Swiss Water Decaffeinated Coffee Inc.

Please stand by. Good day, ladies and gentlemen, and welcome to your Swiss Water Decaffeinated Coffee Incorporated conference call. All lines have been placed in a listen-only mode and the floor will be open for your questions and comments following the presentation. As a reminder, today's call is being recorded. If you should require assistance throughout the conference, please press star, then zero. At this time, it is my pleasure to turn the floor over to your host, Frank Dennis, President and CEO. Sir, the floor is yours.

Thank you, Belinda. Good morning, everyone, and thank you very much for taking the time to join us. I'm Frank Dennis, President and CEO of Swiss Water Decaffeinated Coffee Incorporated, and with me today is Ian Carswell, our CFO. Ian and I are here today to discuss Swiss Water's financial results for the three and nine months ended September 30, 2020. I'll begin with a brief review of our results. I will also update you on the COVID-19 pandemic's impact on our operations. Then Ian will provide more detail about our financial performance before I return to tell you more about our longer term plans and expectations. After that, we'll be happy to take your questions. Looking now at our results, we are pleased to report that our overall volumes have proven to be much more resilient than we'd anticipated when the COVID-19 pandemic first hit us and everyone else toward the end of the first quarter. In fact, when compared to a very strong Q3 last year, our third quarter volumes are down by only 1%. And for the nine months to the end of September, they are only off by 6%. When you consider the headwinds we are already facing coming into the year due to nearly unprecedented spikes in the coffee commodity price last December and the near total shutdown of the world economy this past spring and early summer, our business model has performed extremely well. It's also important to remember that in each of the 12 quarters prior to the onset of the pandemic, we consistently won new business and increased volumes as coffee industry participants migrated away from solvent-based decaffeination in favor of our chemical-free Swiss water process. In addition to the consistently high quality of our products and services, the resilience Swiss Water has demonstrated is largely due to the high degree of customer diversification we've built into our business. We serve a broad spectrum of the coffee trade in over 65 countries around the world. This diversification has certainly served us well as we look back over the past couple months. During the early stages of the pandemic, we experienced strong short-term volume pull from those customers that serve the retail grocery trade. This was driven by consumers loading their pantries in anticipation of quarantines and supply disruptions or simply consuming their coffee at home. As things have unfolded, the at-home coffee market has remained strong but has leveled off from the initial spike in demand. Meanwhile, our customers who serve the out-of-home coffee market through cafes and restaurants have been much more susceptible to serious disruption as health authorities around the world have declared widespread or targeted food service shutdowns to combat upsurges in COVID cases. Despite this turbulence, some coffee outlets have stayed open throughout the pandemic to serve takeaway and drive-through customers. However, traffic to those locations has dropped significantly as more and more coffee consumers work from home rather than by stopping by on their morning coffee commute or office coffee break. In May and June, many jurisdictions lifted their lockdowns and the out-of-home channel began to recover as food service outlets reopened, albeit with significantly reduced seating. This helped bring volumes shipped to our specialty customers back up, driving an 8% increase to this important segment during the third quarter. Now, many countries and regions have started to experience a second wave of COVID-19 and have reinitiated lockdowns. These include a number of states and major cities in the U.S., our largest geographical segment. Given the uncertainty regarding the timing and widespread availability of a vaccine, we can't reliably predict the ultimate impact the pandemic will have on our business, particularly our business with the out-of-home coffee market. Accordingly, the risk remains that Swiss Water may well report an overall volume decline in 2020. However, we are cautiously optimistic that after a stronger than expected Q2 and Q3, our volumes have shown good resiliency and may continue to recover faster than we originally anticipated. We are in continuous contact with customers in all of our markets and are well-positioned with sufficient green coffee inventory and production capacity to respond as the situation demands. As we announced in September, we are now producing commercial-grade coffee at our new technically advanced decaffeination facility in Delta, B.C., Initial production from this line is destined for growing international markets focused on the rapidly growing ready-to-drink coffee segment. We also continue to operate both production lines at our legacy plant in Burnaby, BC on the normal 24-7 basis, as well as our Seaforth coffee handling subsidiary, while taking all necessary measures to protect the health and safety of our employees, customers, and other stakeholders. At the same time, we are moving ahead strategically to repair the company for resumption of the strong growth trajectory we'd firmly established prior to the pandemic. Before I update you on plans for the future, I'll now turn the call over to Ian to take you through our results in more detail. Ian?

Frank, good morning, everybody. As always, I'll begin my review with volume-shift customers. As Frank indicated, Swiss Water's processing volumes have remained remarkably resilient, despite the significant trading challenges wrought by the pandemic. It continued to strengthen during the third quarter. When compared to a very strong 2019, total Q3 volumes were down only 1%, and nine-month volumes were down just 6%. When compared to the 16% drop in year-over-year volumes we recorded in the first quarter and the 9% drop we saw for the first half, you can see a favorable trend as the year has unfolded. 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 5% in the third quarter and down by 4% for the first nine months of the year. Shipments to importers, those customers who resell our coffees to roasters where and when they need it, were down 11% in Q3 and by 10% for the year to date. Looking at the roaster segment another way, specialty roaster account volumes were up 8% in the quarter and down by 6% for the nine months. And shipments to large commercial roasters, which were down by 6%, were down by 6% for both periods. Looking now at revenues, third quarter revenue was 24.9 million, an increase of 5% over Q3 of 2019. Nine-month revenue was broadly comparable to last year at $73.1 million, reflecting an increase of 1%. Revenues remained strong despite the decrease in processing volumes because of the positive impact of changes in customer mix, which resulted in higher process revenue, higher coffee quality differentials, and increased freight revenue. Looking at the cost side, our third quarter cost of sales was 21.5%. 4 million, an increase of 2.5 million, or 13% from Q3 of last year. The quarterly increase was driven by higher green coffee costs, as well as by increased depreciation charges following the commissioning of our new manufacturing facility in Delta, BC in September. For the first nine months of the year, our cost of sales increased by $400,000, or 1%, to $60.3 million. A slight increase in the nine-month period reflects our operating activities so far this year. Quarterly gross profit was $3.4 million, a decrease of $1.3 million compared to Q3 2019. The change was due to the higher cost of sales during the period. For the nine months, gross profit was $12.8 million, an increase of $400,000 from the 2019 level. The year-to-date improvement was driven by positive changes in our sales mix, stronger than expected coffee differential gains, improved supply chain efficiencies, and lower natural gas costs in the first half of this year. Third quarter operating expenses were $2.8 million, an increase of $400,000 over Q3 2019. Nine-month operating expenses of $7.8 million were comparable to last year. Quarterly increase was driven by a combination of timing of marketing expenditure, higher professional fees, and the inclusion of engineering salaries and expenses this year. In Q3 of last year, during the construction of our new Delta BC manufacturing facility, we were able to capitalize engineering salaries. The higher quarterly expenses were partially offset by lower than expected travel and recruitment fees due to pandemic restrictions. while nine-month expenses were reduced by recovery of stock-based compensation costs during the first half as a result of a lower share price. Q3 operating income was $600,000, a decrease of 75% from the same period last year. However, the nine months to the end of September, operating income increased by 9% to $5 million. Net income for the third quarter increased was $100,000 compared to $900,000 in Q3 2019. Nine-month net income was 3.3 million compared to 2.2 million last year. The year-over-year difference in net income during both periods reflects the combination of changes in gross profit and both operating and non-operating expenses. This year's non-operating expense was reduced by the revaluation of an embedded derivative as a result of our lower share price, partially offset by a slight loss on risk management activities. Moving forward, we expect net income to continue to be negatively impacted by higher depreciation and overhead expenses following the completion of our new manufacturing facility. However, in time, these expenses should be offset by higher sales volumes. Third quarter EBITDA was $2 million, a decrease of 1.4 million, or 42% from the 2019 level. For the first nine months of the year, we recorded EBITDA of $7.9 million, a decrease of $1 million, or 12% from last year. EBITDA, excluding the impact of IFRS 16, decreased by 1.4 million, or 50%, to $1.3 million in Q3, and by $700,000 or 11% to 5.9 million for the first nine months of this year. We had expected the drop in quarterly EBITDA for a couple of reasons. Firstly, although gains on coffee quality differentials had a positive impact on our nine-month results, they softened remarkably during the third quarter. This combined with the timing of our overhead spending and marketing investments brought down our EBITDA for both periods. It is normal that coffee quality differential gains will temporarily soften following a period of strength. We do not expect the negative impact on EBITDA reported in Q3 to be repeated in Q4. With that, I thank you for your attention, and I'll now turn things back to Frank.

Thank you, Ian. As those of you who follow our story know, we must relocate all production from our legacy facility in Burnaby, BC by June 2023 due to the coming expiry of our lease there. In order to ensure that our ability to deliver on customer orders is uninterrupted and to meet the growth and demand we see ahead, we need to build additional new production capacity before we depart Burnaby site. Accordingly, planning for the financing, design, and construction of a second line in Delta is now underway with a targeted completion date before the 2023 deadline in Burnaby. Based on engineering reports from a third-party engineering firm, when both are completed, we expect the two new lines in Delta together will have a targeted end capacity at least 40% greater than the current Burnaby facility. Preliminary cost estimate for the design and construction of the second new production facility in Delta is approximately $45 million plus commissioning costs of around $2 million. These estimates are preliminary and like all major design and construction projects are dependent on local and global economic factors. And as with all plans these days, subject to the potential negative impact of the COVID-19 pandemic on costs and timing. We are now formulating the financing strategy and expect to have this finalized by the end of the year. Although the pandemic continues to create a good deal of uncertainty, Swiss Water's performance so far this year is encouraging. We have a strong brand and competitive position and benefit from a broad and diversified customer base. Whether consumers drink their coffee at home, at their office, or in a cafe or restaurant, Swiss Water is well-equipped to supply the growing demand for chemical-free decaffeinated coffee, whatever the customer channel or geography. That wraps up our comments for today, and Ian and I would now be happy to answer any questions that you may have.

Thank you. The floor is now open for questions. We ask that you please limit yourself to a single question. If you do have a follow-up, please resignal to rejoin the queue. You may signal by pressing star 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset to provide the best sound quality. Again, ladies and gentlemen, if you do have a question or comment, please press star then one on your telephone keypad at this time. And we'll pause briefly to assemble the questions queue. Our first question comes from Blake Pelham with Raymond James. Please go ahead.

Oh, hi, gentlemen. A question on you mentioned the out-of-home segment had an 8% increase in coffee sales in the third quarter. Is that over the third quarter of last year or over the second quarter?

It's over the third quarter of last year.

And really, that's the specialty market, which represents out-of-home to some degree, but that isn't exclusively out-of-home, the way that we define specialty. It's our higher-end coffees and smaller chains. But it is generally an out-of-home number, but yes.

Okay. Is there anybody else in the queue, or can I continue to ask questions?

That was a really simple question. So, yeah, go ahead, Blake. That was a pretty easy question. I'll give you one more. Okay.

Oh, you give me one more. Okay. In Q3, was there a specific amount of additional overhead costs included in the numbers to start up the Delta production line?

Yeah. I would say that the ongoing incremental cost that we're going to be carrying from running the line is approximately $200,000, and that's largely additional people that are on our payroll that we need to employ in order to run this plant. What I would say is that that's incremental versus Q3 last year, but we didn't add those people in Q3 of this year. They've been in our overhead cost. Well, it sits within cost of sales, but they've been with the company since the beginning of this year. So it's not a new cost for this year. It's just a new cost versus Q3 of last year. And that's running at about $200,000 per quarter. Per quarter. Okay. Okay.

Great. I think that's the only questions I have right now. So I will go back into the queue if I can think of some more. Thanks, Blake.

Next, we go to Lyle Parkin, private investor. Please go ahead.

Hi. Could you clarify on... what's involved in the construction for this second line. It sounds like you're having to construct another building in addition to the second line. I would have thought you would just be able to put a second line in the building that you just finished constructing.

Well, the... The envelope, we call it, for line one here in Delta, we constructed to just cover that line. It is far easier to construct a decaffeination facility when you don't need to move components into a building. So, in fact, what happens is we build the superstructure, we move in a lot of major pieces of equipment like dryer and a huge furnace and stainless steel tanks for carbon and coffee before we put the envelope on. So, in fact, it's much more efficient to... build the decaffeination facility and then create the envelope around it. The envelope is not insignificant, but it's not a huge cost relative to the entire decaffeination plant itself, if that makes sense.

Yeah, it does. I haven't been to your facility, so I don't really know the sizes of the equipment involved, but what you're saying makes sense.

Yeah. Yeah, I mean, in the past, for example, in Burnaby, we had to, when we were building our second line there, we were airlifting and craning in huge pieces of equipment. In fact, we had to rip the roof off of the building there to put equipment in, which was a very expensive and laborious process, and it also annoyed our landlord to no end. So we're trying to avoid that. And so this process, in fact, makes a lot more sense. And I always invite you to come out to see our facility whenever you like.

Just a couple of follow-on questions then. So given that it's a big deal to replace some of this equipment, is the new facility structured in such a way that you'll be able to do that in the future?

Sorry, Lyle.

If you had to replace one of these tanks or the furnace or the dryer.

I see. Yeah. Our experience, Lyle, has been that replacing components of our process really has rarely been necessary because of how we do maintenance work. on the facility. So I think the only thing we've ever replaced in Burnaby is it is a dryer in 2001. Other than that, we maintain the equipment, we maintain furnace dryer, etc. And the stainless steel tanks really don't wear out. It's valves and pumps that wear out. So No, it's a pretty integral process. However, they are not particularly movable, which is what we have found, and that's why we're doing what we're doing here in Delta.

Most of the major pieces of equipment are being depreciated over a 35-year lifetime, and that's in line with the age profile requirements. and the depreciation that we're applying on the existing assets in Burnaby, we find that, as Frank said, maintenance plans that we have in place ensure that there's no major risk around those assets. So they shouldn't need replacing.

And does the company own the land?

No, not currently. It's disclosed within our MD&A that we have an option to purchase the land in the future. The full details of that are in the MD&A. Sure. Thank you.

Next, we go to the line of private investor Steve Luck. Please go ahead.

Hello. I have a question under the contractual obligations. the purchase obligations, there is some amount for capital. I guess I was wondering what those were and about how much they are.

I'm not sure I fully understand the question. Can you repeat the question?

Under contractual obligations, there are a total of $31,374,000. And that is made up of outstanding capital, coffee, and natural gas purchase commitments. So my question is, what is the outstanding capital? What does that refer to? And about how much of that $31 million is capital-related?

Well, I believe that the number that you're referring to covers the commitments that we have in terms of coffee purchases, utility purchases, and any other contract that we have signed for either commodity. But I think it also includes, I believe, it includes the commitments that we have on lease payments. So, I don't have the breakdown of those numbers in front of me, but I'd be happy to, if you want to contact me, I would refer you to the documents that we have issued, which are financial reports in the MD&A, and if you can't find the information there.

I am looking at the MD&A, yes. My question is right from there.

Typically, it's not information that we would share just from a competitive point of view beyond what we share in the MD&A. Okay, thank you.

Next, we go to the line of Blake Pelham with Raymond James. Please go ahead.

Hi, guys, again. Just curious about your green coffee inventory or your finished inventory. I noticed that inventory as September 30th was $18,443,000 and that's down from the June 30th inventory number. Do you think run rate in the future is similar to what you have or does it increase as a result of the Delta facility? And I'm not familiar enough with past inventory levels, etc., to to really ask this question with a sense of wisdom or anything.

I think it's important to note that those numbers are influenced by the underlying coffee price, which is tracking higher than it was this time last year. I would say that as a general rule, we're very careful about the level of stocks that we carry in the business and we manage our working capital very carefully.

Yeah, and I think, Blake, if you saw the number was down in September versus June, which is what you're, I think, referring to, in the first quarter we saw the C move from basically what it is right now at $1.06 to almost $1.45, and that would have taken a little bit of time to move through our balance sheet. So you would have had an increased number through the second quarter and then declining into the third quarter, September, from a dollar point of view. Although, from a total pound point of view, which is actually how we manage our inventory, we don't really manage on a dollar basis, as Ian mentioned, from a New York C, because that influences it so much. But on a pound basis, it's actually... probably down a little bit as well, despite the fact that we're operating the new facility. And really, that inventory amount is more kind of in a tighter relationship to our total volume. And what we see is that we can leverage volume quite nicely without having huge increases in pounds of inventory carried. It's by no means a linear relationship. which is a nice part of our business because so much of our business is done on what's called a back-to-back basis where our customers buy and sell the same coffee, and so we really don't end up having to carry that. So long story short is as we open up Delta, we are adding additional inventory. As we get major new customers, through next year into the future, that's when we'll see additional towns coming through our total inventory number. Does that make sense? Yeah, yeah, that makes sense.

One follow-up there. You said in the Delta facility you're focused on international customers. When you say international, does that mean anything outside of Canada, firstly? And is that just a function of, I guess, a second follow-up on that? Is Burnaby, you're just going to continue to operate Burnaby and supply your existing customer base and then expand on that?

Yeah, that's a good question, Blake. When we say international, yes, we do. It means outside of Canada, but really what we think about is we kind of think North America and then sort of Asia and then Europe. That's kind of our major three market breakdown. So when we think about international, yeah, that isn't coffee that's going to North America. That's going externally. And as far as... managing volumes. You know, right now, the majority of our volume is still being serviced out of Burnaby. And we're building in volumes into Delta as that makes logical and financial sense. But, you know, what we don't want to do ever is have our customers tell us where they want their coffee run. And so we try to manage the most efficient way supply chain for them. And, you know, we don't want a situation where someone says, well, I only want to have a coffee from your new plant. I don't want that old plant coffee. Well, no, no, no, no. Old plant coffee is still really good. And we still have a lot of, you know, need for that particular volume. So if that helps kind of the nuance of what we're doing between the two facilities, hopefully that makes sense as well. Yeah, that does. Okay.

All right. Thank you, gentlemen. Thanks, Blake.

There are no further questions. The floor returns to Mr. Dennis for closing remarks.

Thanks, Melinda. And so if there are no further questions, I will conclude today's call. And Ian and I wish you all good health and thank you very much for joining us.

Thank you. This does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time. Have a great day.