Swiss Water Decaffeinated Coffee Q2 2024 Earnings Call Transcript

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August 8, 2024

There are 3 speakers on the call.

Operator

Welcome to the Swiss Water Decaffeinated Coffee Incorporated Conference Call. At this time, all participants are in a listen only mode. After management's prepared remarks, there will be a question and answer session. Before Swiss Water Decaffeinated Coffee Incorporated 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.

Operator

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 Incorporated 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 Coffees Incorporated's management's discussion and 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 floor over to your host, Frank Dennis.

Operator

Please go ahead.

Speaker 1

Thank you, Jordan. Good afternoon, everyone, and thanks for taking the time to join me. I'm Ian Carswell, CFO of Swiss Water Decaffeinated Coffee, Inc. Frank Dennis, our President and CEO, is unable to attend today's call, so I'll carry the ball this time. I'm here to discuss Swiss Water's financial results for the 3 6 months ended June 30, 2024, which were released yesterday.

Speaker 1

I'll begin by taking you through our financial results and then I will tell you more about our longer term plans and expectations. After that, I'll be happy to take your questions. We continue to see strong and growing demand for our chemical free decaffeinated coffee offering during the second quarter and first half of this year and are pleased to report strong volume growth and profitability during the quarter. However, as we noted during our last call, when comparing our quarterly results for 2024 with the same period last year, it's important to note that the distribution of quarterly sales volumes in 2023 did not follow a normal seasonality pattern. In particular, Swiss Water reported much stronger than normal volume growth and financial results during the 1st and 4th quarters last year.

Speaker 1

In Q1 2023, this was mainly due to the front loading of customer orders in anticipation of a period of production constraint during the second and third quarters. During this period, our capacity was temporarily restricted because we had to shut down and exit our legacy production facility in Burnaby, BC prior to the full commissioning of our second new decaffeination line at our Delta, BC facility. As our new Delta Line 2 ramped up over the summer and fall of last year and with all production now consolidated in one location, the order backlogs built up over the transition from Burnaby were processed and shipped during Q4 of 2023. With this context in mind, the year over year decline in volumes for the 1st 6 months of this year was fully expected when compared with the abnormally high volume we recorded in the Q1 and first half of last year. I believe it's fair to say that our results for the current year to date are consistent with the return to normal order patterns in plant operations.

Speaker 1

With that context in mind, let me now take you through our financial results. As always, I'll begin my review with volume shipped to customers as this is the key metric that drives our financial performance. Taken together, volume shipped to customers in all categories were up by 12% in the quarter. However, for the first half, volumes were down by 5% from the 2023 level, largely due to the front loading of orders into the Q1 of last year, as I've noted. Looking at the volumes by customer type.

Speaker 1

Shipment to roasters, those customers who roast and packaged coffee to sell to consumers in their own coffee shops or for home or office consumption were down by 4% in the Q2 and by 9% for the 6 months. While shipments to importers, those customers who resell our coffees to roasters where and when they need it were up by 40% in the quarter and by 1% for the first half. Looking at the roaster segment another way, specialty roaster account volumes were up by 32% in the quarter and down by 2% in the 6 months to June 30. These accounts serve the out of home consumer primarily in cafes and restaurants in our key geographic markets. Shipments to large commercial roasters were also down in Q2, shrinking by 5% compared to the Q2 of last year.

Speaker 1

For the first half, shipments to these accounts were 11% below last year's level. Turning now to revenues. 2nd quarter revenue of $43,400,000 was unchanged from Q2 of last year. However, at $82,100,000 first half revenue was down by $10,300,000 from the 2023 level. As with the volumes, the drop in 6 month revenue was largely an expected result of a normalization of order patterns when compared to a first half last year that was strongly skewed by volume loading and higher than normal sales during the Q1.

Speaker 1

Lower coffee quality differentials and changes in our mix of business also had a negative impact on revenues. During the first half of this year, we had a higher proportion of toll sales, which do not generate green coffee revenue, but only a processing fee. Looking at the cost side, Our 2nd quarter cost of sales was $35,700,000 down by $4,200,000 or 11% compared to Q2 last year. The decrease in the quarter was primarily driven by cost savings associated with the consolidation of operations at one location, lower utility rates and a $400,000 decrease in one time depreciation expense. In addition, the higher proportion toll sales this year also reduced cost of sales.

Speaker 1

For the first half, cost of sales was 69,300,000 down by $14,800,000 or 18% from the 2023 level. The 6 month decrease was driven by lower sales volume, cost savings associated with the consolidation of operations at one location and a $2,500,000 decrease in depreciation expense. As you may recall, in 2023, we incurred significant non cash depreciation expenses in both the second quarter and first half. These resulted from the write down of unsalvageable assets at our old Burnaby facility as we prepare to vacate the site in June of last year. There was no such charge in Q2 or the first half of this year.

Speaker 1

As to green coffee costs, at an average of $2.20 per pound in the second quarter, the NYC was up by $0.35 from $1.85 per pound in Q2 last year. For the first half, the NYC averaged $2.05 per pound, up by $0.15 from $1.80 last year. With coffee prices now on an upward trend and interest rates remaining high, we can expect some of our customers to consume their own inventories and wait for the market to come back down again before replenishing their stocks. This is a normal market dynamic that may negatively impact our volumes temporarily. Foreign exchange rates can also have a material impact on our profitability and cash from operations.

Speaker 1

This is because most of our revenues are generated in U. S. Dollars, while a significant proportion 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.

Speaker 1

S. Dollar appreciates as it did during the Q2. In Q2, the U. S. Dollar averaged CAD1.37, up CAD0.03 from CAD1.34 in the Q2 last year.

Speaker 1

During the first half, U. S. Dollar averaged CAD1.36 compared to an average of CAD1.35 in 2023. This appreciation had a positive impact on our revenues when they were converted to Canadian dollars. 2nd quarter gross profit was CAD7,700,000 an increase of CAD4,300,000 when compared to Q2 of 2023.

Speaker 1

For the first half, gross profit was $12,800,000 up by $4,500,000 or 54% from last year's results. And gross profit percentage increased to 18% for the quarter compared to 8% in Q2 last year. For the first half, gross profit percentage was 16%, up from 9% last year. The profitability improvements this year were in part the result of cost savings and efficiencies generated from our consolidation of all Swiss Water production and other operations at one location. This has generated savings from reduced building maintenance, utilities consumption, staffing and transportation between locations.

Speaker 1

The Q2 increases were also driven by higher sales volume, higher green coffee differential margins and the positive impact of the $400,000 decrease in one time depreciation expenses. For the first half, the $2,500,000 decrease in depreciation expense partially offset by comparatively lower sales volume and the decline in green coffee differential margins during Q1 helped drive the improvement. 2nd quarter operating expenses were $3,900,000 up by $600,000 when compared to Q2 2023. For the first half, operating expenses were $7,700,000 up by $900,000 from last year. The administrative portion of operating expenses was up by 35% in Q2 and by 19% for the 6 months.

Speaker 1

The primary driver of the increase in both periods was planned headcount and wage increases and increased professional fees. These negative impacts were partially offset by cost savings associated with consolidation of all operations at one location. The sales and marketing component of operating expenses was up by $200,000 or 16% in the quarter and unchanged for the first half. The main drivers of the difference during the quarter were increased travel and trade show activity as well as the timing of marketing activities. Q2 operating income of $3,700,000 was up significantly from $76,000 in the Q2 of 2023.

Speaker 1

First half operating income was $5,100,000 compared to $1,500,000 last year. Now turning to net income. We reported net income of $947,000 for the quarter compared to a net loss of $371,000 in Q2 last year. For the first half, net income was $47,000 compared to a net loss of $1,100,000 for the 1st 6 months of 2023. The loss we recorded in both periods last year was largely due to the temporary capacity constraint and additional costs incurred as we exited our old Burnaby facility.

Speaker 1

As with gross profit, the improvement in net income this year was driven by savings resulting from our consolidation of operations at one location in Delta as well as gains on foreign exchange. This was partially offset by higher interest expenses on our construction loans and increased mark to market losses on our risk management activities as well as the higher operating expenses. 2nd quarter net finance costs of $1,800,000 were up by $200,000 or 12% over Q2 of 2023. For the first half, net finance costs were $3,700,000 up by $700,000 or 21 percent from last year's level. The increase was primarily because following the commissioning of our 2nd decaffeination line in Delta, the interest on the construction loans for the project could no longer be capitalized.

Speaker 1

2nd quarter adjusted EBITDA of $4,500,000 was up by $2,700,000 from Q2 2023. And for the 1st 6 months of this year, we recorded adjusted EBITDA of $7,300,000 an increase of $500,000 from the first half of last year. The increase in both periods was mainly driven by savings realized by consolidating operations in Delta, partially offset by a higher operating expenses. As we noted previously, we built up inventory levels during the Q1 of last year to ensure that we had sufficient coffee on hand to meet customer demand during the transition from Burnaby when a production capacity was temporarily constrained. However, during the second half of twenty twenty three, the commissioning of our second production line in Delta led to an acceleration in raw material usage and increased shipments of finished goods.

Speaker 1

As a result, inventories closed 2023 at their lowest levels since Q1 of 2021. As planned, our inventory levels fell further during the Q2 and first half, in part because we consumed the last remaining coffee inventories we've built up to bridge last year's move out of Burnaby. Furthermore, shipping delays affecting freight passing through the Panama Canal also slowed the arrival of coffee into Vancouver. At the end of the second quarter, we held $28,800,000 in coffee inventory, down from $30,300,000 at December 31, 2023. While slightly lower than historical levels, this is sufficient to support our operations and near term growth.

Speaker 1

The reduction in working capital commitments resulted from the lower inventory level enabled us to continue reducing our debt and to accumulate cash deposits. As always, we remain focused on optimizing inventory levels and proactively managing our working capital commitments. With construction of our new production assets now complete and fully paid for, debt reduction is a key priority for Swiss Water going forward. Under the terms of our agreement with Mill Road Capital, we are scheduled to fully repay the $15,800,000 with warrants held by Mill Road in October of this year. Having finished the 2nd quarter in a strong liquidity position with over $18,400,000 cash on hand, we expect to be able to fund the Mill Road obligation with a combination of available cash reserves and proceeds from operations.

Speaker 1

If necessary, these funds can be supplemented by incremental borrowings on our existing debt facilities. As we look ahead, Swiss Water is well positioned for the future. We have a diversified global customer base, new state of the art production facilities, quality products that are in growing demand, increasing brand awareness and a proven team. All our operations are now consolidated in a single location with 2 modern processing lines, including our recently completed second decaffeination line. These assets enable us to optimize our operational processes and produce premium decaffeinated coffee of consistently high quality.

Speaker 1

We have sufficient production capacity to meet our current needs and with ongoing optimization along with some modest targeted investments, enough capacity to meet our medium term growth needs. The performance of all our Delta production assets has been excellent, and we are optimistic that we can utilize what we have learned from operating Line 1 to unlock further efficiency gains on our new Line 2. In general, trading conditions remain favorable in our key markets and we see growing demand as ever more industry participants move away from chemical decaffeination in favor of chemical free and organic processes like ours. As we noted during our last earnings call, this positive trend is supported by some interesting developments on the regulatory front. In March of this year, the State of California considered a proposal regarding the use of methylene chloride to decaffeinate coffee.

Speaker 1

Methylene chloride, which has been banned for use in paint strippers and cosmetics, is the most common chemical method used to decaffeinate coffee. If passed into legislation, as of January 1, 2027, California will require any entity that offers for sale coffee that has been decaffeinated using methylene chloride to label the final produce clearly stating that methylene chloride is used in the decaffeination of this product. Furthermore, in January of this year, the U. S. Food and Drug Administration filed a food additive petition and a color additive petition that call on the agency to rescind its approvals for 4 carcinogens in food.

Speaker 1

Methylene chloride, which is noted for its use in coffee decaffeination is one of these chemical additives. These actions have generated significant media coverage and are clear signals of growing consumer demand for greater transparency regarding the products they eat and drink. As a result, there's meaningful consumer attention on decaffeination and the availability of chemical free and organic alternatives such as our Swiss Water Process. Despite the strong position these and other factors have put us in, caution continues to be called for. Volatility in the coffee futures market persisted through 2023 and continued during the first half of this year, as roasters reset their inventories following a prolonged period of logistical challenges.

Speaker 1

However, looking forward, we are seeing evidence that some roasters are choosing to replenish their inventories more slowly than we anticipated due to affordability concerns caused by a persistently high NYC coffee commodity price. Rapid increases in the NYC and elevated volatility destabilized short term demand for decaffeinated coffees as roasters delay orders to reduce their working capital commitments. In a balanced market, price is fundamentally driven by the availability of coffee. The NYC and the London Robusta markets have risen to near record highs and both remain inverted. This is leading to slowing roaster demand and increased risk management costs.

Speaker 1

It has also resulted in very limited spot availability for coffees to backfill supply chain issues leading to some shortages. Adding to our challenges like businesses everywhere, Swiss Water is not immune to wider macroeconomic risks. Inflation has not fully abated and economies around the world are struggling to get a grip on it by raising or at least maintaining high interest rates. The ongoing war in Ukraine and the crisis in the Middle East have disrupted the global order and continue to create a lot of uncertainty in Europe and around the world. And as I noted, Swiss Water has experienced significant inflationary pressure in virtually all our input costs from natural gas to freight to labor.

Speaker 1

These risks and increasing costs demand our close attention and may require further mitigation measures in the future. Despite these challenges, we are optimistic that we will be able to deliver volume growth and improved profitability in 2024. Whatever the future holds, Swiss Water is now much better positioned for the years ahead. That wraps up my comments for today. I would now be happy to answer any questions you may have.

Operator

There doesn't appear to be any questions at this moment. There does appear to be one. One. The first question comes from the line of Richard Ruggley from Glenbrook Capital. You may now go ahead.

Speaker 2

Thank you. Yes, thanks for raising the methylene chloride U. S. Opportunity. And but I had some questions about the elevated coffee prices, which you alluded to.

Speaker 2

And as you've said before, especially your smaller customers often restrain themselves from buying in the hope that they can obviously buy to the lower level. But do you think these historic highs may be more secular and that they really might not get as many opportunities as in the past to buy at lower levels? And also I had another question about the implications of the impending EU restrictions on coffee grown from clear cut land, what implications would that have for Swiss water either directly or indirectly?

Speaker 1

Thank you, Richard. With regards to the first question, I mean prices are elevated right now. I mean, they have been at this level in the past. They're not historic levels. And in the past, they have dropped back down to kind of more normal levels.

Speaker 1

I do expect in time, the market will drop back. I can't guarantee that. But certainly the level of volatility that we're seeing right now is unusual. I mean, we're keeping a close eye on it. I'm not sure anyone in the industry right now loves the high prices that we're seeing.

Speaker 1

But ultimately, most businesses operating within the coffee industry have supportive credit agreements that allow them to continue to invest in working capital, and we certainly do have that. So I'm not sure that fully answers your question, but it's the best that I have right now. In terms of the European legislation, legislation, and that's something that we're looking very closely at right now. We don't have a strong view yet on what the potential impact could be for Swiss Water. The majority of our business is in Asia and North America.

Speaker 1

We do have some exposure in Europe, but it's the smallest part of our business from a geographical perspective right now. So it's something that we're looking into and as and when we have a better understanding of that, we will provide more information.

Speaker 2

Well, thanks very much. And yes, congratulations again on all the business progress you've made. And look forward to talking to you next time.

Speaker 1

Thanks, Richard. Appreciate it. Okay. If there are no further questions, I will conclude today's call. Sorry.

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