EcoSynthetix Inc

TSX:ECO

Earnings Call Analysis

Earnings Call Transcript 2024-Q2

[Operator]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the EcoSynthetix 2024 Second Quarter Results Conference Call. [Operator Instructions]. 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 27, 2024, which is posted on SEDAR. This morning's call is being recorded on Wednesday, July 31, 2024, at 8:00 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. Good morning, and thank you all for joining us today. Yesterday afternoon, we reported sales of $3.2 million in Q2, up 8% from the same period last year. That figure demonstrates the lumpiness we warned of during our last call, primarily in this case, due to pricing. Demand is improving, and we're seeing positive trends across our end markets. Volumes have increased 21% this quarter and 43% year-to-date compared to the same periods in 2023.



Earlier this week, we also announced 2 new wins that did not contribute significantly in Q2. The 2 wins were on new lines at existing accounts. These wins validate the performance of our product offering across multiple end markets as a solution that offers innovation and value to large global manufacturers. I'll speak to each one specifically in a moment. Together with the increased demand and the new wins, we are also seeing strong activity across our prospect pipeline. This activity touches all end markets, including pulp, packaging, tissue and wood composites. The results we're seeing from this trial activity have been positive across the board.



With that being the case, it raises the question why we aren't seeing these results converted into sales more quickly. Industrial change is hard. We're replacing entrenched technologies that have often been used for decades in the manufacturing process. Commodity prices are also a headwind. The price of urea formaldehyde and SB latex to petroleum-based binders, our technology replaces are highly competitive at current levels. Tissue trials using our SurfLock products run faster with less investment required than packaging or wood composites trials. Packaging and wood composites manufacturers typically take more time between trials as well.



But we continue to demonstrate the advantages of our binders and strength aids with positive trial results. The 2 new wins are evidence of those results. Last month, I traveled to our key accounts and distribution partners to check in personally with the leaders responsible for the programs or in the case of our distribution partners, the owners and operators. The resounding and consistent message I heard from those meetings is that we are very instrumental to the future of all of these organizations and the adoption of our technology is clearly a priority. To a company and to a person, they see our technology as an important enabler of their growth and their sustainability agendas.



I reported previously that we have grown our base of distribution partners. We're at a stage now where we believe we have the right partners in place, and we're focused on digging deeper with those partners. The prospects they've identified are expanding, and I had the opportunity to go through those in detail with them last month when I visited our partners. Moving on to a discussion of our end markets. Let's start with pulp. Our key strategic prospect in this market is a large global manufacturer. They ran an extended trial from February through July that has just wrapped up.



We've had positive feedback in terms of the production process and run ability and the technical results of using our products. The output from that trial is now in the market for end customer feedback. We estimate that the market value of the pulp produced during this trial period is greater than $5 million. So it's a meaningful amount to them, and it can have a meaningful impact to our business. This prospect has developed their own value proposition for their pulp product that uses our strength aids and they're developing marketing materials to support their commercial strategy. That progress speaks positively to their level of conviction and engagement on the program.



Beyond this first key strategic prospect we have also now engaged in trials with a second pulp producer that recognizes the potential advantages of our SurfLock strength ads to their pulp production. We are early in the process with them, but it's definitely positive to see the pipeline broadening in this core end market. We believe the pulp end market represents the largest opportunity available to us from a usage per mill perspective. Moving on to the tissue, packaging and paper end markets. These end markets account for the 2 new wins.



The first is a new line at a separate facility within an existing tissue paper account. We've been working with this account for approximately a year and now have multiple lines up and running. Keep in mind that while tissue lines can move faster, they typically represent up to a $250,000 opportunity per annum, which is smaller than a packaging pulp or paper line. The second win was with a large paper and packaging manufacturer. We've been working with this account for several years on their paperboard applications for packaging.



Based on that work, they moved ahead with the adoption of EcoSphere on one of their paper lines. A typical packaging or paper line represents a $500,000 to $3 million opportunity per annum to us, and we believe this account has the potential to fall right in the middle of that range with each line. We believe tissue, packaging and pulp together with the wood composites and personal care markets will be the long-term drivers of the business. We don't envision a significant opportunity in the graphic paper end market given the macro headwinds from diminished demand.



However, EcoSphere has a proven track record of performance and value with paper manufacturers and will continue to support those manufacturers. Our pipeline remains strong and growing in the tissue pulp and packaging end markets. Trial results from tissue manufacturers continue to get stronger. With the support of our distribution partners, and as we all continue to learn and apply together, we're seeing some of the best results ever from these trials, even just in the past few weeks. These performance metrics include improvements in strength, improvements in line speed, improvements in softness, reductions in refining energy and the substitution of higher-cost fiber out for more recycled and lower-cost fiber in.



We're also seeing meaningful packaging opportunities in the pipeline. Packaging is one of the areas that had been impacted by end market demand. Our first packaging account has seen improved demand more recently in the SKUs where our technology is proven, and we're seeing their order patterns improve.



Moving on to wood composites. Our key strategic account, which is an international retailer that has backward integrated its wood panel production remains highly engaged. Production at their first facility that uses our DuraBind resin continues consistently.



We are actively pursuing ways to expand the usage within the SKUs where we're validated and to add more SKUs at that facility. At their second facility, which has conducted multiple positive trials over the past several months, we're cautiously optimistic that full-scale production will commence in their fiscal 2025, which starts in September for them. Based on my trip to see them last month, it's clear that they recognize the value of our technology to help them achieve their sustainability agenda and reduce their carbon footprint. They're a large organization. Large organizations don't move fast. Their conviction remains intact. They are the thought leader in the space. Their commitment to the use of bio-based glues to reduce their carbon footprint by replacing petroleum-based glues is unchanged.



To that end, they have assisted us in moving to the trial stage with 2 additional supply chain partners in their wood panel procurement roster. We're actively engaged with these 2 manufacturers, one of which has performed trials with us previously with earlier generations of our resin. So they're familiar with the process already. The influence of our key strategic account with their supply chain partners is a huge tailwind for us. The manufacturers wouldn't be moving as quickly as they are, if not for that influence. Which once again speaks to the conviction of the key accounts. Moving on to the personal care end market.



Our development and marketing partner, Dow set a higher target for sales in this program for 2024. They're tracking on target through the first half of the year. As a result, our volumes are up considerably, but it is still off of a small base. Dow was excited to launch MaizeCare, which uses our technology into skin care and color cosmetics applications at the trade show in Cosmetics Paris earlier this year. They are marketing 8 new formulations in these applications. Skin care and cosmetics represent 50% of the beauty and personal care market. These applications are much larger opportunities than hair fixatives alone. To support the launch, Dow published a peer-reviewed article earlier this year, highlighting the technical attributes of MaizeCare and skin care applications.



The results of the study show that maze care can provide skin tightening sensation and deliver optical benefits like soft focus, which masks skin imperfections. The paper also highlights the demand for bio-sourced and biodegradable technologies within the personal care industry and by end consumers. This need is recognized industry-wide. For example, L'Oréal, a world leader in beauty recently announced that it aims to have fully eco-designed formulas by 2030, with 95% of its ingredients derived from renewable plant-based resources or abundant materials. Our all-natural technology is perfectly aligned with this demand.



Dow recognize the direction the market was moving early on, and that's why they partnered with us. The demands on product safety and natural attributes are stronger today than ever, and Dow's marketing and development work is directly focused on that growing end of the market. Before turning it over to Rob to discuss the financials, a couple of more points worth mentioning.



On the supply side, the constraints we experienced in 2022 and early 2023 are behind us. As I mentioned in our Q1 call, raw material availability is in a good position. Through those challenging periods, we expanded our supply chain vendors, and we have multiple active suppliers from which we procure raw material now, which offers us greater diversity and flexibility. On the manufacturing front, our North American production line at our center for innovation here in Burlington is operating well.



We're consistently producing commercial scale quantities for our North American accounts across multiple end market applications. And the benefits of having commercial production under the same roof as the development team, is really showing up in the velocity of our work and learning and turnaround times. It's an aspect of the transition that I think we underappreciated at the time we made the decision to bring manufacturing in-house. And with that, I'll turn it over to Rob to review the financials. Rob?

[Robert Haire, executive]

Thanks, Jeff, and good morning. Net sales were $3.2 million in Q2 2024, up 8% compared to the same period in 2023. As Jeff mentioned, we're seeing increased demand with volumes up 21% or $600,000 in the quarter. During the quarter, lower average selling prices impacted sales by $400,000 or 13%. The lower average selling price was primarily due to lower manufacturing costs, which were passed on to customers. Gross profit was $860,000 in the quarter, an increase of $310,000 or 56%. The improvement was primarily due to higher volumes, lower manufacturing costs, partially offset by lower average selling price.



Net of manufacturing depreciation, gross profit as a percentage of sales was 31% in the quarter compared to 25% in the same period in 2023. The improvement was primarily due to lower manufacturing costs, which were partially offset by the lower average selling price. SG&A expenses were $1.4 million during the quarter, an increase of $280,000 from the prior year period. The change was primarily due to asset relocation costs associated with internalization of North American production here to the Burlington facility. R&D expenses were $640,000 in the quarter, unchanged from the same period in 2023.



R&D expense as a percentage of sales was 20%, in line with the same period last year. Our R&D efforts continue to focus on further enhancing the value of our existing products and expanding our addressable opportunities. Adjusted EBITDA loss was $790,000 in the quarter, unchanged from the same period in 2023. As of June 30th, 2024, we had $33.2 million of cash in term deposits compared to $33.3 million as of December 31st, 2023. During the second quarter, we invested $550,000 to purchase and retire 160,000 shares in the NCIB, and we have invested $1.1 million year-to-date to retire 326,000 shares.



We've demonstrated our ability to responsibly manage our cash reserves through multiple cycles while continuing to invest in the long-term growth strategy. With that, I'll turn it back to Jeff for closing comments.

[Jeff MacDonald, executive]

Thanks, Rob. We're building momentum across the business. Demand across our end markets is up. Our diversification strategy beyond graphic paper is working. We're seeing strength in the tissue, packaging and pulp end markets and increased interest from new prospects in wood composites. Volumes are up 43% year-to-date. We won 2 new lines. Our key strategic pulp prospect and wood composites account remain highly engaged. Trial activity is robust across all end markets.



And therefore, our commercial priorities are: one, converting those prospects and trials to commercial accounts; and two, supporting the accounts using our products today to drive increased usage at existing facilities and expand into more of their facilities just like we have with the 2 new wins. The opportunity available to us within these accounts alone exceeds our next goal of achieving $100 million in sales. The traction and momentum we have earned with our key accounts and prospects sets the stage for us to deliver long-term sustainable returns for investors. And with that, I'll ask the operator to open up the call to your questions. Thank you.

[Operator]

Thank you, sir. [Operator Instructions]. And your first question is from Brian Morrison.

[Brian Morrison, analyst]

Thank you. Morning Jeff. So Jeff, I want to ask you, it's nice to see the press release on Monday with the SurfLock win, I think, at a minimum, that illustrates proof of concept. It's been some time now since the move to the service providers. I'm wondering are they progressing as you planned? Are they deeply engaged with your product? And what's your level of confidence in their ability in the short to medium term to drive further penetration of the SurfLock product?

[Jeff MacDonald, executive]

I guess one detail I can add to what I said in the script, Brian, is that one of the wins was through a service provider. So I think that's further demonstration of their ability to deliver. I think in really simple terms, we could not do this alone. That was further reinforced during my time visiting with these people. Just the relationships they have, the technical depth and experience that they have, the people within the mills that they have are just something you can't replicate in any kind of reasonable time frame nor would we want to, having seen how effective they are at doing this.



They have definitely over the last year, the 2 furthest advanced ones within the first market we were penetrating, they have advanced tremendously in the last year, and I'll say that in a few different ways, the learning of how to apply our product and the benefits it's achieving just continue to improve. So we've had some trials just in the last few weeks here that follow on some successful trials, specifically at some tissue manufacturers that have pushed the envelope even further in terms of the value we can offer to the end customers. These people are also really experienced in building commercial businesses, closing accounts, advancing new products into these accounts, it's how they've built their businesses.



In particular, one of the ones that I had not met before is an extremely professional, well-run advanced business serving this market that has a super track record and capability in getting things done. And I guess the other thing that's super important to them and to us was just the level of conviction that they have in this as a growth enabler to their businesses. So they do see the green attributes for the future. The main selling point of SurfLock, in particular, is value and cost savings today. But in the longer term, the green attributes are important to these companies as well. And they see this as an enabler to their growth. Just economic growth, but also the growth that they're seeing, they're going to need to make changes in for their future as well conviction level was really high with all of them.



They've made significant investments in both cases with the most advanced ones. There have been people added, there's been equipment added and priority placed on what we're doing together. So I honestly, I went over with some tough questions along the lines of what I just mentioned in the script, why does it take so long? And I left very charged that they're doing a great job in expanding the pipeline and getting some wins and getting closer to more wins.

[Brian Morrison, analyst]

So just following up on that. So is it fair to say, and I think you mentioned this, but are they capitalizing on the learnings from each trial that they can utilize with others and that could expedite future tissue or pack ten board contracts? And secondly, I know you don't want to talk in detail the number of trials, so I won't go there. But can you just give us a sense of the activity? You say it's robust. Are we talking multiples of previous numbers you've disclosed?

[Jeff MacDonald, executive]

Yes. So firstly, it is multiples of the numbers that we've disclosed before. So it's a very robust pipeline and significantly up from where we would have been a year ago just in terms of the size of the pipeline and the advancement through the pipeline.

Are they taking and applying the learning from each trial and expanding that across others?



You have to do that very carefully because there are certain things that are proprietary, not only proprietary but specific to a line and the inputs to that line. That, in some cases, don't necessarily translate and in other cases, you have to respect some of the things that might be proprietary to a customer. So it's always a fine line you have to walk in applying industrial learning. But certainly, a lot of the learning is basic to the performance of our products and how to apply it and get things done in an even faster way. And they're definitely continuing to learn. We're learning alongside them and applying that learning. So yes, I think with each month, actually with in some cases with each passing trial, that just gets better.

[Brian Morrison, analyst]

Okay. And you talked about achieving desired results. Any data points in terms of improved strength, speed, cost savings? Or is this very amongst trials. But in general, what are we seeing?

[Jeff MacDonald, executive]

It varies amongst trials. I mean, I'll give you a very valuable data point from a recent one. We had a customer that recognized over the course of a week-long trial, about an 8.5% improvement in speed on the line. That's for a line that is at its maximum capacity, the ability for them to sell 8.5% more product would be huge. So it's that kind of impact that we're seeing that the product can have.

[Brian Morrison, analyst]

And in terms of strength, is there a way to measure that?

[Jeff MacDonald, executive]

Well, that is coming from strength. So what we start with is the ability to build strength. And once you demonstrate that ability to build strength, you don't need that strength, you don't need a stronger role of tissue paper. So what do you do with it? You make your line go faster because you could pull it faster because it's stronger? Or you substitute out some expensive long fiber for shorter fiber. So that's how they end up capitalizing on it.

[Brian Morrison, analyst]

Very good. Okay. Let's turn to pulp. It's your largest potential segment. You said that you just completed a major trial as noted, but any color into feedback on the initial results? What are the next data points we should be looking for to see if we can progress towards a potential contract, commercial agreement? And it sounds like you mentioned word of mouth is spreading. Is this another major industry player?

[Jeff MacDonald, executive]

I would say it's not to the same magnitude, but it is a significant industry player. Word of mouth is spreading. So we are seeing the and hearing about the pulp products showing up for trials at end customers. So that's a good sign that the commercial rollout is happening well with the first major pulp producer. We don't have great visibility into what the next steps will be. We do know that they've got this pulp out there into the market now. They've definitely checked on our readiness to support further steps. But it's really in their commercial hands right now.



We know that the run ability, our ability to support them, everything that's within our control, we're pretty confident we've delivered on, and it's really in their hands now to execute on the commercial strategy. The great thing that's happening in the market and it's specific to certain geographies or I could say, worse in certain geographies.



The shortage of long fiber to generate stronger products just by having long fiber is an issue in major markets. And so there are a lot of companies out there that are struggling to get their hands on enough long fiber to create the products that they need to. And so if they can't do that, then they either need a stronger pulp or they need to enhance the product that they're producing, which bodes well for both parts of our SurfLock strategy.

[Brian Morrison, analyst]

Right, so if my math is correct, I think that structural gap is about $2 million, which if you were to be a solution for that would be approximately $50 million or so to your top line, correct?

[Jeff MacDonald, executive]

Yes. Yes. That's roughly the math that sort of follows on what the pulp producers are putting out there in their materials as the structural gap in the market. And what that means is that in order to fill growing demand for packaging and tissue, there is insufficient supply of long fiber, which, if that growth pans out the way they believe, there's about a 2-million-ton gap in pulp available to fill that gap. So you need short fiber pulp or recycled pulp to be able to fill that gap in some way, and that's where we come in.

[Brian Morrison, analyst]

Is there anyone close to you that you're aware of that could also fill this gap? Or are you kind of the leader?

[Jeff MacDonald, executive]

Well, I think there's not a direct, I would say, biochemical player that has a solution to this. But the solutions are just in how you create the mix of fiber and other things in order to generate the end product that you need. And typically, that's done with a mix of chemicals and a bunch of long fiber if you need a stronger product. What we're helping to do is to be able to create the same strength in products using a different lower cost and more available mix of pulp inputs. So there's not, it's never really a direct substitution of one product out and one product in.



It's always how do I change my recipe in order to create a lower cost product that is more resilient with respect to what I have available in my supply chain. That's really the problem we're trying to solve. And given that it's not sort of that one-to-one substitution like SB Latex for EcoSphere, that's where some of the complexity comes in and how you create that entirely new recipe and process to create a better product. So that's exactly what we're working on in all these trials.

[Brian Morrison, analyst]

Okay. Now, I think that's exciting. If I turn to Dow, it's been kind of quiet with respect to the hair fixative. I'm wondering if there's any visibility on potential product launches. And the second part is you mentioned the cosmetics, how big is that relative to hair fixatives? And is it at the same margin profile?

[Jeff MacDonald, executive]

So it is at the same margin profile. It's all MaizeCare. I would say the opportunity for value based on brand in skin care and cosmetics is probably at the peak of the personal care market. Remember, we're one step removed. So we're not the personal care experts, we are the experts in creating bio-based products for those who are. Yes, it represents 50% of the entire personal care market in terms of value, which is much bigger than the hair fixative market. I don't have numbers on how that market breaks down in front of me, but it is a bigger value share of that whole personal care space.



Yes. I mean, visibility into the pipeline of our customer and then their end customers is not direct for us. We do know that they remain incredibly engaged. We did have a team of their people here in Q2. They're very bullish on their opportunities for the second half of the year and into 2025, and we're actually seeing it show up in our results. So they are achieving wins. They're not huge SKU changeovers among major brands to a large extent. It's more a collection of smaller wins of new adopters of bio-based technologies, but they are wins nonetheless, and we are seeing the book of business growing.



Yes. So we're following on their optimism. It is exciting, though, that they've taken us into an entirely new category. Like these are 8 pretty neat new formulations. Maybe I'll just touch on one of them that I thought was really interesting. So it's a new category in a rapidly growing category apparently in humid environments. But when people apply makeup. Obviously, in a human environment, that's subject to the humidity and may smear or not stay in place on your face. And so there's a new category of fixative for makeup. And our product is absolutely perfect for this. So essentially, you're spraying on an all natural, call it, like a locker cover over your makeup to keep it in place.



And as new as that sounds, it does make sense at the same time. So that's where, that's one of the interesting new areas that they're excited about, and I found that one pretty neat and that it is something that's being talked about a lot in Asia right now.

[Brian Morrison, analyst]

Okay. Very good. IKEA. It sounds like you're making progress on the second [line] and potential to move forward with their external supply base? Is that a fair comment? And are we seeing that move forward? And should we expect to see that in the results as we get into the back half of the year and next year?

[Jeff MacDonald, executive]

Yes, for sure. I would characterize it as lots of good activity in the first half of this year. We were busy with yes, more trials than we've had in the wood space and all driven by the large player in the first half of the year than we have in quite some time. So, multiple trials at their second line, which have gone really well. I would say we achieved performance in the panel and speed targets that were same or better than the formaldehyde resin speeds that they were achieving in quite short order. So that's been really positive. And then the initial trials that their 2 supply chain partners also went very well. They were in attendance to support and review the results. And I think it's fair to say everybody was happy coming out of them, and there are some more trials coming to advance that further.

[Brian Morrison, analyst]

Okay. Last question for me. I realized I'm dominating the call, I apologize. But it sounds to me like you're on the verge of many more contracts, timing is obviously uncertain. But I mean your free cash flow neutral almost at this point in time, you're going to serve free cash flow and you've got a very solid balance sheet, and it looks like you're going to be nicely free cash flow positive certainly next year if things go as it sounds like it will. Have you and the board thought about your capital allocations? Like I know there's probably not a lot of M&A activity required here. But would we look at building the balance sheet further capital expenditures or even preferably getting more active with the NCIB? What are your thoughts there? And am I correct with my free cash flow assumptions?

[Jeff MacDonald, executive]

Yes. It feels like we're a few significant wins, but just a few wins away from getting to that position, and that is exciting. Yes, the Board reviews our capital allocation literally every quarter. When the time comes, I'll say, relative to the change and the growth that we have to achieve in really building the business, the decision on capital allocation will be a relatively easy one for us to make. I don't want to be little that too much, but we have a lot bigger things that we're working on that are really there to drive the value of the business. But I think the thing that I would like to see us use the capital foremost is where we're going to put the next line when we achieve the growth that we see in front of us.



So nice to be able to be in the cash position we're in with the growth opportunities ahead of us and know that we're going to be able to fund those. But when we do get to free cash flow positive, we'll certainly be looking at our whole capital allocation strategy and how we best deploy that.

[Brian Morrison, analyst]

And when you say where to deploy your...

[Jeff MacDonald, executive]

I should just add there, too, because you asked specifically about the NCIB. We've stayed consistent on that. We continue to see the value of our shares as being attractive relative to where we're headed. And so if people aren't seeing that, we are consistently on our NCIB on a quarterly basis.

[Brian Morrison, analyst]

Jeff, when you say allocate the next line, do you mean if a major pulp producer was to move forward with the commercial contract that you would probably put something close to that? Is that what you're referring that?

[Jeff MacDonald, executive]

Yes. I mean that's one possible scenario. It really depends where the growth is coming from. But let's say the growth was not as concentrated in one geography, but spread out, let's say, over a region like where we're not established with a line today, could we put a line into one of those geographies as well. So yes, it's scenario planning that we do think about regularly. Certainly, the one you suggested is one that's on our minds. But also there are other geographies with the potential lining up in their pipeline that could warrant that as well.

[Brian Morrison, analyst]

Okay. That's great. Well, I think I would all like to see it move a little quicker, but I think the opportunities are extremely attractive, and I look forward to seeing your progress.

[Operator]

Thank you. [Operator Instructions]. And at this time, Mr. MacDonald, it appears we have no further questions. Please proceed.

[Jeff MacDonald, executive]

Okay. Thanks very much, and thank you all for joining us. Have a good August, and we look forward to talking to you again soon.

[Operator]

Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending. And at this time, we ask that you please disconnect your lines. Enjoy the rest of your day.