EcoSynthetix Inc

TSX:ECO

Earnings Call Transcript 2019-Q3

[Operator]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the EcoSynthetix 2019 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 such future events. Any 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 Annual Information Form dated March 4, 2019, posted on SEDAR. This morning's call is being recorded on Tuesday, October 29, 2019, at 8:30 a.m. Eastern time. I will 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]

Good morning, and thank you for joining us today. Yesterday afternoon, we released our 2019 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. We continue to operate the business in a fiscally responsible manner, which was demonstrated by our results in the quarter. Net sales were impacted by the decline in the end market for paper. Market demand for coated freesheet paper has declined nearly 18% year-to-date, and our net sales are down 19% year-to-date, which includes the loss of one account we announced in the first quarter. Despite these challenging market dynamics, we maintained stable bottom line performance. Adjusted EBITDA loss was nominal at $40,000, and cash flow from operations was positive $297,000. While we showed improvement in our bottom line results through the course of the 2018, that was on the back of rising net sales in our paper and paperboard markets. Our progress toward profitability and the durability of our bottom line performance is clear based on the test we surpassed in the past 2 quarters. The paper market is one of the 3 legs of our stool together with the wood composites market and our recent entry into personal care. While our immediate prospects in wood composites have moved a little to the right, we continue to make good progress and receive positive feedback in that key vertical. But it cannot happen fast enough given that attrition in the paper market is moving faster than anyone expected. Today, the majority of our sales still come from the paper and paperboard market. Our commercial accounts in the paper market remain intact. Even in the case of the one account that we lost in the first quarter, they remain engaged and we are trialing with them in other applications they manufacture. As we've outlined previously, our experience is that once we are commercial with an account, the business is sticky. EcoSphere continues to offer cost savings compared to current SB latex pricing, which is trading at approximately $0.91 per pound. In spite of the downward pressure on SB latex, we have retained our margin effectively in this end market. However, converting new paper accounts is challenging in market with falling demand and historically low SB latex pricing. Among existing commercial accounts, volumes across the customer base reflect the demand decline in their current ultimate end markets. We do continue to see select opportunities in specialty paper and packaging markets. Specialty paper is a growth market, typically characterized by higher-value, smaller-volume opportunities with higher technical standards that require formulation development. In short, a standard coated paper account exceeds the value of a specialty paper account to us. Though while we drive the majority of our revenue from the paper market today, wood composites remains our primary focus for growth. Our lead commercial account SWISS KRONO remains very engaged with the agenda to offer no added formaldehyde products. They continue to engage their customers on the healthier attributes of their BE.YOND brand as an alternative to particleboard manufactured with formaldehyde-based binders. They report good responses from their customers and are working diligently to broaden interest, but at this early stage of their launch, our volumes are limited. We continue to engage a strong pipeline of prospects, including other manufacturers among the top 10 globally. The retail pull from key strategic players in the market remains as committed as ever. We're seeing strong engagement within their organization and specifically from parts of their organization that are new to and fundamental in the decision-making and execution cycle. So while there is no slippage in terms of the level of their engagement, time lines for decision-making and execution are obviously not within our control, and the process is taking longer than we and our prospects have anticipated. From our side, we have ensured the resources and technical requirements are in place to enable decisions and execution in the most expedient manner possible. Pulling back more broadly, what is clear from our pool of prospects today is that European accounts are more open to an agenda of change away from formaldehyde than North American accounts. The North American accounts have only recently moved to the CARB2 standard, and there are new mills coming online while the market is already dealing with idle capacity in some regions like the Southeast U.S. As a result, North American accounts are not showing the same level of interest as our prospects in Europe. Keep in mind that Europeans are working to meet the new German standard of halving the emissions level, which comes into effect on January 1, 2020. Beyond the forward-thinking European accounts, we are trialing with select prospects that are looking for operational improvements to runability and line efficiencies, which DuraBind can offer, for example, as a results of its improved tack relative to pMDI alone. Tack is a key element of runability in commercial scale lines that involves the integrity of the material holding together prior to reaching the press. We remain confident that wood composites is the highest-value near-term market among the 3 legs of our commercial strategy. On the personal care front, in the second quarter, we highlighted an exclusive license arrangement we had signed with an ingredient and formulation manufacturer in the personal care space. They're marketing and development our biopolymer as an all-natural ingredient to personal care brands globally. Initial feedback from the early stage of their launch has been very positive.We do not expect significant sales from this end market in the near term as they advised a successful launch typically takes 12 to 18 months from introduction to shelf. But they're excited about the progress they've made with accounts to this point and by the performance of our biopolymer across multiple different formulations. In closing, the progress and changes we made to the business over the past 2 years have served us extremely well. We rightsized the business and focused resources on the highest-value near-term opportunities. We have a foundational business in paper that while under pressure recently, has allowed us to maintain a breakeven position, while we execute on our commercial strategies for wood composites and personal care. And as a result of our financial stability, we are in a great position to push forward with these 2 exciting opportunities. And with that, I'll turn it 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 $4.5 million in Q3 2019 compared to $5.6 million in the same period in 2018. This 19% decrease was primarily due to lower sales volume, which included a $400,000 impact due to loss of business at a paper mill -- paperboard mill announced in Q1. Gross profit was $1 million in the quarter down 5% compared to the same period in 2018. This change was primarily due to lower sales volume, which was partially offset by lower manufacturing costs. Net of manufacturing, depreciation gross profit as a percentage of sales was 26.2% in the quarter compared to 22.7% for the same period in 2018. The increase was primarily due to favorable customer mix and lower manufacturing costs. Operating expenses were $1.6 million in the quarter flat to the same period in 2018. We will continue to be disciplined in our approach to cost management, and we're confident that our current investment level is appropriate to deliver significant growth. Adjusted EBITDA loss was $40,000 for the quarter compared to a nominal loss in the same period in 2018. During the quarter, we generated $297,000 positive cash flow from operations compared to $170,000 in the same period last year. The company purchased and canceled 319,000 common shares during the quarter under our normal course issuer bill -- bid for total consideration of $688,000. As of September 30, 2019, we have $44.4 million in cash and short-term investments compared to $44.8 million as of December 31, 2018. We have more than sufficient cash reserves to execute our growth strategy and will remain disciplined and manage our cash responsibly while continuing to invest in our long-term growth strategy. With that, I'll turn it back to Jeff for closing comments.

[Jeffrey D. MacDonald, CEO & Director]

Thanks, Rob. We've managed headwinds in the paper market during 2019 and still generated stable bottom line results. The business generated positive cash from operating activities in both the third quarter and the year-to-date period. It demonstrates the durability we've reached at this stage of our evolution. We've engineered the business to ensure we have the resources in place to successfully commercialize on the wood composites front and support the commercial launch of our licensee in personal care, while also servicing our paper and paperboard accounts. We have sufficient cash on hand to support our commercial and development activities. As Rob mentioned, we've been active on the normal course issuer bid, demonstrating our confidence in the business. We believe we're on the right side of the change agenda, change toward healthier, renewable or all-natural ingredients. It is now a question of timing. We are at a point where our offerings are in the market with blue-chip partners, and we have a foundation that is generating cash. Looking ahead, we are engaged with the right strategic accounts, accounts that are differentiated and are investing resources because they have conviction in what NAF products or all-natural ingredients can mean to their customers and brands. We appreciate the trust and the patience that our shareholders have shown, and I'll look forward to continuing to update you on our progress. With that, I'll turn it back to the operator to open up the call for questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Raveel Afzaal from Canaccord.

[Raveel Afzaal, Analyst]

Just starting off, can you just give us some more color on the paper vertical? Based on the discussions that you've had with your customers in the space, do you foresee any additional losses? Or do you think this is it for now?

[Jeffrey D. MacDonald, CEO & Director]

We don't foresee any further losses of accounts. I think we have to bet on the attrition of coated paper continuing, hopefully, not at the same pace that we're seeing through the course of this year, but there is structural decline. I think the most important thing is that we are shifting in the paper space to focus on those opportunities that our customers are focused on for growth in packaging and specialty paper. And of course, filling more in for those losses with the new verticals of wood and personal care that we're focused on. But no imminent losses that we can see in terms of accounts moving away from us or moving out of the business.

[Raveel Afzaal, Analyst]

Got it. And how much does packaging and specialty paper represent of your revenues right now? Is it like 5%, 6%? Or is it even below that?

[Jeffrey D. MacDonald, CEO & Director]

No, it would be more than that. We don't segment it out but just keep in mind that paper and paperboard packaging still represents 90% plus of what we do today.

[Raveel Afzaal, Analyst]

Got it. And just one more question on this before I move on. So for modeling purposes, do you think we should be forecasting something like a 10% decline on the paper side for 2020? Or how would you think about it from a modeling perspective?

[Jeffrey D. MacDonald, CEO & Director]

Yes, so the numbers that the paper industry themselves published, puts it in sort of 4% to 6% decline range. I think that's probably the best guidance we could go with ourselves. But of course, we're looking for those opportunities that can fill in those gaps. So we'd like to hold our own in paper while we grow the other spaces.

[Raveel Afzaal, Analyst]

Perfect. And then moving on to the wood vertical. The standards are coming in place, as you mentioned, at the beginning of 2020. So what are some of the players in this space doing at the moment? Are they just planning on using more scavengers to be on the right side of the regulations? Or are many of them off-site, many are in compliance? Can you give us some color on the -- on how the market looks today?

[Jeffrey D. MacDonald, CEO & Director]

Yes, I think everybody is anticipating that the change that Germany is putting in place will become a pan-European change. It's just so difficult to control where things are produced and then sold in such an open market. So what we see is a lot of people are considering this is a really European-based change in the making. What companies can do and are doing in the short term, given that this has come upon them so quickly, they can substitute out more expensive resins, which as you said, have additional scavengers in them. And in doing that, they assume more cost and they also assume the cost of having their lines slow down. When these modified resins for lower emissions are put in place, the line actually slows down. So we had discussions just in the past couple of weeks with one very large European player. And -- yes I won't share specific numbers, but I was surprised personally at the cost penalty that they will pay just by switching over to these more expensive resins and slowing their lines down. So we think that presents a really good opportunity for us to have customers considering whether they just go all the way at this point.

[Raveel Afzaal, Analyst]

Got it. And just based on some of these wood players serving -- servicing Germany at the moment, are many of them off-site at the moment as we stand today? Or are many in -- already in compliance in anticipation of these 2020 regulations?

[Jeffrey D. MacDonald, CEO & Director]

I don't anticipate that as we transition into 2020 that anyone serving the market will be at least knowingly off-site, and they have the means in place today to be able to switch over. It's just a matter of buying a different more expensive material and adjusting the process. So they could basically do that overnight but just at a cost.

[Raveel Afzaal, Analyst]

Got it. And then just moving over to IKEA. It seems like your discussions are moving along very well. Do you know what some of the gating items are right now that are probably holding back a commercial contract with someone like IKEA?

[Jeffrey D. MacDonald, CEO & Director]

Yes, I mean there's a lot of work still to do on both sides. When I say both sides, it's us supporting some of the work that they have to go through. There's technology that has to be installed on their lines. But probably the most important thing that's happened in the last quarter is just the broadening of organizational involvement in the initiative. So I mean we're seeing new faces on the program, faces that need to be there in order to see this through to implementation. So we see that as really positive and moving from a special project to a really organization-wide project. But of course, when you do that in -- I guess in -- especially in a consensus-driven organization like they have, you have more stakeholders that you need to satisfy and they have questions that need to be answered. So overall, I see it as a real positive that we're seeing all the people really necessary to move to this execution.

[Raveel Afzaal, Analyst]

Perfect. One more question, and I'll get back in the queue. On the personal care side, are you in a position to speak about the margin profile of this vertical and the revenue opportunity that you see based on your discussions with your customer?

[Jeffrey D. MacDonald, CEO & Director]

I think it's still too early to talk about what the revenue expectations would be, but I'll say just given the size of that organization and their current standing and their ambition in this market, they wouldn't do this for few hundred thousand dollars. So they have significant ambitions and that's what gave us the confidence to enter into an exclusive arrangement with them. In terms of the margin profile, I'll simply say that it is a much, much higher margin profile than the 2 other verticals that we're serving. Yes -- and so even -- like even at lower volumes, the amount that drops to the bottom line for us is very, very attractive.

[Operator]

[Operator Instructions] Your next question comes from the line of John van Leeuwen, who is a private investor.

[John van Leeuwen]

Long time, no talk. Just questions I guess about the personal care market, it's interesting to talk about that. What do you see as the main drivers for the EcoSynthetix technologies versus what's out there today? And can you comment a little bit on the market size? You probably have in the past, but I just don't recall.

[Jeffrey D. MacDonald, CEO & Director]

Yes, so the key driver, and it's by far the most important one, is just the move toward all-natural ingredients within the personal care space. It's what everyone wants, and it's what a lot of the traditional ingredient manufacturers are lacking in their portfolio. So with that pull from the largest customers of our partner, they needed to broaden their portfolio of all-natural ingredients. And they're seeing a need to have much greater share of their products coming from sustainable, renewable ingredients not only within personal care but just more broadly. So we fit that profile very, very well. The ingredient that we're replacing is a high-value ingredient, and I think initially what they were targeting was to have parity on performance to this ingredient. But what's got them quite excited is that we're seeing performance in our product, which is beyond with the incumbent petroleum-based chemistry is capable of. So basically they're seeing greater performance from an all-natural ingredient at competitive pricing. And for us, that competitive pricing, as I said, translates into a nice margin opportunity. The size of the market, there's so many ways to segment that down, but we're being conservative. We're looking really at the haircare space where our product has been introduced initially. Our partners already trialing us in other applications beyond just haircare. But there were in -- sort of the incumbent ingredient that we're looking to replace is in the sort of $0.5 billion to $1 billion range in terms of value. And so -- obviously, our partner is looking to take a meaningful share of that incumbent chemistry away.

[John van Leeuwen]

So second question is, I remember EcoSynthetix worked with a fairly large player in this space before and if I am not mistaken, they withdrew from the business because of micro plastics. I'm hearing a lot of noise, especially in Europe about legislation coming in place to eliminate micro plastics from products, cosmetics but also packaging and because of the global environmental impact of these things. Could you comment at all about your products versus technologies that have micro plastics in them as to what the impact could be?

[Jeffrey D. MacDonald, CEO & Director]

Yes, so today we don't have an offering that directly replaces micro plastics. But one of the things for all ingredients that are going into personal care and even more broadly, as you said, in Europe, they're looking for biodegradability, ocean biodegradability, compostability. So that ingredients that are going in go away under natural conditions. And there we have a biodegradable offering in our standard product. So that's obviously very attractive for the personal care space. Micro plastics has been solved to a large degree with alternative ingredients. We don't have something directly today to replace that. The other areas though that in Europe and beyond, here in Canada as well, we're seeing just the backlash and the ban on certain elements of packaging that are not renewable. And there I think our offerings for paperboard going forward becomes more and more important. Because essentially, you're coating paperboard with the styrene-based coding. Styrene is a plastic. And then we have in the specialty space where it's not only a backlash from environmental conditions, you have some applications where you have, for health reasons, certain chemistries that are being banned. So in wraps for sandwiches, for example, the predominant barrier material that's used in the wraps at McDonald's and Subway is -- are coated with fluorocarbons. And that's a known nasty chemistry that those companies are looking to get out of. And we have an application there that -- of our biopolymer that is effectively replacing that as a grease barrier coating that some of our customers are introducing to the market today. So those kind of trends definitely play in our favor. We can't be everything to everybody, but we think we've got some pretty neat offerings in -- actually in all of our verticals.

[John van Leeuwen]

And my last question is on this partner in the personal care space. You're talking that it's a large -- you're talking about that's a large partner. Can you say anything about their reach? Are they North American? Are they a global players? Are they looking at this in a certain region to launch? Or -- often it's -- your penetration would be a function of how many samples to put out and how many projects get approved. Can you give us an idea of the magnitude of how many samples they're putting out? Is it in the tens? Is it in the hundreds? That would probably help.

[Jeffrey D. MacDonald, CEO & Director]

So it's one of the largest of the global players, and they see the global market as their market. They use a combination of direct distribution and a network of resellers in different geographies and depending on the scale of the end customers, they do distribution, I would say, like no one else. They have formulation capability like no one else. We really couldn't ask for a better partner. Sorry, I'm forgetting second part of your question.

[John van Leeuwen]

] The sampling, that will be great.

[Jeffrey D. MacDonald, CEO & Director]

Yes, the sampling. Yes, so those distribution channels have responded really well to what we've put in their hands. Basically, they launched in May, and we were -- I think we were among 4 important launches for them. And they've said that we're among the best, if not the best, relative to the other group that came out and launched this year. The response they've had, I'll just say, it's in the hundreds of companies that have been sampled, and they've already got some things that are filtered all the way through the pipeline with early adopters, where they're starting to see it make its way into applications. So although they said don't expect anything meaningful for 12 to 18 months after launch, there are some early adopters, in a small way, to get started that are moving.

[John van Leeuwen]

And with the launch, was it by press release? Or was it by -- at a trade show?

[Jeffrey D. MacDonald, CEO & Director]

Multiple trade shows. So it's seems like the springtime is the time for cosmetics trade show launches. So they were launching in New York and Paris and Indonesia. And they got, by all accounts, a pretty good response.

[John van Leeuwen]

So it sound like it's a global approach for them?

[Jeffrey D. MacDonald, CEO & Director]

Absolutely, yes. They are global and they wouldn't do it any other way.

[Operator]

Your next question comes from the line of Raveel Afzaal with Canaccord.

[Raveel Afzaal, Analyst]

Just a quick follow-up -- 2 follow-ups. You mentioned that it -- on the personal care side, it also lead to greater performance at competitive price. Can you touch upon greater performance? Like what are some of the characteristics that are leading to greater performance? And how are you measuring that?

[Jeffrey D. MacDonald, CEO & Director]

Well, that's a fun one to answer, actually. So the test that I think is the most visual that people can get their heads around is a test for what's called curl retention. And so in their laboratories, they have these frocks of hair that are hung and they apply different competitive products to them and then subject them to different environmental conditions. And our product had demonstrated significantly better curl retention, and I guess, especially, under humid conditions versus the incumbent product. And that is apparently one of the most important attributes for a film-forming hair fixative like ours. And that's one of the thing that has them so excited. That's just one example.

[Raveel Afzaal, Analyst]

And then on the manufacturing side too. On the one side, we speak a lot about the speed of line. Are there any attributes that improve the manufacturing of this product as well? Or anything you can speak to on that side?

[Jeffrey D. MacDonald, CEO & Director]

You mean on personal care as well?

[Raveel Afzaal, Analyst]

Yes, on the personal care, yes.

[Jeffrey D. MacDonald, CEO & Director]

So I think there it's just -- what they measure is just ease of getting our product into formulations, and those were kind of gating tests that we had to pass early on. And our product works very well at getting into formulations. So they wanted to be able to put an ingredient in the hands of their customers that they can use to replace incumbent ingredients or develop new formulations really easily. And so far, that's played out very well. Our product is pretty easy to use.

[Raveel Afzaal, Analyst]

Perfect. And a question for Rob on the gross margins. Can you elaborate a little bit more on the favorable customer mix and lower manufacturing costs? Like why -- are we talking about the favorable customer mix within the paper side? Can you just elaborate on both of these a little bit more?

[Robert Martin Haire, CFO & Corporate Secretary]

Yes, I guess -- yes, probably simplest way to think about it is when we sell to companies in a dispersed form, that has a higher manufacturing cost than when we sell to customers in a dry form. So we just have a bigger book of our business that is sold in a dry format. One customer in particular installed last year -- a large packaging account installed material handling equipment to be able to receive it in a dry form versus wet form. So just by the simple shift of our customer mix, it has lowered our manufacturing cost. Also if we look at last quarter compared to this quarter, we have just seen some of the input cost go down, and that's more so on the processing aids that we use. But that's not the biggest component. It predominantly has been driven by customer mix.

[Raveel Afzaal, Analyst]

Perfect. And then with respect to acquisition opportunities, are you guys now at a point where you would consider acquisition opportunities? Or is that still some time away?

[Jeffrey D. MacDonald, CEO & Director]

We're constantly looking at strategic relationships of all kinds in the industry, people we can partner with, channel partners we can sell through, as we've done in personal care. So we've got our ear to the ground on really anybody that's important to the verticals that we're serving. So we're always looking. I'll just say -- I mean there's nothing imminent, but if something came along that was ideal for us to be combined with, we'd certainly consider it.

[Operator]

Your next question comes from the line of John van Leeuwen, who is a private investor.

[John van Leeuwen]

Just one follow-on question. So just when you're talking about U.S. haircare, is there any application for your products in skincare, which I think is a larger market?

[Jeffrey D. MacDonald, CEO & Director]

So all I can say right now is that there's optimism that our product can be used in those spaces, and our partner is looking at applications in their labs today that go beyond haircare. But at this point, nothing proven yet where it's been adopted in any other formulations beyond haircare, but that's certainly the idea is to broaden it out from there. Things like -- do you think about our product being a really good all-natural film former, think about skin masks, for example, that's exactly what you want to do, and you want to do that without sticking nasty ingredients on your face. So applications like that we're optimistic we can play in.

[Operator]

And there are no further question at this time. I will turn the call back over to Mr. MacDonald for closing remarks.

[Jeffrey D. MacDonald, CEO & Director]

Thanks again to everyone for joining us and great to have some good questions at the end there. We'll talk to you again soon.

[Operator]

This concludes today's conference call. You may now disconnect.