Supremex Inc

TSX:SXP

Earnings Call Transcript

[Operator]

[Foreign Language] Good morning. My name is Jessa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Supremex Inc. Third Quarter Results Conference Call. [Operator Instructions] Mme. Danielle Ste-Marie, you may begin your conference.

[Danielle Ste-Marie]

Thank you, Jessa. Good morning, ladies and gentlemen. My name is Danielle Ste-Marie. I'm an independent adviser and act in an investor relations capacity for Supremex. With us today is: Stewart Emerson, President and CEO; and Guy Prenevost, Chief Financial Officer and Corporate Secretary.I would like to welcome you to today's conference call to discuss our financial and operational results for the third quarter ended September 30, 2018, which were released earlier today. This call will be held in English. [Foreign Language]For a more detailed analysis of our results, please see our financial statements, our management discussion and analysis and our press release disclosed earlier this morning and available on the company's website and on SEDAR. In addition, we posted a presentation supporting this conference call, which will be available through the webcast and on our website.I would like to remind listeners that this conference call contains forward-looking information within the meaning of applicable Canadian securities laws, and I refer the audience to the forward-looking statements as detailed in the presentation supporting this conference call. Furthermore, risks and uncertainties are discussed throughout the December 31, 2017 MD&A under the heading Risk Factors.Unless stated otherwise, all figures are expressed in Canadian dollars. During this call and on the accompanying presentation, we use various non-IFRS measures, including adjusted EBITDA, adjusted net earnings. These terms are also defined in our MD&A.With these formalities out of the way, I would like to turn the call over to Stewart Emerson, President and CEO at Supremex, to review this quarter's key operational highlights and recent events. Stewart?

[Stewart Emerson, President, CEO & Director]

Thank you, Danielle, and welcome, everyone. Thank you to all of you for joining us here today to discuss our third quarter results.Although we're pleased with our performance on the packaging side, which accounts for almost 30% of our revenues, the loss of volume from envelope activities, combined with a lag on passing through raw material increases across all of our lines of business, was a significant drag on results.We'll start with the envelope revenues. We experienced lower volume on envelope sales in Canada as a result of previous discussed -- previously discussed movement of orders, contracts and accounts between distributors. As we explained last quarter, these units are still in the market and have not disappeared.Headwinds from secular decline of the industry continued to be an ongoing challenge. Canada Post has not published their Q3 volumes yet, but we expect them to be in line with their Q1 and Q2 numbers, which were minus 4% and minus 5.9%, respectively, perhaps a little bit higher.There may also have been some potential effect from the Canada Post labor dispute. It's very hard to quantify, and we do not feel this was a major factor in the quarter but we do know that it exists and we continue to monitor the situation closely.Lastly, as stated in previous calls, we have been willing to accept some of the volume reduction as a result of our price leadership strategy. Conventional wisdom is, and as the largest envelope supplier in an industry in long-term secular decline, we believe a price leadership and differentiation strategy helps keep our ecosystem healthy, sustains reasonable margins and allows us to provide higher-quality products and customer experience.This being said, we were unable to pass through the unprecedented and precipitous paper and other raw material increases in lockstep with when they occurred. We have been through 3 subsequent price increases since the start of the year and 4 in the last 4 quarters. There are many reasons for this inability to just stay [ whole ] when even those with exceptional pricing power in the market would be hard-pressed to pass these increases along in lockstep.There are multitude of different pricing agreements with customers, and most of them virtually assure a lag in implementation. The good news out of all of this is that the industry does generally catch up and at some point in the cycle, gets to recalibrate its pricing based on current raw material costs. This just happened to be a quarter where you have all the increased costs and only a part of the pass-through.With respect to U.S. envelope, I'm very pleased with the progress our team continues to make. While the market remains aggressive and overall volume was down 5.4% in the quarter, net of the inherited underpriced contract we walked away from in January and the expiration of a long-term contract manufacturing agreement, we saw a very nice improvement of almost 10% on the volume side.More importantly, we saw a 15.7% increase in average selling price, partially as a result of the expiration of the contract manufacturing agreement in Buffalo but primarily from an improvement in mix, our margin improvement strategies and what appears to be, finally, a more disciplined approach to pricing from our major competitors. All in all, I'm very encouraged by the progress in the U.S. envelope market.On to packaging. On another positive note, revenue growth in our packaging business still managed to offset the decline in the envelope market, leading to a 4% increase in total revenue in the quarter. This growth came from the acquisition of G2 Printing and Pharmaflex, which was concluded on April 30, 2018, and from organic growth in the folding carton, corrugate and e-commerce packaging offerings.I'm very pleased that we grew all 3 lines of our packaging business organically quarter-over-quarter. In order to accelerate the growth in the packaging platform, we continue to prioritize resource allocation through our organizational and sales structures. As a result, we have strengthened our team and reworked the structure. The new structure can be found on Slide 5 of the webcast presentation. We are confident this new packaging structure will continue to drive growth and further enhance the integration of our acquired businesses to extract both top and bottom line synergies.During the quarter, we appointed a new Vice President and General Manager for the newly created Supremex folding carton operations, which encompasses the former Stuart Packaging and G2. As a folding carton veteran, his mandate is to build a lean, customer-centric folding carton division with a value proposition that allows us to become a formidable player in the midsized order space in regions in which we operate, in the large and growing pharmaceutical, nutraceutical and consumer packaged good markets.We continue to drive synergies, reduce production costs and open additional capacity by integrating the production activities of the former Stuart Packaging and G2 Printing, now known as Supremex Folding Carton.As for the corrugate activities, Durabox has commissioned its recently acquired corrugator and die cutting press in its new state-of-the-art facility in Lachine. We are on track to be fully operational in the new facility by the end of November, at which time, we will exit the current facility ideally by the end of December.As stated in the Q1 and Q2 call, we continue to run our new equipment simultaneously with our legacy equipment as a prudent risk mitigation approach. This overlapping production added some expenses in the third quarter, and we will continue to incur additional expenses in the fourth quarter as we make the move, including for the decommissioning of the legacy equipment and plant.Once we are fully operational at the new facility, we will [ allow ] external procurement of corrugated sheets, seek new markets, and we expect this expanded vertical integration strategy to bolster the bottom line.I'm also pleased to report that in the third quarter, we also experienced nice growth from our e-commerce fulfillment offering. As I said before and I'll say it again, I'm most proud of this division. With a strong team in place, we have internally incubated this business into a fairly well-known, innovative player in a niche segment of the explosive e-commerce market. This business continues to grow its reputation, expand its reach and add to the Supremex bottom line. We continue to be very excited about its future.Amid this excitement, we do want to provide a little bit of insight or update on a quasi-negative piece of this business that will affect us over the next 4 quarters. As part of the successful onboarding of a sizable customer in Q3 2017, we were required to provide a turnkey solution of both manufactured and distributed products.As both we and the customer got more comfortable with the agreement and various components of the innovative solution, we mutually agreed that the end customer should source the distributed product we were supplying. This change in purchasing habits started at the beginning of Q3 this year.While there was a modest margin in the distributed product, there was ample complexity in the supply chain, and both parties felt it was beneficial that the customer manage that part directly and that Supremex focus on its core business, which was the manufacturing of the mailer.With this, I'll turn the call over to Guy for a review of our financial results for the third quarter ended September 30, 2018. Guy?

[Guy Prenevost, CFO & Corporate Secretary]

Thank you, Stewart. Good morning, everyone. Revenue for the 3-month period ended September 30, 2018 increased by 4% to $45.2 million, up from $43.4 million during the equivalent 3-month period of last year. As Stewart said, revenue growth came primarily from packaging and specialty products, which now represent 28.7% of our consolidated revenues for the quarter.Revenue from the Canadian envelope market was $21.2 million, a decrease of 11.5% from $24 million. Volume declined by 14.6%, primarily as a result of the combined effects of industry-wide secular decline, historical customer movement and pricing decisions aligned with the company's strategy to maintain a disciplined market approach with price leadership and differentiation.Average selling prices increased by 3.6% to help mitigate the effect of significant input cost inflation. However, it was not enough to offset the rapid rise of input cost during the year.Revenue from the U.S. envelope market was $11 million, up 9.4% from $10 million in Q3 of 2017. The volume of the units sold decreased by 5.4%, primarily from the previously discussed nonrenewal of a low-margin contract and the expiration of a production allowance with a long-standing commercial partner. Excluding the above, the volume of the units sold increased by close to 10%.Average selling prices increased by 15.7%, resulting from the end of the aforementioned expired strategic production allowance, a more favorable production mix, increased customer prices to mitigate rising input costs and a favorable foreign exchange translation effect from the weaker Canadian dollar.Revenue from packaging product was $13 million, an increase of 37.7% compared with the equivalent quarter of the prior year, primarily resulting from the acquisition of G2 Printing and Pharmaflex that concluded on April 30, 2018 and from organic growth in the folding carton, corrugate and e-commerce packaging offering.Our adjusted EBITDA stood at $5 million compared with $6.4 million in the third quarter of 2017, representing a decrease of 21.8%. This comes from the loss of envelope volume combined with inflationary pressures on input cost, mainly paper and transportation.Third quarter 2018 adjusted EBITDA margins stood at 11% of revenues compared with 14.6% in the equivalent quarter of 2017. EBITDA was adjusted for a gain of $200,000 on the disposal of property, plant and equipment from the sale of a building in Mississauga and Printer Gateway's manufacturing equipment and for $1.1 million, which represents the accelerated provision for the remainder of the earn-out related to the Stuart Packaging acquisition after a mutual agreement was reached with the -- in the third quarter to terminate the founder's employment relationship with Supremex. This gave way to the accelerated recognition of the provision for the contingent remuneration, which was paid in full in the fourth quarter of 2018.Net earnings reached $1.2 million or $0.04 per share compared with $3.2 million or $0.11 per share in the equivalent third quarter of 2017, partly from the acceleration of the $1.1 million earn-out expense. Adjusted net earnings reached $2.1 million or $0.07 per share compared with $3.5 million or $0.12 per share for the equivalent period of 2017.Operating activities generated cash of $9 million compared to $9.7 million during the equivalent period of 2017, resulting mainly from the lower net earnings and inventory buildup related to the ongoing CapEx project to increase corrugated manufacturing capabilities, the acquisition of G2 Printing and Pharmaflex and increased input costs.The Board of Directors declared a quarterly dividend of $0.065 per common share payable on January 16, 2019 to the shareholders of record at the close of business on December 31, 2018. During the third quarter, we purchased 25,000 common shares for cancellation under our NCIB program for a total consideration of $83,000. Our net debt to adjusted EBITDA ratio remains at 1.9.I would like -- I would now like to turn the call over to the analysts for questions. Operator?

[Operator]

[Operator Instructions] Your first question comes from the line of Neil Linsdell from Industrial Alliance.

[Neil Linsdell]

Let's start with the Canadian envelope business. So you've got your secular decline that you're dealing with. But obviously, with the decline, there was some customer losses, despite the fact that you've been able to increase your average price. Can you talk about the customers that you've lost? Are they shifted? Can you gain some back through just different distribution channels? Or -- and how are your competitors able to compete? Are they competing on price? Do they have additional capacity available to take on this business? Or what's the dynamic of that?

[Stewart Emerson, President, CEO & Director]

Sure. Okay. So there's always ins and outs to customers, and we'd sort of describe it as ebbs and flows, but we -- last quarter, we were more direct and clear on that. There were 2 significant pieces of business that moved between distributors that moved from us as the incumbent to the distributor that won the business from our customer. That happened in Q3 and Q4 in 2017. They were 2 very sizable pieces of business. I don't know that it was necessarily taken from us on price because we're so far and that we're a little further down the food chain. It was one of the chartered banks, and it was an all-encompassing paper-related contract. So it moved from us, and how much the envelope played into that, we don't really know. But again, it was Q3 and Q4 last year. So we have a little bit of -- it was a tough comp for us in Q3, and we'll be through that in Q4, and we expect that we'll -- our distributors will continue to win contracts back and we'll be the beneficiary. So I don't really know that it was on pricing.

[Neil Linsdell]

Okay. So if we look forward though, should we go back to the normalized kind of 5% per year decline? Or is there ability to win back some business that you still lost in the meantime when you talk about the ebbs and flows between distributors?

[Stewart Emerson, President, CEO & Director]

Yes, we're out there. I mean, we've mitigated -- frankly, it's hard for you to see the numbers, but we've mitigated a fair bit of that decline that moved from us by wins in other areas. And we're aligned with all of the key distributors that are out there. And as they win business, we'll be the beneficiary. Now back to the secular decline question, I mean, I know you've indicated, moved your secular decline target to 7.5%. We've been 5%. We're both kind of in the range somewhere, maybe a little closer to your number as we start to look out. But again, we're through the Q3, Q4 issue of last year. And I think going forward, it should -- our decline should be closer to the secular decline.

[Neil Linsdell]

Okay, fair enough. And I see in your adjusted numbers, you've adjusted for the payout on Stuart Packaging and such. You haven't broke out any of the, say, additional cost that would be related to your new facility in Lachine. Can you give us any kind of scale of the additional cost of running the 2 facilities, the older box facility and the new plant, or any additional expenses that aren't being capitalized that are kind of creating aberrations in this quarter or maybe next?

[Stewart Emerson, President, CEO & Director]

I can't really, Neil. No, I mean, in Q3, they weren't material. They weren't significant and they're not going to be hyper-material in Q4 either. I mean, there's -- I can't give you that number. I'd be speculating at this point without the numbers at my fingertips.

[Neil Linsdell]

Okay. And then maybe lastly, jumping on the input costs...

[Stewart Emerson, President, CEO & Director]

Sorry, Neil. Could we just -- sorry, I -- the only -- the clearest answer I'd give you there, really, the duplication is around carrying additional inventory, which is more of a working cap issue and rent. It's not staffing and things like that. It's really around rent.

[Neil Linsdell]

And inventory?

[Stewart Emerson, President, CEO & Director]

Yes. The inventory increased significantly as we've prepared for the transition. Sorry, cut you off on your next question.

[Neil Linsdell]

Well, maybe just to follow up on that as well. We've talked before about how much you can potentially be saving as far as your margins, as far as your operating expenses when you finally transition over to the new facility with not having to source your corrugate outside and such. Any kind of updates on further calculations there?

[Stewart Emerson, President, CEO & Director]

We're not going to provide that. What we will say is that you know what the cost of the capital project was. It's $6 million to $7 million. With a reasonable ramp-up in sales, the project was well less than a 4-year payback.

[Neil Linsdell]

Four years, okay. And just lastly, we talked about paper before as far as the supply of paper, and you guys stood in a good position being a major purchaser of paper compared to some of your other competitors. Is that still the case? Or as far as you know, are your competitors are having more difficulty getting some of these materials?

[Stewart Emerson, President, CEO & Director]

I will tell you that we secured. So you're talking about envelope paper right now. We secured our envelope requirements for, 2019 last, month. We actually over-secured. So we had to tell some of the major mills that we didn't need as much as they wanted to sell us. So that was very positive, and I think that goes hand in hand with sort of Supremex' balance sheet and the way we treat our vendors. Our competitors, I've seen nothing in Canada, let's say. In Canada, I haven't seen anything that would lead me to believe they can't get paper. I do know their supply chain has become more complex as they've been getting paper from different sources.

[Neil Linsdell]

Okay. And then sorry, one more thing. Just in the U.S., it looks like -- I mean, there's a lot of movement of the contracts that you're talking about. So with the strategic manufacturing agreement that has now expired, that's freeing up capacity. Are you going to be able to use that capacity for higher-margin business? And can you tell us what your -- the partner's now doing instead of manufacturing in your facility?

[Stewart Emerson, President, CEO & Director]

Yes. We should have been more maybe more transparent on that. It's not that we're hiding anything. We just didn't want to get into the detail. But we had 2 machines embedded in the customer's facility, our employees and our machines in the customer's facility, and we've been doing that for about 10 years. And then there was a shotgun clause in it. And we did such a good job with it, the customer exercised the shotgun clause, took our employees and now are producing them for themselves, took our employees, bought our equipment and are now producing the envelopes for themselves. So there are no additional capacity for us.

[Operator]

[Operator Instructions] Your next question comes from the line of Ahmad Shaath from Beacon Securities.

[Ahmad Shaath, Research Analyst]

Just a couple of questions just to wrap our head around, I guess, the U.S. growth. And where do you see that going forward with the current contracts and capacity you have? Is the current run rate of around $10 million to $11 million revenue, is that something you see going forward? And secondly, on the packaging and the last note, you mentioned in your prepared remarks about the legacy business and the change of relationship there, can you just give us a little more color because it looks like there's quite a significant impact quarter-over-quarter in the packaging revenue from that if I round the numbers correctly. So just -- can you give us a little more color on that as well?

[Stewart Emerson, President, CEO & Director]

Sure. I'll address U.S. revenue first. Yes, the run rate is a little greater than $3 million -- or $30 million, sorry, not $10 million. It's $30 million. We took a step back with the 2 contracts. One was definitely addition by subtraction, and we inherited it with the acquisition. And then the other one we just talked about with Neil there was the supply agreement. But we've been laying solid foundation for 3 or 4 years now, growing that business. We've got a nice base of customers that continue to grow. We're trying to change the mix a little bit. We have a bit too much resale business and not enough direct, but we're working to change that. But the foundation is really solid. I think the biggest thing down there is the change in pricing. And one quarter doesn't sort of make a year or make a trend. But as our major competitor exited bankruptcy, it looks like there's more discipline coming out from a pricing standpoint, and we'll all benefit from that. With respect to the e-commerce business, without providing too much color, certainly it bodes providing more color. So we have a major consumer packaged goods customer in the U.S., and there's 2 part -- well, 3 parts to its business. Two of them, we manufacture, one of them we distribute. And because it was move from a box to our product, the customer just wanted us to handle the whole thing taking off. So we found a partner in the Southern U.S. to help us fulfill the piece that we couldn't make. And it was wildly successful. The project was excellent. We serviced the heck out of the customer. It strengthened our relationship with the customer. But then as they looked at it, they said, well, why are we buying this through you? Why aren't we just buying it on a direct basis? And we sort of said, you're right. We ask ourselves the same question. It was more or less a flow-through from us -- for us from a margin standpoint. And in fact, it was probably net 0, but it's roughly $1 million in revenue a quarter.

[Ahmad Shaath, Research Analyst]

Okay, okay. That's very helpful. So lastly, on the pricing discipline. So we should go back to -- remember, we talked about the U.S. strategy there. We always thought that you have -- you'll have pricing power there better than in -- similar to Canada. So is that -- do you think that's coming back in 2019 with a new competitor coming back into the business and the pricing discipline you mentioned?

[Stewart Emerson, President, CEO & Director]

I hope I never said that we would have pricing power in the U.S. because we won't. It's a tough market. It's a challenging market. One competitor holds roughly 50% of the capacity and 40% of the volume. I won't say that customer or that competitor was a bad actor. But as I said, as he emerged, as they emerged from Chapter 11, all indications are that they're going to be more disciplined actor. And I think the rest of the industry has endured enough pain down there that they're following quickly. I know when they put their increase out in late September, we announced exactly the same day -- just demonstrate that we're on board with an increase.

[Operator]

There are no further questions at this time. I turn the call back over to the presenters for closing remarks.

[Stewart Emerson, President, CEO & Director]

Great. Thank you, Neil and Ahmad, for your questions. I'll just -- my closing remarks are really around -- I'll reiterate that I'm not satisfied with the results in the third quarter. Headwinds from the Canadian envelope sector are to be expected and don't come as a surprise to any of us, and we have a very sound strategy to overcome that secular decline.That said, the frequency and pace of the raw material increases across all of our businesses, not just envelope, created an environment that was virtually impossible to overcome despite some amazing work internally and our continued growth in the packaging segment.While we can rationalize the whys and the hows, we remain dissatisfied with the end result. There continue to be challenges on the envelope side. There's no denying that. But there are many, many encouraging signs on the horizon. Most encouraging is that we're seeing margin improvement across all of our lines of businesses as we play catch-up on the price increases.The forecast for now is a more stable raw material pricing environment, which should allow all paper-based manufacturers to get back to more normal margin levels. In addition to improved pricing, the challenging quarter strengthens our resolve to further focus on our packaging platform and dedicate additional resources to extract available operational, procurement and top line synergies from all of our businesses.We remain focused on our objective of prudently achieving our goal of a 50-50 envelope-packaging revenue split. Envelope remains a very profitable part of our business, and we intend to protect its contribution and profitability from further erosion by paying special attention to our costs and better aligning our prices with input cost inflation affecting the overall industry.We've almost completed the 2017-2018 CapEx program and have built significant available production capacity at all of our packaging product lines. We are in the best position ever to meet the growing demand for high-quality folding carton and e-commerce fulfillment packaging solutions.Looking ahead, I'm confident in our ability to one, further execute our M&A road map on the folding carton side; two, generate organic growth across our 3 packaging categories; and three, manage the effects of the decline of the Canadian envelope business on our operating profitability.We remain committed to our short-term goal of returning value to our shareholders by way of dividends and share buybacks. Our cash flows remain strong and continue to allow us to maintain our level of debt and continue to invest in our long-term growth and diversification strategy.I look forward to meeting you again on this call in February to discuss our fourth quarter and year-end results. Thank you. Have a good day and a good weekend, and we'll talk to you in February.

[Operator]

Thank you. This concludes today's conference call. You may now disconnect. [Foreign Language]