EcoSynthetix Inc

TSX:ECO

Earnings Call Transcript 2018-Q4

[Operator]

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the EcoSynthetix 2018 Fourth Quarter and Year-End Results Conference Call. [Operator Instructions]Listeners are reminded that portions of today's discussion may be forward-thinking statements that reflect current views with respect to future events. Any such statements are subject to risk and uncertainty 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 March 6, 2018, posted on SEDAR.This morning's call is being recorded on Wednesday, March 6, 2019 at 8:30 a.m. Eastern standard 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 all for joining us today.Yesterday afternoon, we released our 2018 fourth quarter and year-end 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 good quarter. Net sales were up 19% to $6 million, driven by higher volumes. We improved our adjusted EBITDA loss to just $70,000 from $1.1 million in the prior year period, and we generated positive cash flow from operations.Before we outline the highlights and developments during the quarter, let's step back and take stock of where we are and where we're headed. The platform we have developed and commercialized at EcoSynthetix has tremendous potential as a sustainable bio-based binder given its breadth of application and flexibility to deliver value and performance.Our 2 primary markets today are wood composites and paper and paperboard packaging. Our paper and paperboard packaging business has matured to a stage where it is delivering a solid base of sustainable sales through cycles with some lumpiness in volume and margin depending on relative price of the primary ingredient it replaces, which is SB latex.The primary market drivers for the adoption of EcoSphere, historically, are economics and performance. But more recently, we are generating increased interest from a sustainability perspective.Our wood composites business is at an earlier stage of adoption in the market. We are commercial with our first account, which has expanded the number of lines and SKUs that use DuraBind. We also have a pipeline of highly engaged prospects that are pursuing alternatives to conventional formaldehyde-based binders. These prospects include dedicated manufacturers as well as integrated retailer manufacturers. The primary driver in the wood composites market is health and safety, but performance and value are also essential.Successfully penetrating these 2 core markets is our priority. However, we also believe in the flexibility of our platform and that other markets exist where we can make small bets with partners, which could contribute to shareholder value over time.From an operational standpoint, in the past 3 years, we have made changes to our cost structure to deliver profitable growth. In Q4, we generated positive cash from operations. We are managing the business to deliver a profitable 2019. At this stage, we still expect some lumpiness in our results from quarter-to-quarter, but we're confident in our ability to achieve that goal in the 12-month period.So that's where we are today. Where are we going? We believe additional growth exists in the paper and paperboard market. In the long term, we believe that business could double or more. However, the scale of the wood composites market and the demand for manufacturers, retailers and customers for no added formaldehyde, or NAF alternatives that are cost effective and offer comparable performance, make wood composites our #1 priority.Our DuraBind technology is a bio-based binder that delivers value and performance as an alternative to conventional formaldehyde binders in the manufacture of engineered wood products. DuraBind works as a co-binder with another industrial binder called pMDI to replace formaldehyde binders.There are 3 primary wood composites markets: one, oriented strand board, or OSB, which is used in new home construction and for shipping goods; two, medium-density fiberboard, or MDF, which is used in flooring; and three, particleboard, which is used in furniture. Today, formaldehyde binders dominate the manufacture of MDF and particleboard while formaldehyde and pMDI are both used in OSB. In the absence of a viable alternative technology, MDF and particleboard manufacturers were left to use formaldehyde, which is cheap, and it works. However, as awareness of the harmful effects of exposure to formaldehyde emissions grows, end customers, retailers and manufacturers are searching for safer, economical alternatives to formaldehyde-based binders.Our DuraBind technology is the first viable bio-based alternative that can replace formaldehyde binders in the MDF and particleboard markets by working with pMDI. The question now is one of the pace of change from formaldehyde to a bio-based alternative. The end customer can be a key driver of change, but we haven't seen that yet in this market. Regulators, like the California Air Resource Board and those in Germany, continue to raise the standard on reducing formaldehyde emissions. But in our view, the key stakeholders that will drive change and respond to it are retailers and the manufacturers in their supply chains. Large retailers like IKEA are at the forefront this agenda, setting standards that drive formaldehyde-based binders and other harmful chemicals out of their supply chains.The conviction of IKEA to adopt NAF alternatives is as strong as ever. They are committed to reducing formaldehyde and increasing bio content in their resins and to introducing NAF products into the market. We continue to work with IKEA on their goals. They are highly engaged. But for competitive reasons and out of respect for them, we cannot detail their work. What we can say is that we're making progress, and our confidence in the capabilities of DuraBind remains as high as ever.IKEA's level of commitment is also driving change among other manufacturers. In October, our first commercial wood composites account, SWISS KRONO, launched a new particleboard line, which they have branded SENZA NAF Solutions. SENZA uses our DuraBind technology as an alternative to formaldehyde binders. SENZA receives certification for the highest quality and ecological standards for wood-based materials. It has the highest natural content of any particleboard to our knowledge.This launch represents an expansion of our relationship with SWISS KRONO. We are already commercial with them on another line in a German plant across multiple SKUs. And SENZA has been validated in 2 plants: one line in Poland and another line in Switzerland.SWISS KRONO invested in the particleboard development program through a period where pMDI prices were historically high. It demonstrates their conviction in the potential of NAF solutions and the advantage of being a first mover in the market. The industry certainly took note of the launch. Manufacturers were taken aback that SWISS KRONO had taken steps through a challenging pricing period and emerged as a leading player in the NAF space. As a result, we received renewed interest from prospects that we have worked with in the past but deferred development due to the pricing dynamics and supply constraints of pMDI.You can see the movement of pMDI on Slide 10. The supply constraints from 2017 and 2018 have eased, capacity utilization has moved back into the 80s and the price is now below historical norms. At today's pricing levels of pMDI, our NAF alternatives of DuraBind and pMDI can provide manufacturers variable resin costs at or below parity to formaldehyde binders. However, the falling cost of pMDI makes progress in the smaller OSB market more challenging. When pMDI prices were high, we were generating significant interest in DuraBind as the method for manufacturers to reduce resin cost. But given the current pMDI pricing dynamics, there is less of an economic incentive for OSB manufacturers to use DuraBind.Our primary focus today is the larger-market opportunities in particleboard and MDF where conversion away from formaldehyde is the priority. We have a focused pipeline of prospects. We're engaged with the right accounts to drive material adoption in the market. Converting those prospects already in the pipeline to commercial accounts is our top priority.Moving to EcoSphere. Higher volumes in the paper and paperboard packaging markets drove our increased sales in 2018. What we know from experience is that converting an account to EcoSphere is the primary challenge. Once we have secured an account, they become sticky given our ability to offer them a lower cost binder even when SB latex prices regress. The stickiness of an account is why we view EcoSphere as a strong base business. However, the recent pricing dynamics of SB latex and its oversupply in Europe are creating some headwinds for us. On Slide 12, you can see that since December, SB latex is priced below $1 a pound, which narrows the savings a new account generates by adopting EcoSphere.There's been a significant amount of consolidation within the paper and packaging market. The remaining players are stronger, showing improved results and operations. While these players are reporting a softening in demand for coated paper in the current economic cycle, we are positioned with the right players in the market.We're also seeing more opportunities in the specialty paper market, where the sustainability benefits that EcoSphere offers continue to attract significant interest. An example of this is using EcoSphere in oil and grease-resistant paper wrap in food packaging as a replacement to fluorocarbons as a substance of concern. We expect paper and packaging to contribute growth as SB latex returns to historic levels. In the interim, EcoSphere provides a strong foundational business for EcoSynthetix. Wood composites remain our high growth opportunity as the pace of change accelerates and retailers promote change within their supply chains to NAF alternatives. We are committed to profitability in 2019 by delivering top line growth and executing on items that are fully within our control.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 $6 million in Q4 2018, an increase of 19% compared to the same period in 2017. This increase is primarily due to higher sales volumes of 15% and higher average selling prices of 4%. Net sales were $22.8 million in 2018, an increase of 27% compared to 2017. 22% of this increase was due to higher volumes, and 5% was a result of higher average selling prices.Gross profit was $1.2 million in the quarter, up 42% compared to the same period in 2017. In the annual period, gross profit was $4.5 million, up 23% compared to 2017. These increases were primarily due to higher sales volume and higher average selling prices, partially offset by an increase in manufacturing costs.Net of manufacturing depreciation, gross profit as a percentage of sales was 23.5% in the quarter compared to 22.1% in the same period in 2017. In the annual period, gross profit percentage, net of depreciation, was 23.4% compared to 25.1% in 2017. The change in the annual period was primarily due to higher manufacturing costs, partially offset by the increase in average selling prices.Adjusted EBITDA loss was $70,000 for the quarter, an improvement of 94% compared to a loss of $1.1 million in the same period in 2017. During the quarter, we incurred a $200,000 unrealized foreign exchange loss under Canadian dollar cash held at year-end, which directly impacted our reported adjusted EBITDA in the quarter.Adjusted EBITDA loss for the year was $1.4 million, an improvement of 71% compared to $4.8 million in 2017. Improvements in both periods were due to lower operating expenses and higher gross profit. We continue to be disciplined in our approach to cost management.SG&A expenses were $1.4 million in the quarter compared to $1.3 million in the same period of 2017, an increase of 4%. In the annual period, SG&A was $5.5 million compared to $6 million in 2017, a decrease of 8%.R&D expenses were $410,000 in the quarter compared to $1.1 million in the same period of 2017, a decrease of 63%. R&D expenses in the annual period were $2.2 million compared to $4.7 million in 2017, a decrease of 53%. The decreases were primarily due to lower people-related costs, discretionary spending and lower mill trial-related costs. The company's R&D efforts continue to focus on further enhancing value for its product lines and expanding our addressable opportunities. We are confident that our current investment level is appropriate to deliver significant growth.As of December 31st, we had $44.8 million in cash and term deposits compared to $49.3 million as of December last year. During fiscal 2018, the company acquired and canceled approximately 2 million common shares for a total investment of $2.5 million under our normal course issuer bid for an average price of approximately CAD 1.87 per share. It is our opinion that these purchases have been made on terms, which will enhance the value of the outstanding remaining shares. We have more than sufficient cash from 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. We're committed to maintaining the trajectory of the business and delivering profitable growth while investing in product development and our sales platform. Our activity on the normal course issuer bid underscores the confidence we have in the long-term prospects of the business. As we enter 2019, we are encountering headwinds from the paper and paperboard business with the softening of SB latex pricing and some softening of demand for coated paper. But the accounts that we are already active with are strong, and they have demonstrated consistent buying through multiple pricing cycles.On wood composites, we are working closely with the 2 most important players in the market. They are recognized for their operational excellence and desire to position their companies in a different and better way for consumers that value bio-based sustainable solutions. The pace of change in wood composites is challenging to predict, but the market is moving toward us. We are engaged with accounts that have conviction and the retail pull to deliver on an agenda of change. We appreciate the trust and 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 over to the operator to open up the call for questions. Thank you.

[Operator]

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

[Raveel Afzaal, Analyst]

My first question relates to oil prices or SB latex prices. Can you help quantify what the impact could be to your paper revenues by changes in SB latex prices?

[Jeffrey D. MacDonald, CEO & Director]

Raveel, thanks for joining us. I think -- let me start by saying that the hurdle that we've always consistently used and which has demonstrated to be the right hurdle to predict the impact on our business has really been $60 a barrel oil. And we said that when we we're $60 and above, the prospects for expansion of our volume and good pricing are quite positive. And when we drop below that, we do face headwinds. And we saw the positive side of that cycle last year. We're seeing a little bit of the negative with oil dropping into the 40s in December. That's really working its way through the system today. The customers, as I mentioned, the customers that we're with, we believe have pretty good staying power in the market, so we don't expect them to go away. They are seeing some pressure on volume, and we are seeing some pressure on price as a result of SB latex. So quantifying it, still pretty uncertain. We've heard from some of the public paper companies that they are seeing some softening in demand, but they haven't quantified it. So it's kind of difficult for us, too. Anything to add, Rob?

[Robert Martin Haire, CFO & Corporate Secretary]

Yes. Raveel, I mean, the way to kind of think about it, I would say we had -- we saw some stronger movements in the SB latex market in 2008. And with that, we were able to increase our average selling prices in the range of -- it was 5% for the full year. So I kind of think about the prior year, if it remains at these levels, we could see pressure in that range again. The other side to also think about it though is on our cost of goods sold. We also actually had a higher increase. If we just isolate our cost increase to our selling price increases last year, we essentially had more cost increase by 100 -- by approximately $100,000 over our average selling price on the full book of business for the year. So we do have an expectation. And we are seeing some of our cost of goods sold also reduce. So we're actively looking at trying to keep those 2 in balance.

[Raveel Afzaal, Analyst]

Got it. And these customers, certainly the ones that you have proven to be very sticky, I'm wondering though, I mean, can they not use more SB latex during this time compared to EcoSphere? Or is there some reason why they have to continuously use pretty much the same proportion of SB latex to EcoSphere in their product?

[Jeffrey D. MacDonald, CEO & Director]

I mean, a change in formulation for a customer is always an exercise that they have to go through. And there is certainly cost and time associated with that. They could change to SB latex though and replace us. But as long as we're offering some savings, there's really no motivation to do that. And we've shown, even when oil prices have been into the 30s, we've still been able to price our product to offer enough savings that they stick with their current formulation. And we'll follow a similar strategy if this down cycle persists.

[Raveel Afzaal, Analyst]

Very helpful. That's great. And then just moving on to the wood vertical. We are certainly seeing increasingly stringent regulatory requirements. Can you speak to how that's translated into growth in the sale of NAF products? Like are we seeing more sale of NAF furniture, wood particles? If you can just speak to that.

[Jeffrey D. MacDonald, CEO & Director]

I think in the North American market, you saw when the CARB2 regulation came in, everyone really focused on ensuring they were consistently conforming to that as a first step. NAF would be the next step that people would be working on in the North American market. There's more uncertainty though in terms of where Europe is going, and I think that uncertainty plays well for us. The German market has sort of broken ranks with the rest of Europe. And they've announced what they're calling a half-step reduction, so essentially reducing allowable omissions by half in their market for anything that's produced or sold in Germany. And so that's got the rest of the European market, trying to figure out how they're either going to follow or somehow remain different than Germany as one of the largest markets in Europe. That's driving questions within customers as to whether they take steps to buy formaldehyde resins that are more expensive in order to achieve lower emissions, whether they change their processes and slow their machines down in order to achieve lower emissions or do they go all the way to the NAF step. And certainly, SWISS KRONO, as an example, is definitely exploring going all the way to the NAF step. But it -- ultimately, it has to make sense for them from a market perspective and from an operational perspective. And that's really what SWISS KRONO is pushing to find out and make good on at this point.

[Raveel Afzaal, Analyst]

Perfect. Just one more question for me. So when we look at the existing lines that you have, especially the first 2 lines on the wood side that you -- that were awarded to you, can you speak to what sort of ramp up we have seen at these lines? And what's been stopping these lines to ramp up to your target of $3 million per line? Has it just been the pMDI prices being higher last year, or is there something else that's also impacting that?

[Jeffrey D. MacDonald, CEO & Director]

Yes. We have to be a little bit careful because we can't disclose exactly what the applications are that those customers are working on. But we -- as we got started with SWISS KRONO on their first line, we talk about the range of $0.5 million to $3 million. They started right around the $0.5 million mark, and it has progressed up beyond sort of the middle of that range. What's preventing it from being more is adoption across more SKUs, expansion of their substitution rates. And I'll just say simply that economics in the current pMDI pricing cycle haven't worked in favor of that. I won't say anything more on the application itself, but I think you can understand where we face that pressure.

[Raveel Afzaal, Analyst]

Makes sense. I mean, but have they or other customers given you some indication of what type of ramp up they expect to see in 2019, or is it something that's still being discussed?

[Jeffrey D. MacDonald, CEO & Director]

Well, I think, we stick with and our customers support that range that we've put out there, $0.5 million to $3 million. And I think if you look at a particleboard line in -- within SWISS KRONO, we would expect similar trajectory as they get started. I think we do need to say that they did announce that product to the market in November. They've got several launch events coming up over the next few months. So that product is still in the early stage of the launch. And while there was a very important announcement about it, we haven't considered it to be of commercial volumes yet. That's still to come.

[Operator]

[Operator Instructions] Your next question comes from the line of Robert Nemy from Nemy International.

[Robert Nemy]

I just jumped on the call late. So I just wanted to get -- to catch up with a few things. As far as -- obviously, your top 2 customers are ramping up and starting to do well. But I think you were 13 to 15 in the top 20 in wood. And like how's it going there? How's your traction? What stage of trials are you in, in the other 10 or 12 that you were into?

[Jeffrey D. MacDonald, CEO & Director]

So I think we -- I mean, we definitely suffered from a slowdown in the higher pMDI pricing environment. And so there were some customers that simply didn't progress during that time. Some of them have picked up and restarted exposure across the top players, and we're still active and working with the ones we were working with before. No one has really dropped out of that. We have trials on the go though that are everywhere from lab phase to later-stage industrial work. So that profile of trial activity has remained the same, but it's -- it definitely took a slowdown in the last year with higher pMDI prices.

[Robert Nemy]

And how about on the -- in the paper market? Are you getting the traction in new customers on the paper side?

[Jeffrey D. MacDonald, CEO & Director]

Yes. I mean, we had a fair bit of trial activity in the last year. And especially, I think some interesting new stuff in specialty paper, which has led to, I'll say, some small initial wins, not ones that we would report as big commercial wins yet at this point. The SB latex market moving against us here in the last quarter, again, puts a bit of a damper on that when it comes to cost savings. But we see that the specialty projects in particular continue to progress. They're much less sensitive to the cost of SB latex.

[Robert Nemy]

And you get sort of a breakeven point as far as demand on the oil price is above $60. How about pMDI, what's your mark there on demand? Where it's -- where are you seeing it to get a pick up in demand?

[Jeffrey D. MacDonald, CEO & Director]

Well, when we really got started with our DuraBind trialing efforts, we were at pMDI prices, I'll use the European price of somewhere between EUR 1,200 and EUR 1,400 per tonne, and we saw good activity, then customers were looking at that as being sort of parity or may be a small premium to their formaldehyde resins. We're below that level now. So we're definitely in a good spot now, but that kind of EUR 1,200 to EUR 1,400 range is an important range, economically.

[Robert Nemy]

Where exactly are we at on pMDI right now?

[Jeffrey D. MacDonald, CEO & Director]

It's the number we put up there. Around 14 -- even a little bit lower than EUR 1,400 today.

[Robert Martin Haire, CFO & Corporate Secretary]

Rob, you got to think about -- that is actually our market rate. The customers that we're dealing with there and the prices that Jeff's referencing would be more at the customer level. And you can see upwards to a 10% discount off what our market rate would be for a very large customer or even more.

[Jeffrey D. MacDonald, CEO & Director]

So if the spot in Europe today is EUR 1,400 per tonne, we see some customers that are buying even in the EUR 1,200 range.

[Robert Nemy]

Okay. And my final question, you may have answered this early in the call, but I missed that. Are we still pursuing government grants?

[Jeffrey D. MacDonald, CEO & Director]

We are. It's actually -- there is a note in our release. We've been successful in securing a nice government grant in the fourth quarter. There's a -- as we usually go, there's a nice announcement to go along with it. With the cabinet shuffle, I think that announcement's been delayed a little bit, but there should be a press release to go along with that in the next little bit. It's a nice 5-year grant that supports our efforts in R&D and the wood composites space, specifically. Yes. So we are, and we're successful in that pursuit.

[Operator]

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

[Raveel Afzaal, Analyst]

Guys, just one more question. You mentioned that you're also looking at some complementary products to go. Can you just speak a little bit more about these complementary products and how they fit into your overall vision?

[Jeffrey D. MacDonald, CEO & Director]

Sure. So specifically in wood composites, when we talk about complementary products, we have the core DuraBind product, which is the co-binder that works with pMDI. But as we got deeper into applications with customers, we saw the need for some other, let's say, benefits that we could offer to the line such as tech, which is essentially just holding the board together as it moves through the line, and some catalyst products, which are able to help speed up the line. So we've spent a fair bit of time developing those. And those are actually instrumental in some of the important trials that we're working on literally today. So that's -- in the core market of wood composite, that's one. The other thing I referred to earlier was just placing small bets in other markets where our biopolymer could be interesting. And there, we've had some limited success in the past at arm's length with ingredients for personal care products. And it moved toward all-natural ingredients in the personal care space is a really, really interesting opportunity. And there, we continue to look for partners and specific opportunities where we could take that one further. That's an example. There are a few other partnership opportunities like that, that we're pursuing as well.

[Operator]

There are no further questions at this time. I'd like to turn the call over to Jeff MacDonald for final thoughts.

[Jeffrey D. MacDonald, CEO & Director]

Okay. Thanks again, everyone, for joining us today, and we look forward to speaking with you all again soon.

[Operator]

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