Codexis is hoping that its IPO will break the biofuel industry's losing streak and signal its ascendancy as a shining star in the space. Management claims it has a four-pronged business model with significant upside and limited risk. And the CEO has a British accent!

Management is quick to point out that it's a biotech company participating in the biofuel market. Not a biofuel company messing around with biotechnology and falling into the "valley of death" trap. Codexis argues that a partnership with Shell, a big patent portfolio and savvy genetic engineering are the underpinnings of its super business model.  But for now, it's a story, not a proven model. And the story is an optimistic version of how a tangled partnership web will play out.

Four Leaf Business Model Clover

Codexis claims to have a four-part business model. First, it does some initial screening of naturally occurring enzymes that have promise for making drugs or biofuels (this quick work is part of the sales process -- consider this a biotech proposal). Once a promising enzyme is identified, Codexis creates a research and development partnership to create what it calls a "super enzyme," a genetically engineered molecular worker bee that performs a desired task, like turning sugar into fuel, but holds up to nasty temperature and pH extremes like no natural enzyme can. 

In general, there's limited upside in contract R&D arrangements, but they provide the day-to-day funding to sustain operations and eke out profits. The company's current R&D contract with Shell accounts for 76 percent of its 2009 revenues, but it expires in 2012. The third and fourth parts of the Codexis business model are where the company says it has big upside: royalties on products made (i.e., a price per gallon), plus sales of its super enzymes, which act as biocatalysts. 

Codexis is positioning itself as a pharmaceutical biotech company that is moving into the large-scale world of biofuels. It plans to parlay the model it perfected with drug companies like Merck into a big win with Shell.  But there are key differences between drugs and biofuels -- a painful lesson that hotshot biotech venture capitalists have learned in recent years as their advanced biofuel biotech "plays" have become advanced biorefinery money pits.

The Brutal Economics of Biofuels

The upside in the Codexis business model assumes that Shell goes into large-scale production with one or several of the super enzymes now in the works. But the economics of biofuels are far more brutal than pharmaceuticals. One gallon of fuel typically fetches around the same amount as a tiny pill -- or even less. A lot of really smart people have been spending a lot of time and money trying to economically produce advanced biofuels. It takes a lot more than a killer microbe or super enzyme to hit it big. You need to be able to churn out huge volumes of fuel cheaply -- even after accounting for feedstock cost, the cost of capital and operations overhead. That's where biofuels and biotech part ways. Codexis plans to sidestep these problems through its partnership with Shell. Furthermore, Codexis plans to keep a tight balance sheet and build a beautiful income statement with big partner royalties and the sale of super enzymes made with contract manufacturer equipment -- not its own. 

The clean Codexis story belies a tangled partnership web, and the speculative nature of ever reaching large-scale fuel production. 

Complex Partnerships

First, there's The Royal Dutch Shell Petroleum Company, which Codexis is positioning as its muscular partner for scaling up. Turns out, there's a third player, a much smaller, little-known company in Canada called Iogen, that's been plugging away at cellulosic ethanol for 13 years, and that's only recently begun to hit demonstration-scale production.

Shell Petroleum and Iogen

Codexis, Shell and Iogen are strategic partners in a deal whereby Codexis develops cellulosic ethanol enzymes for Shell to convert cellulose into sugar so it can be fermented into ethanol. Iogen plans to scale-up production and pay a royalty per gallon to Codexis. Iogen's ways and means are a little different from Shell's, to say the least.  Shell is subsidizing the build-out and operation of the Codexis research and development team and paying fees for research milestones. Shell is also a major equity holder with slightly less than a 20-percent (pre-offering) interest in the company. The Shell investment represents a sizable portion of the Codexis' $159 million accumulated deficit. 

But the Shell partnership is not all roses and sunshine -- Codexis is locked down by the agreement. Codexis has an exclusive cellulosic ethanol relationship with Shell through November 2012.  In this period, Codexis cannot develop or sell cellulosic ethanol technology to anyone else. On the other hand, Shell is under no obligation to use the Codexis technology -- it can walk away from the deal. But Codexis surrenders all intellectual property it develops under the relationship to Shell, up until the time of patent expiration. Lastly, Shell is not bound by exclusivity. It is free to work with anyone else in biofuels -- and the company is definitely taking advantage of this latitude. For instance, Shell is working with Virent on the development of biogasoline in a process that uses thermal conversion technology.  The Codexis work for Shell could translate into huge future recurring revenue streams from Iogen and Shell; on the other hand, it could end up being a traditional contract research and development relationship where Shell walks away with some interesting science and nothing more.

But there's a twist -- a pending deal between Shell and Cosan.

Cosan, the Brazilian Sugar Cane King

While Iogen is making ethanol from cellulose, it's doing so in limited quantities, specifically 327,925 gallons in 2009 and 307,925 gallons year to date (per the company website).  Cosan, on the other hand, is a Brazilian ethanol play on the other end of the production spectrum, thanks to low-cost sugarcane, a big Brazilian ethanol market and hefty exports.   In February 2010, the long-term future of the Shell-Codexis relationship took on an interesting wrinkle when Shell entered into a memorandum of understanding for a joint venture with Cosan.  But there's an interesting twist involving Codexis. As part of the deal, Shell plans to contribute its equity stake in Codexis to the joint venture. This would give it a new master, likely with a new management team and with a new set of priorities.

This is not a done deal. Shell and Cosan are currently negotiating the terms of the joint venture and it is subject to regulatory approvals, etc. Assuming it goes through, the Codexis-Shell relationship will morph into a new Codexis - Shell/Cosan partnership. The unanswered question is why Shell would do this. It could be a way to expand the Codexis R&D relationship into first-generation ethanol, a play at moving Cosan into cellulosic ethanol (from sugarcane bagasse), a move to disentangle Shell from Codexis -- or something else entirely.

Codexis, Maxygen, Someone Else, the Patent Shuffle

Codexis management cites a large patent portfolio of 235 issued patents and 280 pending patents. However, a significant number are sub-licensed from original parent company Maxygen (Codexis is a spin-out). Maxygen, in turn, has licensed some of the patents from other third parties, some of whom are competitors to Codexis.  Codexis further discloses that it claims original title to 35 issued patents and 115 pending patents, a fraction of what it lays claims to overall. The company goes on in its S-1 to state that some of the actual patent holders may be competitors. 

The Codexis patent portfolio, it turns out, is far from bulletproof. Rather, it's a complex genetic engineering trading game with lots of moving parts. 

Is Dyadic the Partner Behind the Curtain?

Codexis has a license agreement with "pink sheet" company Dyadic for access to a gene "expression system that is capable of producing the necessary biocatalysts for the commercialization of cellulosic biofuels." The relationship gives Codexis non-exclusive access to Dyadic's proprietary fungal expression technology for the production of enzymes. 

The "expression system" is apparently for a fungus called C1. This appears to be a valuable chunk of genetic code. Dyadic cites an upfront license payment of $10 million from Codexis or almost half of Dyadic's $21.4 million in revenues, putting Dyadic in the black for the year ($8.6 million in profits) and representing a significant expense for Codexis. However, Codexis does not have exclusive use of Dyadic's prize C1 technology. It turns out that Dyadic also entered into a licensing agreement with biofuel company Abengoa, also giving it rights to use its C1 platform technology.  Sound familiar?

Dyadic's C1 code is a prize asset, and one that it's happy to shop around.

Separating Hype from Reality

What we do know is real is the R&D relationship with Shell and the contract revenues that are pouring in. Shell clearly believes in what Codexis is doing and its capabilities -- for now. But Shell also has a vested interest in keeping Codexis afloat and making it a growth story. This pumps up the value of its stock holdings. Shell may ultimately sell its Codexis stake to capitalize on new cellulosic ethanol production in Brazil and use Codexis super enzymes to scale production, all the while skirting around super-conservative Big Oil project stage gates. All of this could be part of a brilliant corporate strategy that makes a mint for investors, Shell, Cosan, Codexis management, Maxygen and all of its equity holders.  On the other hand, Shell-Cosan could decide to take a different direction, pull the plug on Codexis and leave yet another advanced biofuel penny stock languishing with other fallen angels like Origin Oil and Petrosun. 

What ultimately becomes of Codexis will depend on decisions made behind the scenes in the private conference rooms of a (possible future) joint venture. You won't be invited to the meeting.  But you can definitely expect quarterly updates.