Does Solazyme Have a Monster Lurking in Its Financial Statements?

Image source: Solazyme video.

In 2013 I pondered if Wall Street had doomed renewable oils manufacturer Solazyme (TVIA) by setting expectations for revenue growth too high given real-life production constraints. Most variables might have changed in the 18 months since, but investors are still at risk of being misled when it comes to performance expectations. Unfortunately, this time, false hopes might be fed by the company's own financial reporting.

Careful analysis of Solazyme's SEC filings for the first nine months of 2014 (the final quarterly report was delayed and unavailable for this writing) show total production costs were much higher than reported in the "Cost of Product Revenue" line of income statements. Similar to the careless projections announced by Wall Street in 2013, the company's production cost accounting method could have dangerous consequences for investors. 

What investors see
Let's begin by quickly framing this discussion around Solazyme's business. For the foreseeable future only three high-margin product portfolios will contribute to top-line and bottom-line growth: Algenist cosmetics, Encapso drilling lubricants, and AlgaVia food ingredients. However, the company reports the financial performance of its renewable products using just two categories.

The first category is called Solazyme Consumer Products, or SCP, and includes cosmetic and skin-care products sold in the Algenist portfolio. The second category is called Intermediates & Ingredients, or I&I, which in 2015 will be exclusively comprised of products sold in the Encapso and AlgaVia portfolios. Last year, Solazyme also manufactured low-margin products such as fuels, commodity replacements, and lubricants for textile manufacturing that were included in the I&I category. 

Knowing that, consider the following income statement lines reported by Solazyme for the first nine months of 2014.

Note: I&I stands for Intermediates & Ingredients, or all non-cosmetic products. Source: SEC filings.

For investors relying on these numbers as reported by Solazyme, it appears product revenue is growing (it is) and product gross profit margins are improving (they are). But there's a catch. 

What investors don't see
Solazyme does not account for all production costs directly in the "Cost of Product Revenue" line of its reported income statements. Instead, a portion of costs incurred during production are allocated to the "R&D expense" of its reported income statements.

The company justifies this accounting method by assuming this portion of production costs are derived from scale-up operations, the activities that occur before manufacturing facilities reach maximum output and optimized costs. In other words, these are costs that would not necessarily occur from "normal" operations at full-scale production capacity. Here's an example from the third-quarter 2014 10-Q filed with the SEC: 

The gross margin for our products sold in the fuels, chemicals and oil field services was 7% in the third quarter of 2014, which excludes certain production costs related to the scale-up of plant operations which are recorded to research and development expense. [italics added]

The accounting method isn't necessarily right or wrong, but it hides a large amount of production costs from the place investors are most likely to look. It's also pretty arbitrary. In reality, there is no reliable way to determine which costs are incurred as the result of scale-up activities and which are incurred from "normal" operations. After all, Solazyme has never achieved full-scale production yet -- how would it know what costs should be? 

Either way, investors need to consider the additional production costs currently allocated to R&D expense when determining true cost of product revenue. Solazyme reports the amount as an R&D expense subcategory each quarter under the "Operating Expenses" section of its 10-Q. Here's an example from the first-quarter 2014 10-Q filed with the SEC:

Our research and development expenses increased by $7.1 million in the first quarter of 2014 compared to the same period in 2013, due primarily to $4.9 million of costs related to development of new algal oils and scale up commercial production at the Clinton/Galva Facilities, as well as increased personnel-related and facilities-related costs of $1.8 million and $0.3 million, respectively. [italics added]

It's important to note a few things highlighted by the quotes directly above.

1. Investors can focus solely on the I&I category, since cosmetic products are not manufactured at commercial-scale facilities currently undergoing scale-up activities.
2. Commercial-scale operations began in the first quarter of 2014, which makes it easy to distinguish the increase from the previous year, in this case 2013, when there were no production costs or major scale-up activities.
3. Solazyme clearly distinguishes between development and production costs and personnel-related and facilities-related expenses, so there isn't much crossover in the reported subcategories of R&D expense.
4. It's impossible to determine exactly how much of the reported development and scale-up subcategory is incurred from ongoing R&D activities and how much is incurred from production. However, since large increases in this subcategory occur simultaneously with the beginning of commercial operations, it's fair to say a significant portion is derived from production costs. 

The importance of calculating total production costs cannot be understated. The performance of the I&I category is crucial from both a commercial production and profitability standpoint because the products can potentially be manufactured in relatively high volumes at attractive gross profit margins. If production costs are too high for Encapso and AlgaVia products, then Solazyme might only break even -- or worse -- for the foreseeable future.

The analysis
After rummaging through each quarterly report filed with the SEC, investors find the following development and production costs allocated to the R&D expense subcategory explained above.

*Investors must add subcategory totals for the third quarter of 2013 and third quarter of 2014. Source: SEC filings.

Of course, if Solazyme's true production costs are higher than reported in the "Cost of Product Revenue" line of its income statement, then product gross profit margin on the I&I portfolio is also much lower than reported. 

I'll reiterate that most, but not all, costs allocated to R&D expense for scale-up activities are production costs. Costs relating to the development of new renewable oil profiles really do belong in the R&D category. For that reason, we'll compare the profitability of the I&I portfolio as reported by Solazyme to a range of scenarios that adjust gross profit margin to account for varying percentages of the R&D expense subcategory in question.

Note: I&I stands for Intermediates & Ingredients, or all noncosmetic products. Source: SEC filings, author calculations.

Even in the best-case scenario here, Solazyme's true gross profit margin for noncosmetic product sales would be far from the 6.9% reported during the third quarter of 2014. Put another way most Solazyme shareholders would understand, production costs on a volumetric basis ($/MT) are very high. Using statements about production from the manufacturing facilities in Clinton and Galva, Iowa, made by management during quarterly conference calls during the first nine months of 2014, we can also roughly estimate I&I production costs per metric ton.

Note: I&I stands for Intermediates & Ingredients, or all noncosmetic products. Source: SEC filings, author calculations.

What does this actually mean?
Consider that the company aims to reach gross product margins of 50% on Encapso drilling lubricants and 40% on AlgaVia food ingredients. After factoring in previous market research, the table above suggests Encapso sales will be lucky to break even. And while select AlgaVia products could find success at current production costs, additional finishing expenses are incurred after production (these are food products after all). These added costs have yet to appear in Solazyme's income statements due to the simple fact that the portfolio has yet to be commercialized. 

Either way, these are the production costs required to reach the targeted 40% gross profit margin for AlgaVia products:

Source: Solazyme presentation.

Even if investors only account for 25% of the R&D expense subcategory relating to scale-up activities, only one AlgaVia product would have reached target margin in the third quarter of 2014. Keep in mind that doesn't include additional finishing costs required for food products.

In other words, Solazyme has much further to go on the road to profitable commercial operations than many investors might think.