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1 Small-Cap Biotech Stock to Buy Right Now

Enzymes. You may not realize it, but they're pretty important to daily life. Your high-efficiency, phosphate-free laundry detergent that removes even the most stubborn stains in cold water? That's made possible through the addition of a handful of stain-fighting enzymes that work at lower temperatures. The widespread adoption of these products has saved energy from heating water and allowed brand owners to remove environment-polluting phosphates from the ingredients list.

The ability to reduce energy consumption, simplify ingredients or inputs, and reduce waste has long made enzymes important to various industrial manufacturing processes as well, including the production of stone-washed jeans, food ingredients, and pharmaceuticals. But designing enzymes that work as advertised and can be manufactured cheaply enough to enable widespread use requires a specialized technology platform.

That's where a little company called Codexis (NASDAQ: CDXS) comes in. It's not close to being the biggest enzyme company today, with a market cap of just $335 million, but a new management team has executed beautifully in recent years. As the company begins to expand its niche, you might regret not having had it in your portfolio.

Image source: Getty Images.

The business

Codexis designs and manufactures enzymes that allow industrial customers to save time and money in their own manufacturing processes. Because of the complexity involved, the enzyme industry is comprised of relatively few major players: DSM, Novozymes, DowDuPont (through Genencor), Biocatalysts, and several others. How does the relatively tiny Codexis keep up?

The company has developed CodeEvolver, a technology platform that allows researchers to use software to design an enzyme for a specific application, physically produce it, test its effectiveness, and incorporate that real-world data into the next iterative design through machine learning. Synthetic biology investors may know this as the "Design, Build, Test" cycle, which has proven valuable in managing the complexity of biochemistry.

While those technological capabilities represent the minimum level of competence needed to run an enzyme business in 2017, Codexis has focused almost exclusively on a single niche since mid-2012: supplying enzymes to pharma customers for manufacturing small molecule drugs. By contrast, peers garner a majority of their business in less risky and less regulated enzyme applications such as food and materials manufacturing. But luckily, the gamble paid off for Codexis.

The small-cap company was able to improve an already impressive technology platform while generating high-margin business with blue-chip companies along the way. Consider a few highlights:

  • In 2005, a single project took 40 scientists one year to complete. Today, the same project can be wrapped up in one year with only two scientists. 
  • Major partners that have bought into the technology platform include Merck, GlaxoSmithKline, and 15 of the top 20 pharma companies worldwide.
  • Codexis has won three Presidential Green Chemistry Awards from the U.S. EPA in the last 11 years -- an amount only matched in the history of the award by blue chips such as BASF, Merck (won two with Codexis), and DowDuPont.
  • The company has raised money -- through debt or stock offerings -- just once since it went public in 2010. 

Those successes have translated into a steadily rising stock price -- with the operational improvements to back it up.

Management expects total revenue of up to $53 million in 2017, up from just $35 million in 2014. That's despite sharply falling revenue sharing from Merck's blockbuster Januvia, which has lost market share to newer type 2 diabetes therapies. Booming product revenue and additional major partnerships have more than helped make up the difference. 

Years of hard work building a leadership position in pharma manufacturing aides has paid off for Codexis, which turned a corner in 2017 with accelerated growth. While the legacy market will continue to play a crucial role in the future, Codexis is quickly expanding the reach of its platform beyond its historical niche.

Beyond supply

To better understand growth opportunities, it's important to understand how Codexis classifies and generates revenue. There are three primary sources of revenue: 

Revenue

Description

Product revenue

Sales of enzymes, pharmaceutical intermediates, and panels and kits.

R&D revenue

Includes R&D cost reimbursement, upfront licensing fees, milestone payments, royalties from customer product sales, and technology access fees.

Revenue sharing

Includes revenue from a single legacy collaboration with Exela PharmSci. This is slowly becoming irrelevant.

Data sources: SEC filings.

Product revenue is the most reliable source of sales each quarter. Consider that in the first half of 2017, product revenue hit $12.1 million, up 74% from the first half of last year. The best part: There weren't any big, one-time orders driving the gains -- just more customers. After recently raising guidance, management expects product revenue of up to $27 million this year. 

In stark contrast, R&D revenue has been quite lumpy quarter to quarter. Codexis has signed one new major partner in each of the past few years, which results in large upfront payments in one quarter. Partners pay upfront to gain access to CodeEvolver, then they pay technology access fees over time. Enzymes created from the platform can then generate product revenue, milestone payments, royalties, or profit-sharing fees from product sales they enable. 

In fact, Codexis just announced its fourth major CodeEvolver license partner, Nestle Health Science, which will result in a $14 million upfront payment to be recorded in the fourth quarter. However, the deal was slightly different from past partnerships with Merck and GlaxoSmithKline. While Nestle Health Science scooped up a license to CodeEvolver for pharma and cosmetics applications, it also agreed to collaborate on clinical drug candidates Codexis has developed behind the scenes. That's right, in addition to supplying enzymes to pharma customers to manufacture their own drugs, the small-cap company has decided to get in on the action.

In early 2018, Codexis will begin a phase 1 trial for an enzyme it developed as a potential treatment for a metabolic disorder called phenylketonuria. The enzyme biotherapeutic was designed using CodeEvolver to be 50 times more stable in a patient's gastrointestinal tract than previous drug candidates, which should not only allow for an oral dosing regimen (rather than an injection), but also for smaller doses overall. Nestle Health Science will be responsible for any development costs beyond the early stage trial, and it will provide Codexis potential milestone payments and royalties.

The high-margin enzyme supply business greatly de-risks Codexis' foray into the clinic, but that's just one of four new revenue streams being developed by the company. By the end of the decade, it could boast the following revenue streams:

  1. Enzymes for pharma manufacturing: The company's platform is currently generating revenue from five generic drugs and two patented drugs already on the market. Another five enzymes for drugs on the market are in development, in addition to enzymes for manufacturing 10 drug candidates in phase 2 or later. 
  2. Novel biotherapeutics: Codexis has five biologic drug candidates in its yet-to-be-released pipeline, including the one with Nestle Health Science. 
  3. Enzymes for food ingredient manufacturing: In December 2016, the company announced a major partnership with Tate & Lyle to supply enzymes for food manufacturing applications. One enzyme is generating product revenue today, and three more are in development. 
  4. Enzymes for molecular diagnostics: Codexis is actively developing an enzyme to be used in Next Generation Sequencing (NGS) and diagnostic applications. 
  5. Enzymes for industrial applications: The company has yet to announce specific candidates in this area, but other industrial biotech companies have entered the space with metalworking enzymes and those aimed at textiles manufacturing. 

That's quite the ramp-up in activity for a company that has historically relied almost exclusively on supplying enzymes for manufacturing small molecule drugs for pharma customers. Considering that the legacy business was just shy of allowing profitable companywide operations in 2015 and 2016, and given the rise in both margins and total revenue in 2017, the new revenue streams being developed may deliver positive EPS much sooner than Wall Street analysts expect. 

Codexis offers impressive growth, high margins, ample expansion opportunities, and a stock that is flying under the radar. That's why, at a market cap of just $335 million, this is one small-cap stock begging to be bought.

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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.