Codexis Expects Its Most Important Source of Revenue to Decline in 2020

Well, that wasn't what investors were expecting. 

Codexis (CDXS +7.60%) announced disappointing full-year 2019 operating results on Feb. 27. It ended September needing a relatively small amount of fourth-quarter sales to meet full-year 2019 revenue guidance, but managed to miss the low end of internal projections and whiff on Wall Street expectations.

That wasn't even the most concerning part of the earnings report. Codexis expects full-year 2020 product revenue to decline compared to last year, while product gross margin is forecast to slip due to shifts in the product mix. It will mark the fourth straight year of stagnant or declining product revenue growth. How concerned should investors be about the small-cap stock? 

Image source: Getty Images.

By the numbers

Codexis combines microbes, genetic engineering, and machine learning to engineer enzymes. Enzymes are complex biological molecules that catalyze chemical reactions. 

While the molecules are what make organic life possible, they have a number of applications outside of their natural settings. Enzymes can be used to speed up industrial manufacturing processes used to make everything from pharmaceutical ingredients to food ingredients. They're instrumental in diagnostic and genetic sequencing applications (it would be impossible to read DNA without enzymes) and can be used as drugs to treat diseases.

The company generates revenue by licensing its CodeEvolver software platform, supplying enzymes tailored to the needs of customers, and earning milestone payments from a drug development collaboration with Nestle Health Science. Codexis managed to grow total revenue in 2019 compared to the prior year, but sales fell below the low end of full-year 2019 guidance of $69 million to $72 million. 

Data source: Press release. 

Codexis turned in mixed results relative to full-year 2019 guidance. It expected $69 million to $72 million in total revenue, but missed the low end of the range by $0.5 million. It forecast $26 million to $29 million in product revenue, but topped the high end of the range by $0.5 million. Product gross margin was projected to be 48% to 52%, but missed by 100 basis points (a relatively large miss).

The results were even worse when compared to Wall Street expectations. Analysts were looking for full-year 2019 revenue of $71.1 million on average, although the lowest estimate was $70.5 million, according to numbers compiled by Yahoo! Finance. 

A concerning trend

Investors shouldn't expect much relief in 2020. Codexis issued relatively disappointing full-year 2020 guidance. 

Data source: Press release.

While total revenue is expected to grow by double digits in 2020, that will only be possible due to a surge in R&D revenue. That's not the end of the world, but it's not ideal. 

R&D revenue is unpredictable and non-recurring, which makes it an unreliable source of consistent, long-term growth. For example, Codexis expects to announce a drug development deal in lysosomal storage disease in 2020, but the growing reliance on drug development collaborations is not without risk. Many of the company's disease targets are being targeted by potentially curative gene therapies. There's real potential to develop lower-cost treatments based on enzymes, but investors have no clinical results to gauge progress at this time.

More worrisome is the expectation for declining product revenue in 2020. That means Codexis will report its fourth straight year of stagnant product revenue: The business reported $26.7 million in 2017, $25.6 million in 2018, and $29.5 million in 2019. Product revenue isn't expected to top $27 million in 2020. 

While individual customers tend to make choppy purchases of enzymes from quarter to quarter, product revenue as a category is a more consistent source of earnings and growth over the long haul. It can be generated from many customers across diverse end markets, including food manufacturing, pharmaceutical manufacturing, and DNA sequencing applications. 

Consider that Codexis generated at least $0.5 million in product revenue from at least 11 customers in 2019. By contrast, it generated software licensing revenue from only three customers and is dependent on Nestle Health Science for all drug development revenue. Even if the company executes a new drug development deal in 2020, revenue guidance suggests over 70% of revenue will come from non-recurring contracts involving just four customers. 

Investors aren't the only ones who need to reset their expectations. Wall Street was projecting full-year 2020 revenue of $82.5 million on average, according to data from Yahoo. That's above the high end of the company's expected revenue range. 

Image source: Getty Images.

Investors will be forced to adapt in 2020

Codexis delivered a mixed end to 2019 by missing revenue and product gross margin guidance. It issued relatively disappointing full-year 2020 guidance highlighted by expectations for declining product revenue and surging operating expenses as drug discovery and drug development become bigger areas of focus.

On the one hand, Codexis has a technology platform that's well suited to exploit drug development opportunities. The activities are also partially de-risked by the non-pharmaceutical parts of the business. On the other hand, investors had come to appreciate the lack of exposure to drug development risks. That benefit is slowing eroding.

Codexis could earn a higher market valuation if it increases its exposure to drug discovery, but the risk of owning the company's shares will increase, too. Investors with a long-term mindset shouldn't panic over the latest earnings report or guidance, but they'll certainly need to adapt.