Supremex Inc. (SXP) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by and welcome to Supremex Inc.'s Fourth Quarter and Fiscal Year 2019 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to your first speaker today, Danielle Ste-Marie, Investor Relations for Supremex. You may begin your conference.

Thank you, Julienne. Good morning, ladies and gentlemen. My name is Danielle Ste-Marie. I'm an independent adviser and act in 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 fourth quarter ended December 31, 2019, which were released earlier today as well as the recent acquisition of Royal Envelope. This call will be held in English [Foreign Language]. For a more detailed analysis of our results, please see our financial statements and management discussion and analysis in 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 is available through the webcast and on our website. We 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, 2019, 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. 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 of Supremex, to review this quarter's key operational highlights and recent events. Stewart?

Thank you, Danielle, and welcome, everyone. During 2018 and 2019, we invested significantly in our packaging operations in order to raise capacity and capabilities. These were good investments in our future, but they were short-term material brains. Durabox has been a real challenge. If you recall, we were pretty ambitious with our expansion plans. We moved from 37,000 square feet to 144,000 square feet over the past year. We actually increased both our capabilities and our capacity significantly. Unfortunately, the ramp-up has been much slower and costlier than expected. After more than 6 months of a very steep learning curve, we have been self-sufficient on the corrugator since June of 2019 and have capacity available. Unfortunately, as soon as we got through the issues on the front-end of the operation and started to stress the back-end, we started having material issues on 2 of the 3 lines. We limped along through the balance of 2019 and into early 2020. These challenges caused serious inefficiencies, outsourcing and R&M costs and forced management to temporarily essentially abandon the sales growth process. We have rebuilt one line and the second line has been repaired to a reliable state. We're not completely out of the woods yet, but the new management team has done an excellent job. We are producing well, and think we have cleared our -- we'll have cleared our backlog by mid-March, at which time we can focus on selling the available capacity and executing on the original business case. Folding carton was also an unexpected drag on earnings in 2019. The primary culprit was the decommissioning of an old and the commissioning of a new press at our Montréal facility. The combined inefficiencies increased based in R&M, along with significant outsourcing costs were a sizable drag. Add to that, some turmoil associated with integration and ERP implementation. These issues at Durabox and folding carton, in addition to the loss of the above-mentioned e-commerce customer, explains the $4.3 million shortfall in adjusted EBITDA versus 2018 in our packaging and specialty products segment. The fundamentals of both of these businesses remain good. The folding carton business was without its moneymaker for essentially 25% of the year and struggled staying focused with distractions. The corrugated business simply took much, much longer to ramp-up than we could have reasonably expected. We changed the management, paid the penalty and are ready to move forward. We are disappointed by the outcome, but I'm encouraged by what I see and what I'm living. We have put considerable effort into rectifying the challenges. I don't foresee additional material CapEx required in either of these businesses, and I believe the personnel changes we have made, and are making, are the right ones. On the e-commerce side, we are making steady progress and have had 3 good wins in the last couple of months, with subscription-based e-commerce customers in the oral hygiene, shaving and eye care space and have several other really interesting projects on the go. After the letdown of the large customer that we've talked about for a few quarters now, it finally feels like we have some wind at our back. U.S. envelope is doing exactly what we need it to do. It is driving volume, activity and efficiencies to the Canadian plants as the Canadian secular decline continues at a rate in excess of the U.S. decline. Units produced in Canadian plants for U.S. affiliates were up 27% year-over-year, which is an increase in excess of what we managed from 2017 to 2018. The role we'll take on even more importance as a result of the Royal Envelope acquisition. By conservative estimates, by combining the entities, producing in local markets and taking advantage of the efficiencies associated with ganging runs, we believe we can increase the available capacity by up to 10% to 15% with the existing manpower. As a result, we have a full-court press on U.S. volume. On the Canadian envelope front, there is no surprise that we continue to feel the effects of secular decline. Volumes were down 12.6% in 2019, which is roughly in line with the 11.3% transactional mail volumes declines experienced at Canada Post during the last quarter. That said, we posted above-expected revenue and earnings by improving mix, passing through delayed raw material increases, tightly managing cost and through the effects of Project Canada restructuring from Q4 2018 and Q1 of 2019. Although the Canadian envelope market continues its secular decline, these operations remain a key and steadfast contributor to our profitability and cash flow generation. As an important part of our strategy, earlier this week we announced the acquisition of Royal Envelope, which, we are confident, can be quickly integrated and will immediately generate top and bottom line synergies. About Royal Envelope. The company had $30 million in revenue in the last 12 months, primarily in Eastern Canada. It employs 135 people and operates primarily out of a 56,000 square foot facility in Concord, Ontario, with a small operation in Lachine, Québec. Royal Envelope is a Tier 1 supplier, known for quality products and good service. They have a modern fleet of equipment and some capabilities and competitive advantages that Supremex had not invested in. We paid $27.4 million, and their profitability margins are roughly in line with ours. The rationale is fairly straightforward. The North American envelope market remains challenging and continues to face secular decline. We require additional scale to help us deliver cost-effective products to both the Canadian and U.S. markets. Not surprisingly, given our size and geographical proximity, there are some attractive cost synergies available to us. The unique capabilities and capacity from the Royal assets are necessary to support the growing needs of our U.S. organization. Supremex had allocated the majority of its CapEx over the last couple of years to the aforementioned packaging projects and was getting to a point where we needed to do several machine updates or upgrades over the next few years. And when we did the analysis, buying the equipment from Royal versus new or from a broker helped justify a good portion of the acquisition cost. In the current tight labor market, this transaction provides access to high-quality skilled labor and strong envelope human resources throughout the business. Adding the equipment, employees and know-how from Royal to the Supremex platform helps us remain relevant to envelop employees, customers and suppliers over the longer term. We have an impressive track record in integrating envelope operations. We have a deep talent base from which to draw and the business itself is well run. Our intention and expectation is to do exactly what we achieved when we concluded the 2015 acquisition of Premier Envelope in Western Canada. We increased operating rates, improved our Western envelope division's margins and freed up capacity, setting the stage for our growth and diversification strategy into the U.S. market and then subsequently into packaging. We expect the Royal acquisition will do just that. Yes, the acquisition of Royal Envelope is an offensive play in a declining market, but it will help protect our market share and bottom line, providing the means and resources to improve our cash flow generation capabilities and provide additional cash flow to continue executing our diversification strategy. With this, I'll turn the call over to Guy for a quick review of our financial results for the fourth quarter and fiscal year ended December 31.

Thank you, Stewart. Good morning, everyone. Fourth quarter total revenue was $49.2 million, down 9.2% versus Q4 2018. Revenue from the envelope segment stood at $35.8 million, down 6.8% or $2.6 million compared to the fourth quarter of 2018. Canadian envelope revenue was $23.9 million, down 7.3% from $25.8 million in the fourth quarter of 2018. Canadian envelope volume declined by 14.2%, primarily resulting from the combined effect of industry-wide secular decline, customer movement and the company's strategy to maintain a disciplined market approach with price leadership and differentiation. Average selling prices increased by 8.1% to mitigate the effect of significant cost inflation that occurred throughout 2018 and in the first half of 2019. Revenue from the U.S. envelope market was $11.9 million, a decrease of 5.7% versus Q4 2018. The volume of units sold decreased by 7.1% while average selling prices increased by 1.5%. Packaging and specialty products segment revenue stood at $13.4 million, a decrease of 15% compared to the equivalent quarter of 2018. The majority of the decline results from the loss of business with an e-commerce customer and from weaker revenue in the folding carton division. Packaging and specialty products represented 27.3% of the company's revenue in the quarter, down from 29.2% in Q4 2018. Fiscal 2019 total revenue was $191.7 million, a decrease of 1.8% versus 2018. Revenue from the envelope segment was $137 million, down 0.8% versus prior year. Canadian Envelope revenue was down 3.3% to $91.7 million from a volume reduction of 12.6%. During the year, we managed to increase average selling prices by 10.6% to help mitigate cost inflation. U.S. envelope revenue increased by 4.8%, reaching $45.5 million compared to $43.4 million in 2018. The volume of units sold decreased by 2.7% while average selling prices increased by 7.7% to offset rising input costs. Average selling prices were impacted by a positive foreign exchange translation effect of approximately 2.4% from a weaker Canadian dollar when compared to the equivalent period of last year. Packaging and specialty products segment revenue decreased by 4.1% to $54.5 million. The loss of volume from a single e-commerce packaging customer was partly mitigated by higher folding carton sales from the acquisition of G2 Printing. Moving on to earnings. Fourth quarter adjusted EBITDA was $5.4 million compared with $8.1 million in the equivalent quarter of 2018. The decrease of $2.7 million stems primarily from the lower contribution from the packaging and specialty products segments. Fourth quarter 2019 adjusted EBITDA margins were 11% of revenue compared with 15.1% in the equivalent quarter of 2018. Envelope segment adjusted EBITDA was $5.8 million in the fourth quarter, down from $6.1 million in 2018. Lower contribution of the U.S. operation was mitigated by a slight improvement of operating profitability of the Canadian envelope operations. Envelope segment adjusted EBITDA margin stood at 16.2%, up from 16% in the fourth quarter of 2018. Packaging and specialty products segment adjusted EBITDA was $0.3 million, down $1.7 million versus Q4 2018. Operational inefficiencies in folding carton was the largest contributor to the reduction in operating profitability followed by inefficiencies from the slower-than-anticipated ramp-up of the new Durabox facility. Packaging adjusted EBITDA margins were 2.4% compared with 12.9% in the equivalent quarter of 2018. Fiscal 2019 adjusted EBITDA was $20.2 million, down from $26 million during the equivalent period of 2018, primarily from lower contribution from the packaging and specialty products segment. Adjusted EBITDA margin stood at 10.6% compared with 13.4% last year. Envelope segment adjusted EBITDA was $20 million, in line with 2018. Envelope adjusted EBITDA margin stood at 14.6%, slightly up from 14.5% in 2018. Packaging and specialty products segment adjusted EBITDA was $2.7 million, down from $7 million in 2018. Operational inefficiencies at the folding carton division was the largest contributor again to the reduction of operating profitability, followed by inefficiencies related to the ramp-up of the new Durabox facility and the loss of volume with an e-commerce customer. Packaging adjusted EBITDA margins were 5% compared with 12.4% in 2018. Fiscal 2019 net earnings were $7.1 million or $0.25 per share for the 12-month period ended December 31, 2019 compared with a net loss of $4.8 million or $0.17 per share in the equivalent period of 2018. Net cash flows from operating activities were $20.2 million in fiscal 2019 compared with $11.9 million last year. The improvement is mainly attributable to the impact of IFRS 16 and to a $2.5 million reduction in inventory. On February 20, 2020, the Board of Directors declared a quarterly dividend of $0.065 per common share, payable on April 15, 2020, to the shareholders of record at the close of business on March 31, 2020. This dividend is designated as an eligible dividend for the purpose of the Income Tax Act in any similar provincial legislation. I would now like to turn the call over to analysts for questions. Operator?

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

Obviously, you've had a lot of challenges with some of the growth, some of the ramp-up with the new facilities and such. Can you just rehash though the headwinds that you're having both on the envelope and the packaging side? I'm trying to figure out with the customer loss -- the e-commerce customer losses on the packaging side and the customer movement that you talk about on the envelope side, when can we expect to be past these headwinds? And what kind of normalized growth or declines on the envelope side should we be thinking about going forward?

So there's no customer movement on the envelope side. It's all secular that we're facing. So there's nothing on that side that's material. Then you've got the addition of the Royal Envelope side, which kind of changes market share. On the e-commerce side that we're through customer number one, if you will, decline. We've gone through our full 4 quarters after Q4. So we're past it. We had a lot of -- frankly, we had too much customer concentration in the e-commerce side. I mean our first win was a big win. And ultimately, I mean, it helps a lot on the upside, but it hurts a lot on the downside as well. We'd like to have customer concentration more in line with what we have on the envelope side, where no one customer is more than 5% of our total sales, but just the way it played out.

Okay. Well, just, sorry, going back on the Canadian envelope. So I'm just reading through the press release here and you do talk about the volume decline being from the secular decline and customer movement. Was that customers that may be moved over to Royal Envelope and now you've gotten back with the acquisition?

Well, there's certainly some of that with the acquisition, but most of that played out in 2017 and 2018. I think what we're talking about in the press release is sort of normal ebbs and flows of customers moving around. There wasn't anything material or any major customer that bounced. We're all kind of sitting here looking at one another and saying what was the customer in Canadian envelope, but it's more of the ebbs and flows.

Okay. Fair enough. And now with the acquisition, obviously, you've got your new credit facility, you've taken on some increased debt due to the acquisition of Royal. So how do you feel now with your leverage ratios, your debt level the way it is now? Is there going to be a focus on paying down the debt? Or are you going to be investing more in growth more on the packaging side?

So we actually addressed that in my closing comments.

You were speaking very quickly, I missed some of it.

No. My closing comments after you're finished -- after your question. But -- I mean, we can jump ahead there. No problem whatsoever. I mean our capital projects are mostly completed, and we really don't see any other significant investments in equipment or being required. And until sort of profitability margins demonstrate consistent improvements, we don't include to -- or don't intend to conclude any major acquisitions until such time as we get the other 2 businesses turned.

Okay. Is there anything...

CapEx -- maintenance Capex. Sorry.

No. Go ahead, finish.

Maintenance CapEx will sort of be in -- consistent with previous years, $2 million, $2.5 million.

Okay. Anything specific on the pharmaceutical side on that packaging after you bought G2 and the Pharmaflex labels? Or have we seen any like really positive opportunities come in or anything on the horizon?

No. And frankly, the challenges are primarily around the original business, the cosmetic business. And there's a few things there. One was the press, and there's been a switch in customer preferences from one raw material to another, which squeezes margins a little bit for the manufacturers. But there's been no big wins. Couple of losses on the cosmetics side. But nothing like e-commerce.

Okay. And then just finally, with the Royal Envelope acquisition, I don't think there's much expected from costs associated with any of the integration or restructuring that's going to happen as you integrate those 2 business, I believe. And I think you -- can you talk about when or how are you going to start seeing synergies between the business and a little bit of detail?