EcoSynthetix Inc

TSX:ECO

Earnings Call Transcript 2023-Q1

[Operator]

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the EcoSynthetix 2023 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 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 on February 28, 2023, which is posted on SEDAR.

This morning's call is being recorded on Thursday, May 4, 2023, at 8:30 a.m. 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 and good morning. We issued our 2023 first quarter results yesterday afternoon.

As we mentioned on our call in early March, Q1 was a challenging period. Net sales were $3.1 million, down 28% compared to the same period in 2022. While that short-term result is certainly frustrating, it's not the best method to evaluate the business.

We address multibillion-dollar industrial end markets, replacing fossil-based chemistries that have been used for many decades. We have direct relationships with the right customers to deliver significant growth, customers like SWISS KRONO, Dow and our key strategic wood composites manufacturer that is backward integrated into a leading international retailer.

The prospects we have in front of us today have never been better. In addition to progress with important existing relationships, this opportunity set is fueled by both new products and new relationships. The pipeline improved during the quarter with important progress made. Admittedly, that's not yet showing in our sales volumes. But the opportunity in front of us has not changed. It is as large as ever, and I'm confident in our ability to execute on it.

Why am I so confident? Our goal of becoming a $100 million revenue business is achievable with the customers we have in hand today. If we didn't add any new accounts in the coming years, if we went nowhere else, the opportunity set is there for us to surpass the $100 million figure with our key large accounts that each have multiple mills in their supply chains.

The opportunities are right there for us to realize on that goal, and I believe we can do it. And in fact, we have a broadening pipeline, with renewed interest on the wood composites front and continued new interest in our Surflock strength aid products.

During the quarter, the backward integrated wood composites manufacturer published its 2022 Climate Report. In it, they identified wood-based glues as 5% of their total carbon footprint. The manufacturer and retailer has identified bio-based glues as one of the critical movements in material choices within their supply chain and a key enabler of achieving their overall climate goals. That is a significant step forward in how they've positioned that goal to their supply chain and more broadly through the mainstream press.

It benefits us in 2 ways. First, the manufacturer committed to a meaningful step in its implementation of DuraBind for particleboard production at the first mill where we are operational. This step is about further industrialization and implementation beyond earlier commitments as they gained experience with DuraBind in their operation. That is great news that is not showing up in the quarter-over-quarter volumes at this point. So while this manufacturer became a meaningful account to us in 2022, we expect their volumes to step up significantly in the second half of this year.

Second, and potentially of even greater significance, the climate report and the media reports that followed it, made it clear to the retailer's supply chain partners that bio-based glues were critical to achieving its climate goals. That was a strong statement to the supply chain that the ship is sailing. Fossil-based glues are on their way out at the retailer and bio-based blues are the critical movement.

And I think that caught some of the third-party manufacturers in the industry by surprise that this much progress had been made. This international retailer is a forward-thinking thought leader in the market. When they move, it causes their supply chain and the broader industry to move. And we're starting to see that on new inbound interest in DuraBind.

In the early days of our DuraBind program, we had several prospects that went quite far in the technical evaluation of DuraBind and its use in their production processes, with largely successful results. They stopped short of moving to commercialization because they didn't see the market catalyst to warrant significant industrial change. The demand for more sustainable, healthier alternatives wasn't as evident then. That has changed with the commitment from this international retailer. They have set the tone for the market. And in the meantime, we have made significant improvements in the DuraBind product family.

We have new trial programs on the go in the second quarter. We're in a position to be more discerning about who has the capabilities and the conviction to move ahead with DuraBind. We're working with a few key prospects that we think can significantly move the needle for both the industry and for our results as well.

Later this month, we'll be attending the LIGNA conference in Germany, which is a major industry trade show and conference that takes place every 3 years. We expect that the awareness from the international retailer's commitment will drive new attention and interest in DuraBind at the event.

We are poised for greater success in the wood composites end market, and it's supporting our diversification strategy with the "multiple shots on goal" approach. It's working. While sales have remained stable the past few years, the composition of the revenue mix has changed substantially. The graphic paper end market used to make up more than 90% of our revenue just a few short years ago and almost all of our gross profit. With the industrial change we've enabled in our newer end markets, we have a good start, where today, our revenue coming from end markets outside of graphic paper is approximately half, and the contribution to gross profit is more than half.

The deterioration in the legacy graphic paper market continues. North American coated freesheet paper production was down more than 28% in Q1 versus the same period in 2022. Destocking is happening throughout the supply chain. As a result, industry operating rates have also dropped significantly over the past 6 months from 97% in September to 76% in March.

SB latex, the petroleum-based binder our EcoSphere binder replaces, remains below its historical pricing levels. These pricing dynamics, together with the cost profile of our feedstock, has EcoSphere at a disadvantage.

We made decisions in 2022 to secure sufficient feedstock to keep our key accounts in supply. That feedstock was higher cost, and it's working its way through our results. More recently, we have seen positive news on both the availability of feedstock and improved pricing than what we were seeing as recently as January, which is great.

The accounts that are using EcoSphere see the value proposition in it. The higher-priced feedstock has impacted demand, but as we work our way through that expensive feedstock and return to more normalized pricing levels, we continue to believe EcoSphere is a valuable contributor to the business.

I'm sometimes asked, "Why not just exit the graphic paper market if it's so challenged?" That is not our strategy. First, it is a good base loading level for our operations. It makes a positive contribution, more so in a normal pricing environment, but even in the recent supply-constrained situation, it is still a net positive contributor.

Second, we've established strong relationships with some of the largest pulp and paper manufacturers in the market. They rely on us. They trust us, and they are important to us as we look to broaden our reach with Surflock, our wet end strength aid.

The rollout of Surflock is moving slower than we anticipated due to general softness in the macro market, but interest in the product and the broadening of the pipeline is definitely happening. We're going into new geographies and new accounts on a monthly basis.

We have a number of key prospects in the pipeline that we have discussed before, and those prospects remain in place and remain the most important and advanced in the pipeline. But we have significantly more irons in the fire, so to speak.

Our primary go-to-market approach has traditionally been direct to manufacturers, and it's still key to us, but we've opened up another front, engaging the chemistry service providers that implement and monitor wet end chemistries at the mill level. There are a number of regional players that we're actively engaged with that could prove to be important channel partners for us over time. Our goal with them is to ensure they understand and can optimize a chemistry package that involves Surflock.

These players have a track record of excellent service to the mills right in the local environment, whether that's Eastern Europe, Japan or the U.K. We believe this group can be an important part of the go-to-market strategy in the pulp, tissue and paperboard end markets to realize the full potential of Surflock.

On the personal care side, our development and marketing partner, Dow, continues to make progress on the hair fixative end market. The results have not come as quickly as they expected. They continue to believe they can make a material impact in the market with all-natural formulations. And they've also broadened the addressable market with new formulations of MaizeCare for skin care, which they introduced at a recent cosmetics conference. Based on their feedback to us, Dow is enthusiastic about the opportunity for MaizeCare across both the hair fixative and skin care end markets.

We have the products in front of the right partners and the right customers to deliver a $100 million business. It's taking more time than we anticipated, but the opportunity set is as strong as ever, and we're confident in our ability to execute.

Now Rob will address our financials.

[Robert Haire, executive]

Thanks, Jeff, and good morning. Net sales were $3.1 million in Q1 2023, down 28% compared to the same period in 2022. The decline was due to a step down in demand across a number of our end markets, which resulted in lower volumes of $1.6 million or 37%, which was partially offset by higher average selling price, which impacted sales by $400,000 or 9%.

This demand pressure also included approximately $700,000 lower sales due to inventory destocking at a large distributor into the graphic paper end market as well as continued demand deterioration in graphic paper and softer demand due to temporary market-related customer mill downtimes.

These headwinds have continued to persist into the early stages of the second quarter. The higher average selling price this quarter was due to the continued need to offset significant inflationary pressures with price increases.

Gross profit was $600,000 in the quarter, a decrease of $500,000 from the same period last year. The change was primarily due to an increase in sales volumes and higher cost of manufacturing, partially offset by higher average selling price.

Manufacturing costs also included a $200,000 charge in additional depreciation on certain machinery and equipment due to a change in the useful life as a result of our plans to internalize our North American manufacturing.

During 2023, we expect to incur approximately $1 million in noncash-related accelerated depreciation charges related to this investment. Net of manufacturing depreciation, gross profit as a percentage of sales was 32.6% in the quarter compared to 28.9% in the same period last year.

As Jeff mentioned, we are holding higher costs, raw materials and inventory. Based on the recent pricing we're seeing in the market, we expect our feedstock costs to start to normalize in the back half of the year. However, this will also likely impact our selling prices.

SG&A expenses were $1.3 million in the quarter, a decrease of $90,000 compared to the same period in 2022. This improvement was primarily due to lower discretionary spending. R&D expenses were $600,000 in the quarter compared to $430,000 in the same period last year. The change was due to an increase in scale-up costs related to new product launches during the quarter. We continue to invest in innovation to improve our value proposition and expand our addressable market opportunities.

Adjusted EBITDA loss was $600,000 in the quarter compared to a loss of $200,000 in the same period last year. This change was primarily due to lower gross profit and higher operating costs, while compared to the prior period.

Cash provided by operating activities was $300,000 in the quarter compared to cash used in operating activities of $1.6 million in the prior year period. This improvement was primarily due to working capital improvements.

As of March 31, 2023, we had $35.6 million in cash and term deposits compared to $36 million as of December 31, 2022. During the quarter, we invested $400,000 in property, plant and equipment related to our manufacturing capacity realignment strategy. In 2023, we expect to invest up to [ $2.0 million ] on these production capacity investments. In addition, $200,000 was invested in the NCIB during the quarter to purchase and retire 68,400 shares. We have demonstrated our ability to responsibly manage our cash reserves through multiple cycles while continuing to invest in our long-term growth cycle.

With that, I'll turn it back to Jeff for closing comments.

[Jeff MacDonald, executive]

Thanks, Rob. We have direct relationships with customers to achieve our $100 million revenue target with no new account wins. Higher volumes and more mills within the existing account base get us there, and we expect to win new accounts. This will come with the new attention that DuraBind is attracting from the supply chain of the international retailer, the progress we're making in the wet end strength aid market and Dow opening new opportunities in personal care. We are positioned for growth.

With that context and given the softness in capital markets, the Board has decided to lean into the NCIB share buyback program. It will be a balanced approach that recognizes both our belief in the long-term prospects of the business and the importance of maintaining a strong cash reserve in difficult markets and the value our large customers place on knowing that we have the resources to sustain through market cycles. But in the current environment, we see significant value in the stock at today's levels, so we'll be allocating more capital and using the NCIB to address that fact.

And with that, I'll ask the operator to open up the call for your questions. Thank you.

[Operator]

[Operator Instructions] Your first question comes from [ Brian Morrison, ] a private investor.

[Unknown Attendee]

Jeff, do you hear me?

[Jeff MacDonald, executive]

Yes, we can hear you, Brian.

[Unknown Attendee]

Okay. So let's start big picture. It seems like no change to the view of the opportunities ahead. You have that slide with $100 million target and the 5 customers that can get you there. I guess you're talking a very positive story here, but what gives you the confidence in this challenging environment to maintain that guide, both in terms of the quantity of revenues and the timing?

[Jeff MacDonald, executive]

I think it's the conviction and the quality of that customer base that we're working with today. These are high-quality large companies, for the most part, they have done their due diligence in what we have to offer and have built us into their plans. And when we add up the opportunity from among the ones that we're working with today that are most important to us, that gets us to greater than $100 million of opportunity itself. And then the spin-off benefit from that is that those are often the thought leaders in the markets we're working in. And that spin-off impact of them having made moves with us, I think, bodes well for us to continue to expand our pipeline with other accounts.

So we see the opportunity right in front of us. We see the enthusiasm and the interest in the customer base every day. It's not showing up in our results in this quarter, for sure. But the opportunity set has only improved through the last even short-term period of time.

[Unknown Attendee]

Okay. Maybe we can talk about that opportunity in wood products first. So it sounds like the commercial relationship with your major customer, it burned some additional interest from other potential customers. So can you elaborate on that potential opportunity? Are these large market players that have trialed previously? Or -- and if so, how long can this take to potentially become commercial?

[Jeff MacDonald, executive]

Yes. So there are 3 that we're most excited about, and they are all players who have done work with DuraBind in the past and in some cases, took it quite far toward the goal of commercialization.

And I think we have to keep in mind is that, that was at a time prior to some of the new product introductions we've made to the DuraBind family. So we've only enhanced the value proposition since then. So if value was a question at all, which it probably was, we've improved that. And then I think with the catalyst of our large retailer customer giving greater clarity on where they're going, that's what sparked this renewed interest.

The trial programs with each of them have come to the forefront pretty quickly, which we're excited about. And we think they have a head start in their trialing activities based on the learnings they've already achieved.

You asked about scale. So these are 2 top 10 customers in the wood panel market and 1 smaller player that we think is pretty important and interesting strategically as well. One of them happens to be recognized as perhaps the innovation leader within the wood composite space. So I think that bodes well for their ability to take something new and drive it industrially with some reasonable speed and conviction. So yes, we're excited that the news has caught the attention of some important players and has got us started in some good activity.

[Unknown Attendee]

Okay. And your major customer, the expansion goals on that front, are they still tracking the doubling of sales in 2023? Or do you have better visibility on that?

[Jeff MacDonald, executive]

Yes, we would hope so. So we did suggest that they had done that last year as they became commercial with us through the course of last year. And the expectation from the plans that we've looked at together would be that they would do that again, and I'd say that remains on track.

[Unknown Attendee]

Okay. Can I turn to the wet end? Last quarter, you said you had engaged potential clients that were trialing. I realize it's only been about 8 weeks since the last call, but you did say there's more irons in the fire.

Just can you elaborate on the expansion of this catchment area? And then maybe along those lines, with your Surflock product, maybe discuss how the success rate has been in your trialing?

[Jeff MacDonald, executive]

So the trialing success has been pretty much universal at this point. Where we've been able to get it in industrial settings and give it a good run, results have been positive step by step. So we're really excited about that. That gives us great confidence that this is going to fly to a greater extent commercially.

The trial pipeline, I would say the open end of the funnel has continued to expand as we've gone into new geographies and introduced ourselves and Surflock to new customers. I'm still really focused on the ones that we would have alluded to before as being furthest along in the pipeline. And part of the reason for that is, I guess, just while we've introduced the Surflock to a new customer set, we're introducing it in a market that's overall down. And including with the 8 or so that we've had in the pipeline, activities have been slow at literally every one of those accounts. So that's resulted, I think, in a little bit of a slowdown in trialing activity and implementation. But we've broadened the interest.

I did mention that we've started to open up another channel, which we think is going to be pretty important to our commercialization of Surflock and that's through the wet end chemistry service provider companies. In many cases, I'll even say in most cases, pulp and paper mills have farmed out a significant part of servicing the wet end of the mill to these third-party service providers that are actually in the mills 24/7. And so we think they're an important partner in introducing and implementing Surflock and can no doubt have us going faster to realize the potential we think this product has.

[Unknown Attendee]

So this should expedite the process of market penetration here with service providers?

[Jeff MacDonald, executive]

I believe so. That's -- and we're pursuing it with that in mind for sure.

[Unknown Attendee]

Okay. Just through the trialing, I know it varies by client, but help me understand the cost savings. I know the filler replacement is different, but how should we think of in terms of savings per line for a packaging client and for a tissue client?

[Jeff MacDonald, executive]

Yes, it does vary by account and even by line within account. And -- but it's all predicated on the ability to improve strength. And as we've said in the past, nobody really needs a stronger sheet of tissue or a stronger piece of paper.

So it's really what you do with that strength advantage that makes a difference. And so typically, customers are using that strength advantage to substitute in lower-cost fibers, recycled fibers in some cases and even inert fillers, so really cheap products that just take up space in the paper matrix.

What we've heard from one mill manager is that for every percentage on a large paperboard line that you can substitute filler in for expensive fiber, it can be up to $1 million in savings. And we're seeing in our trialing activity several percent increases in filler addition levels. So it's -- we're talking about for large paperboard lines, significant in the millions of dollars of cost savings on an annualized basis. So that's what's got the attention of those large paperboard manufacturers.

In the tissue manufacturing side, the strength improvement is of similar magnitude, so say, 15%, 20% improvement in strength. But those are smaller lines, therefore, smaller revenue opportunities for us and smaller savings, but seems to be working equally well in all of the different paper and paperboard applications.

[Unknown Attendee]

And sorry, the -- there was that amount of savings, what's the revenue per line on the packaging client to you ballpark?

[Jeff MacDonald, executive]

So for a large packaging line, we believe it's in the $3 million to $5 million revenue opportunity for us. And on the tissue line, it's in the several hundred thousand dollars of opportunity. So it's almost an order of magnitude difference between the 2, but there are more tissue mills. And so far from experience, it seems to be easier to get our product implemented on a smaller line like that.

[Unknown Attendee]

So I guess big picture, Jeff, what's the reason once the restocking environment -- once the destocking ends and restocking starts, what's the reason not to see migration to your Surflock product?

[Jeff MacDonald, executive]

We can't see any, based on the results, we've seen so far, Brian. It seems to have a really strong value proposition, and it seems to have the attention of the right players. So I believe it's just getting time on these lines and then realizing it.

It was a constraint for us for a time, and we've talked about this on past calls. We were concerned and actually didn't want to put our foot forward until we had material to support these customers.

That's no longer the case. It is expensive inventory, as you can see in our statements, but we have inventory ready to go as these accounts are ready to go in their use of our products. So that part of it is no longer a constraint.

[Unknown Attendee]

Right. And in terms of the inventory, what are you seeing in terms of starch prices? And is that the reason why you didn't get more aggressive with building your inventory near term for growth?

[Jeff MacDonald, executive]

So what we're seeing is, first and foremost, availability. So I mean, there was a time we couldn't get a starch salesperson to call us back. They're back. They're interested in business and in new business, so the availability has opened up. Pricing was a little bit slow to follow initially. But even just in the last few weeks, we're seeing some indications of pricing beginning to come off.

And I mean there's still a long way to go to get back to where we were. The pricing of our feedstock more than doubled for a period of time. We're starting to see some relaxing of that. And we expect that with the outlook for corn and the supply-demand dynamics that are out there right now, it looks like we're heading to a more favorable environment as we get toward the back half of the year.

[Unknown Attendee]

Okay. I'm sorry to dominate the call, but I have 2 last questions. On the previous call, there was talk of an opportunity on the pulp side and you had been in discussions. This is obviously a huge market.

So can you discuss how big a potential pulp customers could be in terms of lines, revenue per line potential? And where your progress on this front currently stands? And can this equipment that you're writing down be utilized in another geography, if necessary?

[Jeff MacDonald, executive]

Okay. Yes. So if I talked about a tissue mill leading to a packaging board mill being a magnitude of difference in revenue opportunity, a pulp customer would be another magnitude of difference. So we're talking about potentially tens of millions of dollars of opportunity by modifying pulp.

The strength improvement part of that has been proven, and I would say proven quite far through technical validation, probably a couple of steps to go. But it is much bigger undertaking simply because these are large mills with much more complex value chain. So pulp is going to the kinds of customers we're selling Surflock to for modifying packaging products or tissue products and then has to make its way all the way through the supply chain.

But the opportunity, although maybe a little bit more difficult to get at, is of a much greater magnitude. Yes, it's going to take some time still but worth investing the time just given the opportunity there.

So we're talking about, in this case, modifying pulp that would be typically lower value, shorter fiber pulp and making it behave more like the longer fiber, higher value proposition pulp, which is quite attractive to those in geographies that are producing a lot of short fiber pulp products.

[Unknown Attendee]

Okay. Last question, NCIB, you alluded to it on the call. It sounds like you're going to get a little bit more aggressive here, which I think is appreciated certainly from my front. Did I hear it maybe in terms of you'll be increasing that notably? And will that be inclusive of an automatic share purchase plan?

[Jeff MacDonald, executive]

Yes. So we actually renew our NCIB annually in the coming week and will be renewed with the ability to do an automatic purchase plan as well.

[Unknown Attendee]

Okay. I guess last question. What are the data points we should look for in terms of progression towards your targets? What's on the near-term horizon?

[Jeff MacDonald, executive]

I think a big one for us has been what you alluded to was just sort of a resetting of the feedstock market for us. So we're really encouraged that the availability and, I believe, the value proposition coming from flowing back through our feedstock is going to be more attractive going forward. So that not being a constraint and playing out for the second half of the year is an important one.

I think we're pretty much -- pretty close ticking that box now. But otherwise, of course, it's about revenue growth. And I think it's just wins at customers, number one, I believe, just given the velocity of implementation on tissue mills, albeit that they're smaller in revenue size. I think we're best poised to achieve some wins there in the nearer term.

I would also say, just given the uptick in overall interest from the large retailers announcement, we'll be talking, obviously, in our next call about progress on trial programs with other wood panel manufacturers. So progress on that front is going to be important, too.

And remember there, again, that each mill is a $3 million to $5 million revenue opportunity for us, very similar in size to a large packaging board mill. And what gets us excited, we feel we're pretty much at that point today, but it's just one of these mill opportunities at the margins we can achieve there that gets us to being positive on the EBITDA side. So that's a nearer-term goal for our team than the $100 million revenue target, which we consider our midterm goal.

[Unknown Attendee]

Okay. I've used enough of your time, Jeff. I look forward to seeing the progression.

[Operator]

[Operator Instructions] Your next question comes from [ Steve Hiland, ] a private investor.

[Unknown Attendee]

Can you hear me?

[Jeff MacDonald, executive]

Yes, we can hear you, Steve.

[Unknown Attendee]

Okay. Just a question on your cash balances. Are they getting -- the interest rates are moving up. Are you getting good rates on the short-term cash?

[Jeff MacDonald, executive]

Yes, we are, Steve. So definitely better than we were 1 year plus ago. It's really on a rotating basis. So we have kind of a staged investment program in different facilities. But definitely, the interest is starting to show up in our numbers again. So yes, I think we're investing at what everybody should consider competitive rates today with our term deposits. That's definitely improved in the last year.

[Unknown Attendee]

Okay. With respect to the share buyback, did you ever consider a modified debt option?

[Jeff MacDonald, executive]

No. Honestly, not. So have not considered that. I think we can get done what's really within our capabilities of our balance sheet and relative to the value we see in the stock using the NCIB. So we've got the ability to purchase, I would say, a meaningful volume of shares back over the course of the next year, and we expect to be able to do that.

[Operator]

Thanks, Steve. There are no further questions at this time. I'll turn it back to you.

[Jeff MacDonald, executive]

Great. Thanks again to everyone for joining us today, and we'll update you again soon.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.