This Synthetic Biology Stock Is Soaring, but Investors Shouldn't Overlook a Key Risk

On the surface, it appears that synthetic biology pioneer Amyris (AMRS) has finally turned a corner. Shares have gained 200% in the last year and are up more than 75% in 2018 on the heels of strong revenue growth in each of the last several quarters. The company sold its high-cost manufacturing facility to the world's leading industrial biotech powerhouse, DSM, and is now reaping the rewards of a business model built on royalty revenue from the deep-pocketed partner. Or is it?

Investors who dig a little deeper will see some worrying details in the company's SEC filings. In addition to auditors doubting the business' ability to continue operating as a going concern, the business is only reporting revenue growth because of an accounting rule change that took effect on the first day of 2018. That might seem innocuous, but the impact from how the company is applying the rule cannot be overlooked.

With the new accounting rule, Amyris has reported year-over-year revenue growth of 19% in the first half of 2018. Without it, revenue would have slipped 27% in the comparable periods. It's something investors need to pay closer attention to. 

Image source: Getty Images.

What's going on?

When investors comb through a company's financial statements, generally accepted accounting principles (GAAP) are king. Companies often report both GAAP and non-GAAP financial metrics, but the latter can be adjusted in questionable ways to juice a company's performance. So it's best to stick to numbers prepared using GAAP, which are set by the Financial Accounting Standards Board (FASB).

This year, a number of companies, from Tesla to Amyris, began applying a new standard handed down from FASB called ASC 606, which provides guidance on how and when to recognize revenue from customers. Boring, right? It very well might be, but the rule has had a big impact.

For instance, Tesla now records revenue as soon as a vehicle is marked for delivery rather than when it actually receives money from a customer. That alone led to a $664 million increase in automotive sales revenue in the first half of 2018 compared to the year-ago period, to go along with a $354 million decrease in leasing revenue in that span.

AMRS data by YCharts.

In general, the timing of revenue recognition isn't a huge issue for selling physical goods such as cars, as the money will change hands at the set price. But things are a bit different for Amyris. The synthetic biology pioneer has decided to apply ASC 606 to the recognition of royalty revenue, which is generated in a three-step process. DSM licenses technology from Amyris to manufacture a chemical called farnesene, which is sold to a company called Nenter, which uses farnesene to manufacture vitamin E. When the resulting vitamin E is sold, a portion of the profit travels back to Amyris through DSM and gets recorded as licensing and royalty revenue. 

Here's the problem: Amyris records royalty revenue at the time DSM sells farnesene to Nenter, not when Nenter sells vitamin E and records a profit. In other words, it's impossible to know the amount of royalties due at the time Amyris currently records them.

To get around that, Amyris says it assesses a complex set of variables to estimate royalty revenue due. But SEC filings show there's a huge gap between the company's estimates and the dollar amounts actually changing hands. Consider how each revenue category fared in the first half of 2018 as reported -- that is, with the new timing of recognition allowed by ASC 606, or how much Amyris estimates it will be paid -- compared to the same period last year:

Source: SEC filings.

Now consider how the business would have fared in the first half of 2018 if it recorded revenue exactly as it did in the year-ago period -- that is, without applying ASC 606, or the totals if Amyris only reported revenue that has actually been received:

Source: SEC filings.

As the tables above show, the difference between royalty and licensing revenue reported by Amyris and what it has actually received in the first six months of this year is $15.7 million. That's 86% of the total reported. That's a huge red flag.

While it's possible there's simply a lag period between vitamin E sales and when royalties can exchange hands, the numbers may not support that explanation. Amyris recorded $11.4 million in royalty and licensing revenue in the first quarter of 2018 but had only received $670,000 of that by the end of June -- a full three months later.

While Amyris might argue it has signed licensing agreements with DSM in which the deep-pocketed partner must pay a minimum of $33 million in total royalty payments between 2018 and 2020, it's important to remember that DSM only actually handed over $2.6 million in the first half of 2018. (DSM is the only licensee at the moment.) Besides, if Amyris accounts for all $33 million of that minimum this year -- which it's on pace to do -- then it may not receive any royalty revenue in 2019 or 2020.

Simply put, there's only one easy way out of the accounting mess that might be brewing for Amyris: to receive all (or most) of the royalty payments estimated to date as soon as possible.

Image source: Getty Images.

Will Amyris have to restate its revenue?

On the one hand, revenue reported using ASC 606 is GAAP (the numbers investors should have the most confidence in) and the company is following the accounting principle as written. On the other hand, there's still a significant risk that Amyris is overestimating the royalty revenue that will eventually be received. That might force the company to restate past income statements and adjust them lower while changing how it estimates and accounts for royalty revenue going forward.

Earlier this year, Amyris made a statement that it had uncovered material weaknesses in its financial reporting that might result or might have resulted in numbers being misstated. It remained unresolved as of the end of June 2018. By now, investors probably can guess that the issue centers on ASC 606 and the recognition of royalty revenue. Given all of the complexity, until this can be sorted out I strongly suggest investors stay away from Amyris stock.