A Pure-Play Protein Engineering Stock
The donkeys and the elephants are preparing for war in November when they should really be focused on more amazing things – like protein engineering. We recently wrote about how scientists are Designing Proteins to be Molecular Machines using algorithms that need to consider more amino acid combinations than atoms in the universe. The proteins responsible for nearly all of what happens in biology are made up of only 20 amino acids, with each protein having its own arrangement. Now, machine learning algorithms are helping us to create synthetic proteins that can do some remarkable things.
A great deal of innovation around protein engineering is coming out of the Institute for Protein Design in Seattle Washington which is churning out startups left and right. For retail investors wanting to get in on the action, there are some stocks offering pure-play exposure to the protein engineering theme. One of them is Codexis (CDXS), a company that’s focused on the “near infinite, untapped source of new value creating materials.”
Founded in 2002, Codexis has taken a path that mimics many of the earliest synthetic biology companies – start in biofuels and then pivot into something that’s more economically viable. From 2006 to 2012, a major portion of their business revolved around a research and development collaboration with Shell pertaining to biofuels. When the Shell agreement was terminated in August 2012, the company undertook a significant restructuring to focus on the biocatalysis market, something described by Nature.com as follows:
Biocatalysis is the chemical process through which enzymes or other biological catalysts perform reactions between organic components. Biocatalysis has been used widely in the pharmaceutical industry to make small molecule drugs.Credit: Nature.com
Today, Codexis breaks their business down into two broad segments:
- Product revenue – consists primarily of sales of protein catalysts, pharmaceutical intermediates, and Codex® biocatalyst panels and kits
- Research and development revenues – includes license, technology access and exclusivity fees, research service fees, milestone payments, royalties, and optimization and screening fees
The distribution of revenues between these two segments can be seen below:
Product revenue appears to be increasing as a proportion of total revenues over time while both segments appear to be trending in the right direction.
Codexis and Revenue Growth
When evaluating any stock that’s dabbling in disruptive technologies, the first thing we like to look for is revenue growth. Unless you’re a serial entrepreneur with an incredible track record of success, backed by some of the world’s most astute investors, the promise of revenues means little. Having an idea is the easy part. Getting someone to pay for a product or service is the toughest part as it involves finding the right “product market fit,” and then executing on that model successfully. It’s what venture capital firms refer to as “traction.”
Codexis certainly has traction with double-digit revenue growth over the past five years for both segments combined.
As for 2020, guidance was $78-82 million, but was recently withdrawn given the widespread panic caused by “the rona.” The bigger concern here might be the overreliance Codexis has on a small set of customers for a big chunk of revenues.
Key Customer Risk
While revenues have been growing at a consistent pace, they’re largely coming from a few big-name customers. Big pharma giant Merck has accounted for around 30% of revenues for the past three years in a row.
For the past three years, the above four customers have accounted for at least 64% of Codexis’ revenues. It’s surprising how consistently they’ve been able to grow revenues given how sporadic the cash flows are, something that results from uncertain payment structures such as milestone payments or royalties. All this unpredictability leads to stock price volatility which translates to risk.
Back in 2015, Codexis was working with 18 of the top 20 global pharmaceutical companies. Today, they’re collaborating with 21 of the top 25 big names in pharma. To date, Codexis has entered into platform technology licensing agreements with three of them – GlaxoSmithKline, Merck, and Novartis. These companies are using the CodeEvolver® protein engineering technology platform to discover and develop novel proteins for internal use, each with their own set of terms and rules. One would hope that more platform licensing agreements are coming as all these big pharma collaborators evaluate the platform and eventually adopt it. (The last to adopt the platform was Novartis in May 2019.)
Having some of the world’s biggest names in big pharma as key clients is a double-edged sword. Each of these relationships is governed by an agreement with lots of stipulations in place. One commonality across all these agreements is that these relationships can be terminated with a 90-day notice. Regardless of how likely these companies are to terminate their agreements, it highlights a significant risk.
Codexis is dealing with key customers who have all the leverage in the relationship. It’s likely firms of this size are using more than one protein engineering solution. Most large companies want to avoid sole vendor risk, and will use more than one provider for business continuity reasons, or as an added layer of quality assurance so they can then cross-check their work. The fact that these companies can just cancel their relationship with a 90-day notice – penalty payments or not – seems risky. What happens in the next recession when pharma companies start shuttering programs and consolidating vendors in an attempt to rein in costs?
Then, there’s the pace at which the whole synbio industry is evolving. As Codexis correctly points out:
Our technologies and products may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors.Credit: Codexis
Codexis Stock – To Buy or Not to Buy
When Codexis had their IPO in 2010, it was being touted as a cleantech play given their focus on biofuels and backing from both Chevron and Shell. The need to pivot cost shareholders who were in it for the long haul. Since that 2010 IPO, shares have returned about -16% to date compared to a Nasdaq return of +325% over the same time frame. If your business is to create value from a disruptive technology, you better be able to at least keep up with the world’s most popular tech stock benchmark.
When we look at five-year returns, shares of Codexis have performed quite well, returning +223% compared to a Nasdaq return of +150% over the same time frame. Maybe they’re finally hitting their stride. At least they’re finally starting to show some revenue growth, even though it’s not very diversified. There’s also an entire pipeline of novel biotherapeutics being developed, each of which contributes greatly to share price volatility.
The investor deck details these promising partnerships, all of which represent a great deal of uncertainty around future cash flows. Uncertainty increases risk, and we’re mainly interested in reducing risk.
Using the limited information we have today, we need to evaluate this company based on their future potential. Then, we need to determine if the risk-reward potential merits an investment. As risk-averse investors, we see a few meaningful risks we’re not willing to take:
- An overreliance on large pharma companies that have all the leverage in the relationship.
- Uncertain cash flows that make for an extremely volatile share price. We like to sleep well at night.
Investing in any given stock incurs an opportunity cost. The money you’ve invested in Codexis could be invested in other synthetic biology companies which we would argue have greater curb appeal when it comes to risk vs. reward – companies like Twist Bioscience or Berkeley Lights.
Just because a company is a pure-play on a particular technology theme doesn’t mean they’re guaranteed to outperform a broader market benchmark. The first synthetic biology stocks that became available to retail investors performed horribly as these companies all had to drastically pivot their platforms while pretending like their first efforts weren’t an utter failure.
As they teach you in business school, the number one priority for any company is to survive. Codexis has done a good job on the surviving part, and could increase their odds of survival even more by reducing their overreliance on such a small set of customers.
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