Swiss Water Decaffeinated Coffee Inc

TSX:SWP

Earnings Call Transcript

[Operator]

Good day. Before Swiss Water Decaffeinated Coffee Inc. conference call starts, they are required to remind you that certain information in today's presentation is forward-looking in nature. Any such forward-looking information or statements are based on assumptions that they considered reasonable at the time the information was prepared. Such information involves known and unknown risks, uncertainties and other factors outside our control that could cause actual results to differ materially from those expressed in the forward-looking information.

Swiss Water Decaffeinated Coffee Inc. does not assume responsibility for the accuracy of completeness of the forward-looking information. Similarly, they do not undertake any obligation to publicly revise this forward-looking information to reflect subsequent events or circumstances, except as required by law. Please refer to Swiss Water Decaffeinated Coffee Inc.'s Management Discussion and Analysis posted on SEDAR and Swiss Water's website for a full discussion regarding forward-looking statements and the risks therein. I would now like to turn the floor over to Frank Dennis, CEO. Sir, the floor is yours.

[Frank Dennis, executive]

Thank you, [ Molly ]. Good morning, everyone, and thank you very much for taking the time to join us. I'm Frank Dennis, President and CEO of Swiss Water Decaffeinated Coffee Inc. And with me today is Iain Carswell, our CFO. Iain and I are here today to discuss Swiss Water's financial results for the 3 months ended March 31, 2022. As usual, I'll begin with a brief review of our performance, then Iain will provide more detail of our financial results and then I'll return to talk to you a little bit more about our longer-term plans and expectations. After that, we'll be happy to take your questions.

If you've had a chance to read yesterday's press release and review of our quarterly MD&A, you will already know that the strong performance improvement we achieved during the second half of 2021 strengthened further during the first 3 months of this year. In Q1, our volumes, revenues and profitability all exceeded our expectations, leading to a stronger-than-expected start to the year. As always, volumes were the key driver of our performance with total first quarter volumes growing by 23% year-over-year. The volume growth, along with a higher green coffee cost drove a 50% increase in our quarterly revenue, which at $38.4 million, was up by $12.7 million over last year.

The robust growth of our business along with the resulting high-capacity utilization of our production assets enabled us to post strong profitability despite the inflationary pressures that we are increasingly facing. At [ $5.8 ] million, our first quarter gross profit was up 62% over last year. While adjusted EBITDA of $3.9 million was nearly double what we had recorded in Q1 of 2021. This strong performance resulted from the combination of a number of positive factors. First and most important of these is the recovery of demand from the vital out-of-home coffee market as COVID-19 restrictions are eased in North American and international food service economies returned to pre-pandemic levels of activity.

Second is that as cafes, restaurants and retail grocery outlets in our key markets adapt to increasing environmental responsibility and food safety requirements, coffee roasters and coffee consumers are increasingly choosing chemical-free water processed decaf over coffee decaffeinated with methylene chloride or ethyl acetate.

While the volume growth was notable in all our geographic markets, it's particularly noteworthy that in North America, we achieved strong double-digit growth with volume up 18% over Q1 of last year.

The improvement came from a combination of new customer acquisition and organic growth with existing customers, most of whom are now ordering ahead of pre-pandemic levels. As I've indicated in previous calls, we began shipping to some new high profile out-of-home customers during the second half of last year. This new business is helping boost our results and provides an encouraging indication of future growth potential. Prime example is Peet's Coffee is San Francisco-based specialty coffee roaster and retailer with commercial distribution across the United States.

Another interesting development is that our international markets overtook Canada as our second largest geographic segment during the quarter with business outside of North America growing by 37%. We -- the big driver here were volumes delivered to the Asia Pacific region, which were up by 63% in Q1, mainly due to organic growth. In Europe, volumes were up by 3% in the quarter. Growth in Europe was not as high as in previous quarters because of delayed deliveries due to ongoing destruction of the global supply chain and problems with the port of Vancouver.

Importantly, we also see the positive changes in our customer mix as another clear sign of the strong recovery of the out-of-home coffee market, while at the same time, at-home consumption has remained buoyant. The relaxation of restrictions on food service outlets in the U.S. and elsewhere and the return of more people to their offices and other workplaces helped us increase volume shipped to our higher-margin specialty customers by 27% in the first quarter. This, coupled with 20% volume growth with our commercial customers' indicative of both the general recovery and demand for decaf and the increasing number of industry participants converting to our chemical-free process.

What's unusual is that we've achieved this exceptional volume growth across the business despite a stubbornly high New York futures contract coffee price or NYC. The NYC rose steadily through the second half of last year and has remained unusually high for an extended period. During the first quarter, the NYC hit a peak of USD 2.58 a pound and average $2.35 a pound. This compares to the average of USD 1.27 we saw in the first quarter of last year. Normally, when the NYC rises and remains at high levels, our customers tend to consume our inventories as they wait for the -- NYC to fall back rather than buy more coffee from us.

However, during '21, an unusual double frost in Brazil, together with the widespread disruption of global supply coffee chain -- supply chains and growing inflationary pressures across the economy, has created a persistent fear of a coffee shortage among industry participants at all levels. These concerns have helped support our volume growth and may even have caused some customers to move their orders forward to ensure that they have sufficient inventory on hand to meet demand. Over the coming weeks and months, we will see how this continues to play out. Before I tell you more about our outlook for the balance of the year and our preparations for our future, let me now turn the call over to Iain to take you through our financial results.

[Iain Carswell, executive]

Thanks, Frank. Good day, everyone. As always, I'll begin my review with volume shipped to customers as this is the key metric that drives our financial performance. As Frank indicated, Swiss Water's processing volumes continued to grow in the 3 months to March 31, primarily due to the ongoing recovery of the food service economy. Total volumes were up by 23% in the first quarter when compared to the same period in 2021. Looking at volumes by customer type, shipments to roasters, those customers who roast and package coffee to sell to consumers in their own coffee shops or for home or office consumption, were down slightly dropping by 1% in the quarter.

However, shipments to importers, those customers who resell our coffees to roasters where and when they need it, were up substantially growing by 56%. Looking at the segments another way, as Frank noted, specialty roaster account volumes continue to trend upwards, growing by a healthy 27% in the quarter. These accounts serve the out-of-home consumer primarily, and the strong growth here reflects the reopening of cafes and restaurants in our key geographic markets. Shipments to large commercial roasters we serve the grocery market principally were also up, growing by 20% in the quarter.

Turning now to revenues. First quarter revenue of $38.4 million was up by $12.7 million or 50% from Q1 of 2021. The revenue increase was due to the strong growth in our volumes as well as significantly higher prices for green coffee this year. Looking at the cost side, our first quarter cost of sales was $32.7 million, an increase of $10.5 million or 47% compared to Q1 of last year. The increase was mainly driven by higher green coffee costs and our significantly increased production volumes. As Frank noted, the NYC coffee commodity price has been trending sharply upwards since early in the third quarter of last year.

In Q1 this year, the NYC averaged $2.35 per pound compared to an average of $1.27 per pound in the first quarter of 2021. As you would expect, such a significant rise in coffee prices triggers a major increase in our working capital needs and increased value of our inventory and our balance sheet is reflective of this. We are monitoring our working capital needs very closely and evaluating options to increase credit availability as needed. First quarter gross profit was $5.8 million, an increase of $2.2 million or 62% compared to Q1 of 2021.

The improvement in gross profit was primarily driven by the high processing volumes we put through our facilities. Importantly, high utilization of all 3 of our production lines enabled us to realize significant production efficiencies. First quarter operating expenses were $2.9 million in line with Q1 of last year. The administrative portion of operating expenses was up by $300,000 or 18% due to higher professional fees and salaries as well as the incremental cost of operating from 2 locations. Growing inflationary pressure and production increase such as natural gas, packaging, shipping and labor are all putting upward pressure on expenses.

However, during Q1, the increase in operating expenses was offset by an equal reduction in sales and marketing expenses, which were down by $300,000 or 25% compared to Q1 of last year. Q1 operating income was $2.9 million, an increase of $2.1 million or 290% compared to the $738,000 recorded in the first quarter of 2021. After accounting for increase in finance expense and income taxes, this flows down to net income, which is $1.4 million for the quarter compared to a loss of $96,000 in Q1 2021, representing a year-over-year improvement of 175%. The change reflects the combination of improvements in gross margin and operating income.

First quarter net finance expenses of $1.1 million were up by $200,000 over Q1 of last year. The increase was due primarily to a higher interest rate on our debentures with warrants as well as higher outstanding balance on our construction loans and credit facilities. Despite inflationary pressure on the company during the quarter, we achieved a significant improvement in adjusted EBITDA. First quarter adjusted EBITDA of $3.9 million was up by $1.9 million or 95% compared to Q1 in 2021. Operationally, our adjusted EBITDA improvement this year was driven primarily by the volume growth and an increased financial contribution from our Seaforth coffee handling subsidiary, which operated at record levels during the quarter.

As I've noted, these positive impacts were partially offset by higher green coffee costs and incremental labor and production expenses associated with operating 2 stand-alone facilities. Once we consolidate all production in our Delta location and exit the legacy Burnaby facility in mid-2023, the resulting efficiencies will bring down our operating costs significantly. On a final note regarding financing, subsequent to the end of the first quarter, we reached agreement with Mill Road Capital to increase our senior debt covenant from $60 million to $65 million. With that, I thank you for your attention, and I'll pass it back over to Frank. Frank?

[Frank Dennis, executive]

Thank you very much, Iain. As Iain and I have indicated, we are very encouraged by the fact that the positive momentum we saw building across the business in the fourth quarter and full 2021 fiscal year, continued to gain steam in the first quarter. While 2022 is off to a good start with a strong order book, a high capacity utilization rate and the return of generally favorable trading conditions in our key markets, caution continues to be called for. Like all businesses, Swiss Water is not immune to macroeconomic risks that are evident across the world. The COVID-19 pandemic continues to raise its ugly head in China and elsewhere and may well cause future disruptions to the coffee commodity supply chain. The Russian invasion of Ukraine is also creating a lot of uncertainty in Europe and around the world. Here at Swiss Water, we are continuing to experience delays in coffee deliveries as persistent supply chain bottlenecks disrupt the flow of coffee and in particular, the reduced supply of steamship service to Vancouver.

Furthermore, the continuation of a very high coffee futures price is resulting in a significant increase in our working capital needs and may well impact coffee demand at the consumer level in the near future. At the same time, we are experiencing very significant inflationary pressure on virtually all our input costs from natural gas to freight to labor. These risks are increasing costs -- these risks and increasing cost demand our close attention and will likely require further pricing actions and mitigation measures.

They could also have a negative impact on our margins and our 2022 volumes. Operationally, we continue to run both decaffeination lines at our legacy production facility in Burnaby, BC on a 24/7 basis as we did throughout 2021. Aside from a scheduled maintenance shutdown in January, the initial line at our new facility in Delta, BC operated smoothly and efficiently, also on a 24/7 basis throughout the quarter, and we are continuing to migrate more of our production here. Since it's start-up, we've been gradually increasing the processing speed of Delta Line 1 as we work to optimize and maximize its production.

I expect you all know by now, we must relocate all remaining production from Burnaby by June of next year due to the upcoming expiry of our lease there. Accordingly, in order to ensure that our ability to deliver on customer orders is uninterrupted and to meet the growth in demand we see ahead, we are now building a second new production line in Delta. Financing for this project was arranged in Q2 of last year, and the necessary permits were secured last summer. Foundation was completed during the third quarter last year and ground construction began in Q4. The project is currently proceeding on time and on budget toward target completion date before 2023 lease expiry in Burnaby.

As I've noted before, based on engineering reports third-party engineering firm, when both are completed, we expect the 2 new deadlines in Delta together will have a targeted end capacity, at least 40% greater than the current Burnaby facility. The preliminary cost estimate for designing and construction for the Line 2 project in Delta is approximately $45 million plus commissioning costs of around $2 million. These estimates are preliminary and like all major design exception projects are dependent on local and global economic factors. In the meantime, we are working to quantify the exit costs associated with permanently shutting down our Burnaby facility next year.

This process involves value adding the costs associated with moving and relocating some production assets into storage for possible future use as compared to [ immediate ] disposal on a piece-by-piece basis. We will report the results of this analysis to you once we determine the best options. That wraps up our comments for today. Iain and I would be happy to answer any questions that you might have.

[Operator]

[Operator Instructions]. Your first question for today is coming from Grover Wickersham.

[Grover Wickersham, analyst]

It's Grover from Glenbrook Capital and we've been long-term shareholders, and we've actually added during the weakness in the stock because we're very optimistic about the company. I was concerned in reading the earnings report that you were talking about ways in which to increase capital. And I noticed that you do have some additional lines of credit, but my question is, are you going to be issuing equity? And I would just say that if there is an equity issuance, I would hope that existing shareholders have an opportunity to participate.

[Iain Carswell, executive]

Thanks, Grover, I appreciate the question. And I appreciate your interest as well in additional equity should that become available. What I would say at the moment is that we are evaluating all of our opportunities right now should additional capital be required.

[Frank Dennis, executive]

Yes. I mean, Grover, the -- basically, as we are evaluating our capital structure, the [ one ] reason for that is the working capital requirements of managing a significantly inflated New York 'C'. And so you've probably seen some of our working capital needs increase. If you look at 'C' quarter-by-quarter over the past few years -- months, really, not quarters, you've seen an increase in working capital. And so that's just having us evaluate our kind of shorter-term needs. I'm not certain that, that's going to lead into a view in terms of issuing equity, but thank you for your point about being interested, as Iain had mentioned.

[Grover Wickersham, analyst]

Yes. I would just say, in addition to that if there were a rights offering, that would -- obviously, that would give everyone an opportunity because I -- the way we look at it is the stock is really depressed. And I guess I have one other kind of a marketing question is that I'm based both in British Columbia and in the States, mostly California and Oregon. And I really -- I have -- I think the brand is incredible, and I really haven't noticed any marketing efforts to really promote the brand.

And I was wondering if that might be something you might be doing more in the future, either using -- going online with social media or even just print advertising. And again, that's not something you tend to see, but it is a terrific brand. And I think that -- you do mention that people are gravitating away from the chemical processes. But I think a lot of people are not necessarily aware of Swiss Water even though it's been around for a long time.

[Frank Dennis, executive]

Yes. And so that's a great point. And I'm glad you mentioned. Do you drink decaf?

[Grover Wickersham, analyst]

I do. It depends -- for my job, I have to be heavily caffeinated...

[Frank Dennis, executive]

I do too, of course, which is a perfect answer. And actually, that was a bit of a setup question, Grover, because -- in fact, we are doing quite a bit of city-specific work in the U.S. online right now through a couple of different platforms, primarily YouTube. And essentially getting click-through work done. And I think it's 10 or 11 cities, and I think we just went live on probably our -- I don't know, how many cycles we've done so far. But we've been very diligent.

I mean not aggressive. It's not heavy weights, but we've been very diligent and very targeted. And so that's why I asked you if you drank decaf. I'm almost glad you haven't seen what we're doing because that means we're targeting well. And so yes, we are developing. In fact, our brand awareness is increasing. We do follow our brand awareness metrics, and we're seeing nice increases in the U.S. I mean there aren't leaps and bounds and it's also -- it's targeted city by city. It's not blanket.

And so with those increases, I can tell you that, that is a part of what is behind our growth. We aren't growing just because the supply chain is disrupted and things are moving. I mean the fact that Peet's has come to us in another -- if you're in the kind of Oregon, California range, you would know some important drive through kiosks there that have picked up our brand again after having lost that business like 10 years ago, they're back working with us. And so we are seeing really strong continued demand in North America, and that's -- it's bubbling over into Europe and Korea because awareness is developing in the state.

So our long-term strategy, as slow as it may seem, is working. And I can tell you these types of results that we've had over the past year and a half. And going back pre-pandemic, when we were growing plus [ 14 ], these aren't -- it's not magic. I mean it's not just happening. These are -- it is driven by our brand development work that our excellent marketing team, who are ex-Starbucks, in fact, they're successful. And it's exciting to see. So I totally support your point about marketing, and it is targeted. It's not high weights. It's not heavy expense, but it's working.

[Grover Wickersham, analyst]

With Howard Schultz back at Starbucks, and then with them just being right across the border, I guess you probably talked to them to see if there are any opportunities there. But that would, of course, be a home run.

[Frank Dennis, executive]

Yes, that's a much, much longer story. Over a coffee, some day, Grover, probably. But yes.

[Operator]

[Operator Instructions]. Your next question for today is coming from Brent Davies.

[Brent Davies, analyst]

Brent Davies from Lincluden Investment Management. Just out of curiosity. So what you're saying was essentially Delta is going to be -- or have 40% higher capacity than Burnaby. But I was curious what would be the capacity in terms of -- or compared to the 3 lines that are currently operational?

[Frank Dennis, executive]

Well, it will be some -- just somewhat less than that, right, because we've got -- we have the benefit right now. And thankfully, we do actually, as we're dealing with some of these kind of these big whipsaws that are happening with global supply chain. We do have a little bit more capacity right now to kind of get through some heavy periods that are happening because of pent-up demand through Q4, Q1. So we will be slightly down, and I don't have the percentage metric. And as you know, we don't discuss pounds for competitive reasons. So we will be slightly down from where we're at right now, but the 40% number is still what our target is vis-a-vis base Burnaby.

[Brent Davies, analyst]

Okay. So -- and currently, the utilization of the 3 lines is around 80%?

[Iain Carswell, executive]

Yes, it's tracking at that.

[Brent Davies, analyst]

And I guess one final question. In one of your previous earnings calls, you had listed Tim Hortons as making up 75% of your out-of-home business. Is this still the case/I would assume that if there's still a round that it should be significantly less?

[Frank Dennis, executive]

That is an interesting point. The 75% -- I'm not sure that metric was ever really true. The 75% sounds like -- that's kind of almost like the share of Tim Hortons out-of-home basis in Canada. But in any case, Tim Hortons still remains our largest customer. And when -- without kind of revealing too much vis-a-vis, again, a competitive basis, if you think about the fact that Europe in this quarter ended up being larger than Canada means that we are essentially diluting the concentration risk around Tim Hortons within our portfolio, and we can continue to dilute that over the years.

But Tim Hortons is still growing organically within our total portfolio. So their business is still growing. Now they've been up and down through the pandemic, et cetera, but they continue to open shops around the world and in Canada and drive their same-store sales. So I'm not sure if that perfectly answers your question. I'm not sure kind of where you're coming from, if you're looking at concentration risk or you are just thinking about how Canada sits, but I'm not exactly sure where the 75% kind of sits because I don't think we ever did actual metrics on what our -- exactly where our food service business is because it's a very hard determination to get because so many of our customers, like Mother Parkers, for example, does a lot of food service business but also has their own retail products. So it's difficult to -- it's very difficult for us to see, and I'd be surprised if we were speaking very specifically about a 75% number without that kind of accuracy.

[Brent Davies, analyst]

Okay. Makes sense. Perhaps I misheard one of the previous [indiscernible], but I appreciate that. It was largely based around concentration risk.

[Frank Dennis, executive]

That's what I thought.

[Brent Davies, analyst]

And sorry, there was one final question. We see pretty significant growth happening in Asia and Europe. You had mentioned in previous -- or in a previous call that perhaps you guys would expand to the East Coast of the U.S. or potentially overseas given customer demand. Is this still the case?

[Frank Dennis, executive]

It is a long-term strategic opportunity. We have a lot of kind of work to get through in the next 24 months. We ended up having to move out of Burnaby faster than we had thought. But ideally, we will be in a position in kind of 24 months to evaluate that longer-term strategic opportunity. I think that there are benefits to having processing capacity in more than one physical location. There are additional costs to that though. I mean, operating 2 facilities in a reasonably kind of small business is an expensive proposition, no doubt. But we continue -- we will be evaluating that in the future, and it is still on the -- on our potential strategic horizon, yes.

[Brent Davies, analyst]

Okay. Perfect. And sorry, additionally, not so much as a question, it's more of a comment. A few years back, you made a relatively passionate speech about the quality of Swiss Water's decaffeinated -- decaffeination in comparison to Mountain Water or some of your other competitors that use chemicals. I found that, that was -- the passion was there, and it was very nice to hear.

[Frank Dennis, executive]

Well, thank you very much, and we remain just as passionate for sure. Appreciate the support.

[Operator]

[Operator Instructions]. There are no further questions in queue.

[Frank Dennis, executive]

Thank you, [ Molly ]. So if there are no further questions, we will conclude today's call. Iain and I wish you all good health, and thank you very much for joining us.

[Operator]

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.