EcoSynthetix Inc

TSX:ECO

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, ladies and gentlemen, thank you for standing by. Welcome to the EcoSynthetix 2018 Third 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's risks and uncertainties related to these forward-looking statements, please refer to the company's Annual Information Form dated March 6, 2018 posted on SEDAR. This morning's call is being recorded on Wednesday, November 7, 2018 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.

[Jeffrey D. MacDonald, CEO & Director]

Thank you. Good morning and thank you for joining us today. Yesterday afternoon, we released our 2018 third quarter results, which you can find on our website at ecosynthetix.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.It was a great quarter. Net sales were up 24% to $5.6 million, driven by higher volumes. We improved our adjusted EBITDA from a loss to a break-even position, and we generated $170,000 in cash from operations. This is the culmination of the plan we implemented nearly 3 years ago to achieve break even and become profitable. We are delivering on this commitment through topline growth, and by executing on items that are fully within our control, specifically disciplined cost management. Break even is a major achievement for the team across EcoSynthetix, but we fully recognize it as the first step, as we transition the business to a new stage, profitability driven by topline growth.On that front, there have been multiple market developments in the wood composite sector, since we last spoke. First, the pricing levels of pMDI have receded significantly. pMDI is the chemistry that our DuraBind binder works with, to enable particleboard and medium-density fiberboard production with no added formaldehyde. These 2 categories are the largest wood composite markets and manufacturers continue to use formaldehyde for the vast majority of their production. Oriented strand board or OSB is the third and smallest category. pMDI is already used in approximately 50% of this category.The price of pMDI increased significantly through late 2016 and 2017. But as you can see from Slide 6, it has returned to more normalized levels at approximately $2,000 per metric ton. The rise in pMDI delayed our commercial activities with wood composite manufacturers, as the price of pMDI meant that binder system of DuraBind with pMDI was no longer cost competitive with formaldehyde. As you will recall, our focus during this period transitioned to OSB manufacturers as a cost savings opportunity on their pMDI resin input. With the normalization of pMDI pricing, our ability to offer DuraBind at a cost-competitive or neutral position to formaldehyde has returned for the larger particleboard and MDF categories, which remain our primary targets. This was a major development in the market landscape.Second, retail leaders in the market like IKEA, continued to champion lower formaldehyde emissions with their supply chains, pulling the market toward NAF solutions. IKEA's long-term objective is formaldehyde emission levels at those of natural wood. IKEA presented to manufacturers at the European Panel Federation Symposium in Hamburg on October 11. Their presentation was titled IKEA's Step-Wise Approach to Lowering Formaldehyde Emissions. IKEA's consistent commitment to drive emissions out of wood composites is resonating with the market, which brings us to the third development.In October, SWISS KRONO launched its latest innovation in the market, which is branded NAF Solution, a particleboard using our DuraBind offering. This is an exciting step in our commercialization strategy for DuraBind. SWISS KRONO is one of the world's largest and most innovative manufacturers of wood-based panels, and an industry leader in its approach towards sustainability. SWISS KRONO was the first commercial customer of DuraBind in late 2016. This new product launch is a natural extension of our relationship with them. We are highly supportive of their initiative to market an NAF branded solution for particleboard and their vision to invest in building a new market with a differentiated product.SWISS KRONO remains committed to its eco-sustainable philosophy, developing the new product, despite the pricing dynamics of pMDI, with an understanding that being a first mover was important, which enabled them to see beyond temporary pricing conditions for pMDI in 2017. In their announcement, SWISS KRONO highlighted that 2 production lines will be manufacturing their NAF Solution; the Zary, Poland and Menznau, Switzerland facilities. These 2 facilities are in addition to our ongoing work with them in another product offering from SWISS KRONO Germany. At this stage, we are not able to quantify the potential financial impact from this product launch, since it is in an early stage of market launch. But we're very excited about this development for multiple reasons.SWISS KRONO views the launch as a differentiated product, which they are branding NAF Solution. They have a market launch roll-out plan that involves a series of events during the course of the next 6 months to 12 months, as they build awareness for this product. That's a meaningful investment in our view. And the introduction has piqued interest among other major manufacturers. It's important to recognize that it's still early in the market development of this category. We do not expect significant volumes in the near term. But this launch does represent a significant development as manufacturers move to lower emission levels to demonstrate to retailers like IKEA that solutions exist.Finally, the fourth development is the regulatory driver. As I've said previously, the pull for retailers is the most significant market driver, but the regulators continue to play a role as well. In October, Germany announced new regulations for the testing of emission levels that will come into force in 2020. This new regulation is another example that regulators are supporting lower formaldehyde emission levels through a series of incremental step downs that manufacturers must adhere to. Manufacturers are faced with the decision to make small changes multiple times to meet the new requirements as they are introduced or to transition away from formaldehyde with a broader change agenda. As the regulatory landscape evolves, the decision process moves in our favor.That's the market landscape. One, pMDI pricing has moved down; two, retailers continue to champion lower emission levels; three, SWISS KRONO is in the early stages of launching its NAF Solution particleboard using DuraBind; and four, regulators continue to drive incremental change, most recently in Germany. As it relates to our commercial activities for DuraBind, pMDI pricing and the SWISS KRONO launch are certainly re-energizing discussions, as I mentioned earlier. Our primary objective is to convert the prospects in our pipeline into commercial customers. We are engaged with the right players, including many of the largest particleboard and MDF manufacturers in the world. Our pipeline represents a significant growth opportunity.Turning to the paper and paperboard business. We continue to see momentum in this category as SB Latex pricing dynamics remain in our favor, continuing to trade above the $1 per pound range this quarter. At these levels, our EcoSphere binder offers a clear value proposition to paper and paperboard manufacturers. We are conducting trials in each of our primary markets, including North America, Europe and Japan. These trials include expanded use at existing customers, as well as activity with new prospects. These are accounts that do not use EcoSphere today, but are attracted by the savings and stability of our pricing relative to SB Latex.What we know from experience is that converting an account to EcoSphere is the primary challenge. Once we have secured an account, they become very sticky given our lower cost binder even when SB Latex prices regress. The opportunities in the paper and paperboard market are stronger today than at any time since I joined the company. Based on SB Latex pricing dynamics, we are confident there are additional opportunities in paper. It's a good environment for new business. However, the opportunity for DuraBind in the wood composites market remains our #1 priority given the scale of that market and the demand for NAF alternatives that are cost effective and offer comparable performance.With that, I'll turn the call over to Rob to review the financial highlights.

[Robert Martin Haire, CFO & Corporate Secretary]

Thanks, Jeff and good morning. From a top line perspective, net sales were $5.6 million in Q3 2018, an increase of 24% compared to the same period in 2017. This increase was primarily due to higher sales volumes of $1 million or 23% and higher average selling prices, which improved sales by $100,000 or 1%. Gross profit was $1.1 million in the quarter, up 7% compared to $990,000 during the same period in 2017. Net of manufacturing depreciation, gross profit as a percentage of sales was 22.7% in the quarter compared to 26% in the same period last year.As Jeff mentioned, the pricing dynamics of SB Latex continues to provide us with the -- with a reasonable level of pricing power. However, while the cost of corn inputs have been steady, there has been pressure on cash margins related to the cost of freight and processing aids.Adjusted EBITDA was essentially [ $0 ] for the quarter compared to a loss of $1 million in the same period of 2017. The improvement to break even on adjusted EBITDA losses in the quarter was due to lower operating expenses and increased gross profit.We continue to be disciplined in our approach to cost management. SG&A expenses, adjusted for depreciation and share-based compensation, was $920,000 in the quarter compared to $1.2 million in the same period of 2017. R&D expenses, adjusted for depreciation and share-based compensation, was $430,000 for the quarter compared to $900,000 in the same period of 2017. The change was primarily due to lower mill trial-related costs, people-related expenses and third-party development costs. Our R&D efforts continue to focus on further enhancing value for our existing product lines, and expanding our addressable opportunities. We are confident that our current investment levels is appropriate to deliver significant growth.As of September 30, 2018, we had $46.9 million in cash and term deposits. We have more than sufficient cash reserves to execute our growth strategy and we'll remain disciplined and manage our cash responsibly, while continuing to invest in our long-term growth strategy.With that, I will turn it back to Jeff for closing comments.

[Jeffrey D. MacDonald, CEO & Director]

Thanks, Rob. Achieving break even on an adjusted EBITDA basis during the quarter, and generating positive cash from operations were major milestones for our team. We reached these objectives by delivering consistent topline growth in the past [ 2 ] years, as well as demonstrating cost discipline. We're committed to maintaining the trajectory of the business and delivering profitable growth, while investing in product development and our sales platform.The market developments in wood composites, since we last reported, demonstrate the market is moving towards us. We are engaged with the right strategic accounts like SWISS KRONO, accounts that have a conviction, and the retail pull to deliver on an agenda of change. Our pipeline of paper and paperboard prospects conducting mill trials is robust, providing us confidence that it remains a growth vertical. With this level of positive momentum, we remain active in the market, making use of our normal course issuer bid. We have consistently been at our daily limit when the trading window is open, as well as purchasing larger blocks when available.During the quarter, we purchased and canceled nearly 250,000 shares for total consideration of $300,000. This initiative underscores our confidence in the trajectory of the business. We appreciate the trust and the patience that our investors have shown, and I look forward to updating you again on our progress very soon.And with that, I'll turn it back to the operator to open up the call for questions. Thank you.

[Operator]

[Operator Instructions] And our first question comes from the line of Raveel Afzaal from Canaccord Genuity.

[Raveel Afzaal, Analyst]

Congratulations on the break-even EBITDA, a big milestone. A quick question on MDI. We understand that the operating rates have come down closer to 90% compared to where they were in Q4 '17, close to 95%. Is this the reason why we have seen the decline in MDI prices, because some of the commentary that we're hearing in the market is that the market still remains pretty tight, and MDI demand is going to remain robust. So are you guys hearing some view on whether the decline that we're seeing in the pMDI prices, if it's sustainable or whether we'll see an uptick in the pMDI prices once again?

[Jeffrey D. MacDonald, CEO & Director]

Thanks for your congratulations as well. It is a big milestone for us. pMDI, it seems to be searching for its new home, although, if you look at the public statements of the major players, they're still projecting kind of a 6% growth in demand and a 5% growth in supply over the foreseeable future. There have been some meaningful supply announcements just in the last quarter, which I think gives people confidence that the supply will be there to at least maintain that balance. I think there is a -- I would say a light expectation that prices may come back up again a little bit in the New Year, but certainly not back to the levels that they're at today. And I think when you talk about capacity utilization, it's not a one paintbrush for the whole world. It really depends on which geography. North America seems to be remaining tight, Europe demand, or supply and demand both have contributed to where it's at, kind of at the 90% range, and then we're hearing that China has fallen below 90% in terms of utilization level. So it's a little bit different depending on geography. And an interesting thing about pMDI, I'll get briefly technical here. It's a 100% solid liquid, which means that it transports around the world fairly cost effectively, and that's allowing some of the large operations that do have the supply, and in particular, Dow's Sadara facility, to be shipping it around quite cost competitively to multiple markets. So we're seeing, I would say, an improved supply situation from a customer perspective overall. And I think that's the biggest contributor to where the pricing levels are at, and may go up a little, but I think people are expecting it's back at a more normalized level.

[Raveel Afzaal, Analyst]

And then we don't have the urea formaldehyde prices, but hearing those prices are also going higher. Can you give us some color around that?

[Jeffrey D. MacDonald, CEO & Director]

Yes. So we've seen really over the last year, methanol prices, which are the main driver of formaldehyde, up kind of in the 25% range. Formaldehyde usually falls that quite closely. Especially in North America, the market is supplied by merchant formaldehyde suppliers, whereas in Europe, they're more backward integrated. And so transparency on the pricing there is a little more difficult. But certainly formaldehyde resin pricing levels for both camps have come up in the last year. So with pMDI coming down and formaldehyde coming up, we're back -- we're definitely back to a place where we're talking about competitive economics for a conversion.

[Raveel Afzaal, Analyst]

And is there some color that you guys can provide us with the number of mill trials you have ongoing at the moment on the wood side and then on the paper side as well?

[Jeffrey D. MacDonald, CEO & Director]

Yes. We haven't disclosed numbers or specific customers. But I would say on both sides, we've got a robust level of activity today. I would say, up in paper and then fairly steady to where we have been in wood. We are definitely relative to last year, partly as a result of where pMDI took us, but partly having been with now, many of these customers and proven things technically, we're taking a much more focused approach on the wood composite trials, but still the ones that we're participating in are quite meaningful ones.

[Raveel Afzaal, Analyst]

Got it. And then when you think about your EBITDA break-even point, as these mill trials ramp up again, how do you see this EBITDA break-even sustainability going forward? Do you think EBITDA could dip down back again in the negative range as you ramp up your R&D spend, or do you think this is the new norm for the business?

[Jeffrey D. MacDonald, CEO & Director]

Yes, we see it as a new normal. As you know, our top line and gross margins can suffer from a little bit of lumpiness. So I guess, at this point, given that we're just right at that level today of break even, I wouldn't guarantee, we're not going to bounce around a little bit. But the future looks pretty bright in terms of pipeline and we expect to be growing from here. The investment in R&D, we've kind of settled in on a level today, which is around $2 million on an annualized basis. And we think for the state of the business today, the opportunities we see in front of us, that's a pretty good level of investment for us to be looking at to get done what we need to.

[Operator]

[Operator Instructions] And there are no other questions. I will turn the call back over to Jeff MacDonald for closing remarks.

[Jeffrey D. MacDonald, CEO & Director]

Okay. Thanks everyone for joining us today and we look forward to talking again really soon.

[Operator]

And this concludes today's conference calls. You may now disconnect.