Solazyme Earnings Show Steady Progress Against 2015 Goals

To say that the past 12 months have been tumultuous for investors in renewable-oil manufacturer Solazyme (SZYM +0.00%) would be an understatement.

This time last year shares were trading at $10.68, the company had just announced the beginning of operations at its manufacturing facility in Clinton, Iowa, and would soon announce the beginning of operations at its largest manufacturing site in Moema, Brazil. The company appeared to be accomplishing exactly what it said it would. Fast-forward to today, and the company has stumbled in ramping up manufacturing capacity to significant levels; backed away from high volume, lower-margin commodity replacement products; and pivoted its production focus toward low-volume, high-margin encapsulated oil products.

Image source: Solazyme.

Despite the volatility in expectations, share price, and near-term potential, in the first quarter of the year the company did show steady progress toward its previously stated goals for 2015. Hurdles and some heavy lifting are still required moving forward, but investors hanging on for the day the company capitalizes on its original growth potential are beginning to see the seeds of optimism.

By the numbers
Except for the Algenist skin and beauty portfolio, which continues to chug along rain or shine, Solazyme didn't necessarily perform any better than it did one year ago from a production standpoint. But it was successful in lowering combined R&D expenses and selling, general, and administrative expenses after reducing headcount in late 2014.

Source: Solazyme first-quarter 2015 press release.

That's good news for investors, especially considering current circumstances require a major reduction in operating expenses for Solazyme to maximize the value of each dollar spent. On that note, cash and cash equivalents decreased from $207 million at the end of 2014 to $173.5 million at the end of the first quarter, which was in line with company expectations. At the current cash burn, Solazyme has enough capital to fund operations for another six quarters, or through October 2016. Given the current state of operations, it seems likely that the company will need to raise additional capital before then.

The quarter may have lacked the big announcement or update that many investors wanted to see, but steady progress was made toward previously stated goals for 2015.

Unfortunately, the quarter also lacked a more detailed breakdown of production costs, which I've been critical of in the past. Without the ability to produce goods at a profit, Solazyme will struggle to grow into the monster growth stock investors are hoping for.

To recap, Solazyme only reports a portion of its production costs in the "cost of product revenue" line of the income statement. The remaining portion, which has historically accounted for what is likely over one-third of total production costs, is allocated to an R&D expense subcategory. That skews gross profit margins on production from commercial manufacturing facilities quite a bit: Counting just 75% of the subcategory would have made non-cosmetic gross margin negative 83% in 2014, whereas the company's accounting methods made it breakeven on paper.

We won't be able to conduct a full analysis of total production costs until Solazyme submits its quarterly report to the SEC, since the R&D expense subcategory isn't reported in quarterly press releases. However, thanks to Algenist's steady performance and some color from management on quarterly gross margins, we can roughly break down production costs as follows. (Remember, Encapso drilling lubricants and AlgaVia food ingredients are reported in the Intermediates & Ingredients category.)

Sources: Solazyme first quarter 2015 press release, SEC filings, author calculations.

Gross margin on Algenist sales took a slight hit during the quarter from a one-time inventory adjustment charge, sodon't expect the uptick in the portfolio's production costs to outpace its revenue. As for Encapso and AlgaVia, product revenue nearly matched the reported production costs. It's very likely that after adding the R&D expense subcategory for "production costs derived from ramp up," gross margin for these products was negative.

To be fair, we're still pretty early into Solazyme's new production focus on high-margin products. Low utilization rates of existing facilities will result in higher production costs by default. But investors will eventually need to see the ability to achieve positive gross margin for products not named Algenist. Otherwise, it may be time to rethink your position.

Additional highlights
There were several additional highlights from Solazyme's conference call. I've written about many of them recently, so a brief discussion should suffice.

• Moema updates: Redundant steam and power tie-ins should be completed by the end of the second quarter, which should allow the company to begin ramping the facility to higher levels of production in the second half of 2015. Management noted that oil production in the past 10 weeks was more than 4 times the total production from all of 2014. However, management also noted that oil extraction equipment has yet to be optimized.
• Algenist: Earlier this week, I discussed how Solazyme could more fully monetize its production of alguronic acid, the key ingredient in Algenist, by supplying it and finished formulations containing it to other personal-care brands. On the conference call, management noted that it will for the first time supply its personal-care ingredients to a customer that will have it in formulated products on store shelves this summer.
• Encapso: Management essentially reviewed the recent announcements regarding Encapso and Flocapso distribution deals with Flotek, which I also covered. Furing the Q&A session, CEO Jonathan Wolfson stated that case studies in the Bakken demonstrated "savings in excess of $100,000 per well drilled" for well operators and that a typical well may use "10 metric tons to 50 metric tons or more" of Encapso, which is proportional to my findings several months ago. Of course, he also admitted that petroleum prices and drilling activity will need to pick up before Encapso products can have the chance to reach their full potential.
• AlgaVia: It was a record quarter for AlgaVia food ingredients, although sales from the portfolio tallied less than $2.5 million, perhaps less than half of that. Nonetheless, investors are seeing the seeds of a big opportunity in food take root, with three new customers signed in the first quarter. It won't happen overnight, but AlgaVia will probably (and easily) become Solazyme's most important brand within the next few years. That vision could have received a boost from a new joint development agreement with Bunge, which will develop a next-generation food ingredient. (Perhaps it's Q'Ello?)
• Roquette settlement: After investors learned of overwhelmingly positive news regarding the legal battle with Roquette, which literally stole Solazyme's technology and deployed it after the pair's former joint venture dissolved, no updates were given. I wouldn't take that as bad news, however, since legal issues are treated very carefully. Management will disclose additional details when the lawyers give the green light.

What does it mean for investors?
All around, it was a good quarter of progress -- management and production engineers can only do so much in 13 weeks. Nothing was reported that would change the minds of Solazyme investors one way or the other. I would simply remind investors to form realistic expectations, remember which metrics (production costs) and updates (food ingredient deals) are important, and consider which updates will pack less of punch because of realities in market conditions and/or market development. As it stands today, I will continue to exercise a cautious tone about Solazyme as an investment-worthy company until I see more details or positive trends in production costs.