small cap indexes and is trading under $1. So it is not on the radar screen of institutional investors. This creates a big opportunity for those able to stomach the illiquidity.

I would elaborate further on the different pieces of the business and what they might be worth, but a fellow shareholder who I regularly correspond with has done a better job than I ever could, and has given me permission to share his comments in anonymous form below. I fully endorse them:

Where we WERE:

#1. The CL19 deal with Firmenich is still in place, and the company recognized $10 million of extra commercial revenue during 2017, giving it a cash runway through 2019 and into 2020. Beginning this year, Firmenich will not be sending royalty payments for use of S2227 or CL19 for a period of three years. Management has indicated that the $10 million it received can be thought of as having two parts: about two-thirds of the money was an up-front licensing fee in exchange for Firmenich owning the exclusive right to produce and use CL19 (for which it will pay a royalty beginning 2021), and about one-third of the money was pre-paid royalty obligation for 2018, 2019, and 2020. This is still very relevant, still very important. The company announced the use of a strategic advisor in July of 2017. About four months later, it was able to execute a deal involving a novel, non-core flavor ingredient that no analyst had been building into their models for commercial revenue growth, and it was able to pull ~5.5x expected annual revenue in an up-front licensing fee in exchange for exclusive rights to produce and sell. That deal propelled the stock virtually overnight to the $1.60 range, until the slow drip of negative sentiment ("what have you shown me lately") began to kick in.

#2. Management had begun to signal in January that there had been a change in goal setting with respect to siratose partner deals, that the focus had tightened up to signing "the right" deal instead of just signing deals for the sake of signing them. This was a change from its language in late-October, when it continued to push the idea that siratose non-exclusive partnership "syndicate" deals would be coming by the end of 2017. The new language was suggestive of the possibility of negotiations becoming focused on one partner that potentially had terms on the table the company found agreeable.

#3. CEO John Poyhonen indicated in January, and had indicated over the previous six months, that everything is on track for the company to announce a proof of concept yeast strain that will help it produce siratose by mid-2018. This can be safely interpreted to mean the company will be putting its pencils down and showing the progress during the late-July earnings call. He stated that one of the reasons the company is so confident is because "half the process was known" before it even started, by which he meant that a key intermediate pathway for producing the siratose molecule out of the sucrose molecule via a series of enzymatic reactions was already known, and it had been in fact producing small amounts of siratose for testing purposes through this pathway. In other words the company had already been producing siratose, as opposed to extracting it from the monk fruit plant. But the amounts are small in comparison to what it needs for commercial scale and to reach cost targets.

Extra Point #4: Poyhonen had indicated that the company was "surprised" by the accelerating opportunity for BITTER BLOCKING (foreshadowing) and Umami products.

Extra Point #5: He also alluded to "unique beneficial properties" for siratose in its manufacture that were not present in other mogrosides. I could not even venture a guess as to what he may have been referring at the time, but management has since clarified that there is a final stage in producing Rebaudioside-M (the rare, highest quality sweetener molecule from the stevia leaf) or Mogroside-V (the most common sweetener molecule in monk fruit) via enzymatic processes that is costly but key in determining purity of the product, and therefore its taste. It's found siratose is unique in that it does not require this extra step. It is one of the reasons it's so confident in a low cost structure.

Where we ARE:

#1. The company announced it engaged two strategic advisors (Needham and Conexus) to evaluate opportunities for a wide array of options that include a full sale of the company. The possibilities on the table should include more licensing and/or pre-paid royalty arrangements, similar to the CL19 deal it executed with Firmenich. It could involve outright sale of intellectual property or products. It could involve selling or spinning off business segments. It could entail a series of business sell-offs that essentially constitute a full breakup and sale of the company. Or perhaps it finds a company willing to swallow Senomyx whole. The commitment level to the idea of a breakup or full sale is best exemplified by the fact they hired Needham (who has the ability to do a fairness opinion) to spearhead the effort, in addition to Conexus (who leveraged deep ties with senior members of flavor companies in order to pull in the CL19 deal).

#2. Poyhonen announced a new business unit during the recent quarter call. It is essentially consulting work for pharma companies, utilizing their screening platform to discover the taste receptors involved in bitter taste from certain active pharmaceutical ingredients (APIs). Senomyx is charged with figuring out how to block these bitter tastes. This could mean Senomyx is able to use current bitter blocker products to counter the bitter taste (remember how Poyhonen foreshadowed that bitter blocking sales are accelerating to a surprising degree), or it could mean that a previously screened sample has unanticipated value and it will proceed with patent and GRAS filings for a new product. It could also mean a research project attempting to discover a new set of bitter blocking agents that will get the job done.

The opportunity set is dictated by a number of dynamics unique to the pharmaceutical industry. The first is that regulators are pressuring pharma companies to get their safety approved products into the pediatric market faster. Pharmas had previously been charged with figuring out pediatric applications in post-market, after the new drug application was filed and approved. The reason this was more convenient to pharmas is because pediatric medicines must be liquid form, and the taste is absolutely awful. Regulators are no longer accepting the foot-dragging method of figuring out the pediatric application in post-market. They want the pharmas to figure out the pediatric application earlier in the regulatory process.

The second dynamic is a bit two-fold in that any talk about "natural" versus "artificial" is just out of the equation altogether in a drug, and also the sheer volume of bitter blocking agent that would be used in a medicine suspension would be much higher than what would be used in a consumer product. The third and final dynamic is that these pharma companies have very deep pockets due to huge margins on their products, which is a different industry dynamic from consumer product and food spaces where margins are generally tight. This makes for an attractive opportunity set, and that is why Senomyx is branching into the space in earnest. The pharma companies would normally have the capability of doing a significant amount of this research themselves, but the problem is Senomyx has significant patent protections in place around T2R receptors in its screening platform, and that has caused pharmas to contact it, unsolicited, about doing the work.

#3. The company restated some information from previous 10-K filings, specifying how much of previous commercial revenues were the direct sales segment as opposed to royalty. Direct sales went from $640k in 2015 to $1.1 million in 2016 and $1.8 million in 2017. We know from management statements that royalty revenues have a 93% gross margin, as the partners are generally responsible for the production and sale of the substance and merely cut Senomyx a royalty check based on sales of the product. Senomyx then takes 7% of this royalty and kicks it out to the University of California as a license fee for certain research that was key in the founding of the company. The margins on the direct sales business are unknown, however the restated size of the direct business revenues in 2015, 2016, and 2017, combined with given Cost of Commercial figures, allows us to see that the margin on direct sales has been moving, but seems to be settling out at a little under 50%.

#4. Guidance for 1Q2018 revenues is down sharply due to the drop-off of Pepsi (NYSE:PEP) minimum annual royalty obligations associated with S617. I had previously expected this revenue drop-off to be first recognized in 2Q2018 rather than 1Q2018, but I had failed to account for a change in the timing of revenue recognition that the company had disclosed would occur starting January 1, 2018. This change in accounting policy meant that $1.5 million is being taken out of 1Q2018 revenue and tucked instead into opening retained earnings. The disclosure in the 10-K allows us to get our arms around how much revenue is dropping off as Pepsi is no longer responsible for minimum annual royalty payments, but it comes with a catch. You will notice that accounts receivable is at a very high level. That is because from a strict cash flow standpoint, while Pepsi has already incurred the minimum annual royalty obligation and Senomyx's new accounting policies dictate that the cash (whether paid or not) should have been recognized immediately as the obligation was incurred, Pepsi doesn't actually pay the bulk of the cash until the end of the period year.

If the $1.5 million tucked into opening retained earnings is an indication of the quarterly revenue associated with minimum annual royalty payments, then Pepsi will have to send Senomyx a sizable (upwards of $4 to $6 million) cash payment some time during the first half of 2018. Management has acknowledged this cash payment. This is a big part of the reason management believe it has the cash flows and cash balances necessary to continue operating through 2019. The down side is that when we get to 1H2019 and normally the company would be due a large cash payment from Pepsi, that will no longer be the case. The officially recognized commercial revenues, which had reached just under $12 million in 2017 (excluding the $10 million one-time payment from Firmenich for CL19), should be expected to drop by as much as $6 million throughout 2018, though the company will not feel the sting of that drop from a cash flow standpoint until 2Q2019, when Pepsi's check does not come.

#5. The company states that it remains on track for a significant proof of concept strain announcement as part of its 2Q2018 earnings release and conference call. This is not so much a binary announcement, as there will be qualitative language that must be parsed by investors in order to surmise how close management is to achieving its very low cost targets for siratose. It may state that it has more work to do in its iterative process in order to get on track for the cost targets, or it may state that it's on track to achieving the cost targets. Confidentiality agreements with potential siratose partners currently in negotiations will mean that the company is able to tell them more than it is able to tell investors, and since those negotiations are ongoing the actual announcement during 2Q earnings may not be a significant event for those in negotiations as they may already be privy to the information. Even so, the development and selection of one strain that is able to take it all the way through the enzymatic process of converting sucrose to siratose would represent a significant piece of evidence that the cost targets are achievable, with a little more work.

What has CHANGED:

#1. Clearly the change that has the market's attention right now is over siratose partner deals. The fat lady has sung on the company's promise that the first deal(s) would roll out during 2017. They weren't announced when the company did presentations at Needham Growth in January, and they weren't announced on the 10-K release and call. The market apparently believes the deals are simply not coming, or perhaps market participants remain uninterested in the stock until they do. Management has consistently failed to communicate the risk that potential partners would want to see proof of concept, or otherwise see significant evidence of the achievability of cost targets. Management has also failed to communicate realistic targets for the size of these deals. By not properly communicating the risks, it's created a sense that the missed deadline means partnerships are dead now and forever. By leaving a total blank in place of realistic expectations for the size of the deals, it's allowed microcap cowboys to run the stock up on unrealistic expectations, and to pummel the stock when reality missed the expectations. This sort of up and down activity damages the stock's credibility as a solid investment and leads to a valuation impairment.

The truth is evidence of cost achievability was always the primary impediment to signing a non-exclusive partnership deal. It will continue to be the factor that dictates the success or non-success of the syndicate formation. This is because, while siratose has clear and demonstrable taste superiority over Rebaudioside-A, there are arguments to be made that Rebaudioside-M (which is already being sold) at its highest purity levels has some edges over siratose on a few taste factors (though not a clean beat, as siratose has some edges over Reb-M in other taste factors). I am sure that Cargill/Evolva (OTC:ELVAY) would claim that EverSweet (which they claim can replace 100% of sugar content in a product) has a superior taste profile vs. siratose.

The source of value in the siratose discovery lies in the unique solubility, photostability, and hydrolytic stability properties of the family from which it comes (monk fruit as opposed to stevia), and some of the aforementioned "beneficial properties" in the molecule (higher sweet intensity; pathway that does not require final stage hydrolysis), which indicate a much lower cost target. In other words, siratose is nearly as good as other next-gen sweeteners, but a whole lot cheaper, and far more soluble/stable/workable. Siratose is VHS and Rebaudioside-M/EverSweet are Betamax. Yeah the latter may be widely held as slightly higher in quality from a pure sensory standpoint (whether that claim is valid or not), but if siratose beats the pants off them on cost and application then it'll have its place in the market, and may even "win" just like VHS won over Betamax.

But if you're trying to position yourself as the low cost producer, don't be surprised when the potential customers you're petitioning loans won't give them to you unless you show them that you can actually meet those cost targets. Even if the first siratose partners had signed up in 2017 as was promised, the amount of money involved was always going to be smaller than the market's imagination. Partnership funding was never destined to be a significant amount of money until significantly more work had been done on the development side. Management chose not to emphasize the position taken up by a dozen companies in the negotiations, choosing to be Pollyanna-ish because one manager at one company continued to tell them what they wanted to hear. This left no margin for error in terms of meeting market expectations. And when that one manager at that one company passed away, the market was forced to react as if the whole endeavor is one big lie.

#2. While siratose partner deals are the change that has drawn the market's attention, the biggest and most impactful change is management's announcement that it has hired two strategic advisors. The last time the company hired a strategic advisor and announced that strategic options were on the table (but only for a certain subset of ingredient properties), within about four or five months the advisor had laid a deal on the table that took the stock up to $1.60, a 250% gain from the price around the time it announced the strategic advisor. Conexus found the company $10 million in commercial revenues for a product nobody had even modeled. Now it's hired again, and instead of the market anticipating another potential windfall and rise in stock price, the stock is down over 20 percent. What's more, the company has announced that a full sale is on the table, which is a monumental announcement for this company. The tech/screening platform has attracted nearly $300 million of development partner funding, has screened millions and millions of samples, all of which it has data on, including a log of hundreds if not thousands of samples of interest that it can't pursue simply because it as a microcap don't have the resources.

Would these pharma companies with deep pockets pay a mint just to own the T2R receptor patents owned by Senomyx so that they can work on blocking their own APIs? How much would large food companies pay to have access to this screening technology so they can screen their own sample libraries at super high speed? How much would a company pay to see the data on hundreds of promising "hits" that Senomyx is too resource-constrained to pursue? The company has about $4 million in annual royalty cash flow that requires virtually no overhead (all you have to do is collect checks and then send 7% to the University of California) and another $2 million direct sales with about 50% gross margins that is growing at a 60-70% annual rate.

All of that is before you get into siratose, and before you get into FS22. The point is that while all of this intellectual property was housed by a resource constrained microcap whose board was entrenched and wholly inconsiderate of a sale, protected from hostile takeover by some pretty strong provisions in the company charter, the market was free to trade the stock at levels that were at a considerable discount to the asset value of the combined intellectual property and business units. That management has changed its mind, come right out and said that sometime in the next 6 months we will engage in at least one strategic option that could go all the way up to a full scale full breakup, should have made the stock go bonkers.

#3. At the end of the day, I would not be shocked if the unanticipated hero of the hour in all of this turned out to be FS22. Think of that product as the culmination of its long labor with S617, because it's being evaluated by CPG companies the same way. At one time, the stock was trading in the $10-12 range based on the idea S617 was going to become a very big deal in the CSD industry. Pepsi changed its focus to natural options and decided reducing sugar load in some of its flagship brands did not need to be a priority after all, especially if it means press releases and public knowledge of its use of Senomyx products. Pepsi is of the mind that the more you can hide about any changes in formulation or new ingredients being added, the better. It could not hide S617 use in its products due to the partnership structure and royalty arrangement. FS22 on the other hand can be used anonymously.

The point is, Pepsi's shelving of S617 doesn't mean it didn't work. It did. You don't have to take my word for it (I've tasted it in Mug Root Beer myself and was shocked), you can simply read into the double-digit year-over-year sales growth of Mug Root Beer in the Philadelphia and Denver test markets. That data is being evaluated by companies right now for FS22, because they have such similar applications. At least one major company has opined that from a sensory standpoint FS22 is the best product Senomyx has ever had.

So what is that worth? When Senomyx stock was trading in the $10+ range, apparently the market thought it worth upwards of $400 million. Pepsi paid upwards of $80 to $100 million in development funding just to come out the other side with an exclusive license to produce and use S617 in exchange for 3-4% royalties. Firmenich just paid 5 to 6 times average annual royalty expectations for CL19 as a licensing fee.

What would be a conservative estimate of average annual royalties for FS22 if a major company that has tested other Senomyx products believes that this is the best they've ever had? It looks like SR69 royalties are upwards of $2 to $4 million annually. What is 5 or 6 times that, with 3 years of pre-paid royalty tagged on, in a deal identical to CL19 but with "the best product (Senomyx) has ever had)" instead of just a minor novel cooling agent? Anywhere from $20 to $40 million in cash? And that's forgetting what Pepsi paid in development to come out with the exclusive license on S617 ($80 to $100 million). It's forgetting what the market paid for Senomyx stock when it was bullish on S617 ($400-plus million). If the company walked away from this strategic option search with just an exclusive license fee with a major flavor house for FS22, it would likely have enough size to extend its runway into periods when siratose will be producing revenue.

The company value can be thought of as consisting of:

A) A $5 million cash flow stream ($4 million at 93% gross margin; $2 million at 50% gross margin) that requires very little overhead in order to maintain, with the patent life for the bulk of it running through at least 2026. Assuming the revenues are dominated by S6973, which has 9 years of remaining patent life, and assuming that the revenues only grow at the same rate as the discount rate, this alone should be worth an approximation of the current market cap of the company.

B) Another $1 million in expected royalty revenue hooking back into the commercial stream starting 2021, with patent life remaining into at least 2032. Again assuming growth is canceled by the discount rate, we are talking $10-12 million of value in this S2227/CL19 revenue stream on the conservative side.

C) The combination of cash (+16 million), lease obligations (-18 million), accounts receivable (+7 million), accounts payable (-5 million), other current assets (+2 million), employee termination costs (unknown), any legal expenses associated with exiting the Pepsi natural partnership early (unknown), all of which we may figure to be a combined wash.

D) The technology screening platform, which could be used in order to screen new libraries for major food companies, test complex flavor solutions for flavor houses, or identify the T2R receptors activated by APIs for pharmaceutical companies, which can then work on blocking agents that target those receptors.

E) The database of years worth of screening results, including a massive pipeline of samples of interest that the company is not able to pursue because of resource constraints.

F) The FS22 opportunity, either via exclusive licensing arrangement and royalty, or outright sale. Remember this number alone could be anywhere from $20 million, a number informed by the CL19 exclusive license arrangement, into the $80 to $100 million range, which is what Pepsi paid to get an exclusive license on S617. Recall that the market valued S617 all the way up to the $400 million market cap range just a few years ago.

G) Siratose, cleverly positioned as the lowest-cost, most versatile next generation natural sweetener, deriving from a newer and trendier sweetener family (monk fruit) that is particularly well accepted in Asian markets, and possessing a unique profile that management recently pointed out has exciting potential to be used in combination with other next generation sweeteners like Reb-M.

Disclaimer: The above was originally posted by a person who has a long Senomyx position in their personal investment account, but does not mean any of the analysis to constitute a recommendation either for, or against owning the stock. This person speaks entirely for their self, and none of the above analysis should be considered an endorsement of the stock by any affiliate, employer, or anyone otherwise associated with the person. The poster in question has had conversations with Senomyx management but is not privy to any material, non-public information related to the company. They have given me permission to post the analysis and thus I have included it above.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.