| 2014 | 2015 | ||||||
| Price: | 8.10 | EPS | (0.28) | (0.15) | |||
| Shares Out. (in M): | 41 | P/E | NM | NM | |||
| Market Cap (in $M): | 332 | P/FCF | NM | NM | |||
| Net Debt (in $M): | -36 | EBIT | -11 | -6 | |||
| TEV (in $M): | 296 | TEV/EBIT | NM | NM | |||
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For brevity’s sake this write-up will hit on the highlights of the story and is meant to be self-sufficient. For those that want a more robust understanding, a longer version is attached at the end that provides a lot more detail and support for all I will talk about below.
Looking at:
I can honestly say that in my sixteen years of doing this professionally, I’m not sure if I’ve ever come across a more compelling risk/return opportunity.
QUICK INTRODUCTION
The company is Senomyx (SNMX). SNMX uses patented, high throughput testing to screen up to a million molecules a year to find novel food and beverage ingredients. While SNMX has found and/or is continuing to work on finding enhancers for most of the major tastes, as well as discovering heretofore unknown natural ingredients, what I’m most excited about is their work in sweetener enhancers and view all the rest as pure upside. That being said, three of these could be as large if not larger than what I am about to layout, and I will touch on them at the end.
SNMX’s sweetener enhancers work by interacting with the taste buds responsible for generating the sweet sensation so that they register a higher level of sweetness than is actually present. This allows a food or beverage company to reduce the amount of sweetener used in a product without the consumer noticing any change in taste from the full-sugared equivalent.
Two of their sweetener compounds already have GRAS approval (which is the FDA-blessed approval process that a product like this follows), S6973 and S9632. Both of these products allow for the reduction of up to 50% of the sugar (sucrose) used in a food or drink. In addition, the company has isolated, tested and expects to shortly receive GRAS approval for a third enhancer, S617. S617 not only allows for the reduction of up to 50% of the sucrose in a given product, but also an up to 35% reduction in the amount of fructose (which is relevant in products such as the majority of sodas that use High Fructose Corn Syrup, or HFCS, instead of sugar).
Importantly, these compounds have no taste in and of themselves. In other words, adding them to a product has absolutely zero impact on taste because unlike artificial sweeteners or alternative natural sweeteners like stevia or monk fruit, SNMX modifiers don’t work by adding their own similar-but-not-the-same sweetness, but simply by amplifying the intensity of the sugar that is there by up to 2x. This is crucial to understanding this story, so I will repeat it again more directly. SNMX’s enhancers allow for the reduction of up to 50% of sucrose and 35% of fructose in a product with zero change in taste from the full sugar version simply by “tricking” the brain into thinking there is more sweetener present than there actually is.
PEPSI (PEP)
“PEP CEO Indra Nooyi commented in May 2013 that ‘stevia, unfortunately, does not work well in colas.’ However, Nooyi also noted that CSD consumers wanted lower calories with the same taste (along with being naturally-sweetened), and that therefore, PEP is focused on technologies that ‘break all of the compromises that people [don’t] want to make.’ Nooyi stated that if the current consumer attrition from CSDs is allowed to continue for ‘another three or five years, the consumer will walk away from’ CSDs. PEP is focused on reclaiming ‘lapsed users’…Although neither PEP nor SNMX has stated it publicly, there is wide speculation that the modifier PEP will utilize in its new CSDs is ‘S617,’” -Citi Research Note, 1/29/2014
Industry consensus is exactly the above: PEP, in order to stem the current decline and eventual death of sodas, will be rolling out “617-infused” product sometime in Q4. Importantly, based on previous PEP comments on this matter, we should be hearing more on this subject from PEP sometime in late February/early March. This should be an important catalyst as not only consensus becomes fact (thus removing the last of the doubters), but also as PEP gives us an indication of the extent of their plans.
This last part is important because while the majority believes this will happen, no one is doing the math as to what this could mean for SNMX, and therein lies the first opportunity. Here’s my math:
To figure out the implications for SNMX, we need to look at the TAM, the penetration, and the royalty rate. The rationale for all the below can be found in the full write-up, I’ll just give you the output here.
The TAM is Pepsi’s wholesale revenue from their full sugared soda business globally. I conservatively believe the TAM to be $20-$30 billion dollars looking out five years with a blue sky scenario of >$75 billion if the company doesn’t renew PEP’s exclusive when the contract expires in 2016 (opening up KO, DPS, and all the rest of the soda companies to using a SNMX product).
The penetration is harder to gauge because there has never been a product like this, but I estimate it at between 35-55% of the TAM. Again, the work that supports these numbers is in the longer piece, but to gut check this, consider the fact a 617-infused soda will have the exact same taste as the original with 35% less sugar and calories (the equivalent of 6 teaspoons less of sugar in a 20oz soda), won’t contain any artificial sweeteners/will be labled as “naturally sweetened,” and will be cheaper for PEP to manufacture so they’ll be incentivized to market it aggressively. Even with these things working for adoption, I’m still (conservatively, I think) assuming 45-65% of soda drinkers will opt for 50% more calories despite both versions having the same exact taste.
The royalty rate SNMX receives is approximately 3.5% today (my assumption) but is in part dependent on how much PEP saves in COGS (factual). As 617 will cost less to produce as it both travels down the learning curve but is also just made in greater volume, this should be closer to 4.25% five years from now.
Simply doing the math, using $20 billion in TAM*35% penetration*4.25% gets you $300 million in revenue. The company has a GM of 93% on license revenue, giving them $275 million in Gross Profit on the above math.
Using the blue sky (but potentially very real) TAM of even $75 billion, a 55% penetration and the same 4.25% royalty get’s you to $1.65 billion in GP.
DIRECT BUSINESS
While I think the PEP business is exciting and undervalued, it is not the reason I own the stock. The company is also rolling out a new go-to-market strategy that will dwarf all the above, and yet no one is paying any attention to it. While the catalyst here is further out then a few weeks (and probably will just be increased awareness of the opportunity versus a single defining event), this opportunity is not only many times larger than PEP, but also many times less volatile as the customer count here will be in the thousands, not just PEP. Again, all supporting detail for the below can be found in the full write-up that follows.
The current sucrose market is approximately 170-180 million MT but growing as emerging markets adopt Western diets. In five years, estimates are this will be a 200 million MT market.
The company will conservatively be able to address 60% of this 200 million MT. Each percentage point of this 120 million MT TAM the company captures is worth $250 million in revenue based on company disclosed pricing (which allows for their customers, the flavor houses, to make a 30% GM and still price at parity with the price of sugar). I estimate the GM today to be 60% and the company will be able to reduce the costs of this product 50% in 5 years, leading to an 80% GM or $200 million in GP for each one point of captured TAM, (assuming SNMX doesn’t raise prices).
While impossible to predict with any certainty what percentage of the market these products will take, when you combine:
I think a 10% number is a good number to use for this illustration. Based on each point being worth $200 million in GP, a 10% penetration leads to a $2 billion GP number for the direct business, to which we can add the $275 million from PEP.
In contrast to the PEP business where people are aware of the opportunity but not the size, as I mentioned above, people aren’t even focusing on the existence of the direct business, despite my belief it is the much better business as it is not only bigger but should be way less volatile due to 1000s of ultimate customers. In fact, while I love the PEP opportunity, you could tell me PEP was walking away tomorrow and this would still be my favorite idea purely on the direct potential alone.
OPERATING LEVERAGE
The company spent approximately $41 million in opex in 2013. Just under $30 million of this is R&D. I don’t believe there is much need to increase this R&D spend, but let’s double it for conservatism. G&A shouldn’t grow much as the company doesn’t need to add much corporate headcount. This leaves the potential increase in S&M.
There is no S&M in the license business. In the new direct business, SNMX will be selling to flavor houses, who will in turn then sell to the food and beverage companies. The flavor industry is concentrated, with the top 10 companies representing 75% of industry revenue. Let’s assume the company hires 3 people to cover each of these flavor houses, another 3 to provide the flavor houses’ salespeople technical support in big sales, and 20 regional salespeople to cover the bottom 25% of the industry. That’s 80 sales people. At an all-in cost of $250k/per salesperson, that’s $20 million. This sums to $91 million in opex. Let’s add in another $9 million to round up to $100 million.
This gets us to $2.175 billion in EBIT. Tax at 40% and use 53 million FD shares (the company currently has 41 million basic shares and 12 million options with an average strike of $6, I’m assuming for this purposes no benefit from treasury share method and any cash generated between now and five years from now goes to hold share count flat).
This gets us to $25/share EPS. Assuming the blue sky soda business case, EPS would be $40/share.
BARRIERS TO ENTRY
The company has 400 issued and several hundred more pending patents. These not only cover the identification of taste receptor sequences and function and the building of the attendant assays that allow for high throughput screening, but also any interesting product families they’ve discovered (putting up a roadblock on the Interstate while they decide which possible individual driveway that is fed from that Interstate is the best molecule to actually productize) as well as manufacturing.
Moreover, even if they run out of ways to evergreen their base patents (receptor sequences and function as well as attendant assays) and thus anyone could enter this market in fifteen years, the company has already tried and rejected many millions of compounds. Assuming another 15 years of doing this, how many different types of spaghetti will be left to be thrown against the wall especially because any interesting root has also already been patented?
OTHER THINGS WORTH HIGHLIGHTING (IN NO PARTICULAR ORDER)
Catalysts (and my expectation for timing)
End of short version, Long Version starts next below
LONG VERSION
“Excellent companies selling at a discount to their intrinsic value may also qualify as "value" investments irrespective of current P/E, Price/Book or similar ratios (e.g. the notion of value as articulated by Buffett).”
First off, I apologize in advance for the length of this write-up, but despite editing with a very sharp red pencil, I can’t think of anything else to cut that doesn’t hit muscle instead of fat.
Now, onto the story…
The above quote is from the Value Investors Club.com website, and I chose to lead with this quote because the stock I am going to write about is not cheap by any current metric. That being said, the combination of a)the size of the addressable market, b)the reasons this company should take significant share of this market and c) the operating leverage in the business model as this share capture commences argues that if I am only fractionally yet directionally right, this is indeed an incredibly cheap stock.
INTRODUCTION
The company is Senomyx (SNMX). SNMX uses patented, high throughput testing to screen almost a million molecules a year to find novel food and beverage ingredients. Compare this to traditional flavoring companies that maybe test a few hundred compounds a year. This is the equivalent of today’s biotech companies competing against Alexander Fleming. While SNMX has found and/or is continuing to work on finding enhancers for most of the major tastes (ex sour), as well as discovering heretofore unknown natural ingredients, what I’m most excited about is their work in sweetener enhancers and view all the rest as pure upside. That being said, three of these could be as large if not larger than what I am about to layout, and I will touch on them at the end.
SNMX’s sweetener enhancers work by interacting with the taste buds responsible for generating the sweet sensation so that they register a higher level of sweetness than is actually present. This allows a food or beverage company to reduce the amount of sweetener used in a product without the consumer noticing any change in taste from the full-sugared equivalent.
Two of their sweetener compounds already have GRAS approval (which is the FDA-blessed approval process that a product like this follows), S6973 and S9632. (As a quick aside, the company has another 10 products that have also received GRAS approval, but they aren’t relevant to the focus of this piece. I only bring this fact up because it is important to note that the company is actually a perfect 12 for 12 in winning approval for products submitted for the GRAS designation). Both of these products allow for the reduction of up to 50% of the sugar (sucrose) used in a food or drink, the difference between the two being that S9632, which was developed after S6973, can address a few additional beverage categories.
In addition, the company has isolated, tested and expects to shortly receive GRAS approval for a third enhancer, S617. S617 not only allows for the reduction of up to 50% of the sucrose in a given product, but also a 35% reduction in the amount of fructose.
Importantly, these compounds have no taste in and of themselves. In other words, adding them to a product has absolutely zero impact on taste because unlike artificial sweeteners or alternative natural sweeteners like stevia or monk fruit, SNMX modifiers don’t work by adding their own similar-but-not-the-same sweetness, but simply by amplifying the intensity of the sugar that is there by up to 2x. This is crucial to understanding this story, so I will repeat it again more directly. SNMX’s enhancers allow for the reduction of up to 50% of sucrose and 35% of fructose in a product with zero change in taste from the full sugar version simply by “tricking” the brain into thinking there is more sweetener present than there actually is.
One other bit of background is necessary before I get into the story. The company up until now has predominantly been funded via co-funded R&D. If you look at 2013, the company probably did somewhere between $29 million to $30 million in revenue, of which $5 million should be commercial revenue and the rest co-funded R&D (SNMX will report actual 2013 results in early March).
Commercial revenue is comprised of royalty and milestone payments based on either actual commercial sales of licensed products or hitting commercial milestones, whereas co-funded R&D is revenue the company recognizes based on signed contracts with collaborators to discover new compounds. While the company has had other R&D collaborators in the past, for the foreseeable future, the company will have two, and they are both in the sweetener area: Pepsico (PEP) and Firmenich (a privately held Swiss flavor and fragrance company, second in size only to Givaudan (GIVN.VX)).
Now obviously to pay SNMX for playing around in a lab, PEP and Firmenich must get something in return, and historically what they’ve received is the option to have permanent exclusivity (through patent expiration) of any sweetener compound developed on their dime. They split these rights between them as follows: PEP has the rights for non-alcoholic beverages whereas Firmenich has the rights for food and alcoholic beverages.
Notice this is an option. A partner that chooses to exercise this option is then obligated to pay additional money in milestone payments as well as license revenue on future sales, and thus sometimes a collaborator may decide to not exercise this right, causing these rights to revert back to SNMX. In mid-2012, when SNMX announced the discovery of 617, PEP chose to give back their rights to 9632 as 617 was able to not only address all the products 9632 could, but importantly, also address fructose, which 9632 cannot (High Fructose Corn Syrup, or HFCS, is the main sweetener used in sodas, which is far and away the largest sweetened beverage category for PEP). Shortly after re-acquiring this right for the use of 9632 in non-alcoholic beverages SNMX announced they were adding a new business to the above-described funded-R&D-and-license model; in early 2013, the company announced that it would also start selling some modifiers directly to other flavor houses (i.e. Firmenich’s competitors). I will come back to this direct business in more detail later.
Crucially for the story, around this same time, SNMX also renegotiated their deal with Firmenich. The original contract was due to expire July 2014. Under the new contract the two companies agreed upon, the deal now goes through July 2016. In return for these two extra years, Firmenich a)agreed to pay SNMX more R&D dollars b)increased the royalty rate they pay SNMX on any commercial sales starting immediately and c)gave up lifetime exclusivity on future as well as current modifiers , instead accepting temporary exclusivity for some period of time post regulatory approval.
Obviously, this deal is massively in SNMX’s favor, so why would Firmenich agree to it? Now it is true that concurrent with this extension, the two companies signed another contract that names Firmenich the exclusive manufacturer (although SNMX has outs to this contract on both price and availability) for any sweetener enhancer SNMX markets directly out to 2017. Of the few people who even noticed these two deals, many dismissed SNMX’s much improved terms on the former as simply a quid pro quo for the latter.
I disagree with this view. First, it makes sense Firmenich could manufacture these compounds cheaper than anyone else because they are already manufacturing them for their own use, so all else equal it should have been Firmenich’s contract to lose. Second, as mentioned above, SNMX has outs if Firmenich isn’t producing enough or at market rates, so I don’t think Firmenich is planning to make up the unfavorable changes in the first contract by price gauging SNMX in the second contract. But most importantly, even IF this was a quid pro quo, it speaks to Firmenich’s view that SNMX’s direct business could be huge as they are giving up a lot to get the manufacturing rights for it, a belief that would place them at odds with most market participants, who either ignore or downplay the direct business.
So then why do I think Firmenich decided to re-up their contract almost a year and half before they had to, at terms that not only were very favorable to SNMX but also went into effect immediately? Because I think SNMX asked them to do so. While purely my own speculation, I can’t think of any other reason that makes sense. To me, the only explanation is SNMX went to Firmenich and told them they had a choice: Either stick with the existing contract but risk not being able to renew it when it expires, or sign this one now, and while you’re giving up a lot, at least you get a minimum of 2 more years to have some period of exclusivity on any new discovery we make. Obviously to do that, SNMX must have felt pretty confident in not needing Firmenich’s R&D payments post July 2014. Why?
In addition, if most market participants still don’t think the direct business will be big (as I claimed above), and the current funded R&D/commercial license revenue business is only generating $5 million in royalty revenue for SNMX, why has the stock tripled in the last few months? The answer to both of these questions lies in 617 and PEP.
The soda business has been in secular decline for a while. Since full calorie soda sales in the US peaked in 1998, per capita consumption has dropped by half. Now part of this has been offset by growth in diet sodas, but this market has also recently (last few quarters) begun to accelerate to the downside. The industry is shrinking.
To address this issue, PEP was supposed to announce a big strategic overhaul of their North American Beverage business, a $25billion a year business, sometime in mid 2013. In January of 2013, Indra Nooyi, PEP’s CEO, said PEP was going to push this review out until early 2014 because of a “sweetener development that we think can fundamentally change some of the elements of the core product offering in carbonated soft drinks.” At other times during 2013, she referred to this sweetener innovation as revolutionary, as being as important as the introduction of diet sodas, and as being a disruptive technology that will provide a big value-creating opportunity. And finally, she said that if the soda industry doesn’t do something new, it will disappear in the next three to five years.
So not only does PEP sound excited about this innovation, it also sounds like they have reasons to be aggressive in rolling it out. More recently, Nelson Peltz has potentially provided even more stimulus to the company’s urgency by repeatedly saying the company should be broken apart.
And while PEP has yet to officially announce what exactly this sweetener innovation is, it is a generally accepted fact it is the introduction of 617 into their full calorie soda lines. And this is why (in part) I believe SNMX is comfortable they might not need Firmenich’s R&D dollars in the not too distant future, as well as (in whole) why the stock has tripled.
I’m going to touch on quickly how big this business could be and why I still think Wall Street is underestimating it. Then I’m going to tell you why in 5 years, I think this will be a small part of SNMX’s business, and whatever additional upside that is left from the market truly grasping how big the PEP opportunity will be might pale in comparison to the upside that is left when wall street “gets” the direct business opportunity.
PEPSI
While the PEP contract can be found in SNMX’s SEC documents, the relevant part (ie the royalty rate) has been redacted. But what we do know is SNMX is paid two ways on commercialization of their products by PEP. First, SNMX gets some fixed amount per unit volume. Second, they get a percentage of the cost savings PEP realizes by using 617 to reduce the amount of HFCS used. While not explicitly ever disclosed, the general consensus is these two parts add to around 3.5% of any revenue PEP generates selling products incorporating a SNMX product (all the company has said on this issue is that this type of contract, of which PEP is the only one, has a royalty rate of “up to 4%.”)
According to industry data, PEP sells 1.5 billion cases of regular PEP and regular Mtn Dew per year in the US. According to other recent market data, a case of soda sells for $8.61, but this is retail. Assuming a just over 15% discount for both retailer and distributor margin gets you to $7.45 wholesale. This should mean that PEP makes $11.2billion/year in the US on sales of regular Pepsi and regular Mtn Dew. I assume 75% of PEP’s sales of these products are in the US to get to a global TAM of $15 billion today (which ignores smaller CSD’s also owned by PEP such as Sierra Mist and the non-US rights to 7Up as well as is most likely underestimating how big the non-US business is. On these last two, PEP’s website lists PepsiCo’s 7Up sales as “multi-billion dollars,” but since I don’t know exactly how big it is or how much of this is regular vs diet, I will exclude it from my TAM and instead offer it as exhibit A that my total TAM estimate might be too low).
There are a few reasons why I think this global TAM number could grow. First, as mentioned above, US soda consumption is down by half because people don’t like the calories of full sugared sodas or the taste of diet sodas. In addition, there’s recently also been a big backlash against artificial sweeteners. A reduced sugar, non-artificially sweetened product in theory should bring back some of these lapsed drinkers (something Indra herself claims her market research shows). As a reference point, Dr Pepper (DPS) recently introduced a line of 10 calorie sodas across their different brands. According to Nielsen data, 47% of the people who are buying these drinks are new to the soda industry, and while the “10” products are better tasting than the pure diet versions, they still use artificial sweeteners.
Second, we’re a nation (and becoming a world) of gluttons. It’s not beyond the realm of possibility to believe if you tell a soda drinker you can take out 35% of the sugar from the full calorie version at the exact same taste, mouth feel, etc he or she will drink 50% more. The current soda drinker obviously is OK with the amount of HFCS they are consuming per day. Now they get to add 50% more volume per day for that same amount of HFCS. Or like the shopper who spends more than he or she planned to spend in total because “everything was on sale,” they might increase their HFCS consumption b/c each sip contains less than it did before.
Third, Pepsi may decide to raise prices on this product. Burger King recently introduced a reduced fat fry that doesn’t taste anything like the current full fat offering. And while we’ll see what they have to say in their 4q report about how it’s selling, the early indications were extremely positive based on qualitative comments from management as well as Google search data, social media mentions, etc. And they charge 20% more for Satisfries than regular fries.
Fourth, I would expect there to be some share gain by PEP at Coke’s expense if PEP were to have a product with 35% less sugar but zero taste change. According to one industry participant I spoke with, Coke’s recent media blitz discussing why artificial sweeteners weren’t bad for you was based on their concern about Pepsi’s upcoming product launch. While there are definitely die-hard loyalists in each camp, I think the reduction of sugar could compel some people in the middle to lean towards Pepsi, and as Coke’s brands outsell Pepsi in the US almost 2:1 and are much, much larger than that outside the US (the majority of Coke’s sales are outside the US versus PEP that by my estimate gets 75% of its sales within the US, and Coke is still almost 2x larger in the US than PEP), it wouldn’t take much share gain to be meaningful to Pepsi. This is most likely to happen on the fountain soda side of the business, either by QSR’s switching to Pepsi products because of their reduced calories, or because of the fact the fountain versions of Coke and Pepsi taste more similar to each other than do the canned and bottled versions, consumer brand loyalty should matter less in this channel.
Finally, Pepsi’s contract is up in Aug 2016. While Pepsi has been a fantastic partner for SNMX, it’s possible SNMX will decide having the opportunity to sell to the whole industry, including Coke, is worth not pursuing the renewal of the PEP deal. And remember, Coke’s full sugared products sell twice as much as PEP’s in the US, and a lot more outside the US. At the very least, just looking at the recently re-struck Firmenich deal, one has to at least contemplate whether SNMX could get more favorable royalty rates in a new contract with PEP on future innovations (617 and any other enhancer developed before PEP’s current contract expires will be governed by the current contract). PEP has been a fantastic partner to SNMX. That being said, because of the enormity of an either canceled or re-struck PEP contract, one has to consider what it would mean if the economics of the current agreement were altered.
There are a few other reasons, but let’s stick with these for now. I don’t think it’s crazy to say 3-4 years from now, the TAM could be $20 billion based on only partial realization of one or two of the reasons just listed. In fact, assuming PEP’s non-US 7Up sales (to avoid confusion, DPS has the rights to 7Up in the US, so the “multi-billion” in sales PEP references on their website are 100% non-US) are $2 billion (which to me has to be the floor if they are claiming “multi-billion” and not “more than a billion”) and diet sales make up 35% of this number (about the same ratio of Diet Coke to [Coke+Diet Coke] and Diet Pepsi to [Pepsi+Diet Pepsi], although much higher than the ratios of non-cola sodas (the diet versions of Sprite, Mtn Dew and Dr Pepper are each 22% or less of their respective brand sales and probably the better comp), this would mean non-US sales of regular 7Up are $1.3 billion. My assumption for non-US sales of regular Pepsi and regular Mtn Dew is $3.8 billion, which is 3x larger than this $1.3 billion number. In the US, the ratio of Pepsi and Mtn Dew sales to 7Up is at least 9x (the market data I have only covers the top 10 brands and 7Up isn’t included, so its share must be below number 10, Diet Dr Pepper, whose sales I use to get to the 9x number). Just adding in this $1.3 billion of 7Up sales and then assuming regular Pepsi and Mtn Dew outsell this number outside the US by 6x instead of 3x gets you north of $20 billion in TAM without any impact from the other potential growth drivers.
So we have the TAM, the question now is what could the penetration be of SNMX-inside products? This is a lot harder to quantify. I originally tried to look at diet sodas versus regular soda for different brands, but I think that’s flawed logic. Diet drinkers drink diet sodas either because they prefer the taste or they want zero calories. Reducing calories by 35% with the same taste as regular isn’t really comparable. I then looked at the few reduced-but-not-zero calorie soda out there (called mid-calorie sodas), but I again think this isn’t the right comp. Outside of a few trial markets, all these mid calorie sodas reduce calories by adding artificial sweeteners. People drink regular sodas because they don’t like the taste of artificial sweeteners or don’t want to ingest artificial sweeteners. People drink diet sodas because they like the taste of artificial sweeteners or want zero calories. I’ve often wondered why these frankensodas were ever released…they seem like the worst of both worlds and appeal to no one.
So I’ve been left with purely conjecture. Given what we know (same taste, 1/3 less calories, cheaper for Pepsi to manufacture and so they’re incentivized to push it more than regular even if the decide to sell it for the same price) at first blush one might say 100%. It is hard to imagine someone deciding between two identical tasting sodas and opting for the one with 50% more calories if they’re both at the same price.
But you’ll always have some people who just don’t like change. In addition, and I’ll talk more about this when I talk about risks, SNMX’s ingredient will have to be labeled as an “artificial flavor” at the bottom of the list of ingredients on the back of the can, at least in countries like the US where all ingredients have to be labeled (to be clear, the ingredient itself, 617, won’t be listed, just the generic category 617 falls under, “artificial flavor.”)
One important distinction to make here: All of the health concerns with artificial sweeteners have to do with the how they work or in some cases the specific compound itself, not the fact they’re artificial. There are a lot of other “artificial flavors” in all sorts of different products for all sorts of different flavors outside of sugar that are labeled as such and don’t impact buying behavior outside of the still relatively small, but growing, percentage of consumers who only buy “natural” or “organic” products (who probably aren’t regularly consuming soda, full sugar or diet, to begin with). In addition, it seems like there is a new lawsuit almost every day about what constitutes natural, and so a lot of companies are pulling the “all natural” labeling from their products and finding sales are minimally impacted if at all.
Also worth keeping in mind is we’re talking about an ingredient that will have a concentration level of somewhere around 10 PPM (parts per million), or 1/1000th of 1%, or 1/10th of 1 basis point. As one person I spoke with in industry said, if you buy a can of soda from a NYC deli you’re probably ingesting more rat feces than SNMX product. In return, you are foregoing 40,000 PPM of HFCS, or the equivalent of 6 teaspoons of table sugar in a 20 oz soda.
Moreover, the reality of it is simply most consumers probably are not going to know the ingredient that is allowing for a reduction in usage of HFCS is the same ingredient on the back of the can listed in 6-point font as “artificial flavor,” so it’s unlikely they will even have a chance to be confused.
In fact, Pepsi will splash across television ads, in-store banners and the front of the can “naturally sweetened” as 617 isn’t a sweetener, but an enhancer. Alternatively, they could instead prominently point out “No Artificial Sweeteners!” because again, this isn’t. So the question is simply will the addition of the new ingredient “artificial flavor” at the bottom of the ingredient list stop some consumers (and not your average consumer, but those that drink full sugared sodas and thus probably are not health zealots to begin with) despite the much bigger and more colorful font on the front of the can saying “No Artifical Sweeteners!” or “Naturally Sweetened!” And the answer is: it probably will stop some. But how many?
First, about 20% of soda volume in the US is consumed OOH (out of home, ie movie theatres, sporting events, restaurants, etc). Given no taste difference, lower COGS for Pepsi (and thus they are incentivized to push), and no labeling issues (your Regal Cinema cup doesn’t have a list of ingredients on it), I don’t think it’s crazy to think products with 617 inside get 75% of this business, or 11.25% of the overall TAM (75% of sales is US, 20% of that is OOH, 75% of that). Second, most developing countries have less strict labeling laws than the US, and again, using SNMX lowers PEP’s COGS, so let’s assume (and this is completely a guess on my part) 20% of PEP’s non-US business has less strict labeling laws and again 617-versioned PEP gets 75% of that market, that’s another 3.75%. So now we’re up to 15% of total global sales, with 80% left. Let’s assume 25% of consumers that are currently drinking full calorie sodas are willing to switch to a reduced calorie, naturally sweetened version despite an “artificial flavor” listed on the ingredient list. That’s another 20% of TAM, bringing us up to an expected penetration of 35%. Personally, I think this penetration is way too low, but let’s use it for now.
Finally, we need to ascertain a royalty rate. Currently we know it’s around 3.5%. That being said, one of the most powerful parts of this story is that current sweeteners (both sugar and HFCS, which is based on corn) are commodities. Over time, the prices of these commodities will go up (with a lot of volatility) as the main ingredients in sugarcane and corn are labor, water, land, etc…all of which are inflationary over time. 617, on the other hand, should only go down in price over time as it travels down the learning curve as well as benefits from economies of scale. This is another point that’s important, powerful, and rare enough to stress via repetition: over time, SNMX’s solution will go down in price whereas the products it is replacing, sugar and HFCS, will increase. Very rarely in the business world does a deflationary product compete and almost perfectly substitute for an inflationary one. When it does happen, something has to go dramatically wrong for the deflationary product to not decimate the inflationary product.
Looking at a few different process intensive product groups in such industries as synthetic chemicals or industrial manufacturing (including artificial sweeteners), depending on volume, it’s very likely the cost of producing 617 in 4 years will be half what it is now if not lower. Even assuming the cost of HFCS stays flat, if we assume 200 bp of the current 3.5% royalty is from volume and the other 150 bp is from cost savings, this halving of 617 price should increase the overall royalty rate to 4.25%.
Now it’s just math. On what I consider to be conservative assumptions on all three inputs (but laying out my logic so you can make your own assumptions), 35% of $20 billion is $7 billion, of which SNMX would receive 4.25% in license revenue, or $297.5 million. SNMX currently pays a 7% royalty for in-licensed technologies they themselves use, so gross profit just from PEP would be $275 million. I will address overall opex later, but for now, in just analyzing PEP’s contribution, it is important to note there will be no variable opex associated with these license sales.
The company has 41 million basic shares and another 12 million options with a strike of around $6, but let’s for conservatism just use a FD sharecount without reducing the option pool via the treasury share method. Using a 40% tax rate, the above PEP business alone produces $3/share of EPS.
And just playing around a bit with these numbers, let’s assume instead of 25%, SNMX-infused sodas get 50% of that 80% of consumers left so total penetration is 55%, the TAM is $30 billion (which it would be if they captured 25% of the lapsed drinker, the 617 PEP drinker kept his or her HFCS consumption unchanged by drinking more soda, and PEP captured low teens percentage of overall Coke drinkers), and SNMX renegotiates the PEP deal in 2016 to get another 100bp. That’s $9/share of EPS. Or let’s assume they simply don’t re-sign with PEP so as to capture the whole CSD market so the TAM is closer to $75 billion, the penetration remains at that 55% number (although as the rest of the industry skews a lot more to emerging markets than PEP, where the combination of cost reduction and no labeling rules probably makes this penetration even more conservative) and the royalty rate is back to the original 4.25%. This gets you an EPS of $19.
And perhaps one last point, the company is constantly working to find a “better” 617. I won’t walk through it here, but imagine how the above numbers would change if 618 or 619 reduced 50% or 65% of HFCS, both from a TAM, a penetration and lastly a royalty rate perspective based simply on additional cost savings.
In sum, the PEP win argues the stock is much too cheap today, assuming all sorts of conservative inputs. Now let’s get to the really exciting part of the story.
DIRECT SALES
The reason I highlighted the Firmenich contract renegotiation earlier was not just because it shows the power tiny SNMX has with industry giants, the implication that the number two player must believe not only is the product real but also is about to take off, or the fact I believe it shows us SNMX also thinks the PEP business could be huge. To me, the single most important part, by far, of the new contract is that Firmenich is giving up permanent exclusivity for current and newly developed compounds despite paying for their discovery because it DRAMATICALLY INCREASES THE TAM (AND HENCE THE VALUE) OF SNMX’S DIRECT BUSINESS.
Before I get into that, there is one key issue that each of you has to either take my word for or spend the time to examine yourself, because all the rest of this analysis hinges on this lynchpin: the product works as advertised in the categories the company says it does.
I originally started looking at SNMX because in January of last year the then-CEO (now Chairman) exercised early and held 300,000 options, which represented 97% of the options he held that were in the money and 96% of the total options outstanding in the company that were in the money (most of the options at that time, as one can imagine pulling up the multi-year stock chart, were under water). Early exercise and hold can be considered more bullish than insider buying for three reasons: 1) one can do with inside information 2) there are real tax implications under AMT that are magnified if you live in a high state tax jurisdiction like CA and 3)the only reason to do it is a)you think your stock price will be higher at expiry than when you exercise or b) you want the shot clock for LT tax treatment to start early (for what it’s worth, I asked him at the time if he did it for this reason and he said he didn’t plan on selling a single share anytime soon at anywhere near those levels).
With my curiosity piqued due to this large and unusual insider transaction, I dug into the story and identified 8 other reasons I thought the sweetener innovation PEP had recently begun discussing was indeed SNMX, and so I built a position that was more or less a spec on whether or not SNMX would “get” PEP.
In late spring/early summer the company then disclosed that it would gain the rights to sell its first “recaptured” sweetener enhancer under the new Firmenich agreement shortly after a new sweetener enhancer received regulatory approval. Up until this disclosure, while we knew they’d eventually get the rights to all the enhancers, we didn’t know the timing. Post this disclosure, since I believe the next sweetener enhancer (617) is targeted to receive approval in February, we then had a good idea as to when they’d actually be able to get access to one…sometime in mid 2014, or “shortly” after Feb 2014.
Firmenich has the rights to two sweetener enhancers, 6973 and 9632, so it had to be one of these two (we now know it’s 6973). “So what?” you may ask, “didn’t you write earlier that 9632 can actually address slightly more end markets and that SNMX already had PEP’s right to 9632?”
The answer to both of these is yes. But currently, SNMX only has PEP’s right to 9632, and remember PEP only has the rights in non-alcoholic beverages. FIrmenich’s rights include all food and alcoholic beverages, which is a much bigger TAM. How much bigger?
SNMX has said that their rights (ie PEP’s rights, ie non-alcoholic beverages) to 9632 (which they have named SR96) allows them to address a 3.8million Metric Ton (MT) market. The global sugar market is currently anywhere from 170-180 million MT and growing around 4million MT year. Spending some time analyzing USDA sugar end market data and making extremely conservative assumptions (again, beyond the scope of this already unwieldy write-up), I think SNMX will be able to address 60% of this market. So assuming 4-5 years from now the sugar market is 200 million MT, SNMX will be able to address 120 million MT with Firmenich’s rights to 6973. This is 30x larger than what they currently have with Pepsi’s rights to 9632.
I’ll get to what all this means for the numbers in a minute, but going back 7 paragraphs, just realizing the fact that no one was doing this math and realizing the direct business could be huge, I figured this may no longer be just a “spec” on PEP but a true, extremely off-the-radar, massively asymmetric opportunity, and I had to really figure out if this was for real.
Up until this point I had done the taste test SNMX offers and also took some level of comfort from the Firmenich contract renewal as well as my view that SNMX had won PEP which led me to believe the odds were high these enhancers worked as advertised, but offsetting these data points was the fact that Firmenich had had the rights for 6973 at least for a few years and still wasn’t selling that much. Either the stuff didn’t really work but PEP was desperate and Firmenich renewed early just in case the next product worked, or the stuff really did work but for some reason Firmenich just hadn’t seen the results yet. If I were going to make this a true long term investment, I had to attempt to definitively answer this question for myself.
My conclusion: the compounds are as good as advertised and I have a plausible thesis why the sales to date going through Firmenich have been underwhelming.
In order to determine if these compounds work, I spoke to close to 30 industry participants, calling on the expert networks as well as personal contacts and branching out from both of these. Sure, an untrained taster like myself (or the 100s who have done the trials at sell side conferences) can tell having trace amounts of either 6973 or 9632 increases the sweetness of a product, but can it really reduce the usage of sugar 50%? Is there really no change in taste from the full-sugar version to a trained taster? Does it work in a lot of categories or only very specific categories? Can you heat it? Can it be used in different pH levels? What’s the shelf life of a product that has SNMX products in it? Does it work as well in foods as liquids? What products can’t you use it in? Does it work in products that have live and active cultures? Can you freeze it? Is there some other important point I hadn’t considered besides all these? The list of questions I had for the people generous enough to speak with me was long.
Of the 12 people I spoke with out of the 30 that had first hand, in the lab experience with either 6973 or 9632, they all without hesitation said this works as advertised and personally hadn’t found any limitations to its use. Some of the people I spoke with, when I asked where it would NOT work, suggested areas I might want to track down. For example, I spoke with someone who uses it in yogurt in Indonesia who questioned whether it would work when heated, but then I spoke with someone who tested it in cereals who said heating has no impact whatsoever. I spoke with someone who tested it for powdered beverages who questioned if you could use it in chocolate because sugar is such a large component of the product, but then spoke with someone who has tested it in a chocolate candy that said it works just fine. At the end of all my DD, I was left feeling confident it works as advertised and couldn’t find a single product category included in my TAM that couldn’t be addressed by one of SNMX’s enhancers.
This is the fulcrum of my thesis. I feel extremely confident it should work in almost any product without impacting taste at all, and I have yet to find any other limitation to use (i.e shelf life, etc.). So then why do I only assume 60% of the overall sucrose market? Two of the biggest end markets I eliminated were sugar sold through distributors as well as sugar sold to hotels and restaurants. I’m not including distributors because they sell mostly to smaller companies and I’m not including hotel and restaurants because I assume they use as table top sugar to be added to drinks by their patrons. But that being said, there’s no reason why mom and pops would not use SNMX products and in fact even some relatively large food and beverage companies go through distributors (think of the tech analogy, GS buys directly from Dell, but CDW still has many 1000+-employee firms as customers). And there’s also no reason why you couldn’t have a table top version of this, there is for all the artificial sweeteners. But let’s stick with the 60% of global sucrose market assumption for now.
So who’s to say my subset analysis of 12 testers is accurate and repeatable? Again, I encourage you to do your own DD on this issue. Part of the reason I’m posting this here is to have others try to poke holes in my thesis, so all feedback is welcomed. But one can also take comfort from the fact that not only will PEP be using the product in sodas, but at the Barclays back to school conference they said that whatever the sweetener innovation is (which we now know is SNMX), they will be using it on the food side of their business as well; that Firmenich re-signed the contract at very favorable terms to SNMX which one has to think they’d only do if the product worked and we were near the tipping point of adoption; and that the enhancers are currently being used in a variety of products because while small, Firmenich’s contribution to SNMX’s top line isn’t zero.
So then why have Firmenich’s sales to date been slow? First, I spoke to a few people who are aware of companies who have very recently formulated a product using SNMX but are waiting to see PEP’s results and consumer acceptance, so I think one of the reasons has been companies have to decided to wait to see how PEP’s imminent launch goes. Second, Firmenich is only 13% of the overall flavoring business, so 87% of the market hasn’t had access to this product.
Third, 6973 received GRAS approval at the end of 2009. After receiving, Firmenich had to first experiment to find the best way to combine this ingredient into an overall sweet base (the enhancers replace sugar at a 1:4000 molecule rate on average. As sugar plays other roles besides just sweet, ie provides mouthfeel and bulk, you can’t just sell the product neat, you need to mix with other ingredients). Now while artificial sweeteners are a few 100x sweeter than sugar, so a lot of this work has been done and the building blocks have been identified, Firmenich still had to fine tune the knobs to perfect Sucrogem, which is the product name they use for their SNMX-infused sweet base. Due to the fact this was both a more dramatic volume reduction as well as because the nirvana of zero taste impact was attainable with Sucrogem (whereas with artificial sweeteners, because you are starting with an altered taste, the other dimensions matter less) this took time.
Then they had to actually sell to the food and beverage companies themselves, which required an inquiry to Firmenich coinciding with a new product launch or a product reformulation to even begin the process. Then Firmenich’s customers themselves had to test in their labs to see that it worked as promised. Then they had to test in finished product form (one of the longest lead time items in this phase I heard about from a few customers was customers ran actual, not technologically shortened, shelf life tests. On products such as these, that could take up to nine months).
Then the end customer had to test market, first in focus groups, then maybe in chocolate chip cookies in Thailand. Then they had to analyze these results, and then try in both another geography as well as another related product group (oatmeal raisin cookies). Suffice to say, this was always going to take time to get adopted.
Fourth, up until recently, Firmenich had nothing but time. They had permanent exclusivity of these products through patent expiry, or approximately 20 years. They were incented to sell to the biggest food and beverage companies first, who are much slower and more risk averse, because while the process of going after the giants first might take more time up front, once you get in the door the brands and geo’s start selling to other groups and divisions within the company at no cost to Firmenich, as well as Firmenich’s pitches to the mid-tier companies would become easier if they could point to adoption by the big guys who everyone knows test extensively.
Finally, from what I understand, Firmenich has a typical, private family company mentality. They are conservative and deliberate, and I can understand why when you don’t have outside shareholders you take less risks (see the 100’s of articles credibly blaming the 2008 financial crisis on the fact the IB’s had all relatively recently become public companies versus partnerships). While I have nothing to support this besides logic, I can see why salespeople from a conservative organization who were calling on their biggest clients might not pound the table on an unknown, seemingly too-good-to-be true ingredient.
So I think I understand why Firmenich has been slow to seed the market. The other and much more important side of the coin is why will SNMX not be as slow? A lot of it is actually just fortuitous timing. The products FINALLY have a first mover in PEP. Firmenich has already done a lot of the ground work in terms of composition and testing. Food and beverage companies, at least the ones that do business with Firmenich, have now already heard of this product.
Some of it is simply math. Firmenich is 13% of the market, the other 87% will now be able to get their hands on this product.
But a lot of it has to do with a change in industry dynamics based on the urgency at which this product will be pitched.
Supplying the “sweet” base of a given food and beverage business is a lot like winning a semiconductor socket in an electronic product. The food or beverage company decides to either launch a new product or reformulate an existing product, then reaches out to two or three flavor houses to submit their solution for the sweet base. Once that flavor house wins, they keep the socket for the life of the product. For reasons such as consistency of taste, reliability of production, etc, this is NOT a commodity business once it is won. So unlike getting a socket in say the iPhone, where that socket is secured for 9 months and may even be dual sourced, winning a sweet socket may be good for years and is normally single-sourced because there are no industry standards like there are in tech.
When it was just Firmenich, they would be the only one pitching a reduced calorie version using SNMX products, and while even if they were willing to stick their neck out to be innovators, the food or beverage company might be unwilling to even trial something so new and different that only one company was pitching.
With all the major flavor houses now selling SNMX-based sweetener, the game of prisoner’s dilemma does a 180. If everyone has access to this technology, and with the concern over global obesity and the evils of sugar, can you risk NOT pitching a SNMX-infused based if the others in the RFP are? And remember, because of the longevity of a socket win, if you lose you are out for years. Up until now, there truly has not been something as innovative as this. Stevia has taste and cost issues. Artifical sweeteners have (at least the perception of) cancer issues as well as taste issues. Based on nothing but market forces theory, how do the smaller companies not lead with this innovation to gain a never-had socket, because if they lose, it’s just status quo. If they win, they can reshape industry market share one customer at a time. Knowing this, how do the big companies not lead with this product, especially as they begin to lose a few sockets to the smaller guys. Or maybe they’re more forward thinking and see this risk so they just lead with it. Simply by going from pull to push, I think the velocity here is likely to go vertical.
The limitation to the above math is how often will the above occur? Even if we assume everyone pitches a SNMX-infused sweet base, how much of the business will be put out for RFP annually?
Taking a step back, and again just applying logic, I think the amount of business put out to RFP will also markedly increase because the flywheel that I believe will be generated at the flavor house level should also occur at the end product level. Sugar is everyday getting more vilified, so the need for sugar reduction solutions are already front of mind. Labeling laws in the US are set to change so that in a few years, you can’t say a bag of chips is 93 servings and thus has only 3 calories/serving. PEP itself will be a catalyst, not only as the world watches the sodas being rolled out, but as a PEP food product incorporates a SNMX product, forcing their competitors in each industry to react. In other words, the more products that incorporate SNMX, the more other products there’ll be up for RFP.
To sum all of the above, the products work and I personally couldn’t find a product they wouldn’t work in. The only question is adoption risk and timing. As for adoption risk, I think both macro trends against sugar and the introduction of competition to Firmenich argue it’s a matter of when not if. Which leaves us to timing, and I can’t answer that definitively so instead will say a) a lot of the heavy lifting has been done b) we have a first mover in PEP and c)let’s just look out five years.
As I said above, once SNMX gets co-exclusivity with Firmenich for Firmenich’s rights to 6973 (which SNMX will then name SR69), SNMX products will be able to address 120 million MT of sucrose.
The company has told us that for SR96, each 1% penetration of TAM is over $8million in revenue to SNMX. We know that TAM is 3.8 million MT, or 3.8 billion KG. We also know that SR96 can reduce half the amount of sugar used in a product, so assuming getting 100% penetration would be $800 million in SNMX revenue, we know the company is selling SR96 for 42c/kg on a sugar equivalent basis ($800 million/1.9 billion MT). Remember a molecule of SR96 replaces on average 4000 molecules of sucrose, so the actual selling price of SR96 should be around $1,650/kg, but you only need to use 1/4000th the amount vs sugar.
So how does this 42c/kg sugar equivalent price compare to the actual cost of sugar? It depends on the market and the hour (sugar is a volatile commodity in terms of pricing). Sugar is more expensive in the US because of the incredible protection the US sugar industry receives. Using the ratio of raw sugar, US prices today are 35% higher than global prices. The global price of refined sugar FOB in the global market is currently 44c/kg. The US price for refined sugar isn’t quoted, but should in theory be 35% higher. This would give you a price, FOB, for US refined sugar of 59c/kg. The actual price to the manufacturer would be higher, as again, this pricing is quoted FOB.
As a reference point, the global price of refined sugar was 50c/kg in October and 60c/kg in middle of 2012. It got as high as 90c/kg in 2011. And while the US price vs global price spread has also fluctuated, at every point the US refined price would be above these global prices.
Let’s use the current, multi-year low of >60c/kg for industrial prices of sugar (ie, not FOB). SR96 (and assuming they charge the same for SR96 as they do SR69, any SNMX directly sold sweet enhancer) is priced at 42c/kg. On top of this, we’d have to add some margin for the flavor houses. Let’s assume they get their current average GM of 30% on this product (although depending on how fast the downstream flywheel starts spinning, it’s hard to say how low this might go, taking end price lower along with it). This means for the end customer, pricing is exactly the same today with sugar down almost 50% in 30 months.
Now, sugar has also been lower, ie the global prices was 30c in 2008 and 20c in 2003 vs today’s 44c, and it is always possible sugar pricing will continue to go lower. That being said, the current move lower has been caused by overproduction due to an overestimation of the size of another use of sugarcane, ethanol production, and the dynamics of the sugarcane growing business that only allows for gradual, not instantaneous, balancing of supply and demand. Longer term, besides just exhibiting normal inflation as every other commodity does due to general overall inflation, as well as food specific commodity inflation caused by improved GDP/capita in emerging markets and the resultant change in diets, there are very specific sugar inflationary causes that are beyond the scope of this piece but are caused in part by such likely-to-continue trends as Brazilian inflation and alternative energy adoption.
To be fair, depending on the application, there could be other costs to use SNMX ingredients besides the ingredients themselves. In cereal for example, sugar can be 30-50% of the volume of a product. Reducing this amount by 4000x requires the use of bulking agents to retain actual mass, which is why it’s impossible to generalize about cost savings except to say that in certain categories (most beverages as water already acts as a bulking agent, powdered food or beverages, low sugar products, etc) there is most definitely cost savings. In others, even assuming flavor house pricing is at parity to spot sugar, using SNMX products could add a bit to overall COGS, although the cereal manufacturer I spoke with, representing one of the products that would require the most amount of other ingredients, said his increase in COGS was less than 10% but didn’t know exactly how much more (he is on the R&D side, not the brand management side) because his company deems 10% to be the level of no longer being “non-material,” and all he knows is the increase in COGS was considered “non-material.”
So the overall COGS impact ranges from improvement to higher but non-material. Now let’s discuss the benefits: Pricing power if the food or beverage company decides to charge more for a reduced sugar product, goodwill and marketing benefits if they don’t; lack of volatility for planning purposes (including just reducing the tangible cost of hedging sugar in the forward markets, forget the intangible benefits of less volatility in quarterly results); competitive advantage if your competitors don’t offer, necessity to offer if they do; addressing ever-increasing global Government mandates and taxes. The list goes on, and I think of all the arguments I’ve made so far, the most intuitive to accept is that priced at parity with sugar or even up to 10% more, with all the benefits, pricing should not be a barrier to acceptance.
So let’s assume a 30% flavor house margin is sustainable and the end customer is on average paying the same for SNMX products as they would for sucrose. This argues SNMX’s current pricing is at least sustainable, so we’ll use it in our math.
The next step is to figure out what it costs to manufacture these compounds. I’ve attacked this issue bottom up from three different angles and have come up with a range of somewhere between $300/kg to $900/kg today (and while this is a wide range, when we get to operating leverage in the model, you’ll see it actually doesn’t matter that much because the absolute OM is so high). Top down, the company on their q3 call gave GM guidance for the overall commercial business as 75% to 85% with an unknown mix between license rev at 93% and direct sales at x%, which helps us to a degree but as it’s a 3 variable equation where we only know one variable and simply have a range for the 2nd, this helps spot check my assumption but doesn’t answer it.
If I use$ 700 kg though it covers most conceivable ranges for the top down, is within the range of the bottom up analysis, and get’s us to 58% SNMX direct GM. And a)as mentioned above it really doesn’t matter much to EPS because the operating margin will be so high b)we’re all guessing at future penetration and this has more impact by a factor if not more c)whatever it is today it’s going to be lower in the future, whereas ex quarterly or annual volatility, sugar will be going higher, so SNMX will have the ability to keep price the same and take even more share, or raise pricing to increase GM even more.
So let’s use this $700 for now, although I’d argue there’s one more thing worth considering that argues this is probably too high. On my math, as I said above, SNMX is getting 58% GM. Their customers, who will be selling against each other and not contributing anywhere near the IP, are getting 30% GM. In terms of total dollars, using an ASP of 60c for the flavor house and 42c for SNMX, the GP ratio applying the respective GM’s is 1.35x. In other words, SNMX will only be taking home 57.5% of the total pool of Gross Profit dollars if my model is accurate despite owning all the IP. Thinking of the split of the profit pool between DLB vs SNE or INTC vs DELL or QCOM vs AAPL, and adjusting for relevant differences (%age of BOM, wholesale vs retail, availability of alternative suppliers, etc) I think the above is probably conservative.
So what does this all mean. 1% penetration of SNMX’s addressable market, 120 billion KG (120 million MT) is 1.2 billion KG. They can reduce up to 50% of the sugar usage, so getting 1% product share would be 600 million KG of sugar replacement. At 42c/kg, this is $250 million in revenue. At 60% gross margins today and assuming they can reduce costs by 50% in 4-5 years, so 80% GM then, that’s $200 million in GP. And remember, this is really the equivalent of 60bp of the market, because I’m conservatively assuming their TAM is only 60% of the sucrose market and I think this number is a floor, not as a best guess.
So the question is then simply what percentage of the market does a product that has benefits to both the consumer and the manufacturer while also having zero impact on taste get? Before I get to that, there is one risk I touched on above but I want to come back to now: the “artificial flavor” labeling requirement. To me, this is far and away the biggest potential gating issue to consumer adoption I can see. I’m comfortable the product works. I’m comfortable there’s demand for lower sugar products. I’m comfortable that the market is big enough and so are the margins SNMX would generate. I’m comfortable the math works from a food or beverage company’s perspective. I’m comfortable with why they are where they are currently in terms of penetration, and how just adding competition to one level of the food chain will dramatically alter the industry dynamics/create a powerful flywheel.
But if this doesn’t work, it will be simply the consumer doesn’t adopt it, and based on all the benefits, the only reason I can think of they may reject SNMX-infused products is the addition of “artificial flavor” to the ingredient table.
How big a risk is this? I think there’s a hierarchy of why this shouldn’t matter. First, repeated market studies, looking at many different inputs, have consistently found the most important issue (by far) consumers care about in food and drink is taste. Period. People pay lip service to all sorts of things, but when it comes to actual purchasing behavior, the general population cares about taste most, and if they can get other things while keeping taste, great.
Second, you’re not selling to the “kale and carrot” consumers, you’re selling to consumers that are eating sugary products that they already know are not good for them. How important is the ingredient list to these customers?
Third, a lot of products already have artificial flavors on the label, adding SNMX products to these would result in zero labeling changes (you don’t list the number of artificial flavors or their names, just whether there’s more than none).
Fourth, these products can be marketed as “naturally sweetened” or “containing no artificial flavors,” and most people get their ingredient information from the front of the package, not the back.
Finally, let’s assume I’m wrong on all these. You still have countries with different labeling laws than the US, and you have the food services industry. I haven’t spent the time figuring out what percentage of the sugar market goes to products sold to restaurants, fast food places, schools, hospitals, i.e. all the places we consume food and drink that don’t have labels, but as you’ll see when I finally get to the punchline, it doesn’t have to be that big at all to provide not only downside support but actually plenty of upside opportunity even with the stock where it is today.
Let’s take public school food contracts as an example because a few people I spoke with talked about this as being the perfect market for SNMX products. For these RFP’s, none of them have an artificial flavor ban, but almost all of them have a calorie or sugar/serving limit. They allow a certain amount (I heard a few times the quote that “we can’t eliminate all sugar because it’s not nutritious if no one eats it”), but are focused on sensible limits. SNMX ingredients should be widely use by companies bidding on these contracts.
Or think about Satisfries. 40% less fat, worse taste, 20% more expensive, and massively successful buzz (we’ll see how they sell). Imagine a MCD shake that is exactly the same taste, less expensive (if MCD decides to pass along cost savings) with 50% less sugar and importantly for this part of the paper, zero labels. In other words, even assuming each step in the above logic waterfall about why the artificial flavor label shouldn’t be overly TAM restrictive, even if there were to be a consumer revolt on this, there should still be plenty of TAM for SNMX to address.
So we know each 1% share of SNMX’s TAM of the sucrose market (which is probably an overly punitive 60% of the overall sucrose market) is worth $200 million in GP. We know the product works. We know there’s a demand for lower sugar but still great tasting products. We know using SNMX leads to either a reduction, no change, or a minor but “non-material” level increase in COGS with the potential for an increase in ASPs.
Is a 5% penetration possible in 5 years? 10%? 20%? I won’t share what I think because my guess is probably as wrong as anyone else’s. What does the company say?
One of the reasons I like this team so much is because they are so non-promotional. If anyone asks them this question and gets an answer, please let me know, because I’m 0-for-a lot in asking myself. But we do have one data point. At the Roth conference in March 2013, when discussing the size of what is now-named SR96, the current CEO (then COO) said the following (ignore the ASP’s he’s using, the company used to talk about the addressable market size including the revenue to the flavor houses, it was only on the last earnings call they disclosed the above referenced, SNMX-only, $8 million/point number):
“Moving from there, you look at the average cost of sucrose, and the assumption that we used, even though that there has been a great deal of volatility, is $0.60 per kilogram. You multiply the 4000 kilograms times the $0.60, and you get $2400. That is the basis for determining an overall market size of $1.1 billion or $11 million per single percentage point. So this, obviously, is not a sales projection for the Company or a forecast, but we thought it would be useful to give you a sense of the magnitude that this could be with even a 10% share of the market.”
The italics are mine, but I read this comment as they would find a 10% market share to be conservative. But let’s be honest, they themselves don’t really know (as they’ll readily admit), but they most definitely do at least have a more-informed, better reasoned wrong number in mind than any of us would be able to derive.
One quick side note worth considering: due to the 4000:1 reduction in volume SNMX product deliver, 10% product penetration of a 120 million MT market is only 1.5 million kg’s of SNMX product, so the production ramp to hit this target will not be an issue. In order to visualize this, I estimate that capturing 10% of their TAM would require SNMX to sell an amount of sweetener enhancer that could fit inside 23 semi trailers.
So let’s for this purpose use 10%. That’s $2 billion in annual GP. Add in the PEP base case of $275 million in GP, that’s $2.275 billion in company GP.
What will opex be? It is currently $41 million per year. Whatever PEP grows to represent, there is no additional opex needed there. Corporate G&A should increase some as the company grows, but the company doesn’t need another CEO or CFO. That leaves R&D and S&M. There shouldn’t necessarily be an increase in R&D, the company has already isolated and is testing 10’s of 1000’s of compounds per year against four of the five flavors they are targeting. As for the fifth flavor, salt, the company is already working to isolate how the salt taste buds work, so maybe having billions of GP to spend on this they could increase this budget, but I don’t think this is a problem headcount can really solve (as the old software industry saying goes, nine women working together can’t give birth to a baby in one month). Let’s say R&D expense doubles from just under $30 million to $60 million.
This leaves us with Sales and Marketing for the direct business, which is currently so small it is still incorporated in G&A in SEC filings despite the company having built out their US-focused direct salesforce. In fact, when the company announced its direct strategy, they said this could increase opex by a couple million dollars/year in 2013. But even within that number was included the initial stair-step increase of non-variable back office costs like hiring people to interface with the contract manufacturers, etc.
Going back to the fact that 75% of the flavor business is made up of 10 companies, one of which is Firmenich, the simple question is how many sales people might they ever need? Two per flavor company? Three? Could the company hire technical salespeople to accompany the flavor house salespeople on their sales calls? Let’s assume they hire 50 sales people at an all in cost of $250k/year. That’s $12.5 million, some of which is already included in 2013’s $41 million in opex. Let’s double that to $25 million. So an additional $30 million in R&D and $25 million in S&M and opex goes from $41 million to $96million. Let’s add on another $4 million to get to a round $100 million in opex.
That’s $2.175 billion in EBIT. Tax at 40%, that’s $1.3 billion in net income. As stated above the company has 53 million FD shares, not reducing the option count via the treasury share method. Let’s assume that cash generated between now and this five year forward time is used to keep this share count flat. That’s $25/share of EPS.
To just shred any last piece of credibility I have when arguing a company might be trading at 0.3x 5 year forward earnings, let’s use the upside PEP case. Remember, while almost a rounding error, that $25/share EPS assumes no co-funded R&D dollars, which means SNMX is no longer exclusive to PEP. In that case, EPS would be north of $40/share.
One quick note here on the balance sheet and cash flow characteristics of the business. The company had $36 million of cash as of the end of Q3, has said they will be profitable in 2015, has repeatedly said they don’t need to raise any money, and I conservatively model they burn another $15 million between the end of 2013 and reaching breakeven. In addition, they only have the single class of stock and options mentioned above, no other dilutive securities, and no debt. As for cash flow, the $41 million of opex includes $4 million of SBC and another $3 million of depreciation (versus annual capex of under $1 million, which should remain extremely low going forward as they are outsourcing all production of their direct sales material and thus will continue to be an asset-light business). Working capital swings are low and straight forward as the company has industry standard payment terms and actually recognizes revenue on license revenue a quarter in arrears. In other words, the balance sheet is simple and FCF>EPS.
So what is this worth? To address that, I need to touch quickly on their IP and threat of new entrants. The company has 400 issued and several hundred more pending patents. These not only cover the identification of taste receptor sequences and function and the building of the attendant assays that allow for high throughput screening, but also any interesting product families they’ve discovered (putting up a roadblock on the Interstate while they decide which possible individual driveway that is fed from that Interstate is the best molecule to actually productize) as well as manufacturing.
Moreover, even if they run out of ways to evergreen their base patents (receptor sequences and function as well as attendant assays) and thus anyone could enter this market in fifteen years, the company has already tried and rejected many millions of compounds. Assuming another 15 years of doing this, how many different types of spaghetti will be left to be thrown against the wall especially because any interesting root has also already been patented?
So what multiple might people put on this extremely high margin, high barriers to entry, fast growing and still underpenetrated massive market opportunity? I could give some example of similarly sized biotech companies or even look at the multiple SNMX itself was getting in 2005-2006 when the company had no commercial sales, overall sales were much smaller, and people didn’t realize how long it would take to get to where they are today, but I think comparable analysis is a dangerous way to value a company because it assumes your comp is perfectly valued.
Even before we get to the year the company is earning this EPS, if again I’m even directionally but only fractionally correct, what absolute valuation will people put nearer term on a company with: a massive market opportunity, government and consumer vilification of the alternatives leading to desperate potential customers, accelerating rev growth starting from 100% (commercial revenue in 2012 was $4 million. 2013 should be $5 million. 2014 has been guided to $10 million, and 2015 to $25 million, so 25% growth in 2013 to 100% today to 150% next year), structurally increasing gross margins just on the cost side before factoring in pricing power which they have already demonstrated they have, a relatively easily understood thesis/story/industry with great IP and other protection from competitive entry, near term catalysts (both fundamentally (measured in single digit weeks) as well as asymptotically increasing Wall Street curiosity), was up-until-very-recently an ignored/hated stock where things have changed and no one is awake to the concrete, easily identifiable clues out there, crazy operating leverage in part b/c once the inflection is hit a downstream flywheel is created at no expense to SNMX, and current big, sticky shareholders who aren’t playing for 20% upside leaving a relatively small actual float? Or as someone recently rhetorically asked me, what market cap would a drug company get that was past FDA testing and just ramping commercialization on a drug without true competitor targeting a $100 billion disease?
I think even if you agree with everything I’ve written up until now, it’s natural to think this doesn’t really matter because the company will just be bought before then, and I’ve given a lot of thought to this potential as well. I can give you some reasons why I believe there really aren’t any natural acquirers despite a few being seemingly obvious, but that would add another two pages to this monster and in truth, one never truly knows.
Where I do take comfort, however, is the company has some of the most restrictive poison pill language and defenses I’ve seen. Moreover, as there is an incredibly high percentage of PhD level employees with a lot of institutional knowledge, I don’t believe someone could really go hostile. So all that really matters is “what price would the company be willing to sell?” And this is where those three call options mentioned in the first paragraph of the introduction section come back into play.
Everything I’ve just written up until now is simply discussing the sweet enhancer product category. First, this has caused me to ignore until now a real, big, short term opportunity: In a few months, the company will begin selling UM80, a MSG replacement product that we should hear more about on the next conference call but attacks another vilified product (MSG) that is also large ($6.3 billion/year in MSG sales) and where using SNMX products could save the end customer money. Assuming the same 10% penetration and even today’s 60% GM, this is a potential $380 million GP opportunity that’s been relegated to two sentences (although for various reasons SNMX probably will not be able to address the full market so a reduction in TAM will have the same pro-rata reduction on GP potential ).
But more importantly for the question of “where would management sell,” let me discuss briefly the three call options. The first is natural sweeteners, where the company has recently had taste proof of concepts (ie, they’ve had positive, but not yet at the level to be marketable, hits on their assays) for both natural enhancers as well as a natural sweetener. SNMX has also mentioned we should hear more about this area this year. I think it goes without saying that natural enhancers or sweeteners would dwarf all the above I’ve written. And until this is proven out, I doubt management has any interest in selling the company.
Second, the company is working on salt enhancers. While isolating the way we taste salt has been frustratingly slow, the company is still working on this and based on the company’s history I would assume is simply a matter of when not if. Importantly for this exercise, by continuing to work on this the company must also believe they have a high likelihood of success in at least identifying the receptor sequence and developing the attendant assay. This would also be a massive market, and until the company throws in the towel, I don’t think they’d sell the company without the acquirer being willing to pay a lot of this call option.
Finally, once they’ve identified the salt receptors, parallel to working on artificial enhancers I’d assume they’d begin working on natural enhancers and replacements. This would again dwarf any artificial salt enhancer and again I believe the company would expect to be paid for this option in any acquisition.
These three call option should not only increase the multiple investors pay for the stock, but should also provide us protection on the odds of a larger company succeeding in buying the whole company.
I want to touch on one last thought before I wrap this up. And some will probably question my decision to close by discussing a negative, but the point of this whole write-up is to inform, not to market, and saving this part for last allows you to decide whether you should ever make SNMX anything more than a trading position by asking yourself one simple question.
Looking at these three buckets (PEP, direct sweetener enhancer sales, and the three call options), I think the e(V) of these are actually in the following order, largest to smallest: call options, direct sweetener enhancer, PEP. e(V) is the product of two factors, the odds of something happening and the value if it does. I’m going to set the call option bucket aside because addressing this opportunity would not only double the size of this write-up, but is also just a lot less tangible given the company is still years away from any commercial success in any of these three areas (note: years away from commercial, not scientific, success. And if the company is able to prove the commercial success opportunity of their molecules with sweetener enhancers, the stock should rapidly assign close to fair value to any of these call options upon scientific success as the path to commercialization will be almost exactly the same as the one followed in sweetener enhancers).
In comparing PEP versus the direct business, while it is true PEP is much nearer term and more tangible today, an easy mistake to make is to think something that is both nearer term and more understood is actually more likely to happen. I have an extremely high level of confidence that PEP will be a very large customer for SNMX, but I also have an extremely high level of confidence SNMX’s direct business will be wildly successful as well. So instead of trying to quantify a single point estimate for the odds of success for these two (or even a range correlating to different revenue levels), I’m going to address it by working backwards. I think the relative chance of success versus the value if they do have success (which is 9:1 in favor of direct sales as laid out above) argues the direct business has the higher e(V) as long as the odds of success aren’t greater than 9:1 in favor of PEP, which in my mind is a very safe assumption given the high overall chance of success I think the company has in direct and a ceiling for PEP success that is capped at 100%.
I bring this up simply because as long as the vast majority of Wall Street only focuses on PEP, there will always be marked-to-market risk in this stock until we know exactly how big PEP will be, and even then, as this business is only selling to one end customer versus direct which will ultimately sell to 1000s, I would expect from time to time there could be some PEP-related scares that will weigh on SNMX stock (although importantly, there will be a point based on consumer adoption where PEP really wouldn’t be able to leave SNMX even if they strongly desired to do so). But until that point is reached, as long as SNMX is purely a PEP-driven stock, as it is today, the customer concentration of the PEP business just lends itself to greater stock volatility. Moreover, even if one knew with 100% certainty what PEP’s plans were today, there’s no guarantee they wouldn’t change tomorrow.
To be clear, in no way am I backing away from the following statement, so I will repeat it very clearly: I am highly convinced PEP plans on not only using SNMX in their sodas, but plans on being aggressive in their roll out. And I believe consumer reaction will be very positive, so much so that a few years post launch this last section will probably be irrelevant because PEP will have passed their moment of no return.
I also strongly believe a successful roll-out of SNMX products in PEP increases the value of the direct business today if only because it probably speeds up the adoption of the direct business, but importantly, I don’t think it will have any impact on the eventual size of SNMX’s direct business because all of the arguments laid out in that section would be unchanged if the company didn’t have PEP, just potentially delayed. In other words, I think the direct business has a much higher e(V) than the PEP business does, and that the direct business’s 5-year forward e(V) is the same if PEP is a wild home run or the roll out is canceled tomorrow.
I used to say, before anyone knew whether or not SNMX was the sweetener breakthrough about which PEP was talking, that while I hoped it was, I would still own the stock even if I knew with 100% certainty it WASN’T. Today, while we now know they “have PEP,” and anything that impacts this fact will for sure have a temporary but large negative impact on the stock, my underlying belief is the same. I am excited SNMX has PEP and this win alone should provide many times upside to the stock. But I ascribe much higher value to the direct business (as well as the call option bucket), because in my mind the e(V) of these two buckets is so much larger and the end customer base will be so much less concentrated.
In fact, in five years time, I think that PEP, while a great partner and a nice sized business ,won’t really be that big a piece of the story. And in the extremely small but still greater than zero chance the PEP business never takes off at all, the size of the direct business at that point will be the same as in the case PEP was a success.
And that is the question you need to ask yourself as you decide whether you can own anything more than potentially a trading position in this stock: Do you agree with this last statement?
Catalysts (and my expectation for timing)
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