Swiss Water Decaffeinated Coffee Inc

TSX:SWP

Earnings Call Transcript

[Operator]

Greetings. 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 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 & 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 call over to Frank Dennis, CEO. Sir, the floor is yours.

[Frank Dennis, executive]

Thank you, Holly. Good morning, everyone, and thanks for taking the time to join us again. 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 12 months ended December 31, 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 MD&A, Iain and I are pleased to report that the strong performance improvement Swiss Water achieved during the third quarter of 2022 carried forward into the fourth quarter, enabling us to post excellent results for the full year. Our volumes, revenues and adjusted EBITDA all hit record levels in 2022. Annual revenue grew by 41%, exceeding $175 million for the first time, and adjusted EBITDA increased by 58% to $16.7 million. As always, volumes were the key driver of our performance with total annual volumes growing by 15%.

In addition to our strong volume growth and the 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 recorded a small loss of $300,000 in the fourth quarter, principally due to a onetime noncash impairment charge on the plant and equipment related to the upcoming shutdown of our legacy Burnaby site, our net income for the year showed a big improvement over 2021. For the 12 months to December 31, net income of $2.4 million was up by $1.9 million from the 2021 level. And adjusted EBITDA reached $16.7 million for the year which was up $6.1 million or 58% compared to 2021. 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 of these is the recovery of demand for the vital out-of-home coffee market as the 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 like ours over coffee decaffeinated with methylene chloride or ethyl acetate.

It's particularly encouraging that in North America, our largest market, we continue to achieve double-digit growth with year-over-year volume up by 19% in 2022. This strong improvement came from a combination of new customer acquisition, and organic growth with existing customers, most of whom ordered ahead of pre-pandemic levels. As I've noted previously, during the year, we began 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 helped boost our results and provides an encouraging indication of future growth potential.

Asia Pacific markets also grew strongly with volumes shipped to customers there, growing by 10% in 2022. Importantly, we also see the positive changes in our customer mix as another clear sign of a 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 volumes shipped to our higher-margin specialty customers by 28% during the year. The 10% drop in fourth quarter volumes shipped to our commercial customers who primarily serve the grocery channel is likely indicative of the shifts from at home to out-of-home coffee consumption. However, with volumes shipped to commercial customers still up 6% for the year, we can see a growing trend in demand for decaf generally as well as an increasing number of industry participants converting to our chemical-free process.

As I've 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 price or NY'C'. The NY'C' rose steadily through the second half of 2021 and remained stubbornly high throughout 2022. During the year, the NY'C' averaged USD 2.13 a pound, down from the peak of USD 2.58 it hit in the first quarter, but well above the USD 1.69 average in 2021. 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.

We experienced some evidence of this in the fourth quarter, particularly with large commercial roasters that service the grocery trade. While we are delighted to see such strong and sustained growth in our business, it does present challenges. The combination of quarter-on-quarter volume increases, a precedently high NY'C' and growing inflationary pressure on all our input costs has been putting ever more stress on our working capital resources. This has been a problem we've been wrestling with for many months.

Aptly, during the fourth quarter of 2022, we were able to announce an expansion of our credit facilities with our existing senior lenders that goes a long way towards addressing those [ problems ]. The expanded facilities resulted 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 for working capital purposes, while the increased term financing is dedicated to our immediate capital needs, specifically to help finance the second decaffeination line nearing completion at our Delta, BC production facility. Now before I tell you more about the progress of the Delta Line 2 project and our outlook for 2023 and beyond, let me turn the call over to Iain to take you through our financial results. Iain?

[Iain Carswell, executive]

Thanks, Frank, and good day, everyone. As always, I'll begin my review with volume shipped to customers. This is the key metric that drives our financial performance. As Frank indicated, Swiss Water's processing volumes continued to grow in the 12 months to December 31, largely due to the ongoing recovery of the food service economy. While total volumes were down by 4% in the fourth quarter, primarily due to timing differences in shipments, volumes were up by 15% for the full year when compared to 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 up by 12% in the quarter and by 28% in the 12 months. While shipments to importers, those customers who resell our coffees to roasters where and when they need it, were down by 23% in Q4 but up by 28% for the year. Looking at the roasters segment another way. As Frank noted, specialty roaster account volumes continued to trend upwards, growing by 3% in the quarter and by 28% for the year. These can serve the out-of-home consumer primarily and the strong annual growth here reflects the return of cafes and restaurants to pre-pandemic operations in our key geographic markets. Shipments to large commercial roasters were down by 10% in the quarter, but up by 6% for the year. Again, quarterly shipments to these customers were done due to year-over-year timing differences in order patterns.

Turning now to revenues. Fourth quarter revenue of $44 million was up by $8.9 million or 25% from Q4 of 2021. Full year revenue of $176.9 million also showed very strong growth increasing by $51.9 million or 41% for 2021. The revenue increase was due to the growth in our volumes as well as higher green coffee prices in 2022. Record levels of activity and an increased financial contribution from our Seaforth coffee handling and logistics subsidiary also had a positive impact.

Looking at the cost side. On our fourth quarter, cost of sales was $38.2 million, an increase of $7.5 million or 24% compared to Q4 of 2021. For the full year, cost of sales was $150.8 million, up by $43.4 million or 40% 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 price has remained at historically high levels for an unusually extended period.

In Q4, the NY'C' averaged USD 1.77 per pound compared to an average of $2.20 per pound in the fourth quarter of 2021. The However, looking at the full year, the NY'C' averaged USD 2.13 per pound in 2022, up by 26% from an average of USD 1.69 in 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 on our balance sheet is reflective of this. As Frank noted, that's why we were so pleased that we were able to expect credit facilities during the fourth quarter. We believe that the increased availability of working capital will make it much easier to manage and grow our business going forward.

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 be equal, we benefit when the U.S. dollar appreciates, as it did during the fourth quarter and full year of 2022. In Q4, U.S. dollar averaged CAD 1.36, up CAD 0.10 from CAD 1.26 in the fourth quarter of 2021. For the full year, the U.S. dollar averaged CAD 1.30, up by CAD 0.05 and from CAD 1.25 in 2021.

Fourth quarter gross profit was $5.8 million, an increase of $1.4 million or 31% compared to Q4 of 2021. For the 12 months -- December 31, gross profit was $26.1 million, an increase of $8.5 million or 48% compared to 2021. Gross profit percentage for the year was 15%, which was 1 percentage point higher over the 2021 level. The improvement in gross profit was primarily driven by our higher volumes as well as a significantly higher green coffee differential margin. The increased volumes also drove a high utilization rate on all 3 of our current decaffeination lines. This, together with record business at our Seaforth subsidiary enabled us to realize significant production efficiencies in 2022.

At the same time, the comparatively high green coffee price and ongoing inefficiency in the coffee supply chain enabled us to realize very good green coffee differential margin. These positive factors were partially offset by inflationary pressure on our variable cost of production and freight costs.

Fourth quarter operating expenses were $3 million, up by $100,000 when compared to Q4 2021. For the full year, operating expenses were $12.7 million, up by $1.7 million over 2021. The administrative portion of operating expenses was down by 14% in Q4 but up by 19% for the year. The primary drivers of the annual increase were general inflationary pressure, higher professional fees, increased headcount and salaries and the incremental cost of operating from 2 locations, including depreciation and rental expenses. The sales and marketing component of annual operating expenses was up by 47% from the 2021 level. This was a result of an increase in headcount and salaries and a return to a more normal level of business travel and trade show participation following the pandemic.

Q4 operating income was $2.8 million, up by $1.3 million or 84% from the fourth quarter of 2021. For the full year, the improvement was even better with operating income of $13.4 million, double what we recorded in 2021. The big driver here was the improvement in gross profit resulting from our higher processing volumes and improved green coffee differential, partially offset by the higher administrative expenses.

Turning now to net income. We reported a net loss of $254,000 for the quarter compared to net income of $241,000 in Q3 2021. However, for the full year, we posted net income of $2.4 million, an increase of $1.9 million over 2021. As Frank noted, the drop in quarterly net income was primarily the result of a onetime noncash $2.5 million impairment of plant and equipment. This is a noncash expense that resulted from an assessment of the salvageable assets at our legacy Burnaby production facility in advance of the lease expiry there in June of this year. With the help of a third-party engineering consultancy, we carefully considered the potential future use, costs and benefits and related cash flow impacts involved and determined that only a portion of the equipment in Burnaby should be salvaged.

The improvement in full year net income reflects our higher operating income materially offset by the Q4 impairment of plant and equipment. Losses on our risk management activities, primarily due to the strengthening of the U.S. dollar and mark-to-market revaluations of our foreign exchange and commodity hedges as well as higher financing expense due to increased drawings on our debt facilities also had a negative impact.

Fourth quarter net finance costs of $1.4 million were up by $300,000 or 26% in Q4 of 2021. For the full year, net finance expenses were $5.1 million, an increase of $1.1 million or 29% compared to 2021. The increase in both periods was primarily due to higher variable interest rates and higher interest on our debentures with warrants as well as higher outstanding balances on our construction loans and credit facility.

Despite inflationary pressure during the quarter and full year, we achieved a significant improvement in adjusted EBITDA in 2022. The Fourth quarter adjusted EBITDA of $3.1 million was up by $1 million or 46% compared to Q4 of 2021. For the year, adjusted EBITDA was $16.7 million, an improvement of $6.1 million or 58% compared to the 2021 result. Operationally, our adjusted EBITDA improvement was driven by our volume growth and the higher green coffee differential margin we achieved in 2022.

As I've noted, these positive impacts were partially offset by the higher green coffee cost 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 during the second quarter of this year, the resulting efficiencies will bring down our operating costs going forward. With that, I thank you for your attention. And now I'll turn things back to Frank.

[Frank Dennis, executive]

[ Thanks ] Iain. As Iain and I have indicated, we're very encouraged by the fact that the positive momentum we saw building across the business in 2021 continue to gain strength through 2022. And while we remain optimistic with the strong order book and generally favorable trading conditions in our key markets, as ever more of industry participants move away from chemical decaffeination in favor of chemical-free processes like ours, 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 on it by raising interest rates. Russian invasion of 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 have eased, we continue to experience some delays in coffee deliveries from certain regions.

Furthermore, the continuation of high coffee futures prices is resulting in a significant increase in our working capital requirements and will ultimately impact coffee demand at the consumer level. And as we've noted, we are experiencing very significant inflationary pressure on virtually all of our input costs from natural gas to freight to labor. These risks and increasing costs demand our close attention and may require further 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 24/7 basis.

Aside from a scheduled maintenance shutdown in January 2022, the initial decaffeination line at our Delta, BC facility, which we designate Delta Line 1, operated smoothly and efficiently, also on a 24/7 basis throughout the year. Since its start up, we were gradually increasing the processing speed of Line 1 as we work to optimize and maximize its production. At the same time, we've been sharply focused on completing construction and initiating production on our second decaffeination line here, our Delta Line 2 project.

Turning to the transition. As you know by now, we must vacate our legacy Burnaby site before the lease expiry in June of this year. We will decaffeinate our last value of coffee in Burnaby in late April. Following this, we expect to complete construction and commence commercial production from Delta Line 2 by late in Q3. 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 and provide capacity for intermediate term [ growth ]. To manage expectations, it's important to note that from April through August of this year, our capacity will be temporarily constrained as we move all production to Delta. This transition period is the time between the retirement of the Burnaby assets and the full and final commissioning of Delta Line 2.

We have been very proactive in our communication with our customers and suppliers regarding the production of coffee leading up to our exit from Burnaby. During the transition period, when our production capacity will be reduced and about the time it will take until Delta Line 2 begins producing commercially viable product. We are cautiously optimistic that this proactive approach will help minimize any disruptions to our business. To build the inventory needed to meet customer demand as we bridge the anticipated production gap, we have been processing as much volume as possible during the first quarter of this year. This risk has required a front-loaded investment in working capital. The curtailment in volume during the transition will temporarily reduce our sales volumes and likely lead to lower earnings year-over-year on the reported results for the 2023 fiscal year. However, Swiss Water will be much better positioned for the future when the process is completed.

As to budget, the preliminary cost estimate for design and construction of the Line 2 project Delta was approximately $45 million plus commissioning costs of approximately $2 million. During the second half of 2022, the impact of global macroeconomic pressures, including inflation, trade disruptions and supply chain issues, which became more acute in terms of their impact on our project budget and schedule. Given the effect of these factors, we currently project a total $53 million final construction cost. There is no change to the original $2 million commissioning budget. The revised cost estimate takes into account the inflationary factors realized or projected today. With the incremental $12 million expansion of our senior credit term facility, along with our existing available credit and projected internally generated cash flow, we have sufficient funds to complete the project. That wraps up our comments for today. Iain and I would now be happy to answer any of the questions that you might have.

[Operator]

[Operator Instructions] There are no questions in queue.

[Frank Dennis, executive]

Well, thank you very much. And if we don't have any questions, we'll conclude today's call. And Iain and I wish you a great day, and thank you for joining us.

[Operator]

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.