Carbios — Transition year and strengthened balance sheet

2017 was a year of major transition for Carbios as it marked the final year of the Thanaplast research programme. There were also a number of major technological advances in Carbios’s PET recycling processes. 2017 was also the first full year of the arm’s length relationship between Carbios and its 61.3% investment, Carbiolice, its key partner in the development and commercialisation of biodegradable plastics technologies. Carbios’s balance sheet was considerably strengthened during the year, in large part through an equity issue, leaving the company funded through to 2019 (according to the company’s management).

In our 31 October 2017 update note we reviewed a number of the year’s other major developments: a reshaping of Carbios’s management structure to meet the needs of the transition from a research operation to a fully commercial entity; the breakthrough five-year agreement with personal care products titan, L’Oréal, for the exploitation of Carbios’s biorecycled PET technology; and an agreement with TechnipFMC, the major global energy and chemical engineering company, under which Technip will develop methods of integrating modules using Carbios’s technology to produce precursors for PET manufacture.

Carbios originally came into being to execute the five-year and five-stage Thanaplast programme. The Thanaplast programme, partially funded by the French state via national investment bank, Bpifrance, was focused on the development of enzymatic processes for the biodegradation and biorecycling of plastic polymers. Thanaplast was shaped by an agreement with a number of blue-chip scientific, industrial and development partners: the National Centre for Scientific Research (CNRS), the University of Poitiers; the National Institute for Agricultural Research (INRA), the French state body that directs applied scientific research for agriculture; Limagrain, a large agricultural co-operative focused on cereals; Deinove, a quoted biotech company; and the Barbier Group, a major supplier of plastic films.

The Thanaplast programme came to an end on 30 June 2017, having reached all the milestones set at its inception. While this marked the closure of the operational phase of the programme, there was still some uncertainty over the timing of its final financial payments. Carbios received the final payments under the programme in the 2017 accounting period (c €1m in H217). This means a financial line can be drawn under the programme as we do not anticipate any repayment of advances during our forecast horizon to end 2019. The total amount repayable to Bpifrance, of €4.525m, will be triggered only if Carbios receives cumulative revenue, from the utilisation of products resulting from the Thanaplast project, of greater than €10m. The repayments are scheduled to be spread over five years (once the €10m threshold has been crossed) and back-end loaded with a final payment of €1.95m in year five. An additional payment of 4% of its revenues (related to the utilisation of the product) becomes payable if cumulative revenue exceeds €100m. This additional payment is time limited to five years consecutively post the conclusion of the repayment of the original advances and is limited to a maximum of €7.1m.

The conclusion of the Thanaplast programme marks the end of Carbios’s original incarnation as the manager of a scientific research programme, which had already been declining in importance compared to its strategy of scaling up these technologies and licensing the processes developed under the Thanaplast programme.

Carbios’s relationship with Carbiolice, in which it holds 9.5m shares (61.3% but treated as an equity interest in which Bpifrance and Limagrain are minority investors), is starting to generate revenue.

Carbios received three payments worth €0.72m in research fees from Carbiolice during FY17. Two, worth a total of €0.47m, came in the first half and the third, worth €0.25m, came in the second half. In total, the research agreement is worth €1.248m (five payments). The two remaining payments, worth €0.52m, are due to be received in 2018. Agreements, covering other services, including consulting and laboratory equipment provision, yielded smaller amounts, totalling c €76k.

Carbiolice is well funded with its owners committed to investing €18m. Carbios’s potential additional contributions now total €3.4m (post the recent commitment of €1.1m), although payments could turn out to be less than this maximum figure. Live tests of its processes are scheduled to begin with potential clients in 2019. Its intermediate objective is to address an ultimate end-user market of 40,000 tonnes of biodegradable plastics. This will take the form of masterbatches (rather than compound pellets) to produce 100% compostable and biodegradable plastics scheduled for production in 2020.

The holding in Carbiolice does not fit into Carbios’s strategy as a developer and owner of intellectual property, so it is more than possible that ownership will drop below the majority level over time.

The pattern of results across the half-year periods illustrates the lumpy character of Carbios’s revenue line. The timing of research services payments from Carbiolice and the final outright subsidy payment from Bpifrance had a noticeable effect on the revenue line, only partially offset by a jump in miscellaneous revenue in the second half. We had originally factored in the assumption of €300,000 in licence revenue from Carbios’s PET technology, but due to timing issues this has not yet materialised.

There were also some observable trends in operating expenses. At the halfway stage we highlighted that the bought-in services charge had declined sharply as the volume of external research work commissioned under the Thanaplast programme dwindled and although the second half saw a rise due to the ramping-up of business development, year-on-year external charges fell by 22%. In H1, staff costs rose by 33.5% y-o-y due to the hiring of three employees including a new Deputy CEO and while this moderated in H2, staff costs increased by 23% y-o-y for the full year.

Overall we had expected a decline in second-half costs, but these rose significantly, principally due to Carbios’s provisioning for future royalty payments of €0.72m owed to independent researchers as and when their work generates commercial revenues (€0.08m had already been expensed in 2016). This was a non-cash item and led to a rise in end-2017 accounts payable to €1.43m from €0.49m (FY16).

The reported operating loss of €4.65m for FY17 compared to a profit of €3.55m in FY16. However, the FY16 figure included €8m in non-cash income from the licensing deal under which Carbios took control of Carbiolice. Excluding this, we estimate a comparable underlying loss of €4.45m in FY16.

The 2017 balance sheet was strengthened significantly by the €3.6m capital increase in July (at some €7.7 per share), and the issue of new shares worth €1.5m under the Kepler Cheuvreux equity line finance programme. The Kepler Cheuvreux facility was put in place at the end of March 2017 and allows Kepler Cheuvreux to subscribe for a maximum of 380,000 Carbios shares (c 9.9% of the shares at the time the agreement was signed) over a period of 24 months. The shares can be acquired by Kepler-Cheuvreux at a maximum discount of 7.5% to the volume weighted average price (VWAP) in the two days prior to the issue. As at the end of FY17, 200k shares had been issued under this facility. As a result of the equity issues, the FY17 gross cash increased to €7.5m from €4.7m at end June 2017. The free issue of redeemable equity warrants to existing shareholders on a one-to-10 ratio in November 2017 is unlikely to have a short-term effect on Carbios’s liquidity, in our view, as the current share price is below the exercise price of €10.4/share. The warrants expire at the end of November 2018. Management states that it will be able to fund current activities well into 2019 without recourse to fresh external finance.

For FY18 we have assumed total revenue rises marginally, to €1.1m. We forecast a similar small rise in revenue in FY19 to €1.2m.

While we forecast Carbios’s costs of sales will rise, we expect Carbios’s general and administrative expenses will decline in FY18 (versus FY17) given a full year of lower external research costs, non-recurrence of one-off personnel costs and the charge for royalty payments. With the overall cost base relatively stable, we expect this to translate to broadly static operating losses of €4.6m in FY18 and €4.8m in FY19 (from €4.7m in FY17).

We expect capex to remain broadly constant over the forecast period at c €0.7m and for Carbios to make additional contributions to Carbiolice of €3.4m in total in the period 2019 and 2020 (€1.1m committed in 2018). Our forecasts assume capex and expenses are funded via the issue of debt (€7m in 2019 and 2020).

In March 2018 Carbios was able to announce a major technological advance in its PET processes in addition to the production of virgin PET via the depolymerization of coloured PET bottles announced in October 2017. It can now demonstrate the depolymerization of waste PET textile fibres into its original monomers: terephthalic acid (TPA) and monoethylene glycol (MEG). It has also just announced significant progress in the development of the technology in the form of an optimised enzyme that cuts the time required for the hydrolysis part of the process by three.

We understand Carbios is in negotiations with a number of major brand owners for collaborative deals similar to the breakthrough agreement signed with L’Oréal last autumn. Carbios hopes to have sufficient partners on board to launch the recycling consortium formally by the second half of 2018. Ideally, this will include representatives from the major industries currently using PET: drinks, foods and textiles. A decision will probably be made later this year on the specifications and financing of the pilot line for the PET technology. The output capacity of the pilot plant has yet to be fixed and this decision will be driven by the number and scale of collaborative deals with brand owners but we estimate a capacity of c 10,000kgs/year is possible. There is also a range of potential financing options for the plant with a state-subsidised operation directly under Carbios’s ownership as a possibility, in our view.

With the first full-scale commercial revenues still a couple of years in the future, we believe the key influence on the share price in the coming months will be the announcement of further collaborative deals with brand owners. However, there is inevitably a low degree of visibility, on both scale and timing, in this respect. Meanwhile, Carbios is still an early-stage company, on the cusp of transitioning from a pure research entity. This means that future cash flows are uncertain in terms of size and timing as they are governed by technology, execution and commercialisation risk, as well as risk related to market development and product adoption that is still very far out, which means that there is a heavy weighting to cash flows that are still very far in the future. We therefore use a DCF methodology to provide an indicative valuation for Carbios.

We have updated our valuation to reflect the acquisition of a majority interest in Carbiolice in 2016, the recent results, the issue of equity and the additional contribution of €1.1m to Carbiolice in 2018. We have also remodelled our DCF and now base our cash flow projections on two principal business segments: biodegradation and biorecycling. We have extended projected cash flows to 2035, assuming a long-term EBIT margin of 60% (for the period 2031-35 we assume the margin remains at 60%), a discount rate of 15% and perpetuity growth rate of 2%. Using these assumptions indicates a valuation for Carbios of c €15/share (down from the €20-32 per share shown in our report of October 2017). The reduced valuation reflects the increase in the number of shares, higher capex and a more cautious assessment of the timing and magnitude of commercial revenues. The valuation remains sensitive to assumptions on discount rates, perpetuity growth rates and long-term margins. Exhibit 2 below shows the sensitivity of our valuation to long-term margin projections to 2031 (we assume equilibrium 2031-2035) and, in particular, discount rates.