Swiss Water Decaffeinated Coffee Inc

TSX:SWP

Earnings Call Transcript

[Operator]

Greetings. Welcome to the Swiss Water Decaffeinated Coffee Inc. Conference Call. [Operator Instructions] Please note this conference is being recorded.

Before we begin today's call, we would like 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 and 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 will now turn the conference over to your host, Iain Carswell, CFO at Swiss Water. Iain, you may begin.

[Iain Carswell, executive]

Thank you, Paul. Good day, everyone, and thanks for taking the time to join us. I'm Iain Carswell, CFO of Swiss Water Decaffeinated Coffee Inc. Frank Dennis, our President and CEO, is away and unable to attend today's call. So I will carry the ball this time. I'm here to discuss Swiss Water's financial results for the 3 and 6 months ended June 30, 2023, which were released yesterday.

I'll begin by taking you through our financial results, and then I will tell you more about our longer-term plans and expectations. After that, I'll be happy to take your questions.

As outlined in yesterday's press release, in our MD&A and our first quarter earnings call in May, the second quarter of this year fell within a transitional period for Swiss Water. As such, our financial performance during the quarter was not typical of what we have delivered in recent periods, nor of what you can expect going forward. In April, we decaffeinated the last bag of coffee at our legacy production facility in Burnaby, BC as we prepared to permanently shut down our two decaffeination lines there and vacate the site on the expiration of our lease in June.

As the Burnaby asset ceased production before our new second decaffeination line at our Delta facility was fully operational, we began bridging a short period of capacity constraints during the second quarter. This transitional period stretching from April through August of this year was expected and carefully planned for. Several months ago, we began working proactively with all our customers and suppliers to ensure that we were aware of what to expect from Swiss Water regarding the production of coffee leading up to the Burnaby exit.

During the period of lower production capacity and before the new decaffeination line in Delta begins producing a commercially viable product. Knowing that our capacity would be temporarily constrained during the second and third quarters, many of our customers moved the timing of their orders forward into the first quarter to ensure that they had sufficient coffee on hand to bridge the transition. We also built up our own inventory to enable us to meet customer demand. This had a very positive impact on our volumes, and as a result, our financial performance during Q1. Predictively, the capacity constraints we experienced during the second quarter had an offsetting negative impact on our volumes. The temporary reduction in volumes, combined with a number of significant onetime costs related to the shuttering of our old Burnaby facility negatively impacted our financial performance for the 3 and 6 months ended June 30.

When we look at the first half, the strong results we achieved during Q1 helped offset some of the impact of the second quarter transition. It's important to emphasize that this was a temporary disruption of the upward trend in the growth of our business. And then the strong performance that Swiss Waters has demonstrated over the past several quarters. That said, the curtailment and volume we absorbed in Q2 of this year and the onetime costs related to vacating Burnaby will likely lead to lower earnings year-over-year when we report results for the full 2023 fiscal year.

In July, subsequent to the end of Q2, construction of the second line in Delta was completed, and the first bag of trial coffee was decaffeinated on the new line. We expect again producing commercial-grade product from Delta line 2 before the end of the third quarter this year. Now that we have put the Burnaby exit behind us and consolidated all production Delta, we expect to regain our volume trajectory as we ramp up production on our second new line.

With that context, let me now take you through our financial results. As always, I'll begin my review with volume shipped to customers as this is the key metric that drives our financial performance. As a result of the temporary capacity constraints resulting from the shutdown of the 2 lines at our legacy Burnaby facility, Swiss Water's processing volumes were down as expected during the second quarter. Taken together, volume shipped to customers in all categories were down by 25% in the quarter. For the first half, volumes were down by just 5%, largely due to the front-loading of orders into the first quarter.

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 by 18% in the second quarter but up by 27% for the 6 months. While shipments to importers, those customers who resell our coffees to roasters where and when they need it, were down by 46% in the quarter and by 26% for the first half.

Looking at the roaster segment another way, Specialty roaster account volumes were down by 35% in the quarter and by 13% in the 6 months to June 30. These accounts serve the out-of-home consumer primarily in cafes and restaurants in our key geographic markets. Shipments to large Commercial roasters were also down in Q2, shrinking by 17% compared to the second quarter of last year. However, first half shipments were comparable to 2022, growing by 1% this year.

Turning now to revenues. Second quarter revenue of $43.4 million was down by $5 million or 10% from Q2 of last year. While first half revenue of $92.4 million was up by $5.6 million or 6% from last year's results. As with volumes, the drop in quarterly revenue was largely due to the temporary reduction in production capacity during the transition from Burnaby. For the first half, this negative impact was offset by the strong volumes, we could see in Q1.

Looking at the cost side, our second quarter cost of sales was $40 million, down by $0.5 million or 1% compared to Q2 last year. The quarterly decrease was due to the capacity constraint and the resulting reduction in volumes during transition from Burnaby. For the first half, cost of sales was $84.1 million, an increase of $11 million or 15% from the 2022 level. The first half increase was mainly driven by our increased production volumes during Q1, the significant onetime increase in depreciation expense associated with the write-down of non-salvaged assets at our Burnaby location and, to a lesser extent, inflationary pressure on our variable production and freight costs.

As to green coffee costs, while remaining at historically high levels, -- the NY'C was down from $2.25 per pound in Q2 2022 to $1.85 per pound in the second quarter of this year. With coffee prices now on a downward trend, we can expect some of our customers to sit on the sidelines and wait for the market to bottom out.

Foreign exchange rates can also have a material impact on our profitability and cash from operations. This is because the majority of our revenues are generated in U.S. dollars, while a significant portion of our costs are incurred and paid in Canadian funds. Our exposure to changes in the exchange rate is managed in part through derivative financial instruments. However, all other factors being equal, we benefit when the U.S. dollar appreciates, as it did during the second quarter of this year.

In Q2, U.S. dollar averaged CAD 1.34, up CAD 0.06 from CAD 1.28 in the second quarter last year. As I noted, this appreciation had a positive impact on our revenues when they were converted to Canadian dollars.

Second quarter gross profit was $3.4 million, a decrease of $4.5 million or 57% when compared to Q2 of 2022. For the first half, gross profit was $8.3 million, down $5.4 million or 39% from last year's results. The gross profit percentage decreased from 16% last year to 9% in the second quarter. The drop in gross profit was primarily driven by lower sales volumes, reduced green coffee differential margins and onetime incremental depreciation expenses of $400,000 in the second quarter and $2.5 million for the first half.

As with the $2.5 million impairment charge we took in the fourth quarter of 2022, this onetime noncash expense resulted from an assessment of the salvageable assets at our legacy Burnaby facility in advance of the lease expiry there in June. To a much lesser extent, inflationary pressure on our variable production and freight costs also had a negative impact. As we've explained previously, in preparing to shut down the facility and vacate the site, we undertook a detailed analysis of our Burnaby assets with the help of an outside engineering consulting firm. This process carefully considered the potential future use, costs and benefits and related cash flow impacts involved in removing and repurposing equipment and determined that only a portion should be salvaged and the rest written off.

Second quarter operating expenses were $3.4 million, up by $200,000 when compared to Q2 of 2022. For the first half, operating expenses were $6.8 million, up by $400,000 from last year. The administrative portion of operating expenses was down by 15% in Q2 of this year, largely due to a material reduction in professional fees. You may recall that in Q2 of last year, we incurred higher professional fees related to the refinancing of our debt structure.

For the first half, administrative expenses were up by 5% due to general inflationary pressure and higher insurance fees as well as the depreciation and rental expenses associated with operating 2 facilities prior to shuttering Burnaby. The sales and marketing component of operating expenses was up by $200,000 for both the quarter and the first half.

As we move through the balance of 2023, we expect our sales and marketing costs to increase over last year's level due to slightly higher headcount and salaries as well as a return to normal travel and trade show activity. Q2 operating income of $100,000 was down by $4.3 million from the second quarter of 2022. First half operating income of $1.5 million, a decrease of $5.8 million from last year's result.

Again, the big drivers of the drop in operating income were the reduction in production capacity during the second quarter transition, materially lower green coffee differential margins, the increase in depreciation expense and to a lesser extent, the inflationary pressure on our variable production and freight costs.

Turning now to net income. We reported a net loss of $400,000 for the quarter compared to net income of $1.5 million in Q2 last year. For the first half, we recorded a loss of $1.1 million, down by $3.9 million from net income of $2.8 million in the first 6 months of 2022. As with gross profit and operating income, the drop in quarterly net income was largely a result of the same factors as well as a material increase in finance expense associated with increased borrowings under our debt facilities. These negative factors were partially offset by gains on risk management activities, a revaluation of Swiss Water's embedded option within our debentures with warrants, higher finance income, reduced loss on foreign exchange and lower income tax expense.

Second quarter net finance costs of $1.6 million were up by $300,000 or 25% over Q2 of 2022. For the first half, finance costs were $3 million, up by $0.5 million or 24% from last year's level. The increase was primarily due to higher outstanding balances on our construction loans and credit facility as well as higher variable interest rates.

Second quarter adjusted EBITDA of $1.8 million was down by $3.5 million from Q2 2022. And for the 6 months of this year, we recorded adjusted EBITDA of $6.8 million, down by $2.4 million from the first half last year. The decrease in both periods was mainly driven by our lower sales volumes and reduced green coffee differential margin.

As we look ahead into the balance of 2023, we are continuing to see a strong order book, particularly for late Q3 and early Q4. Encouragingly, first half sales volume to our North American customers, our largest market, remained level with 2022 despite the second quarter capacity constraints and general economic headwinds.

Although International sales volume decreased, this was not unexpected, and we are cautiously optimistic this can be partially offset by higher sales volume during the second half of this year. In general, trading conditions remain favorable in our key markets as ever more industry participants move away from chemical decaffeination in favor of chemical-free processes like ours. However, caution continues to be called for. Like businesses everywhere, Swiss Water is not immune to current and emerging macroeconomic risks. Inflation is becoming increasingly entrenched and economies around the world are struggling to get a grip of it by raising interest rates. The ongoing war in Ukraine has disrupted the global order and continues to create a lot of uncertainty in Europe and around the world.

Here at Swiss Water, while the supply chain disruptions of the last few years have eased, we continue to experience some delays in the coffee deliveries from certain origins. The recent labor dispute and temporary shutdown of the Port of Vancouver was another illustration of the brittleness of the international supply chain.

And as we've noted, Swiss Water has experienced very significant inflationary pressure on virtually all of our input costs from natural gas, to freight, to labor. These risks and increasing cost demand are close attention and may require further mitigation measures.

Looking at operations during the first half of this year. Until the shutdown in late April, we ran both decaffeination lines in Burnaby on a 24/7 basis. And here in Delta, the initial decaffeination line, which we designate Delta Line 1 operated smoothly and efficiently also on a 24/7 basis throughout the first 6 months of this year. Having fully optimized the production from Line 1, we are now sharply focused on ramping up production on Delta Line 2, our second new decaffeination line.

As I noted earlier, we decaffeinated the first trial bag of coffee on Line 2 in July and expect to be producing commercial-grade coffee from this new line before the end of the current quarter. We have now completed the exit from Burnaby and are moving forward in our new state-of-the-art production facilities. This transition marks the culmination of a multiyear project to relocate, modernize and expand the capacity of Swiss Water's production assets. The consolidation of all production in Delta will provide us with a number of operational efficiencies as well as capacity for future term growth. As we've noted before, based on analysis from a third-party engineering firm, we expect the 2 new lines in Delta together will have a targeted end capacity at least 40% greater than the old Burnaby facility.

As to the Delta Line 2 project budget, the preliminary cost estimate for design and construction was approximately $45 million plus commissioning costs of around $2 million. During the second half of 2022, the impact of global macroeconomic pressures, including inflation, building trade disruptions and supply chain issues became more acute in terms of their impact on our budget and schedule. Given the impact of these factors, as previously disclosed, we revised the Line 2 construction budget to a total of $53 million. The original $2 million commissioning budget remains unchanged. There were also material costs involved in shutting down our legacy Burnaby facility, salvaging whatever equipment was deemed economical and vacating and preparing the site for return to the landlord.

As I noticed, we developed this exit plan with the help of a third-party engineering consultant. The budget to complete our exit from Burnaby was $1.5 million, and we are not anticipating any costs beyond this. With last year's incremental $12 million expansion of our senior term credit facility, along with our existing available credit and projected internally generated cash flow, we have sufficient funds to cover both the Delta Line 2 project and the Burnaby exit plan.

That wraps up my comments for today. And I would now be happy to answer any questions you might have.

[Operator]

[Operator Instructions] And the question today is coming from Richard Rudgley from Glenbrook Capital.

[Richard Rudgley, analyst]

Yes. So concerning Delta 2, I just wondered when you envisage the logistically full capacity available? And also, when do you perceive demand for running that 24/7 as well?

[Iain Carswell, executive]

Thanks for your question. As I talked about earlier, we are anticipating that we will be running that line commercially before the end of Q3. So within the next few weeks, we are expecting to get commercial product off that line. It is a new line. With all new lines, it does take time to kind of get them up to full operational capacity. And in the short term, we are expecting to have excess capacity on that line. So speaking to my Operations Director, he doesn't have any concerns about our ability to satisfy demand between now and the end of this year. So we'll be running that line as fast as we feel comfortable between now and the end of this year.

In terms of how quickly we'll be running that line on a 24/7 basis, I would expect to be running that line somewhere between 70% to 80% capacity fairly quickly. And then depending on how demand plays out over the next couple of years will determine how quickly we're going to fill the line up.

Obviously, we'll also be looking at efficiencies, small efficiency tweaks that we can make to squeeze additional capacity out of that line as we move forward. But it's kind of an unknown right now, how strong demand is going to be going forward. We certainly expect to -- we certainly expect strong growth to come back into the business now that we have excess capacity.

[Richard Rudgley, analyst]

Okay. Understood. And did I -- was I correct when you said that Delta 1 plus Delta 2 is 40% more capacity than the old Burnaby facility?

[Iain Carswell, executive]

Yes, it would be at least 40% more capacity.

[Richard Rudgley, analyst]

Because if you're going to be running hopefully 70% to 80% fairly quickly, if the business, which has been very good for many years, I mean, is it possible you would be at full capacity and perhaps not have enough capacity to meet demand in the next few years?

[Iain Carswell, executive]

I mean we're -- the rationale for building the second line was to build enough excess capacity to service our growth in the intermediate term. The reality is that if our business continues to grow at strong double-digit rates as it has done for the last few years, yes, there will be another capacity discussion that will be -- that we'll need to have at some point further down the line. That's something that management and the Board are acutely aware of and we talk about whenever we meet.

[Richard Rudgley, analyst]

And is there enough space on site for that because I haven't had a chance to visit. We've been shareholders for over 20 years, I think. So -- and you haven't seen the new facility. So I was just wondering if there is room on site for Delta 3 down the line?

[Iain Carswell, executive]

Yes, we have room for up to 2 additional production lines on site here. So yes, we're not constrained by space as we were in our former site in Burnaby.

[Richard Rudgley, analyst]

Okay. And can I just shift the question. Correct me if I'm wrong, but I think roughly your debt is just over $100 million in total, and that will be paid off in 10 or 11 years. Do you think there's a chance because we've been shareholders as I say, for a long time, so we remember the days of the dividend. And I just wondered if you envisage and if so at what juncture the dividends returning to shareholders.

[Iain Carswell, executive]

I mean it's something that -- again is -- is something that is discussed internally. And certainly, speaking as CFO, it's something that I would like to target. And I think the Board and management will make an assessment of the most appropriate time.

[Operator]

The next question is coming from Graham Starko and Graham is a private investor.

[Graham Starko]

Now that you've reached substantial completion at the Delta facility, can you give us an idea of what you think the maintenance CapEx spend is going to look like going forward maybe into 2024?

[Iain Carswell, executive]

Yes. I mean, generally, maintenance CapEx runs at about $300,000 per line. So I would expect we're running 2 lines. I would expect that to be the path forward. I mean, obviously, these are brand new -- both brand-new assets. Well, one is 3 years old, but the other one is brand new. We would expect maintenance spend to be -- not be excessive in the first few years of life. So yes, I'm not expecting any material increase in maintenance spend.

[Graham Starko]

Okay. Great. So that's $300,000 per line per quarter or per annum?

[Iain Carswell, executive]

Per annum, that's generally what we're running at historically.

[Operator]

The next question is coming from Richard Whiting, Richard is a private investor.

[Richard Whiting]

Could you comment on your business from importers. It seems to be quite a bit weaker than the business from other customer types. And could you comment, is there everything going on there competitively? Are you losing market share or because competitive conditions changed there? It looks like the decline is bigger than would be accounted for just a shift in business temporarily.

[Iain Carswell, executive]

I think there's -- I think it's across the entire market, the coffee market. We're in a period where the coffee price is coming down. We're also coming out of a period of significant supply chain disruption for the coffee market. And as a result of that, some customers will have held higher stocks than normal through last year, over the last kind of 12 to 18 months. I think what we're seeing is, as prices fall, companies are looking to kind of rebalance their stocks and their warehouses. So I think that's contributing to it. And I don't think -- I think that's just a natural consequence of the cycle that the industry has been moving through, probably starting in the pandemic and then moving through beyond that and dealing with some quite significant supply chain disruptions for coffee out of origin.

[Richard Whiting]

So you don't see any change in competitive conditions or you don't feel you're losing market share there in any way?

[Iain Carswell, executive]

I don't feel we're losing market share there, no.

[Operator]

And there were no other questions from the lines at this time. Iain, I will hand it back to you for closing remarks.

[Iain Carswell, executive]

Okay. Well, thank you, everybody. If there are no further questions, I'll conclude today's call. I wish you all a good day, and thank you for joining us.

[Operator]

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