When Will Solazyme Be Profitable?

An algae cell in the drilling lubricant product Encapso, by Solazyme. Source: Solazyme.

In October 2014, I analyzed various scenarios that each represented potential future operations at industrial biotech Solazyme (SZYM +0.00%) by December 2016. The methods used in the analysis remain valuable, but the company significantly altered its near-term growth plans less than two weeks after the article published, rendering the conclusions essentially useless.

Therefore, it's time to revisit the analysis in light of new information and ramp-up plans and attempt to answer the question: When will Solazyme be profitable?

How do we define "profitability"?
We're going to focus on companywide profits (when total revenues exceed total expenses) rather than gross profits (when total product revenue exceeds production costs). While investors are still waiting for Solazyme to achieve positive gross margin on production at commercial scale, for this analysis we're going to assume that's already occurring. It's an obvious and necessary requirement for achieving companywide profitability. 

What are Solazyme's total expenses?
Management began slashing operating expenses late last year, which, in the most recent quarter, reached the lowest level since the three months ended September 2013. That's good news for investors.

Data source: SEC filings. Chart by author.

Of course, quarterly operating expenses aren't fixed. Even though the company is prioritizing cash conservation, operating expenses will increase as Solazyme resumes ramping up production at its manufacturing facility in Clinton, Iowa, in subsequent quarters, which will increase the contributions from cost of product and R&D expense. For the foreseeable future, profitability will be a function of ramp-up; as revenue increases, so too will operating expenses.

Therefore, investors absolutely need Solazyme to rein in production costs (enabling more profitable revenue) and achieve a level of production that covers operating expenses, preferably leaving profits to invest in growth opportunities. Unfortunately, production costs -- and the company's ability to lower them to originally expected targets -- remain one of the biggest unknowns for investors. The company hasn't been transparent about true production costs, although careful analysis of SEC filings shows gross margin on non-cosmetic Intermediate & Ingredient, or I&I, products (where all ramp-up will occur) was likely close to -100% in 2014. While we'll need to be optimistic in our profitability model below, know that production costs are a crucial limiting factor.

How much revenue is needed to reach profitable operations?
To arrive at a rough estimate that is bound by reality, we need to make several assumptions. You can adjust them as necessary, but keep in mind that these are reasonable -- and likely overly confident -- figures.

1. Solazyme's Algenist skincare line will continue to grow at 25% annually from levels reached in 2014 and register 68% gross profit margins.
2. Annual R&D revenue will remain at $25 million.
3. Annual R&D expenses will remain at $70 million.
4. Annual selling, general, and administrative expenses will remain at $80 million.
5. We'll also assume that the Solazyme Bunge Renewable Oils JV is fully consolidated (an obvious requirement), and that gross profit margin on the supply of I&I cultured ingredients is 50%, which is well above the performance demonstrated to date.

First, we must calculate Algenist revenue, which would reach $38.2 million in 2016, $47.7 million in 2017, and $59.6 million in 2018, given the assumption above. With the other numbers being fixed, this sets the bar for revenue levels needed for I&I cultured ingredients, which will determine the remaining production costs. We arrive at the following:

Source. SEC filings, author calculations. *Denotes calculated values the model focuses on, as described above.

As you can see, the bar for production levels out of Clinton and Moema needed to enable profitable operations is lowered every year, although you can forget about attaining profitability in 2016. While it's possible for Solazyme to notch $170 million in I&I revenue in 2018 (or, continuing the same analysis, just $124 million in 2020), especially if food ingredients gain traction, investors cannot be sure it can lower production costs enough to achieve a gross profit margin of 50%. Why not?

On the 2014 third-quarter conference call, management admitted it failed to reach its own cost targets in the initial ramp-up of Clinton, stating, "We will focus on running the plant for a small number of higher-value products at the right volume level to manage both cash burn and our way down the cost curve." More recently, management disclosed that ongoing delays at the flagship manufacturing facility in Moema, Brazil, are partially derived from problems efficiently extracting oils from algae cells after fermentation.

Given the new platformwide focus on high-value products -- most of which are encapsulated and don't require extraction (two of three AlgaVia food ingredients; Encapso and Flocapso drilling lubricants) -- it's fair to question whether this is a platformwide issue. Why else would Clinton be affected by extraction issues thousands of miles away at Moema?

Platformwide extraction issues could plague the economics for the foreseeable future, perhaps permanently, if real-world extraction at commercial scale doesn't prove as robust as earlier extrapolations from smaller-scale trials. Investors may feel uncomfortable with that potential reality and opt to continue to give Solazyme the benefit of the doubt. But like it or not, there are many more examples of companies that fail to reach their expected production costs than examples of those that succeed, especially when pioneering novel platforms. Unfortunately, the evidence to date supports the less comfortable scenario.

What does it mean for investors?
This is a tricky situation. While many investors are waiting for Moema to come on line and for ramp-up to resume at Clinton, neither event guarantees that Solazyme will reach companywide profitability. Worse yet, if production costs remain at uneconomical levels or permanently higher than expected, then attempting to ramp up production could result in even greater losses for longer periods of time.

Then again, successfully lowering production costs while simultaneously securing large sales agreements could make the recent challenges an afterthought in several short years. However, I think that's much more difficult to achieve than many realize. For that reason, investors should have conservative expectations for the ability of revenue growth to provide a timely path to profitability. This will take quite some time -- very likely, much longer than anyone expects.