Earnings Call Transcript - ECO Q2 2023

Operator, Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the EcoSynthetix 2023 Second Quarter Results Conference Call. 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 February 28, 2023, which is posted on SEDAR. This morning's call is being recorded on Thursday, August 3, 2023, at 8:30 a.m. Eastern Time. I would now like to turn the call over to Mr. Jeff MacDonald, Chief Executive Officer of EcoSynthetix. Please go ahead, sir.

Jeff MacDonald, CEO

Thank you. Good morning. We issued our 2023 second quarter results yesterday afternoon. As we move into the second half of 2023, we are beginning to see emerging signs that make us optimistic the business is turning a corner with a return to a growth trajectory. The second quarter, which is now behind us, was certainly a continuation of the macro challenges we experienced in Q1 as we expected and mentioned at the time of our Q1 call in May. Sales were flat sequentially at $3 million and down 29% from the prior year period. This change was due to lower volumes. The reason for our optimism today is twofold. Number one, we are seeing positive signs on the opportunity side, specifically in terms of an expansion of our pipeline in the wood composites, tissue, paperboard, and pulp end markets. And number two, we're seeing positive indicators on starch availability and pricing earlier than we had originally anticipated, which should support margins and pricing to win new business. On the wood composites front, the movement toward bio-based glues is gathering momentum. IKEA published its sustainability and climate reports earlier this year, which we've highlighted previously. In those reports, they've highlighted glues for wood panels as one of the critical drivers to reduce their carbon footprint and achieve their climate goals. Wood glues represent 5% of their total carbon footprint. They've set a goal of reducing that impact by 40% by 2030 through the use of bio-based glues, which they are implementing at one of their facilities. In June, CNN did a feature report on IKEA's development journey on its use of bio-based glues from cornstarch in the production of wood panels like particleboard. As one of the largest consumers of wood panels in the industry, IKEA's influence on their supply chain and manufacturing base is significant. When retailers and manufacturers like IKEA move to bio-based glues, other suppliers follow. We have long said the market is moving toward our solutions, and we appreciate the patience our shareholders have shown as the impact on our sales has been slow to materialize. We believe this new level of awareness in the market is having an effect. Let me explain. In May, we attended the Ligna Trade Show, where the whole wood processing market comes together every few years for 5 days. There were 2 issues that were front and center: number one, like most industries was artificial intelligence; but number two was bio-based glues for wood panels. We are the clear incumbent in the bio-based glue market. We have seen trial activity pick up year-to-date, with new prospects requesting material and support for trials and prospects that have trialed with us before reengaging. They see the movement in the market and they do not want to be left behind. The industry clearly recognizes that we are the leading bio-based offering that is being used commercially and technically successfully today. With the thought leaders in the market leading the way toward greater use of bio-based glues, others in the market see this as a catalyst that the change is real. This movement gives us confidence that the second half of 2023 and into 2024 can be stronger than the market conditions we've just endured. In the tissue, paperboard, and pulp end market, we continue to engage with manufacturers, advancing trials with existing prospects and broadening our pipeline with new prospects and applications. The tissue, paperboard, and pulp market has been dealing with the same macroeconomic challenges that we've faced. The sector was dealing with excess inventory as strong sales of paper-based products through 2022 dropped sharply heading into 2023. These manufacturers have been downsizing staff through layoffs and restructuring production with temporary or permanent mill closures. The purpose in mentioning these conditions is that despite these challenges, customers have continued to engage with us to advance SurfLock trial programs. This engagement demonstrates that they recognize what we have is valuable and important enough to them that they're prioritizing it among some really challenging conditions. It's a cost-saving solution. With that in mind, we wanted to provide a flavor of what we offer manufacturers. We recently published performance results from a successful program implemented at one of our tissue paper wins. This manufacturer produces toilet tissue from 100% virgin fiber and our SurfLock. Their objective in adding SurfLock was to improve the tensile strength with no negative impact on softness or dusting. The manufacturer used a mix of short and long fiber, and, in our trials, they added 2 to 2.5 kilograms of SurfLock per ton of fiber. The results of the study speak for themselves. The manufacturer proceeded to commercial volumes due to a 30% increase in tensile strength, a 40% reduction in base weight, reduced line breaks, which resulted in increased line speed, increased productivity, no negative impact on softness, and a 50% reduction in dusting. It's results like these that make us excited about the opportunity that's in front of us in this end market. This performance resulted in this manufacturer converting to commercial production at this line, and it is now trialing SurfLock at a second line at a separate location. And that's typical of our go-to-market strategy: successfully deploy the technology on one line at a first location and then within the same account move to a second and third location once they've seen the benefits of the first line. That's the same playbook we are using with another account where we are commercial today and now expanding to a second line with new trials. At the same time, we're broadening our pipeline of opportunities through new geographies and new applications. One important characteristic of the value chain in this market is that many paper product manufacturers outsource the management of their wet-end chemicals to distributor service providers. In addition to generally being an important channel to market, we've identified several of these players who are located in geographies where we do not have a strong presence. We've now cultivated several of these relationships and some of these new partners have now received trial product from us to begin new programs. We believe this will be an important channel to market for SurfLock going forward. On the new applications front, we are working with one manufacturer that has an interest in developing SurfLock as a strength aid upstream from the mill process, modifying the pulp at source to make it more valuable for their customers. This manufacturer has already conducted successful initial trials and has now ordered more material to run larger-scale trials later this summer to advance the program. It's another opportunity that expands our addressable market, and it's a concentrated one, think tens of millions of opportunity per line, but with fewer targets. It's a development program at this stage, so it's not a slam dunk we will be successful, but it demonstrates the flexibility of the platform, and it's another reason for our optimism in the long-term outlook of the business. On the personal care front, our marketing and development partner, Dow, continues to be highly engaged with its prospect base on the Mazecare opportunity. At this point, there's no doubt that the pandemic really set the product launch back significantly. But where are we today? Dow has successfully won some smaller players, and they're seeing signs in the market that larger players are engaged in advancing their development programs. Dow has consistently told us they entered the $460 million hair fixative space with an all-natural product because they believe they can take a meaningful share. The engagement they're seeing today with some of the larger players has them excited that bigger opportunity is near at hand. We follow their lead in this end market and when they're excited, we get excited, too. On the legacy graphic paper front, the macro challenges are worsening, both from an overall demand perspective as well as the pricing dynamics of the petroleum binders our chemistry replaces. Coated freesheet is the primary market we monitor as the opportunity for our EcoSphere binder. In Q2, the coated freesheet graphic paper industry experienced significant challenges, a 36% year-over-year decline in demand, a 46% year-over-year decline in production, and current mill operating rates are at 62%. These declines are relative to the 2022 comparison periods where the market had already endured significant declines. On the pricing dynamics, oil remains below $80 a barrel and the price of SB latex, which our product replaces, remains well below historical levels with abundant supply. The price of SB latex, together with the high raw material pricing we experienced in the first half of 2023, eroded the cost savings EcoSphere offered manufacturers historically. With some early improvements that we're recently seeing in cornstarch pricing, we'll be able to recover some share in this market, but we do not expect it to recover fully based on the macro demand dynamics I mentioned earlier. The vast majority of the volume decline we experienced in the first half of this year was a result of the legacy graphic paper market. We'll continue to deliver for our customers in this space, but it's not a growth driver of the business, and that's where our focus lies, in wood composites, tissue, paperboard, and pulp, and with our partner, Dow in personal care. On the supply side, we've seen emerging signs of improvement in both availability and pricing of cornstarch. Earlier in the year, we were told to expect no relief on pricing until the new harvest in the fall. Instead, we're seeing modest early improvements. And while it's definitely not back to normalized levels, indicators suggest a better outlook. On the availability front, we're also seeing an improvement. We're expanding our supplier base in Europe, qualifying alternative suppliers of cornstarch to give us greater optionality in the future. Between the new suppliers and the new harvest coming up, we're in a much better position. It was a tough first 6 months of the year. We managed through it effectively, maintaining our cash position, and we see greater opportunity in the second half of 2023 and into 2024. As a result, during the quarter, we doubled our use of the normal course issuer bid compared to Q1 2023. It demonstrates our confidence in the long-term outlook of the business. While we recognize some stakeholders believe we should be even more aggressive on this front, we believe doubling the program, while at the same time, preserving a strong cash position is an effective and balanced strategy. Our strong cash position is critical to our key strategic wood composites account and our other large customers. It gives them confidence that they can rely on us regardless of the market cycle as a dependable supplier of a key ingredient on their path to greater use of bio-based glues and resins. With that, I'll turn it over to Rob to review the financials. Rob?

Robert Haire, CFO

Thanks, Jeff, and good morning. Net sales were $3 million in Q2 2023, down 29% compared to the same period in 2022. The decline was due to a step down in demand primarily from sales into the graphic paper end market, which included a $400,000 decline in sales due to destocking at a large distributor. Gross profit was $550,000 in the quarter, a decrease of $570,000 from the same period last year. The change was primarily due to a decrease in sales volume and higher cost of manufacturing. This quarter, we hit an all-time peak on our product costs. We built inventory at a higher cost during 2022 and into 2023 due to the constraints we experienced last year in feedstock availability. We are working through that higher cost inventory this quarter. As Jeff mentioned, feedstock costs have come down off the highs we saw earlier this year, and we anticipate further normalization as we qualify a new supplier and the new corn harvest approaches. This will also likely result in lower average selling prices later in the year as we pass on some of these savings to our customers. Net of manufacturing depreciation, gross profit as a percentage of sales was 25.2% in the quarter compared to 30.8% for the same period in 2022. The lower cash margin percentage was due to the higher feedstock costs. SG&A expenses were $1.2 million this quarter, a decrease of $210,000 compared to the same period in 2022. This improvement was primarily due to changes in foreign exchange gains and losses and lower compensation expense related to performance-based share equity awards. R&D expenses were $630,000 in the quarter compared to $500,000 in the same period last year. The increase was primarily due to new product scale-up costs. We continue to invest in innovation to improve our value proposition and expand our addressable market opportunities. Adjusted EBITDA loss was $780,000 in the quarter compared to a loss of $230,000 in the same period last year. The change was primarily due to lower gross profit when compared to the same period last year. Cash provided by operating activities was $870,000 in the quarter compared to $80,000 in the prior year period. The improvement is primarily due to working capital improvements, offset by the net loss. During the quarter, inventory was reduced by $1.6 million, which had a favorable impact on our operating cash flow. We do expect to rebuild this inventory in Q3 as part of our manufacturing footprint realignment project announced in Q1. As of June 30, we had $35.7 million of cash in term deposits compared to $36 million as of December 31, 2022. During the quarter, we invested $900,000 in NCIB to purchase and retire 348,000 shares. Since 2008, we purchased 5.5 million shares and invested $10.7 million into our NCIB program. We have demonstrated our ability to responsibly manage our cash reserves through multiple cycles while continuing to invest in our long-term growth strategy. With that, I'll turn it back to Jeff for closing comments.

Jeff MacDonald, CEO

Thanks, Rob. The positive signs we are seeing across our key growth markets give us confidence the challenges of early 2023 are behind us. Our pipeline of prospects running trials in both wood composites and tissue, paperboard and pulp is expanding in depth and breadth. The movement to bio-based glues in the wood composites end market is being championed by the thought leader and leading consumer of wood panels. The benefits of our strength aids in the tissue, paperboard and pulp market are clear, as evidenced by the case study I shared and the expansion of our early account wins into new trials at separate locations. We've united our team behind our next goal of achieving $100 million in sales, and we can achieve that goal with just the customers we're commercial with today, and we're going to win new accounts, too. We're focused on delivering that growth for shareholders. And with that, I'll ask the operator to open up the call to your questions.

Operator, Operator

Our first question comes from the line of Dan Marks of Stonehouse Capital.

Daniel Marks, Analyst

You previously mentioned that you had around 2 or 3 commercial accounts and 8 accounts in trials. You've indicated that this has expanded. Can you provide some numbers to help us understand the increase over the past 2 or 3 quarters?

Jeff MacDonald, CEO

Yes. Until we are seeing some real predictability where we can build a model around it and tie a pipeline of trial activity to actual wins, commercial successes, and then revenue growth, we're not going to share that as a model. I used 8 at the time as just an example of where we were at that point in time, and it's safe to say that with all 8 of those opportunities, we've continued to advance and we've expanded to new customers and additional lines within existing customers. So the pipeline has only built, and we're going to be, obviously, very forthcoming when some of those opportunities do translate into commercial wins and we're shipping product continuously to customers, which I feel like we're advancing very well and very close to.

Robert Haire, CFO

The only item I would add, Dan, is that we do still continue to sell commercially to 3 mills today.

Daniel Marks, Analyst

Okay. And the trials are obviously a number greater than 8 because none of those 8 have dropped out or had any negative trials or anything that's changed their path forward?

Jeff MacDonald, CEO

No. I can provide some insight regarding the trial activity and its functioning. It isn't simply a matter of receiving a trial and achieving a win; each situation is unique. We've had successful interactions with customers, and a prime example is a second mill at an existing customer that utilized our product initially as a trial, which turned out so well that they continued purchasing it. That represents a particularly strong case. In the last quarter, we had an incident where we produced a batch of material intended for two different accounts, but something went awry during the process. These are the types of setbacks that can occur. We've resolved that issue, and both customers are currently back trialing this month. These delays are part of the process. It's important to note that despite challenges, it's a testament to the value of our product that these accounts have persisted through layoffs and mill closures. We have continued to progress despite these difficulties, and we are beginning to see a decrease in their inventory levels and an increase in order quantities, indicating potential cost advantages as they emerge from their lowest periods. From what we are hearing, they are starting to perceive some improvement ahead.

Daniel Marks, Analyst

Jeff, are there any external benchmarks that investors can follow to get an idea of when those wet-end customers might pick up? On the supply side, we've been watching corn futures regularly as a rough proxy for where cornstarch might be headed. Should we use pulp prices for that market, or is there another indicator we should be looking at? We can't communicate directly with your customers, but what can we track to gauge when things have bottomed out and are starting to improve?

Jeff MacDonald, CEO

Yes. I would say pulp prices are really only relevant to the value proposition that we hope we're going to be able to offer that looks very interesting for pulp manufacturers themselves. So when we can help to enhance the value of lower grade pulp, that's the advantage that they're getting with our product to make it closer to higher-grade pulp. That's the closest link to a macro figure like that. I think you have to remember in this space that, today, we have essentially 0% market share. And so the indicators are really our ability to convert accounts with wins based on the value we're offering. And we're going to have to start to draw a line from that as we get some traction here. I don't see that there's an indicator like we can see on the supply chain side with the cost of our materials in terms of wins, just given that we're disruptive in building from basically no market share.

Daniel Marks, Analyst

I understand. Regarding the pulp side, is the manufacturing opportunity upstream the same product supplied to them, or is it a variation of SurfLock? More importantly, when they sell it to the customer, does that customer need to go through a comprehensive qualifying process like your direct end market customer? You've mentioned before that there might be some capital expenditure needed to upgrade a line. Do your customers’ customers also need to upgrade their lines, or can the product be used as it is, similar to non-enhanced pulp wood?

Jeff MacDonald, CEO

Yes. Good question. We don't want to reveal too much about what makes SurfLock effective, but both products intended for the end applications and pulp mills originate from the SurfLock family. There might be some variations, but they all come from the same source and operate through our assets. Pulp manufacturers' end customers need to undergo a qualification process, similar to what we would do when collaborating directly with an end customer. They must go through this iterative cycle. Given that there are really two steps involved, this shows that we've been working with this customer for quite some time. The process is a bit more complex and requires time for them to conduct their trials in the mill, complete their qualifications in the lab, and guide their customers through the subsequent steps. The ultimate aim is for it to be a straightforward transition, allowing their customer to accept the pulp as they typically would, appreciate the enhanced properties, and reduce costs in their own final products.

Daniel Marks, Analyst

Okay. So the role of them, theoretically, if you have to qualify each line, whether it's your direct customer or an indirect customer, there's still a qualification process. So it's not like you could go to this end guy and go, here's $100 million worth of product; he's going to qualify it with all those guys first.

Jeff MacDonald, CEO

Yes. Absolutely.

Daniel Marks, Analyst

You have a question about the wood composite market. You’ve been in this space for many years, and SWISS KRONO has been a long-standing customer. What gives you confidence that there will be enough motivation for people to move past the economic advantages of non-green options in the wood composites market, considering IKEA is promoting green products?

Jeff MacDonald, CEO

I would like to clarify that the economics between the two solutions do vary. We have experienced times when we've had a cost advantage over traditional formaldehyde resins. Currently, due to high starch prices and a drop in methanol prices, which is a key component of formaldehyde resins, we find ourselves at a cost disadvantage. However, when influential companies like IKEA commit to this change, they are considering the long-term benefits and can overlook short-term fluctuations. This might be frustrating for purchasing managers in the short term, but with IKEA's commitments, I am confident they will follow through with the change. They have reached out across their supply chain to establish expectations for sustainability, including the use of recycled wood, renewable energy, and bio-based glues. This strong commitment gives us the assurance that the market is moving in this direction. Looking at history, IKEA has already made significant changes in their supply chain, like moving away from lead paint, demonstrating their role as a leader in sustainability. Their newfound transparency about their goals bolsters our confidence in this direction.

Daniel Marks, Analyst

Okay. Do you have any concerns? You mentioned you were the incumbent in the EcoGlue arena. Obviously, you're in with IKEA. They had set in some of their stuff that they were continuing to look at alternatives. Can you give us a view of where you see ECO in the competitive arena? Any fears that IKEA is going to help fuel a competitor?

Jeff MacDonald, CEO

Yes, we take your comments seriously and continuously assess our alternatives and their positioning. Our confidence is partly based on insights from a CNN video discussing the journey of developing cornstarch-based glue, which illustrates the long process involved. Other potential solutions will likely face similar challenges. While there are alternatives that reduce carbon footprints, they may not eliminate formaldehyde. It's possible to produce formaldehyde from bio-based sources, but ultimately it remains formaldehyde. Currently, sourcing bio-based ethanol costs significantly more than petro-based ethanol, presenting hurdles for other solutions. It's no surprise that a major manufacturer like IKEA is exploring alternative options, and our responsibility is to keep innovating to stay ahead. Over the past few years, we've introduced cost savings and performance enhancements to our DuraBind product in collaboration with them, demonstrating that our innovation cycle is effective. Although we don't have anything market-ready yet, our R&D team is working on more ways to enhance the value of DuraBind.

Daniel Marks, Analyst

Excellent. One last question regarding expectation management. In your AGM call, you mentioned having some updates on wins in the wet end that you would be able to discuss soon. Have you addressed that today? Additionally, you mentioned that Dow had some near-term developments you were excited about. Could you clarify what you mean by near term? Are you referring to weeks, months, or quarters? This will help us understand when to look for new developments.

Jeff MacDonald, CEO

Yes. We depend on the opportunities mentioned for the best predictability we can achieve. We aim to share as much of that as possible in a responsible manner. However, the predictability we've received has not materialized as quickly as we were informed it would in any of the markets we serve. So, that predictability has not been reliable. Based on where we were during the AGM, I would have anticipated another win by now. We've certainly gone through additional iterative steps in a slower market due to the macro conditions on the wet end side. Nonetheless, the pipeline has expanded. I still believe we have some potential wins this year. Regarding Dow, for a large account to complete the qualification process, including hair salons, we're likely looking at a timeline of 6 to 12 months before a significant win. In the meantime, we continue to see smaller wins with niche brands. For example, Mazecare is based on a new order we just received, reflecting some of the positive smaller wins we are accumulating.

Operator, Operator

And there are no further questions at this time. Please go ahead.

Jeff MacDonald, CEO

I'd just like to thank everyone again for joining us this morning, and we look forward to talking to you again soon.

Operator, Operator

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