EcoSynthetix Inc

TSX:ECO

Earnings Call Transcript 2022-Q1

[Operator]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the EcoSynthetix 2022 First Quarter Results Conference Call. [Operator Instructions] Listeners are reminded that portions of today's discussion may contain forward-looking statements that reflect current views with respect to future events. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. For more information on EcoSynthetix risks and uncertainties related to these forward-looking statements, please refer to the company's annual information form dated February 24th, 2022, which will be posted on Cedar. This morning's call is being recorded on Wednesday, May 4th, 2022, at 8:30 AM Eastern Time.

I would now like to turn the call over to Mr. Jeff MacDonald, Chief Executive Officer of EcoSynthetix. Please go ahead, sir.

[Jeff MacDonald, executive]

Thank you. Good morning and thank you for joining us today. Yesterday afternoon, we released our 2022 first-quarter results, which you can find on our website at ecosynthetixs.com. You can also download a copy of the slides that accompany today's call from our website or alternatively access them on the webcast. Revenue grew 15% to $4.2 million in the quarter off a tough period in 2021. On the face, that top-line number is frustrating given the strong momentum we're making in key parts of the business. The deterioration of demand from the graphic paper market impacted growth. However, the quality of that revenue mix has improved significantly on a year-over-year basis. What do I mean by that? Our multiple shots on goal strategy is working.

During the first quarter, we continued to diversify our revenue mix with a greater contribution coming from wood composites versus our historical mix, which was heavily weighted towards graphic paper. The long-term success of the business will be based on our ability to continue to scale up volumes with our 2 wood composites accounts and the new accounts we bring on board, as well as the opportunities in the personal care space and more recent success we have seen from the wet end paper and specialty paper end markets. We believe this diversification will continue to accelerate through 2022 and into 2023, based on the demand we're seeing from our customers today. The momentum and progress we are seeing in these growth markets is being partially offset by continuing weakness and graphic paper and the broader global supply chain disruptions, which I'll address in a moment.

On the wood composites front, our progress is going well with the key strategic wood composites account, which confirmed contracted volumes with us last November. This relationship is the result of 6 years of development work and time lines didn't always proceed as fast as we would like, which quite frankly should have been expected. Large organizations can be challenging to mobilize, but once they do, they also carry a great deal of momentum. As this account has moved ahead with production on the first line and operationalized us into their supply chain, we are now seeing them push ahead with a plan for additional operations and new volumes, according to a schedule that they have established internally. This is great news.

In the current environment with today's inflationary pressures and the scarcity of supply on other inputs, we have been able to provide them with better certainty than traditional inputs that are more tightly correlated to commodity markets. Our DuraBind resin represents one component of the significant steps they are taking toward an overall greening of their product line as a major retailer that is backward integrated into their manufacturing base. Our ability to grow within the strategic account is a key element of our longer-term commercial strategy and a major focus for our team. We are also making strong progress with our first wood composites account, Swiss Krono.

Through the course of 2022, they have engaged with us in the work necessary to onboard additional lines from different locations. They are deep into trials on one of these new lines, and we are just getting started with 2 other lines. Their level of commitment in using DuraBind is strong, especially in the face of today's higher price environment for conventional resins. As part of their safe and sustainable living and building marketing strategy, we help enable them to produce the most environmentally friendly particle board available that delivers the highest indoor air quality.

In the paper market, we're experiencing 2 very different dynamics. Within the graphic paper application, the macro market demand continues to deteriorate, which has resulted in additional [ mill ] consolidation across the sector. The demand issues have impacted our accounts as they have lightened their volumes or rationalized their inventory management in the face of inflationary pressures. The pricing dynamics of oil and natural gas have driven higher prices for the key binders we replace namely SB latex and SA latex. Within this environment, we have been able to mitigate the raw material cost pressures that we are experiencing on the feedstock and chemical side to protect our pricing and earn a margin that is both fair to our accounts and provides a return to our investment.

Despite these macro challenges, we continue to believe that graphic paper will be a sustainable revenue stream for us in the future. The accounts we are active with continue to see value in ecosphere. However, as we grow in other markets, the proportion of revenue we earn from graphic paper will become less meaningful over time as we do not see it as a significant area of growth. We continue to see opportunities for ecosphere within the specialty packaging application, although these end markets are more niche in nature than the broader paper end market.

A more recent development is the momentum we're seeing in the wet end per market. The wet end is at the front of the manufacturing process where we can address fiber sheet formation. As paper and paper board is recycled, the fibers become shorter than virgin fiber. Lower cost fibers are also shorter and weaker. Our binder is being used to strengthen the fiber at this stage. This is a key opportunity for mills to drive cost savings, replacing more expensive inputs that are required to maintain strength during the formation stage. The potential of our biopolymer as a strength aid enables manufacturers to make lighter weight sheet or use lower-cost materials as well as potentially achieve higher line speeds.

We have one commercial account today with momentum on other prospects. We are conducting trials at their mills and to date, the results have proven as positive as we've seen in the past. The prospects are really encouraged by the offering and we're starting to see demand build in this application for the second half of the year. Unlike specialty packaging, the wet end application is a larger volume market because it addresses the fiber sheet formation stage across multiple product categories, including packaging and tissue. It's an exciting opportunity that expands our addressable market and forms a new growth vector for our biopolymers.

The challenge we are facing with the demand we're experiencing across both the wood composites and the wet end applications is supply chain constraints. We're seeing record costs across the board. We're faced with labor shortages and cost increases with our production partners and cost increases on every single raw material to record levels. The combination of these issues is unprecedented. On the positive side, to date, we have effectively passed this cost increase is on. Our goal is to remain competitive and be fair to customers and to keep those in balance. Paying more for raw materials is one thing, but our ability to secure sufficient supply is also critical. The war in Ukraine has exacerbated the situation in terms of our primary feedstock corn starch.

In order to meet demand, we are using a multi-pronged approach. We're working with multiple vendors, including smaller players, rather than our traditional practice of working through one or 2 large suppliers. These smaller players can often be more agile and maybe good strategic options for us in the future. We're contracting into the future. For instance, last October, we contracted for supply for this spring. We're now at a point where we're beginning contracting discussions for supply in the 2023 growing season, which is a much longer contract that than is typical for us. We're also trialing other feedstocks that would provide us greater flexibility than remaining dependent on just corn starch. We're taking a broad-based approach in this regard and trialing multiple feedstocks to ensure the integrity of the binder's performance.

Finally, for the first time ever, we're evaluating purchase orders in a more judicious manner to ensure that demand from our strategic accounts is met and that less recurring, less strategic business is properly prioritized. The current supply environment is challenging. Based on third-party reports, it's more likely to get tougher to secure supply later this year and into 2023. It's a situation we're monitoring closely and we'll continue to provide updates in future quarters.

On the personal care front, during the first quarter, we started to see a step-change for the first time, since the onset of the pandemic. Our marketing and development partner, who is a global chemical player, is excited by the movement they're seeing in the market. Volumes were up in the quarter while still small on an absolute basis and relative to the impact our partner is expecting it can have in them it's all-natural attributes. Earlier this year, it was one of 4 products they showcased at a major marketing event in Paris. The feedback and follow-up they received has fueled their confidence in the potential for their all-natural product line.

Our diversification strategy is working. The contributions from our wood composites and wet end applications are growing. Personal care is a third element that is beginning to shape up nicely. Demand from the graphic paper market and supply chain constraints are macro headwinds that we will continue to manage. Most importantly, the momentum we have been anticipating from the wood composites application and the flexibility of our technology to address the wet end market has set the stage for sustainable growth. With that, I'll turn it over to Rob to review the financials. Rob.

[Robert Haire, executive]

Thanks, Jeff. Good morning. Net sales were $4.2 million Q1, 2022 up 15% or 560,000 compared to the same period in 2021. The increase is due to higher average selling price, which increased sales by $1.2 million or 32% partially offset by lower volumes, which reduce sales by $600,000 or 17%. The pricing increase was the result of higher market pricing for incumbent chemistries and an effective pass-through of higher manufacturing and raw material costs. The change in volumes was due to customer inventory rationalization and on favorable market conditions and graphic paper, including 22% lower volumes related to the closure of a paper mill that was announced in the third quarter of 2021.

Gross profit was $1.1 million in the quarter up $330,000 or 44% compared to the same period in 2021. The improvement was due to higher average selling price partially offset by the lower volumes and higher manufacturing costs. Net of manufacturing depreciation gross profit is a percentage of sales was 28.9% in the quarter compared to 26% in the same period of 2021. Supply chain constraints and freight and raw materials have created operational challenges and higher manufacturing costs as Jeff mentioned. However, the pricing dynamics of federal-based chemicals we compete with are creating pricing tailwinds for us, which has allowed us to implement pricing actions to help offset cost escalation and improve our margin profile.

SG&A expenses were $1.3 million in the quarter, an increase of 140,000 compared to the same period in 2021. The changes primarily due to lower payments received under government assistance programs of 100,000. R&D expenses were $430,000 in the quarter compared to $330,000 in the same period of 2021. R&D expense is a percentage of sales was 10% in the quarter compared to 9% in the same period of 2021. The changes primarily to lower government assistant payments of 100,000. We continue to invest in innovation and improve our value proposition and expand our addressable market opportunities.

Adjusted EBITDA loss was $190,000 in the quarter compared to a loss of $300,000 in the same period of 2020. The improvement was primarily due to higher gross profit, partially offset by higher operating costs. Cash used in operating activities increased to $1.7 million in the quarter compared to cash provided by operating activities of $370,000 in the same period in 2021. The change was primarily due to higher inventory due to the increased costs of raw materials and lower trade payables and accrued liabilities.

As of March 31st, 2022, we had $39.9 million in cash in term deposits compared to $42.2 million at December 31st, 2021. During the quarter, we purchased term deposits of $20 million. We also invested $600,000 in NCIB share buybacks. We have demonstrated our ability to responsibly manage our cash reserves through multiple cycles while continuing to invest in our long-term growth strategy. With that, I'll turn it back to Jeff for closing comments.

[Jeff MacDonald, executive]

Thanks, Rob. We believe the demand and interest in sustainable healthier ingredients will be a continuing tailwind for us whether it's within the wood composites or personal care markets. The benefits that our biopolymers provide touch on major themes that forward-thinking manufacturers, retailers, and end customers want. The market is moving toward us. Together with the performance and cost benefits we provide to wet end applications, I believe the growth opportunity in front of us has never been stronger. We're working with major manufacturers and partners that recognize the sustainability attributes and the value that our platform delivers. They're actively engaged in the change agenda. They've invested in their facilities and processes, and they recognize the benefits of driving further implementation and adoption across new lines.

The advantages our biopolymers offer across each of our 3 end markets and the market dynamics as customers, retailers, and manufacturers pursue more sustainable and healthier alternatives position us to deliver long-term sustainable growth. We appreciate the trust and patients that our shareholders have shown to us, and I'll look forward to updating you further on our progress. With that, I'll turn it back to the operator for questions. Thank you.

[Operator]

[Operator Instructions] Your first question comes from Meaghen Annett of TD Securities.

[Meaghen Annett, analyst]

Just a couple of questions on the quarter just start off, so understandably some challenges here on the top line, but we did see revenue decline sequentially. Was that mostly the decline in graphic paper or is there any meaningful impact from the supply challenges to call out?

[Jeff MacDonald, executive]

The most meaningful part of the decline quarter over quarter is coming from the decline in graphic paper, and that comes from a slowdown at specific customers, as well as what we believe is some inventory rationalization where some of our customers, I think, due to logistics challenges, and maybe trying to time orders to achieve the best cost position they could, we think there was some inventory rationalization that contributed to that. The supply chain challenges didn't really impact our ability to deliver the number that we delivered, but it did prevent us from delivering more. I would say delivering more to our expectations and what we would've planned to in quarter one. There's still some challenges to come in terms of what we're able to deliver based on those supply challenges, but it's going to be, I think, fair to say early on in the year here, it's still going to be a constraint to growth as an opposed to an ability to deliver to our strategic accounts. We think we've protected the accounts that are most important to our growth going forward.

[Meaghen Annett, analyst]

On the gross margin, understandably a benefit from higher selling prices. Can you just maybe break out how much of the improvement on the gross margin year-over-year was driven by price or relative to the revenue mix?

[Robert Haire, executive]

Predominantly, the expansion of gross margin we could contribute all to product mix. In our graphic paper accounts, we're able to pass through ASP changes to protect the cost escalations, but the margin expansion is coming from product mix.

[Meaghen Annett, analyst]

Just turning to the wet end vertical and the opportunity there, I want to get a sense of what demand is looking like. Understandably supply constraints right now, but in a perfect world, what type of contribution would you see the current demand picture yielding? Can you give some goalposts around the potential opportunity there either on a per-line basis relative to the 5 million to 6 million for IKEA and wood composites or in terms of the larger addressable market opportunity?

[Jeff MacDonald, executive]

On a one-year perspective for us, we believe it can be a significant contributor to meeting our expectations for the full year assuming that we can get starch to support it in the back half of the year. We think that would allow us to be pretty close to your expectations as well, but it is all predicated on our ability to get starch. The opportunity and we are realizing it on a consistent basis, that the first tissue mill that we reported as commercial late last year, we continue to supply to them and to a small tissue mill. Tissue mills tend to be on the smaller side of fiber-based product relative to let's say a packaging mill. That opportunity per mill is going to be in the several hundred thousand per year range versus a large packaging mill, which could be several million. I would put it in a similar scale to what we see from a significant particleboard line in the wood composite space. On the macro side beyond that, I think it's fair to say we're still sorting it out. We have a few data points, they're looking increasingly positive, but I still feel it's premature for us to extrapolate and say that this is going to be a several hundred thousand dollars opportunity or multi tens of millions of opportunity, but certainly, the scale of fiber-based packaging is there that if we have the fairly universal solution that we believe we have, this could well be our most significant opportunity as a company.

[Meaghen Annett, analyst]

Just on the wood composite side, so in the slides, you noted additional planned volumes at your retail manufacturer customer. Can you just confirm the number of lines you would be on at the end of the year or the revenue per line there? If you could also do the same for Swiss Krono, that would be helpful.

[Jeff MacDonald, executive]

Sure. For the strategic retailer, the good news there is that the message hasn't changed since the first quarter, which is great in that they and we are sticking to plans. And the plan would have us fully implemented on all products every day, every night by the end of the year, so full-on operation by the end of the year, and being introduced in the early stages onto a second line. With Swiss Krono, things are progressing well. They see expanded opportunity for BE.YOND, indicative of that, I guess, is that they've actually started to receive larger format deliveries from us at the first operation that's supporting BE.YOND and that's based on their expectation that they're going to see a ramp-up in that. They've also got plans in place. We've done initial assessments at a second site that would support BE.YOND as well.

Then, the other opportunities we're seeing are for different products within their mix. One in very late-stage trials, which we expect to be one we can talk about as being commercial sometimes through the middle of this year if things continue to go as they are. And they are introducing us on to 2 additional lines beyond that as well in early stages of trials. Again, if those go well it's possible that those 2 additional ones could be commercial by the end of the year. That's assuming everything goes well.

[Meaghen Annett, analyst]

Great. Just last question, and then I'll pass it on. On the supply situation with regards to cornstarch, so you did mention alternative feedstocks. What would be the time line to be able to implement something like that within commercial accounts? Is that a near-term or more of a midterm solution here?

[Jeff MacDonald, executive]

I would call it a midterm solution and I'd say that for 2 reasons. Firstly, technically proving it across an application where a customer has already invested the effort improving our primary product is a significant process. We've proven a couple of things here in Burlington to the extent where we are now trialing them in first applications at friendly customers, but I would say it's still a fairly long path to technical implementation. And then I think the other factor, one of the reasons why we're doing this is that we have greater longer-term flexibility should we need to pivot in the future. Certainly, we'd love to pivot today, but the challenges that some of the things we could pivot to today are also under exactly the same pressure. A good example is wheat starch. We've got something that may work, but the situation with wheat, based on what's going on in Russia and Ukraine, doesn't put it in any more favorable light today. That's the same for some of the other commodities that we're trialing as well.

This current situation was a bit of a wake-up call to us to be more flexible for the future. I don't think it represents a short-term solution to our challenges. I would say the development team is focused on some of these opportunities for alternative feedstock, but most important to us right now is what our operational guys are doing to secure cornstarch in the near term. We have a team in Europe next week meeting with literally everybody in the space to secure what we can in the short term, but also as I mentioned to begin contracting discussions for 2023, which we've never had to do before.

[Operator]

[Operator Instructions] Your next question comes from Dan Marks of Stonehouse Capital.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Nice work under trying circumstances.

[Robert Haire, executive]

Thanks, Dan. Thanks for recognizing that.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Morning. Just want to follow up on -- Meaghen had asked about the wet end. I just want to maybe dig a little deeper on that area. First off, in your press release, I note that…

[Jeff MacDonald, executive]

Oh, sounds like we've lost Dan.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Sorry. Something happened there. In your press release, I note that wet end is mentioned before personal care. Are revenues in Q1 greater in wet end than personal care?

[Jeff MacDonald, executive]

I think it's fair to characterize them both as emerging, but as I mentioned in the script there, the contribution we're seeing from personal care has grown to be meaningful. And I would the revenue contribution that we're getting from that first commercial account, as well as trial volumes from wet end have started to be meaningful for us as well. Consider them as, I'll say from a revenue perspective, equally important emerging opportunities today. What we will see from a revenue perspective going forward is the top-line opportunity with wet end is obviously much more significant at good margins, but again, nothing quite like the margin's growth of the personal care ingredient.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Got it. You also refer to you're building a book of business. I understand the constraints with supply and cornstarch. Is it fair to say that your growth opportunities are being hampered by supply i.e., would your revenues be higher if it were not for supply constraints?

[Jeff MacDonald, executive]

I think that's safe to say going forward. Through the latter part of Q1 for the first time in our history, we were beginning to make decisions and say no to certain pieces of business. It's definitely hampered us. You started off on the wet end piece there. It's constrained our growth there looking forward. What we want to make sure is that when we get started in this new space with what are some very large players. We want to be seen as a reliable supplier, and so we want to make sure that when we turn let's say a large packaging line on that we're able to continue to supply to them month after month.

It's safe to say that based on the trialing work we've done, the demand is there today for more than we can see delivering in the near term. I would say so far, they've been respectful of the fact that they see what's going on in the global supply chain. They've been respectful of the fact that we're pacing the opportunity appropriately so that we can get the right things done together. Yes, looking forward, it feels like we could grow a lot more right now, and we're really hopeful that the starch supply allows us to realize on that in the back half of the year.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Is the plan to trial with a bunch of people have them know that it works and then when supplies available, ideally there's a bigger ramp-up?

[Jeff MacDonald, executive]

Yes, it's been a question in some cases of hurry slowly. We've done a lot of the upfront leg work that would give them confidence to go forward as soon as we can guarantee that supply, and that's on multiple fronts. There are a few lines that have taken that all the way to where the next orders would be commercial orders. I'll say a few there, and then there are a few more where we've done some of the upfront work to get into the trialing process. Yes, the stage is set pretty nicely to have this move once the starch is available.

[Daniel Marks;Stonehouse Capital;Analyst, analyst]

Last question. You did touch on the number of data points that you've had and your cautiousness toward is extrapolating the results too broadly. You've obviously had another quarter since last quarter of results. Have they all still been positive? Have you had any negative trials that cause you concern about the viability of the product?

[Jeff MacDonald, executive]

No. Without exception, every trial has actually exceeded expectations both in terms of what we're seeing technically in terms of the strength improvement, and then how customers can use that strength improvement to their advantage -- sorry, I lost my train of thought. There is a second point to that. The most important thing is that technically it's been a success in every single opportunity.

[Operator]

Your next question comes from [ John Van Lewin ].

[Unknown Analyst]

I have a wet end question as well. On the bulk fiber side, I remember one of our earlier customers is now a huge supplier in that in South America, and eucalyptus fiber, typically is shorter. I remember it being an opportunity with the kind chemistry we're talking about here for enhancing their fiber. Of course, that would move you really up in the supply chain. Can you make any comments on whether that's an opportunity or not?

[Jeff MacDonald, executive]

It sure is an opportunity, John, and it's an active one. It is a different dynamic and a different position in the supply chain, as you mentioned. We're further upstream in the supply chain. To finally realize on the opportunity, it takes longer because that customer then needs to provide the enhanced pulp to its customers and explain the economic argument to them in a way that it's a win-win for both sides and then get it to work technically in their end application. There's a few more steps beyond that.

Then, I think the other dynamic at that end of the market is as you remember, we made the trip together, these pulp mills are massive and to stop it and make change, and then evaluate that change is a big deal and an iterative process. But so far, in working through that with them it's looked very positive. One of the challenges that we will face is that in that case, we're enhancing the pulp and ultimately the pulp goes into these end applications that we've been talking about with other customers, whether it's packaging, board, or tissue. I want to be careful that we don't end up double-counting the opportunity because I'm not sure that you can enhance the fiber twice. There's still a lot to learn.

[Unknown Analyst]

In the first customers of tissue mill, are there any other benefits other than cost savings, anything that performs with tissue that is a benefit with this chemistry?

[Jeff MacDonald, executive]

I would say with tissue, not so much a performance benefit of the tissue itself. One of the concerns in putting a new ingredient in with tissue is that you impact softness, and that was the big caution flag that these tissue mills put in front of us to say, "Great if you can do this, but don't hurt our softness." We passed in that regard. There was no negative impact to the key performance attributes. In addition to just the cost of materials though, that we're having an impact on. In some cases, when you have a stronger fiber web, you can actually run the line faster as well. We're hopeful that can be a broader-based advantage.

[Operator]

Your next question comes from Jeff Schacter of TD Securities.

[Jeffrey Schacter, analyst]

I'm just wondering, you mentioned something about going to Europe for securing supplies. What is the strategy of those meetings? Is it to let you know the top price you'll pay and can quickly contract that spread to some of the people who have demand for your products, or is it just simply it doesn't matter the price or just isn't supply to find? If you can help me on that one.

[Jeff MacDonald, executive]

Thanks, Jeff. I wish we had the answer to that 100%. I think it's going to be both, to be honest. But the biggest priority for us in going there, and in our discussions in North America as well is to secure our growth opportunity going forward. It's highly probable I'll say that it will cost us more. These contracts are also based on committing to a volume, and then driving that volume when you have the actual demand according to a formula that's driven off of corn prices. That's traditionally the way this has been done, and we expect that's the way it's going to be done going into 2023. The reality is it's a bit wild west right now out there in the commodities market. We're going to do a lot of learning and then try to secure some commitments that allow us to achieve the growth we see.

[Operator]

There are no more questions on the telephone lines. At this time, I will turn the conference back to Mr. MacDonald for closing remarks. Please go ahead, sir.

[Jeff MacDonald, executive]

Thank you. And thanks very much for joining us today, everyone. We'll be back in touch with you soon.

[Operator]

Ladies and gentlemen, this does conclude your conference for this morning. We'd like to thank you all for participating and ask you to please disconnect your lines.