When renewable-oils manufacturer Solazyme (NASDAQ:TVIA) announces first-quarter 2015 earnings on Wednesday, May 6, investors will be eagerly awaiting updates on its largest manufacturing facility in Moema, Brazil. It's easy to see why. At full capacity, Moema will produce 100,000 metric tons of products every year, which accounts for 84% of the company's total production capacity. There's no doubt that getting Moema back on track will be a welcome development for Solazyme investors, but it won't be the most important update investors receive.
Forget Moema: What about this?
Solazyme encountered some unlucky delays caused by intermittent power supply at the same time commodity prices were slashed by falling oil prices, which explains the efforts management has taken to reel in expenses and conserve cash. Instead of gearing up for growth in 2015, investors were left grasping with two different realities. The lack of a reliable power supply contributed to production problems at Moema, while lower margin products (i.e., commodity replacements) weren't economical to manufacture at the production facility in Clinton, Iowa.
That has forced management to exclude Moema from this year's guidance -- just one year after it contributed 22% of non-cosmetic product revenue -- and refocus existing commercial production at Clinton on low volumes of high margin products in the Encapso drilling lubricant and AlgaVia food ingredient portfolios. The new strategy will attempt to stem losses and limit cash burn until Moema can contribute more meaningfully to the top and bottom lines, demand for products grows, and, most importantly, production costs fall.
Any investor can dig into financial statements to see that gross profit margins reported by the company are much, much higher than what is actually being achieved, since some production costs are hidden in the "R&D expense" category of income statements. Management has admitted the same. As CEO Jonathan Wolfson explained during the third-quarter 2014 conference call:
To be clear, given current reference oil pricing and our early position on the manufacturing cost curve at our facilities, margins on many of our first-generation products would be negative today if we were not assigning some of these scale-up costs to R&D.
I spoke with numerous and unrelated entrepreneurs, institutional investors, and engineers from the field during a recent trip to San Francisco. Interestingly, everyone attributed Solazyme's high production costs to one culprit: downstream processing. Or, more specifically, the process of extracting oil from algal cells. I was taken aback by how readily everyone, it seemed, knew what was plaguing production.
Before you dismiss that as Silicon Valley gossip, the idea that Solazyme is having issues economically extracting oil from algal cells does line up with the company's new strategy and even with what management has already stated.
For instance, except for one high-value cooking oil, the shift in commercial production to high-margin products includes only oils that are encapsulated in algal cells at the point of sale. Encapso drilling lubricants, AlgaVia protein, and AlgaVia flour all get to skip extraction. Meanwhile, management has stated that oil extraction equipment at Moema still needs "significant further optimization." Only once that is achieved will operations in Brazil be able to jump on track.
Of course, now that Solazyme is focused on encapsulated products, extraction costs and processes don't matter much. But production costs still matter -- the metric simply demonstrates the manufacturing performance of different products. Therefore, it's important to note the distinction between updates.
- Any updates on progress at Moema in optimizing oil extraction matter for the long-term growth opportunity in high-volume, lower-value oils that made up a bulk of the previous growth potential of Solazyme.
- Any updates on production costs reported in the income statement from this quarter forward (until further notice) matter for the near-term performance of the company and are representative of production of low-volume, high-value oils.
What matters most to investors
It's important to note that Solazyme could build an enormous business around encapsulated products -- without ever solving problems hindering the oil extraction process at Moema -- but, as demonstrated with lower-value oils, production costs must be favorable. Whether or not production costs of encapsulated products are low enough remains unclear, since previous production costs included inefficient extraction processes.
That changes this quarter, and investors desperately need to see major progress. If costs don't begin trending lower, then investors would be justified in questioning the company's long-term growth potential.
Maxx Chatsko has no position in any stocks mentioned. Check out his personal portfolio, CAPS page, previous writing for The Motley Fool, and follow him on Twitter to keep up with developments in the synthetic biology field.
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