A Tough Road Ahead for This Big Pharma Partner

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Bio-based enzyme producer Codexis (NASDAQ: CDXS  ) reported financial results for the fourth quarter and full-year 2012 last week. How did things go? Well, the company was clearly set back after Royal Dutch Shell (NYSE: RDS-A  ) axed a partnership between the two earlier in the year. What was more surprising for investors was the pullback in pharmaceutical revenue, which is by far the company's most mature revenue stream. Is all hope lost for this once-promising sustainable chemical enabler?

Here are the dismal results:






Product sales





Total revenue





Total expenses





Net loss





Source: Codexis, all figures in millions.

It doesn't take many calculations to see that Codexis had a lousy year without Shell's deep pockets, which provided the bulk of revenue in years past. After a series of cost reduction steps by a transformed management team, Codexis had to focus its limited capital and personnel on core areas. Even that didn't help a big drop in pharmaceutical revenue, which was not spared from restructuring.

A few bright spots include ending the year with more cash than anticipated ($49 million) and several small partnerships for enzyme kits, which management believes can make up an important revenue stream in the next few years. Unfortunately for investors hoping that Codexis would turn a corner and post a profit sooner rather than later, the company's plans have encountered a serious setback.

Management is guiding for pharmaceutical revenue between $35 million and $40 million. Codexis will also focus on higher-margin enzymes, rather than pharmaceutical intermediates, to boost total gross product margin from 15% last year to between 30% and 35% this year. For instance, a recent deal with Arch Labs calls for Codexis to provide enzymes while its partner will provide the intermediates. Still, without a strategic partner on board, the company expects to burn between $12 million and $16 million for the year.

Several small royalty streams will help boost pharmaceutical sales. After receiving FDA approval for a new production process, Merck (NYSE: MRK  ) will begin biomanufacturing sitagliptin with pharmaceutical intermediates supplied by Codexis. Sitagliptin is the active pharmaceutical ingredient in the blockbuster diabetes franchise Januvia/Janumet, which had $5.75 billion in worldwide sales in 2012. The companies also work together to produce Victrelis, a potential blockbuster hepatitis C drug.

Codexis will also receive a milestone payment and recurring royalties from Exela Pharma and Hikma Pharmaceuticals, which had its argatroban injection approved by the FDA. Management admitted that while the company's products will still enable the production of generic drugs, they will increasingly focus on innovator drugs due to a focus on margins.

The company will complete its CodeXol Detergent Alcohol pilot plant in Rivalta, Italy, in the first half of the year. On the conference call, CEO John Nichols said that Codexis' strains "approximately meet" industry specifications for products. Landing a consumer products partner will depend on actual results, but the absence of a partner thus far may speak for itself.

(Tiny) rays of hope
Before we dig into this, let's start by saying that even great technology with science on its side can be restrained by poor financials and execution. Without big partnerships in place, management will have to choose research projects based solely on immediate financial returns, not the long-term viability of the project. One example: The company recently released incredible results for its proprietary carbonic anhydrase enzyme for carbon capture, but it will likely go unfunded for the foreseeable future.

Nonetheless, there are several reasons to believe that Codexis can successfully court commercialization partners for its cellulase enzymes. Here are the biggest two to consider:

1. Competitive enzymes
Nichols boasted that the latest CodeXyme cellulase enzyme could achieve 85% conversion of corn stover with just 1% loading (1 g enzyme/100 g cellulose). If those numbers are to be believed, then Codexis can certainly compete with larger customers. For instance, enzyme industry leader Novozymes -- a spinoff of Novo Nordisk (NYSE: NVO  )  -- needs 3.5% loading to achieve 85% conversion of corn stover at similar conditions for its top cellulase enzyme Ctec 3.  

2. Platform insulated from patent disputes
In a worst-case scenario, Novozymes and Genencor, owned by DuPont (NYSE: DD  ) , would certainly entertain the thought of fighting over Codexis' assets. Novozymes didn't hesitate at the opportunity to buy Iogen's industrial enzyme business earlier this year, so the idea is not as wishful as it sounds. Competition is incredibly fierce.

The two competitors are both much larger than Codexis, but both use Tricoderma fungi as the host microbe for their cellulase enzymes. Google the term "Genencor Novozymes lawsuit" and you'll see that both companies feel entitled to the strain as the base of their competing technology platforms.

At the very least Codexis is in the clear from lawsuits with its C1 technology, which utilizes Myceliophthora thermophila (previously known as Chrysosporium lucknowense) licensed from Dyadic. The fungi have repeatedly been shown to outperform their Tricoderma counterparts and were even featured in a high-profile article in Nature Biotechnology, which was co-authored by several Novozymes employees.

Foolish bottom line
It doesn't take much to see that Codexis is against the ropes for 2013 and may never recover. Therefore, it doesn't make sense to start a position in the company without serious progress on commercialization partners for its CodeXol detergent alcohols and CodeXyme cellulase enzymes. If you do, make sure you understand that you may lose your entire investment.

Can Codexis help Merck beat the patent cliff?
Merck's newly approved production process for Januvia will increase yield, reduce waste, and lower costs. Still, this titan of the pharmaceutical industry stumbled into 2013 and continues to battle patent expirations and pipeline problems. Is Merck still a solid dividend play or should investors be looking elsewhere? In a new premium research report on Merck, the Fool tackles all of the company's moving parts, its major market opportunities, and reasons to both buy and sell. To find out more -- and get a full year of free updates -- click here to claim your copy today.


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