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Due to the growing demand for biodegradable, ecofriendly packaging, Danimer Scientific (NYSE:DNMR ) may be worth considering for your portfolio. Danimer is a publicly-traded company that emerged from a special purpose acquisition company, Live Oak Acquisition Corp., which closed in May 2019. The company's core mission is to deliver biodegradable packaging products that meet a variety of customer demands, especially in food packaging, and provide an alternative to non-degradable, petroleum-based plastics. Danimer has core competencies in fermentation, thermocatalysis, and polymer science. They also have valuable technology protected by extensive intellectual property-hundreds of patents-originally developed by The Procter & Gamble Company ( PG).

While Danimer has innovative technology and chemical pathways to produce biodegradable materials at consumer scale, there are caveats. Risks include the high price of canola oil feedstocks, the difficulty to emulate material properties of the competing, non-degradable polymers, and a murky valuation due largely to a lack of transparency from management. To give confidence to investors, management needs to do a better job to clearly articulate their reasoning behind anticipated EBITDA numbers and the associated risks. Management should also clarify their planned path towards profitability to investors and should better justify expenses incurred including stock-based compensation.

Danimer is a major player in the rapidly growing polyhydoxyalkanoate (PHA) markets with predicted CAGR of about 9% between 2021-2031. PHAs are biodegradable plastics that are made directly from bacteria via a fermentation process. DNMR will possibly be the first ever company to successfully bring PHAs to a commercial scale. The science is fascinating and will be briefly reviewed at 10,000 feet.

Polyhydroxyalkonates (PHAs) can be produced biochemically by microorganisms such as bacteria. PHAs naturally biodegrade, and some PHAs biodegrade both aerobically and anaerobically (e.g. underwater). Since PHAs are made from renewable raw materials such as waste plant oils, molasses from sugar industry, and oil palm shell, PHA production avoids fossil resources and enables nature's cycle of circularity and sustainability shown below in Figure 1. An open-access, informative review article written by Koller et al. is available here and summarizes the industrialization of PHA biopolyesters.

Figure 1. Illustration of the idea of biodegradable polymers replacing single-use and throwaway plastics. The material is derived from plant-based feedstock and is engineered to biodegrade over relatively short time scales to prevent accumulation of plastics in landfills and oceans. (Image created by Absolute Valuation)

The idea of commercializing PHAs was initially put forth in the 1970s in the wake of skyrocketing crude oil prices. However, the price was simply too high to compete against the subsequently falling oil prices. Now, with the world facing a gigantic plastic waste problem, the possibility of PHA commercialization has reemerged, and I believe it has staying power. This time, there is much greater technological insight on how to produce PHAs from inexpensive feedstocks and how to enhance PHA production through advances in metabolic engineering.

When the right strains of bacterial cells are stressed, under just the right conditions, the cells feed on organic materials and produce globules of PHAs as energy reserves. Figure 2 shows electron microscope images of bacteria that have produced these PHA globules. The white polymer globules can be extracted from the cells, then dried, and used as raw materials for blending and extrusion into products.

Figure 2. Electron microscopic image of Ralstonia eutropha containing PHA. The globules are produced as energy reserves when the bacteria feed on organic materials under the right conditions. (Plastix)

The extracted raw polymer comprises of copolyesters with different molecular building blocks. Some polymer segments contain short chain side-groups that easily crystallize and others contain medium or long chain side-groups that offer more flexibility and ductility. The polymer's end-properties depend on the type and composition of side-groups which are determined by the bacterial strain, the feedstock, and the biochemistry that takes place in the bioreactor.

Danimer owns intellectual properties in the biotech space to produce particular combinations of side-groups of different lengths. For example, their main NodaxTM copolymer poly(3-hydroxybutyrate-co-3-hydroxyhexanoate) P(3HB-co-3HHX) contains about 5-8% of longer (HHX) side-groups. NodaxTM is made from natural oils like canola oil, and has been praised for its ability to biodegrade within 18 months. While the precise timescale may be questioned, it is orders of magnitude faster than non-degradable polymers that accumulate in landfills and are finding their way into the oceans.

In 2021, Danimer acquired Novomer Inc., in Rochester, New York. Novomer Inc. developed a catalytic technology to produce poly(3-hydroxypropionate) (P(3HP)), another PHA, with desirable barrier properties. This product goes under the tradename RinnovoTM . Its production involves a chemical pathway that catalytically converts ethylene oxide to a cyclic lactone which subsequently ring-opens to make the product polymer. This pathway enables a biodegradable P(3HP) to be made at much lower cost than the biochemical route. Additional new products are currently in the planning stages, and the polymer can be integrated into existing Danimer products as well, supporting their main business mission at a much lower cost.

Danimer has also been producing biodegradable products containing polylactic acid (PLA). They purchase PLA and formulate it into bioplastic resins through a reactive extrusion process. These products are also compostable. DNMR's PLA business has suffered indirectly from the ongoing war in Ukraine and appears to be a smaller part of their business as PHA scales up.

The biggest driver for demand of Danimer's products will be governmental action to address the plastic waste crisis. There is increased awareness of plastics that are accumulating in the oceans. Then there is human health: microplastics, defined as tiny particles less than 5 mm in diameter, and nanoplastics, particles with less than 1 micron in diameter are everywhere. They have been found in water, air, food, human blood and tissue, as well as human excrement, and researchers are only beginning to understand potential implications on human health. (C&E News, May 2020).

Companies that produce or utilize throw-away plastics may be wise to start thinking of alternatives because governments are starting to take action. However, it is not clear what role bioplastics will play in the future. Just last week, the Scottish government banned single-use plastics including cutlery, plates, beverage stirrers, food containers and cups made from expanded polystyrene. However, the Scottish government only allows reusable cutlery but not biodegradable products. Los Angeles County, on the other hand, just restricted single-use food ware and requires its replacements to be compostable, recyclable, or, for full-service eateries, reusable. This ordinance will take effect May 1, 2023. Decisions of this kind will positively impact demand for Danimer's products.

Danimer has established R&D relationships with companies to develop new products, and relationships with prospective customers of their existing products. Figure 3 was taken from DNMR's first quarter presentation and includes several recognizable brands. While the level of customer commitment and involvement of new research partners is unclear, the partnerships show strong commercial interest in DNMR's technology.

Figure 3. Slide from Danimer's 1Q 2022 presentation showing industrial partners. (Danimer's 1Q 2022 Presentation)

Danimer currently operates one PHA producing plant in Kentucky. To date, they have finished their Phase I construction, and their production rate is about 20 million lbs of Nodax-based finished product per year. Phase II will likely be completed in 2022, bringing their production to 65 million lbs annually, and turning the plant's operations profitable. In 2021, Danimer broke ground for another facility in Greenfield, GA, which will add an additional capacity of 125 million lbs per year, bringing their total capacity to 190 million lbs of finished product annually.

Management has stated that, during 1Q 2022, the Kentucky plant operated at or above nameplate Phase I capacity of 20 million lbs. However, Danimer only reported $13.2 million in product revenue this quarter, with 52% coming from PHA production-presumably from the Kentucky plant. This equates to revenue of about $ 0.60 per pound of PHA, which seems low considering that the market price ranges between $1.00 and $2.40 per lb. Perhaps part of their finished product incorporates less expensive additives, or perhaps they wanted to provide their customers with attractive initial agreements.

My simplified discounted free cash flow model is summarized in Figure 4 below. The model makes many assumptions because management has not released pricing figures, margin targets, or anticipated production costs for PHA products from their Kentucky Plant and their Greenfield plant. This makes it difficult to estimate revenues or profit margins. Instead, I used the company's recently declared performance targets that release shares to employees as a way to estimate EBITDA (Earnings Before Income Tax Depreciation and Amortization). If management believes that achieving these targets could enrich employees, then they presumably are reasonable targets. With EBITDA estimates, depreciation can be added back to obtain free cash flow.

The model first assumes that Danimer will hit analysts' revenue expectations in 2022 and 2023. For 2024, the model assumes they will hit the revenue target of $190 million which is needed for employees to fully vest 30% of newly declared performance shares. Cost of revenue is taken as 50% of revenue and half of the current depreciation is added as well. Sales, general, and administrative expenses are taken as 30% of revenue plus the other half of depreciation. These may be high-ball estimate to cost of revenue and sales expenses, but stock-based compensation is completely ignored. CapEx investments are shown on row 11, and they are concentrated in the next few years to pay for the Bainbridge plant. All CapEx investments are depreciated evenly over five years. Taxes are calculated at 25% of EBITDA, but are corrected for depreciation. Free cash flow (FCF) is calculated at the end of each year by starting with EBITDA, subtracting CapEx, taxes, and interest. Each year's FCF stream is discounted by a rate of 9% to calculate its present value. FCF in the terminal year, 2030, is calculated as eight times the FCF of 2029 and is also discounted to present value. The sum of all FCF is then divided by the total number of shares to determine the stock's intrinsic value. Danimer's intrinsic value for this scenario is $2.99 per share which is about a dollar per share lower than its current value.

Figure 4. Table showing discounted free cash flow model for Danimer. (Created by Absolute Valuation)

The crude analysis suggests that Danimer is currently overpriced by about 30%. However, the assumptions are crude, and the results are very sensitive to profit margins. As time passes, and more data become available, the investment case will develop, but for now, investors may want to patiently watch.

Many of DNMR's products are new, and management acknowledges that there is a risk that customers currently evaluating products have not yet made large-scale purchasing decisions. Since DNMR's products are engineered to biodegrade over relatively short time scales, one may wonder how their physical properties hold up during the intended usage phase. DNMR's customers likely require sufficient mechanical properties and barrier properties during storage and usage phases, yet the product should biodegrade quickly upon disposal. It is possible that the physical properties cannot compete with petroleum-derived products, or the usage phase is too short, for some targeted markets.

DNMR is making large investments but is generating negative cash flows, and this will continue for at least a few more years. It will take time to ramp up PHA production, DNMR only has funds to finish their Kentucky facility and pay for part of their Greenfield Facility at Bainbridge. To raise money, they will have to take an interest-bearing bank loan or issue more stocks, and shareholders will experience dilution. Potential investors should keep an eye out for sharply increasing revenue that meets or exceeds guidance, which will show that customers are really buying their products.

To my understanding, Danimer has had a rather excessive stock-based compensation (SBC) for some time now. In their 1Q 2022 report, they declared $13.7 million of stock-based compensation expenses for the three-months ending March 31, 2022. This compensation was in the form of restricted shares and performance shares that remain unvested until targets are met. This figure accounts for 30% of their total operating expenses for that quarter and appears excessive. This poses a risk, because it weighs on shareholder value.

The main feedstock for PHAs is canola oil. Unfortunately, this is an agricultural feedstock using land that competes with our food chain. As Figure 5 shows, the price of canola oil has increased substantially over the last few years with the bump in 2022 due to the Ukraine war. The best DNMR can do is to minimize risks by buying futures and passing the price on to their customers. However, this carries the risk that DNMR may lose customers. Ideally, DNMR would find a carbon-rich feedstock alternative to canola that has a more stable price and does not compete with the food chain. Also, what really matters is the price of canola oil relative to petroleum because rising petroleum prices benefit DNMR by making their products more price competitive.

Figure 5. Plot of the price of canola oil in Canadian dollars per ton from 2018-2022. (Trading Economics)

Danimer's approach to producing biodegradable packaging products directly addresses a growing demand that is driven by both sustainability and environmental concerns. Danimer would make history if they lead the commercialization of PHA at a large scale. Danimer has a solid intellectual property moat around their major product, PHA, and they can pivot in different directions to meet customer demand. However, there are risks and uncertainties that lead me to rate this as a hold: (i) the company's cash burn is large and I want to see a pathway toward profitability with well understood risks; (ii) while customers want to embrace sustainability, it is not clear that they are willing to place large scale orders; and (iii) canola oil as a feedstock competes against food chain agriculture and its high price will drive up the price of Danimer's PHA products.

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Disclosure: I/we have a beneficial long position in the shares of DNMR either through stock ownership, options, or other derivatives.