Solazyme Pivots Commercialization Strategy, But Does Amyris Do It Better?

Renewable oils manufacturer Solazyme (SZYM +0.00%) got walloped after announcing a new commercialization strategy that will result in drastically reduced production volumes from facilities in Clinton, Iowa and Moema, Brazil and less revenue in 2015 and beyond than originally expected. The company's former commercialization strategy of selling massive volumes of commodity replacements relied on optimized, low-cost production and numerous customers. That stood in contrast to the strategy settled into by fellow industrial biotech Amyris (AMRS +0.00%) at the end of 2012, which relied on producing low volumes of high value products, seeding important long-term markets, driving costs down with new microbial production strains, and adopting an efficient corporate cost structure.

Now, however, Solazyme is simply converging on the realizations of most other industrial biotech companies including Amyris, Pareto Biotechnologies (started with lean commercial strategy), REG Life Sciences, Metabolix, Deinove, Evolva, and others. While the market hasn't taken much interest in the long term value potential of Amyris' strategy, investors will want to educate themselves on the parallels, market realities, and timelines involved now that Solazyme is transitioning to a commercialization pathway nearly identical to the rest of the field. Can Solazyme make a similar strategy work for its platform and two production facilities?

By the numbers

Before we consider if the new strategy will work for Solazyme, it's worthwhile to see how the company compares to Amyris. Both had respectable showings in 3Q14, although there are major discrepancies in general expenses and operating costs.

*Excludes $3.9 million litigation settlement to Therabotanics. Source: SEC filings, Google Finance.

At first glance it may appear as if Solazyme has the advantage when it comes to product gross margin, but it's important to note that the company incorporates certain product costs related to ramp-up activities into its R&D expense. That skews margins higher, especially after considering that R&D costs have increased by about $4-$5 million per quarter since commercial production began -- most of which includes production costs.

Amyris includes all production costs, including those related to ramp-up activities, in the reported cost of product revenue. When investors combine the last quarter's cost of product revenue with R&D costs to yield a fairer overall comparison, Amyris weighs in at $23 million and Solazyme at $27.2 million -- a trend that has held for several quarters. In other words, production costs at Solazyme are likely higher than those at Amyris, but it's products sell for substantially less (discussed below).

Note: Solazyme began modest operations at commercial scale in 1Q14. Source: SEC filings.

It's not as if the former has less ongoing R&D, either. The company plans to introduce six new products in 2015 and has over 20 high value molecules on the backburner. The company has simply held R&D expenses below $14 million for six consecutive quarters -- something Solazyme has achieved only once in the last nine quarters.

Digging deeper, we find that Solazyme's product gross margin, despite being skewed higher, is trending downward as it increases production levels of intermediates and ingredients (fuels, chemicals, and foods) and lessens the overall representation of its high value cosmetic brand, Algenist. The company has yet to reach production costs that allow for steady and favorable manufacturing.

On the other hand, Amyris' product gross margin is trending upward. The company has lowered production costs well below average selling prices with new efficient yeast strains, developed markets of key higher value products enabling near-term ramp-up, and utilized a reasonable run rate at its sole facility in Brotas, Brazil.

Note: Solazyme began modest operations at commercial scale in 1Q14. Source: SEC filings.

Things really will get worse before they get better for Solazyme. Two things are keeping product gross margin above zero: (1) the financial allocation of certain production costs to R&D expenses and (2) the high margins of Algenist products. Zooming in provides some key insights:

Source: SEC filings.

Not even a 36% increase in quarterly Algenist sales from 1Q14 to 3Q14 could stem the downward trend from a lowly amount of additional, lower value products. In other words, increasing production will continue to decrease product gross margin from the Intermediates & Ingredients portfolio in the near term, which is likely already negative, and continue to weigh on overall product gross margin, since Algenist is the highest margin product.

What does this mean?

The comparison above isn't intended to paint a dismal picture of Solazyme, but rather to demonstrate 1.) the need for the commercialization pivot and 2.) that there's work left to be done to make the strategy work at all. The company does have several positives on its side, such as $250 million in cash compared to just $69 million at Amyris, although both will require additional financial assistance. Solazyme also has a fast-growing, high margin brand in Algenist, which should easily pass $30 million in sales in 2015. And when it does figure out the correct product mix and seed demand for multiple markets, the company has 120,000 MT of capacity at its disposal. Amyris needs to reel in additional funding and partners just to complete the construction of a second commercial scale facility (bringing its total annual capacity to 97,500 MT on a farnesene basis) before it can break into higher production volumes of commodity products.

Can Solazyme make the leap?

Investors should realize that things will be difficult for Solazyme moving forward in the next year -- this transition isn't a simple flip of the switch. In addition to greatly reducing its selling, general, and administrative expenses (tough to do when developing markets); the company needs to optimize the operations of its two commercial scale facilities and increase marketing and business development efforts to sell all of the high margin products it can produce.

Yet, despite the large discrepancy in total annual production capacities of the two companies (122,000 MT for Solazyme and roughly 32,500 MT for Amyris on a farnesene basis), Amyris actually has the clearer path to cash flow positive and profitable operations. In fact, the company's facility in Brotas will be producing at an annual run rate of $80 million in 2H15. That run rate represents 70% more revenue than Solazyme expects to generate from Clinton, Peoria, and toll manufacturers combined in 2015.

Amyris has made big improvements to its various yeast strains in recent years, which drives production costs lower. Source: Amyris.

What allows Amyris to capture high sales with such limited capacity? First, the company's current products have an average selling price of about $10 per liter. Assuming an average density of 0.9 kilogram per liter for Solazyme's renewable oil products, the company would need to achieve an average selling price greater than $11,000 per MT to match Amyris -- which is well out of reach of the microalgae platform.

Second, Amyris has pushed the production cost of farnesene (its main molecule for derivatives and direct applications) from $12.50 per liter in the beginning of 2013 to below $3 per liter now, or $3,600 per MT. Since Solazyme's products realize lower average selling prices, it will also need to realize lower production costs to make major gains in gross profit. Shrinking gross product margins coupled with increased production volumes demonstrate that isn't occurring at the moment.

Third, Amyris utilizes 200,000-liter fermentation tanks while Solazyme utilizes 500,000-liter tanks at Clinton and 625,000-liter tanks at Moema. When operating at full-scale and producing lower value products, bigger is better for production costs. However, the advantage isn't as meaningful when focusing on high value products. Amyris doesn't need a fully optimized process to profitably manufacture molecules with a selling price of $50 per kilogram, similar to how Solazyme can enjoy 68% gross product margins with Algenist products that are produced in 125,000-liter fermentation tanks at Peoria and toll manufacturers.

Since most of Amyris' production consists of these ultra-high value molecules, it can work on optimizing its process while improving margins over time. Unfortunately, Solazyme only has one such product in Algenist (and it's doing quite well, but it has limited growth). With higher tank volumes and lower average selling prices across the board than Amyris, Solazyme may not be in a similarly fortunate position.

A glimmer of hope for investors?

Although Solazyme is now focusing on high value, high margin products with the rest of the industrial biotech industry, the term "high value" is relative to each platform. The company cannot attain the same selling prices as Amyris or other companies focused on supplemental flavor and fragrance products, which means it needs to rely on lower production costs to realize respectable gross margin levels. That will be challenging in the near-term, but assuming the right process and technology improvements are made that allow for falling production costs, then it's possible Solazyme can find a product mix that suits its microalgae platform while it gets back on its feet. However, investors should understand that it may take a few quarters to get there.