Zy Spy an IPO: Of Zymergen and its monster public company debut, and the risks investors love

In California, Zymergen raised $500 million last week in its IPO and the stock closed Monday night at $43.00, up 39 percent over itsWednesday trading debut. The company sold an unexpectedly robust $16.1 million shares at $31, the top end of its expected range.

In short, every sign from the market is bullish.

For many companies, the hard yards to be gained lie in developing and sustaining public confidence — there are reliably profitable media companies selling at 3.5 times earnings, to quote an example. It’s clear that Zymergen has mastered the arts of communicating a story — for, with $13 million in revenue and $260 million in losses last year, to go with $12 million in revenue and $240 million in losses in 2019, Zymergen is one of the definitive story stocks.

The Zymergen Story

But, what a story.  As Zymergen tells it skillfully:

The demand for innovative materials has never been greater. Human civilization is material. The materials in the things we use, the clothes we wear, the rooms where we live, the vehicles that take us from place to place, as well as the inputs that grow the food we eat, are the products of a half dozen chemical building blocks invented over the last several decades, mostly derived from cracking hydrocarbons.

We believe the chemicals and materials companies that make these materials have struggled to innovate because they employ a limited molecular palette and have substantial capital expenditures. In addition, they are among the planet’s worst industrial polluters. Recently, synthetic biology companies suggested a better alternative, where microorganisms are coaxed to produce chemicals, but most synthetic biology companies have struggled to manufacture novel molecules at industrial scales. Yet while the traditional chemical industry is stagnant and synthetic biology companies have disappointed, the demand for materials that solve important problems and are environmentally sustainable has never been greater.

Having set the problem, that existing producers have exhausted their potential and exhausted our skies, while newcomers in synthetic biology have failed to deliver, Zymergen provides Biofacturing.

Defined succinctly as creating “better products faster, cheaper and more sustainably.” Thereby hitting all the required notes for success in today’s market excepting perhaps “saves us from COVID” or “ensures electoral reliability”.

Insofar as ‘biofacturing” is defined as the ‘design, development and commercialization of bio-based breakthrough products, economically, at industrial scale, where microorganisms create the biomolecules that are the key ingredients in those products,’ there’s not much that Zymergen brings new to the table. What materials company is opposed to affordable, breakthrough products at industrial scale. As a goal, it is more obvious than what the presence of a net affords to soccer.

The Zymergen Promise

No, Zymergen ’taint about whatcha do, it’s the way that you do it. As they note in their prospectus:

Our biofacturing platform, a unique end-to-end fusion of biology, chemistry and technology…is designed to:

1. Identify and create novel biomolecules that are the basis of new materials with engineered characteristics that possess improved performance compared to existing products;
2. Insert genes into a host microbe that produces the desired biomolecules; and
3. Develop and scale up a production process, including optimizing the microbe to produce biomolecules economically at scale, while retaining product functionality via time-and-cost efficient optimization, leading to commercialization at attractive margins.

Traditional chemicals and materials companies have struggled to create novel materials that satisfy end-market demand. Many of the materials we use today were invented decades ago—cellophane was invented in the 1920s, nylon in the 1930s, Teflon in the 1960s, Kevlar in the 1970s. DuPont spent over 10 years and around $500 million (on a non-inflation-adjusted basis) (according to Delaware Online) in the late 1960s and early 1970s developing Kevlar.

Our goal is to launch our products in about half the time and 1/10th of the cost of what traditional chemicals and materials companies can deliver,

Half the time, a tenth the cost? Where do I sign up? With that kind of power, why is Zymergen still a story stock?

Of ZyPhones and iPhones: metrics from the device market

One factor is timing. Zymergen has come to the public markets 4 months post-launch of its first product, which has an ‘8-18 month cycle of sampling and customer engagement’. In short, we’ll find out about Hyaline’s success in the market some time between late this year and late next.

Another factor is company strategy. As one CEO in the biotechnology toolkit and development business remarked to me, “it’s an interesting way to build a company,” referring to the large costs and light revenues, it’s not every company that can create a narrative to support such an investment.  Those who have signed NDAs and looked deeply into the technology horizons and customer pipeline will be in better position to judge this diagram of opportunity. It looks a lot like Amyris in some ways — a company which had a lot of irons in the fire, delivered, albeit late. It also looks a lot like LS9, a company with a core technology filled with immense promise that did not work out so well for its investors.

The comparisons are not drawn as criticism, or even as cautionary tales — they are drawn to illustrate why Zymergen remains a story stock. Today is where your book begins, the rest is still unwritten” as the song by Natasha Bedingfield put it.

Let’s have a think about Hyaline for a second. What is it? It’s a high optical quality film — specifically, a tightly foldable film. That’s extraordinary. Here’s a picture to illustrate.

What are screens worth? The screen of an iPhone, says here, is worth $66.50 in hard costs. . TechInsight suggests that the cost is more like costs $80.50, here.  There are 1.4 billion smartphone sold a year, doubtless other makers have cheaper materials, but if you’re not seeing a bigger market than $20 billion it’s because you believe other manufacturers spend 70+% less than Apple on smartphone screens. Really?

How much of that could go to a product like Hyaline? Zymergen says that “the display market alone for Hyaline was over $1 billion in 2020”. That’s real money. The margins are bound to be tighter for components than the 300% mark-up for a high-end iPhone, but you get the idea.

As we say in the Department of Early Stage Meetings about Disruptive Technology, if you have technology that will completely disrupt a $10+ billion market that is growing, you have something very special. As product #1 out the door, that’s not quite a black swan but for sure it’s a Trumpeter Swan, something on the Venture Capital Endangered Species List.

So, that’s one of the reasons to be extremely bullish about a company like Zymergen. Do they really have it? Have they nailed it? Time will tell, but you can see why there are investors willing to take the technology bet. The original iPhone cost something like $150 million to develop about 16 years ago. The number sounds outrageous until you consider the returns.

About that Launch Acceleration

Now, having addressed the case for optimism, let me turn to two cautionary tales. Earlier, I mentioned I would not draw one by comparison to Amyris or LS9. But I do want to draw something here from the IPO documentation.

First, I want to draw attention to something called “Launch Acceleration”. Zymergen avers:

Our goal is to make our biomolecules by fermentation, where all biofacturing reactions occur inside the engineered cell in standard fermentation vats, rather than the expensive, purpose-built chemical plants used in synthetic chemistry. However, in some cases, so that we may achieve commercial launch faster, we may initially launch products using molecules that are first produced with non-fermentation based methods, which is a strategy we refer to as “Launch Acceleration.”

Someone is going to shout “Fake it until you Make it!” at this point, that’s not where I am going, I don’t think that’s as respectful to the Zymergites as they deserve.  I don’t think there’s a case for fakery here — though there have been some pretty weird stories in the advanced bioeconomy, I don’t surmise this is one of them. I think this is a simple matter of dual-tracking the marketing and the technology development, there are advantages to scaling a market faster than you can scale fermentation. It can be risky — the company might never exactly shake out the costs and bugs of a process, we have to be clear about that. Also, it undermines the sustainability story, the ESG investment and purchase story. We had better assume that when Zymergen proposes “Launch Acceleration” that the alternative near-term process is going to be less sustainable, perhaps far less so. If the company had a completely low-carbon, sustainable way to alternatively manufacture and didn’t mention that in the IPO, well, we’ll dismiss this concern but would someone fire the S-1 writing team, please? On the assumption that the “Launch Acceleration” approach involves trade-offs on sustainability, how much, and for how long?

So, let’s look at that, the answer might be “not long”.

Zymergen writes:

Hyaline is the first in a franchise of optical films, designed for electronics companies to use for display touch sensors in personal devices and other applications. Hyaline will allow our customers to make robust foldable touchscreens and high density flexible printed circuits. Hyaline uses a biomolecule that was identified through our biofacturing platform. In order to accelerate product launch and meet customer demand, we launched Hyaline with a non-fermentation produced biomolecule sourced from a third party. We are in the process of converting to a fermentation-produced molecule for Hyaline by using a microbe that has a demonstrated ability to produce the molecule through fermentation. We are currently developing commercial scale processes so we can produce the molecule through fermentation at sufficient volumes and costs to support commercial manufacturing. We expect this process to be complete in 2022.

About those Easy to Come by Affordable Industrial Proceses at Scale

So, we have 2022 as a target, so, somewhere in the 9-21 month range. That’s not so bad. But we do note a couple of items.

“We are currently developing commercial scale processes.”

Commercial-scale bioprocess can be a tricky and pesky thing. Timelines have been known to get crushed by real-world experience. Gevo is an example of a company that took much longer than expected to perfect their system. Genomatica is an example of a company that brought a process up to massive commercial scale without a hitch and in record time. Is Zymergen a Genomatica or a Gevo? It is not a question of failure, it is a question of timelines — mighty companies like Solazyme found tremendous trouble as a public company with a burn rate and timelines to reach cost targets stretched out.  The difficulties of the past do not predict the experiences of the future — rather, we can assume that Zymergen has learned prodigiously from what went awry in the past for others and has plans to avoid corporate trauma. But, honestly.

While we’re here, let’s take up one other disclosure in the above-cited section of the S-1.

In order to accelerate product launch and meet customer demand, we launched Hyaline with a non-fermentation produced biomolecule sourced from a third party.

Ah. Let’s put this together with something else that shows up in the S-1.

We launched our first product Hyaline in December 2020 to customers in the electronics industry, beginning the expected 6-18 month product qualification process with customers. We have not yet generated revenue from product sales (except for nominal revenue related to the sale of samples of Hyaline).

OK, what do we have here. We have nominal revenue so far: so far, so good,, biotech companies are known to complete IPOs with limited or no revenue. We have a disclosure that “Substantially all of our revenue to date has been generated from R&D service contracts and collaboration arrangements” and that samples were distributed at nominal costs to catalyze the “expected 6-18 month product qualification process with customers.” Again, unsurprising. Yet, we also discover that that Hyaline has been launched ‘with a non-fermentation produced biomolecule sourced from a third party.’

Is it not fair to assume that the customers are not testing an actual Zymergen product. Rather, they are testing someone else’s product. Now, for the purposes of performance testing, we’re going to assume that all bets are off until the customer is actually testing Zymergen’s Hyaline. That’s not the only point of performance testing, but it it is one of the points of it. Further, what if Zymergen never really does produce a commercially-viable process for Hyaline — how valuable is the market seeding.

So, these are risks. They are not deal-breakers. They are decisions made by sober management under time and financial pressure to create a successful company — pressures that mount when the cash burn is north of $200 million per year.

Though Shalt Avoid the Billions: The Efficiency Gambit

Let me move to another disclosure in the S-1. Zymergen avers:

We then design and develop engineered microbes that manufacture the novel biomolecule that will be the key ingredient in a breakthrough product. Next, we leverage Contract Manufacturing Organizations (“CMOs”) to manufacture the product for us. Finally, once we have launched our product, we use our own sales force and marketing capabilities to contract with customers and sell our products to them.

I don’t see much about “we’ll build a plant later” or “our customers will build a plant later”, so we are left to consider how many Contract Manufacturing Organizations are out there, how much spare capacity they have, and how that fits with the Zymergen ramp-up schedule.

Now, remember, we are issuing a caution, not ringing the fire alarm. There may well be sufficient toll manufacturing capacity to support Zymergen’s growth phase, and Zymergen may well have it locked down. But, do they? If so, why not disclose that?

The Contract Manufacturing Squeeze

Are there reasons to be skeptical? Yes, there are.

As Christopher J. Guske, Ph.D. and Mark Warner, PE wrote in The Digest this month.

North America contract research and manufacturing organization (CRO/CMO) capacity is tightening. In 2020, one CRO/CMO completely shut down its facility to all fermentation work and laid off staff. A second quit conducting outside work as internal demand filled capacity. A third was rumored to be considering shutting down or selling.

The situation in Europe is less dire but even that market is tightening. Additionally, EU regulations (e.g., REACH) make things more challenging. Producing in the EU and then transporting back to the US can be challenging, driving a reluctance to use European facilities, where the bulk of available capacity currently exists. On a positive note, the EU has done a far superior job of promoting and supporting its capabilities through programs like Pilots4U, something the US should consider.

Does un-utilized industrial biotechnology capacity in the US exist? Well, yes, sort of. Tate & Lyle’s Decatur, IL, refinery has large fermentation capacity, once used for producing xanthan gum and Amyris’ farnesene. But the facility has remained idle for several years with no evidence of interest to recommission it despite numerous inquiries. ADM’s Clinton, IA, facility (built to support the defunct ADM-Metabolix JV) operates at fractional capacity with the majority of commercial-scale fermentors still not commissioned. Fermic’s Hannibal, MO, facility remains idle. The issues in bringing sites back into operation are common stumbling blocks: (1) these fermentors are rather large for most early-stage companies, and (2) there needs to be a sustained commitment to bring these up to/back to operational status.

Now. let’s push back here a little. Geske and Warner state elsewhere in their article that “There is some pharma capacity available for CRO/CMO work in the US, but if one has to displace another internal product (which would be the common scenario) and/or operate in a pharma cGMP environment, this is not an economically attractive option unless one has a high-value product, i.e., $100/kg or more.”

So, does Zymergen have product coming through the pipeline that fits that model? Now, you may wish to push back on Geske and Warner for other reasons. I can tell you that our DigestDev research unit is assessing global fermentation capacity right now, in the US and around the world — as a base for advanced manufacturing. What we’ve seen tends to back up Geske and Warner completely.

So, it’s relevant to the Zymergen story. and not just because capacity may be tight, After all, capacity can be built. That’s the American way. So, there’s something more to this — Zymergen in its S-1 described the building of capacity to support molecule manufacturing not as a strength of the American business system but more or less as a weakness.

They wrote:

Commercial-scale plants cost hundreds of millions to billions of dollars to construct. For example, in 2010, GE Plastics (now SABIC), completed the construction of a PEI resin plant in Spain for EUR300 million. DuPont recently announced an expansion of capacity for its polyamide film franchise of $220 million to meet growing global demand. In 2018 Covestro announced an investment of $1.7 billion into a methylene diphenyl diisocyanate production capacity.

What is the purpose of these notes by Zymergen in the S-1 — to point out the prodigious costs and associated risks experience by industrial biotechnology? Perhaps. An alternative explanation would be that Zymergen is telling investors it hopes to avoid these kind of expenses and duress. Zymergen avers:

Based on our experience and expectations with our first four products which are electronic films and insect repellent products, and subject to any regulatory requirements, which could lead to longer timelines and increased cost, we estimate the timelines and costs of launching our products to be roughly five years and $50 million. We estimate that the first step can be accomplished in roughly one-two years and at a typical cost of approximately $5 million, the second step in roughly one year and at a typical cost of approximately $5 million and the third step in roughly three years and at a typical cost of approximately $40 million. Our biofacturing platform is flexible, allowing for each step to be completed in parallel or independently. The platform is designed to accelerate launch of our products, satisfying customer needs more rapidly and increasing the returns of our pipeline investments. Further, our machine learning workflows can improve over time as each round of product design and genome optimization generates more proprietary data, further enhancing our algorithms and deepening our proprietary data moat.

The message here is that biofacturing is cheaper. The reasons are left a little vague, but we do see phrases like “flexible”, “Rapidly”. Machine learning”, and “deepening our proprietary data moat” that suggest efficiency is the key to Zymergen’s appeal.  Efficiency that leads to effectiveness that is the key to the company’s success, for they point out that “only six major polymers have been commercially launched since about 1980” but mention that they have 10 in the pipeline, “Our long-term objective is to generate revenue from the sale of numerous breakthrough products across a variety of industries. Our goal is to launch our products in about half the time and 1/10th of the cost of what traditional chemicals and materials companies can deliver.”

One More Thing

Let me head back to the iPhone for a second. We read earlier that Zymergen estimates that the market for Hyaline in the smartphone screen sector is worth $1 billion or so. We estimated that the screen market as a whole has sales of $20 billion. So, that leaves us with the concept here that smartphone screen operators would focus in on a component that represents 4 percent or less of the total cost. Which product companies do — all the time — but only when they see transformative performance opportunities,. Could be physical performance — or, these days, carbon performance.  It’s not an area that’s going to be targeted because of a drive on costs — just too small.

Which brings the focus right onto Zymergen’s value proposition. It’s a performance company. As ZY points out in discussing its insect repellent opportunities, “the consumer need to repel insects is global, big and likely to get bigger with current solutions being unsatisfactory, suggesting that there is a large latent demand for better products.”

Better products, that’s the Zymergen promise. Of course, that’s what makes it a risky bet because, today, there are no shipped products, excepting the afore-mentioned product marketed as Hyaline which is made by someone else using a process that won’t be used by Zymergen.

Do you like the bet? If you’ve spent time around the company, there’s real reason to feel good about it. The company is stuffed to the gills with smarts. So was Solazyme in many ways, a technology which marches on today under the Corbion brand but was did not work out as a standalone company. So was Twist in many ways, which has been a NASDAQ darling. So was Renewable Energy Group, which has over performed spectacularly.

The jury is out, it’s going to be out for a while. 2022 is the next inflection point, that’s when Hyaline shifts over to the actual fermentation-based product and we can then judge whether the machines that are learning at Zymergen are learning well.

So far, the market votes that ZY is a good bet. The cash raised covers about two years of the current burn rate and that puts Zymergen well over the expected Hyaline finish line in 2022 — so, the IPO has been well-timed. Now, cometh the execution.

More on Zymergen via its S-1 here and the company website here.