Swiss Water Decaffeinated Coffee Inc

TSX:SWP

Earnings Call Transcript

[Operator]

Good afternoon, ladies and gentlemen.

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 consider 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 the 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 call over to Frank Dennis, CEO of Swiss Water. Sir, the floor is yours.

[Frank Dennis, executive]

Thank you, Matthew. Good morning, everyone, and thanks 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 and 9 months ended September 30, 2022. As usual, I'll begin with a brief review of our performance, then Iain will provide more detail about our financial results, before I return to tell you more about our longer-term plans and expectations. After that, we'll be happy to take your questions.

As outlined in yesterday's press release and in our quarterly MD&A, Iain and I are pleased to report that the strong performance improvements Swiss Water achieved during the first half of this year strengthened further during the third quarter. Our Q3 processing volumes, revenue, net income and adjusted EBITDA, all exceeded our expectations. As always, volumes were the key driver of our performance with total volumes growing by 6% in the third quarter and by 22% in the first 9 months of the year. The volume growth, along with the higher green coffee costs, drove a 30% increase in our quarterly revenue, which at $46.2 million was up by $10.7 million over Q3 2021. This brought our 9-month revenue to $132.9 million, up 48% compared to last year.

In addition to our strong volume growth and resulting high level of capacity utilization and increased green coffee differential margin and disciplined management of inflationary pressure enabled us to achieve a significant improvement in profitability. Although we reported a small loss of $204,000 in the quarter, principally due to the impact of a strengthening U.S. dollar on our hedging activities, our net income for the year-to-date showed a big improvement over last year. For the 9 months to September 30, net income was $2.6 million compared to $255,000 in the same period of 2021, while adjusted EBITDA of $4.3 million for the quarter and $13.6 million for the 9 months was up by 9% in the quarter and 61% for the year-to-date, respectively.

These strong results were achieved despite the inflationary pressures that all businesses face today, because of a number of positive factors that are benefiting Swiss Water. The first and most important of these is the ongoing recovery of demand from the vital out-of-home coffee market, as the North American and international food service economies return to pre-pandemic levels of activity.

The 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 like ours over coffee caffeinated with methylene chloride or ethyl acetate.

It's particularly encouraging that in North America, our largest market, we continue to achieve strong growth with year-over-year volume up by 9% in Q3 and 20% in the 9 months of the year. This strong 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 noted previously, we are now shipping to some new high-profile out-of-home North American customers like Peet's Coffee, a San Francisco-based specialty coffee roaster and retailer with commercial distribution across the U.S. This new business is helping boost our results and provides an encouraging indication of future growth potential.

Business outside of North America has also shown strong growth with year-to-date volumes up by 20% -- 28% compared to last year. A big driver internationally continues to be volumes delivered to the Asia Pacific region, which were up by 24% in Q3 and 60% in the 9 months to September 30, mainly due to organic growth.

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. The removal 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 32% in the third quarter and by 39% year-to-date. The 9% drop in quarterly volumes shipped to our commercial customers, who primarily serve the grocery channel, is likely indicative of this shift from at-home to out-of-home coffee consumption once again.

However, with volume shipped to commercial customers still up 11% on a year-to-date basis, we can see a growing demand for decaf generally as well as increasing number of industry participants converting to our chemical-free process. As I noted before, it's unusual that we've achieved this exceptional volume growth across the business despite a stubbornly high New York Futures contract coffee commodity price or NY'C'. The NY'C' rose steadily through the second half of last year and has remained stubbornly high.

During the third quarter, the NY'C' averaged USD 2.19 a pound down from the peak of USD 2.58, it hit in the first quarter. However, this compares to the average of USD 1.80 we saw in the third quarter of last year. Normally, when the NY'C' rises and remains at such high levels, our customers tend to consume their own inventories as they wait for the price to fall back rather than buy more coffee from us. However, during 2021, an unusual double frost in Brazil, together with the ongoing disruption of global 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 has likely caused some customers to build inventories to manage uncertain supply chains such that they have sufficient inventory on hand to meet demand. While we are delighted to see such strong and sustained growth in our business, it does present challenges. While we are delighted to see -- the combination of quarter-on-quarter volume increases and persistently high coffee commodity price and growing inflationary pressure on all our input costs has been putting ever more stress on our working capital resources.

Coffee Futures' volatility has been a challenge, we've been managing for several months as have most in the coffee industry. Happily, on Monday of this week, we were able to announce an expansion of our credit facilities with our existing senior lenders that goes a long way towards addressing this problem. The expanding -- expanded facilities result in $33.25 million of incremental capital availability, consisting of $21.25 million of expanded revolving credit capacity and $12 million of incremental senior term financing. The increased revolving credit capacity is being made available for working capital purposes and will enable us to continue pursuing the outstanding growth opportunities we see ahead for Swiss Water.

So now before I tell you more about our outlook and for the balance of this year and our preparations for the future, let me turn the call over to Iain for financial results.

[Iain Carswell, executive]

Thanks, Frank, and hello, 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 have continued to grow in the 3 and 9 months to September 30, due in part to the ongoing recovery of the food service economy. Total volumes were up by 6% in the third quarter and by 22% for the year-to-date when compared to the same periods last year.

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 for home or office consumption, were up by 11% in the quarter and 38% in the 9 months. While shipments to importers, those customers who resell our coffees to roasters where and when they need it, were up by 25% in Q3 and by 52% for the first 9 months of the year.

Looking at the roaster segment another way, as Frank noted, specialty roaster account volumes continued to trend upwards, growing by a healthy 32% in the quarter and by 39% for the 9 months. These accounts serve the out-of-home consumer primarily, and the strong growth here reflects the ongoing return to cafes and restaurants to pre-pandemic operations in our key geographic markets.

Shipments to large commercial roasters were down by 9% in the quarter, but up by 11% for the year-to-date.

Turning now to revenues. Third quarter revenue of $46.2 million was up by $10.7 million or 30% from Q3 of 2021. The 9-month revenue of $132.9 million also showed very strong growth, increasing by $43 million or 48% over last year's level. The revenue increase was due to the growth in our volumes as well as higher green coffee price this year.

Record levels of activity and an increased financial contribution from Seaforth coffee handling and logistics subsidiary also had a positive impact.

Looking at the cost side, our third quarter cost of sales was $39.5 million, an increase of $10.1 million or 34% compared to Q3 of last year. For the 9 months, cost of sales was $112.6 million, up by $35.9 million or 47% from the 2021 level. The increase in both periods was mainly driven by our significantly increased production volumes, the higher cost of green coffee, and increased freight expenses.

As Frank noted, while down from its first quarter peak, the NY'C' coffee commodity prices remained at historically high levels for an extended period of time. In Q3 this year, the NY'C' averaged USD 2.19 per pound compared to an average USD 1.80 per pound in the third quarter of 2021. As you would expect, such a high coffee price triggers a major increase in our working capital needs and the increased value of inventory in our balance sheet is reflective of this.

That's why we were so pleased to announce the expansion of our credit facilities that Frank outlined earlier. We believe that the increased availability of working capital will make it much easier to manage the growth of our business going forward.

Foreign exchange rates can also have a meaningful 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 third quarter of this year.

In Q3, the U.S. dollar averaged CAD 1.31, up $0.05 from CAD 1.26 in the third quarter of last year.

Third quarter gross profit was $6.6 million, an increase of $600,000 or 10% compared to Q3 of 2021. For the 9 months to September 30, gross profit was $20.3 million, an increase of $7.1 million or 54% compared to the same period last year. Gross profit percentage was sustained at 15%, consistent with the level achieved in the first 9 months of 2021. The improvement in gross profit dollars was primarily driven by higher sales volumes.

The higher volumes again drove a high utilization rate in all 3 of our current decaffeination lines, which operated at approximately 80% of capacity throughout the quarter and first 9 months of this year. This, together with a record business at our Seaforth subsidiary, enabled us to realize significant production efficiencies.

In addition, comparatively high green coffee price and ongoing inefficiency in the coffee supply chain enabled us to make a very good green coffee differential margin. These positive factors are partially offset -- were partially offset by inflationary pressure on our variable production costs and freight.

Third quarter operating expenses were $3.3 million, up by $600,000 when compared to Q3 last year. For the 9 months, operating expenses were $9.7 million, up by $1.7 million over the same period in 2021. The administrative portion of operating expenses was up by 32% accounting for the full 9-month increase. The primary drivers here were general inflationary pressure, higher legal fees, increased headcount and salaries, and the incremental cost of operating 2 locations, including depreciation, and rent.

The sales and marketing component of operating expenses was less impacted, staying level with last year at $800,000 for the quarter and $2.6 million for the 9 months.

Q3 operating income was $3.3 million, which is the same amount as we reported in the third quarter of 2021. However, operating income for the year-to-date was up significantly, growing to $10.6 million, more than double the $5.2 million recorded in the first 3 quarters of last year. The big driver here was the improvement in gross profit resulting from our higher processing volumes, partially offset by the higher administrative expenses.

Turning now to net income. We reported a small net loss of $204,000 for the quarter compared to net income of $135,000 in Q3 2021. However, for the 9-month period, we posted net income of $2.6 million, an increase of $2.4 million over the amount we recorded during the same period last year. The drop in quarterly net income was the result of losses on our risk management activities, primarily due to the strengthening of the U.S. dollar as well as higher financing expense due to increased drawings on our debt facility.

The improvement in the 9-month results reflects our higher operating income during the period, partially offset by the same negative impacts.

Third quarter net finance costs of $1.2 million were up $200,000 or 17% over Q3 of last year. For the 9-month period, net finance expenses were $3.7 million, an increase of $900,000 or 30% compared to the same period last year. The increase in both periods was due primarily to a higher variable interest rate on our debentures with warrants as well as a higher outstanding balance on our construction loans and credit facilities.

Despite inflationary pressure during the quarter and year-to-date, we achieved a significant improvement in adjusted EBITDA. Third quarter adjusted EBITDA of $4.3 million was up by $400,000 or 9% compared to Q3 in 2021. For the 9 months, adjusted EBITDA was $13.6 million, an improvement of $5.2 million or 61% compared to the 2021 result.

Operationally, our adjusted EBITDA improvement this year was driven by our volume growth and the higher green coffee differential margin we achieved this year. As I've noted, these positive impacts were partially offset by higher green coffee costs and incremental labor and production expenses associated with operating at 2 stand-alone facilities.

Once we consolidate all production at our Delta location and exit the legacy Burnaby facility by the middle of next year, the resulting efficiencies will bring down our operating costs significantly.

With that, I thank you for your attention, and I'd like to hand back to Frank.

[Frank Dennis, executive]

Thanks, Iain. While we are very encouraged by the fact that the positive momentum we saw building across the business in 2021 continue to gain strength through the first 9 months of this year, and while we remain optimistic about the balance of the year, generally favorable trading conditions in our key markets as the food service sector returns to normal and more industry participants move away from chemical decaffeination in favor of chemical-free processes like ours, caution continues to be called for.

Like this it is everywhere, Swiss Water is not immune to current and emerging macroeconomic risks. Inflation is increasingly becoming entrenched and economies around the world are struggling to get a grip on it by raising interest rates. The Russian invasion of Ukraine is disrupting the global order and creating a lot of uncertainty in Europe and around the world. And here at Swiss Water, we are continuing to experience delays in coffee deliveries as supply chain bottlenecks persist, and coffee crop yields become less predictable.

Furthermore, the continuation of very high coffee futures price is resulting in a significant increase in our working capital requirements and may ultimately impact coffee demand at the consumer level. As we noted earlier, our newly expanded revolving credit facility will go a long way to addressing the working capital issue. Nonetheless, we are experiencing very significant inflationary pressure on virtually all of our input costs from natural gas, to freight, to hydro, to labor. These risks are increasing cost demand -- these risks and increasing cost, demand our close attention and will likely require further pricing actions and mitigation measures.

It could also have a negative impact on our margins and future volumes. Operationally, we continue to run both decaffeination lines at our legacy production facility in Burnaby, BC on a 24/7 basis. Aside from 2 scheduled maintenance shutdowns, the initial line at our new facility at Delta B.C. operated smoothly and efficiently, also on a 24/7 basis throughout the first 9 months of the year, and we are continuing to migrate more of our production here. All 3 lines have provided ample capacity for us in a period of pipeline refill, and that has been very helpful.

As 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.

As I've noted before, based on engineering reports from a third-party engineering firm, when both lines are completed, we expect the 2 new lines in Delta together will have a targeted end capacity at least 40% greater than the current existing capacity of the two lines at our Burnaby site.

The preliminary cost estimate for design and construction of the line project in -- line 2 project in Delta was approximately $45 million plus commissioning costs of around $2 million. During the second and third quarters of this year, the impact of global macroeconomic pressures, including inflation, trade disruptions and supply chain issues, making it increasingly acute concern in terms of their potential impact on our project budget and schedule. Accordingly, we now consider that there is a risk that we may exceed the preliminary budget by as much as 10%.

With the incremental $12 million expansion of our senior term credit facility, along with our existing available credit and projected internally generated cash flow, we expect to have sufficient funds to cover this risk factor and complete the project on time.

We continue to work diligently with all concerned to mitigate cost impacts in each project on schedule. At the same time, we are working to quantify the exit costs associated with permanently shutting down the Burnaby facility. This process involves evaluating the costs associated with removing and relocating some production assets into storage for possible future use as compared to immediate disposal on a piece-by-piece basis. We'll report the results of this analysis to you once we've determined the best options likely in the fourth quarter.

That wraps up our comments for today. Iain and I would now be happy to answer any questions that you may have.

[Operator]

[Operator Instructions] Your first question is coming from Lyle Parkin.

[Unknown Analyst]

I just wanted to talk about -- discuss with you the second production line. So just looking back over the history here. Back in May 20, 2020, you announced the start of preparations for the -- building the second line. And then in the summer of 2021, building permits were issued for the second line. And with this latest MD&A, you're saying that the second line, you're expecting it to complete at the end of Q3 next year in 2023. So I have a couple of questions about that.

I'll start with -- I guess I'll ask. Your lease on the legacy plant is expiring at June 2023, but you're targeting having the second line running somewhere in Q3 of '23. So it seems like you're going to have a greatly reduced capacity there until that second line gets going, upwards to 3 months after the legacy plant has to be abandoned. Is that -- why is that?

[Frank Dennis, executive]

So we are having -- planning on having end of Q3, fully commissioned and salable product and we will be out of Burnaby in basically June. So basically June to August, let's call it, 60 to 90 days difference through that period. One note that I made in my comments today was that we've had 3 lines running, which is ample, i.e., higher than necessary capacity for basically 2 years here almost, well beyond the capacity that we require. And although there will be that period of 60 or 80, 90 days of basically integration of the new line into our entire supply chain, we'll have the ability to use the extra capacity that we have to preload customers in advance of that shutdown, which is what we're in the process of doing right now.

And also, we are seeing, like I said, excess capacity that we have had over that period of time for the past 2 years, which has enabled pipeline fill for us in our external warehouses, which we continue to do and will do through Q1 and Q2 of next year, so that we can provide services through that period. We, of course, will still be running our line here, existing in Delta, and can maintain a good majority of customers who order on an ongoing basis, while managing customers who are less frequent orderers or have a less frequent order pattern in -- either before or after that period.

So it's -- we aren't seeing a terrific risk at this point through basically being able to manage inventory and use excess capacity that we've had for 1.5 years or so.

[Operator]

There are no other participants in the queue at this time. Lyle Parkin your line is live.

[Unknown Analyst]

Can you hear me?

[Frank Dennis, executive]

Yes. Yes, go ahead, Lyle.

[Unknown Analyst]

So it sounds like you're saying you're hoping that you'll have enough finished product stockpiled in the warehouse that you can satisfy all your customers' demands until the second production line is fully operational. Is that right?

[Frank Dennis, executive]

Well, there are a large number of customers that we can still service with our existing, line 1, Line 1 Delta, we call it. Those are regular order pattern products customers. Those customers who toll coffees, and don't forget that that's a big component of what we do is toll processing. Toll customers are being shifted to pre-May, so in other words, kind of Q1, Q2 and then into late Q3 and Q4 to avoid that period. And we are also building, like I said, inventories in our external warehouses, New Jersey, San Francisco and [indiscernible] to manage the spot demand that we expect through that period. So we're planning for this period of time where there's reduced capacity, but it's not 0 capacity. That's an important component here.

[Iain Carswell, executive]

It's really worth also noting that there is some seasonality within our business. And typically, July as a month is a lower volume period for us.

[Unknown Analyst]

Okay. I've got 1 follow-on question if there's no one else in the queue.

[Frank Dennis, executive]

Yes, sure. Go ahead, Lyle.

[Unknown Analyst]

So summer 2021 is when you issued the building permits. I assume you started construction pretty much right away then. And with your anticipation of being in production with the second line in Q3 of '23, that's about 2.25 years to get that second line built and operational. I'm a bit concerned how long this is taking. Just for comparison, Tesla started two Giga factories, 1 in Texas and one in Germany, at the same time that you started construction on your second production line. And they have finished those factories and they've been in production since early this year.

So in less than 2 years, they've built factories and got production going, but it takes 2.25 years to get a coffee processing line going. What have been the holdups? Why has it taken so long to get this -- I understand they are complex and you've got to be able to treat the building around the plant as you go, but still it seems to me it's been a long time that this has been underway.

[Frank Dennis, executive]

Yes. Well, I mean, I really wish that we were Tesla's size and Tesla's heft. We are not. And being able to bring resources in a post-pandemic world goes to the highest bidder. And that's essentially what is going on. Bringing people -- and this is -- it's labor, Lyle, that we're talking about in terms of being able to get unionized, skilled, pipefitters and steel workers to site. And that takes time.

And really, our time is almost as we had originally outlined. And so the components that we bring to what we do are all bespoke. I don't know what goes into a Tesla plant. I would imagine that a lot of those robots, et cetera, that they use are all manufactured externally. Everything here is built piece by piece. And every inch of piping is created here and welded on site. It's not moving something. It's, in fact, creating a complete bespoke facility here.

So I personally struggle with the comparison to Tesla. But you want to make that comparison, that's fine. I see them as completely -- entirely different industries. So, yes, I -- this is a very similar buildout to the time that we had in 2005. It's very similar to what we did in 2018, '19. I'm not -- I'm not seeing a very different time period. But again, we're a smaller organization. We're a nano cap on the Toronto Stock Exchange. We are not a Fortune 500 organization that can bring resources and have exceeding amounts of working capital and additional cash to draw resources at speeds that a Tesla could do.

[Operator]

[Operator Instructions] Your next question is coming from Sasha [indiscernible].

[Unknown Analyst]

You guys mentioned supply chain disruptions in the third quarter. I was just wondering as we're moving into the fourth quarter, whether there's been material improvement that you guys have noticed in the supply chain disruptions? Or is it still kind of the same deal?

[Frank Dennis, executive]

Well, the simple way that we look at it is that in 2019, there were 5 steamship lines supplying Vancouver. There are now two. And I would still call that a disrupted supply chain relative to 2019. It doesn't mean that we're not getting coffee. It's -- what happens is that we are getting, as opposed to 10, 15, 20 containers every couple of weeks, we'll get 100 containers at a time of coffee coming into Vancouver, and that's not all our coffee. That will also be third-party coffee going to Seaforth, our warehousing operation.

So depending on your view of what disrupted is, I'd say, yes, we are still in a disrupted space. Hapag-Lloyd is thinking about improving service or reinstating service off the West Coast, including Vancouver in the back half of next year. But with that sort of concentration of coffees coming into Vancouver, that drives additional working capital and additional inventory needs, because we are bridging the times between the service levels that we used to have with 5 steamship lines down to 2.

[Operator]

[Operator Instructions] That concludes our Q&A session. I will now hand the conference back to Frank Dennis, CEO of Swiss Water, for closing remarks. Please go ahead.

[Frank Dennis, executive]

Thank you, Matthew. I appreciate your attention today and the questions that we had. 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 concludes today's event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.