Supremex, Inc. (OTCPK:SUMXF) Q2 2023 Earnings Conference Call August 10, 2023 10:00 AM ET
Stewart Emerson – President, Chief Executive Officer & Director
Francois Bolduc – Chief Financial Officer & Corporate Controller
Conference Call Participants
Matthew Lee – Canaccord Genuity
Ahmad Shaath – Beacon Securities
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Supremex Second Quarter 2023 Earnings Conference Call. [Operator Instructions]
Before turning the meeting over to management, please be advised that this conference call will contain statements that are forward-looking and subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated. I would like to remind everyone that this conference call is being recorded on Thursday, August 10, 2023.
I would now like to turn the conference call over to Stewart Emerson, President and CEO. Please go ahead.
Thank you, operator. Good morning, ladies and gentlemen. Thank you for joining us for this discussion of the financial and operating results for the second quarter ended June 30, 2023.
Our press release reporting these results was published earlier this morning. It can also be found in the Investors section of our website at www.supremex.com, along with our MD&A and financial statements. These documents will be available on SEDAR as well. We also posted a presentation supporting this conference call on our website.
Let me remind you that all figures expressed on today’s call are in Canadian dollars unless otherwise stated. I’m joined today by Francois Bolduc, Supremex’s new Chief Financial Officer. Francois joined us in early July and brings more than 25 years of experience as a financial executive with large private and public companies. We are very pleased to have him on board, as the company will benefit from his leadership skills and expertise in all matters related to business strategy, M&A and capital management. Bienvenue, Francois.
Let’s turn to Slide 39 for an overview of the second quarter. For our usual format, Francois will provide additional details in a few minutes but let me take a moment to discuss our market dynamics. To be candid and direct, our results are primarily reflective of the temporary effects of 3 external forces and internal inefficiencies in one of the folding carton plants.
From a revenue standpoint the most material impact we experienced in Q2, as we predicted and commented on after both Q4 and Q1, were the effects of certain customers working through substantial inventories accumulated through panic or overbuying in 2022 when supply was very tight. This was felt primarily in the Envelope segment, where 7 long-term resale customers accounted for 40% of the U.S. unit decline in the legacy Envelope business. This was purely a destocking exercise, moderately exacerbated by a soft economic environment. Second, high interest rates and high inflation have impacted our markets in 2 ways. First, in packaging and I think you’ll understand this, reduced availability of discretionary income for items like fragrances, cosmetics and other health and beauty items adversely affects a core and high value-added segment in our folding carton division.
Additionally and this isn’t obvious to most casual observers, high interest and inflation affects smaller charitable donations many charities like the Humane Society, the Cancer Society, Wounded Warriors and others rely on, particularly in the U.S. market. That is, if home budgets are being squeezed by the high cost of groceries and increased mortgage and car payments as a result of higher interest rates, they are less likely to make the small donations. This prompted major fundraisers to abandon or seriously curtail their mailing plans in Q2.
Finally, on the revenue front, high and fluctuating interest rates materially dampened credit card solicitation mailers, as issuers tried to ascertain what incentives made sense. Imagine being a credit card issuer trying to determine whether 0 interest or 1% interest or 3% interest or no interest for 6 months or whatever, was viable, if it’s unclear rate hikes are over or not.
The cumulative effects of working through bloated inventories and reduced discretionary income took a toll on Supremex and our markets in Q2. From an internal efficiency standpoint, obviously a reduction of volume has a negative absorption effect in all of the facilities. But the issues were compounded in Q1 and Q2 by the underperformance of operations in the relatively newly commissioned machine facility. It’s the same people operating essentially the same equipment, albeit in a new facility that underperformed. It was a confluence of issues, including the rushed nature of the exiting the TMR location and commissioning the Lachine facility at the end of 2022 and the “distraction” associated with the Paragraph acquisition in January and the Graf-Pak acquisition in May and subsequent 90-day consolidation which is now completed, spread local management a little too thin and a general malaise due to soft backlogs.
The combination of temporarily reduced volumes across most business units and a primary facility that underperformed led to the tepid results. The promising news is that we see volumes trending back to some level of “normalcy” in the second half. Resellers have started to replenish inventories, credit card issuers and fundraisers can’t and are not staying on the sidelines indefinitely. They need new clients and they need donations.
Forecasts and booking from the Health & Beauty segments are encouraging. In envelope, we’ve been diligently reengaging with customers we couldn’t serve during the tight supply period of 2022 and engaging with new customers by leveraging our strong brand to continue to gain market share. As you may infer from my earlier comments on Direct Mail, Royal Envelope had a weaker quarter with revenue of $9.1 million. However, we are buoyed by renewed activity in July and August and more robust mailing plans we have seen for the balance of 2023. The operational integration at Royal has gone well.
We’ve extracted important synergies and we rely — and we are actively seeking opportunities to leverage our scale, capabilities and expanded offerings to both existing and new customer relationships acquired in the acquisition. In Canada, year-to-date units in envelope are basically flat for a couple of key reasons. Due to our market share and geographic proximity, we were able to manage the inventories of our resale customers effectively. And as a result, those customers have not had to work through over-inventory situations. And given the small direct mail market in Canada, the downturn related to available discretionary spending and fluctuating interest rates that I discussed earlier were much less dramatic.
In the Packaging and Specialty Products segment, revenue from our core pharma and food segments were strong. Sales in the e-commerce business were also strong and exceeded the prior year. Activity in the retail sector was off at a level consistent with overall market data. And as previously mentioned, the Health & Beauty segment has been a challenge but their forecasts for the second half look encouraging.
Operationally, we completed the integration of the Graf-Pak operations into the Lachine facility within the 90 days as planned. As we referenced when we concluded the transaction, this is a perfect example of a pure synergistic tuck-in that can provide benefits both on the revenue generation and cost reduction side.
As I mentioned in my earlier comments, with the Paragraph acquisition in January and the Graf-Pak acquisition and integration largely completed in May and June, coming immediately on the heels of the consolidation of the former Town of Mount Royal facility, we experienced some inefficiencies which disrupted normal flow of activities. As a result, in packaging, the combination of lower demand from certain markets and operational inefficiency, we had a sales and profitability shortfall. Having said that, the consolidation of folding carton activities at Lachine is an essential component of our packaging strategy.
This facility should and will be the jewel of our packaging operation. It houses great equipment, has an optimal workflow and has a group of employees that have proven they can deliver results. With Paragraph operations now under our wing for 2 quarters, the Graf-Pak closure and consolidation complete and a growing backlog, we are confident that our experienced management team and committed employees will work through their ailments quickly.
With that, I turn the call over to Francois for a review of the Q2 results.
Thank you, Stewart. Good morning, everyone. I’m very pleased to join Supremex, a dynamic, well-managed and financially strong company. Please turn to Slide number 40. Total revenue was up 14.6% to $71.7 million from $62.5 million last year. Revenue from the Envelope segment rose 7.3% to $49.3 million. The increase reflects a $9.1 million revenue contribution from the acquisition of Royal Envelope, completed last November. Revenue was favorably impacted by an average selling price increase of 33.6% which mainly reflects more favorable customer and product mix in our U.S. operation as well as the year-over-year effect of pricing adjustment made in 2022 to mitigate input cost inflation.
Conversely, volume decreased almost 20% as a result of lower industry demand, as Stewart mentioned. Packaging and Specialty Products segment revenue amounted to $22.4 million, up 34.7% from $16.6 million last year. This increase reflects a $7.8 million contribution from Paragraph, higher e-commerce-related sales and the integration of the Graf-Pak operations in our Lachine facility. These were partially offset by the wind down of the Durabox operations in 2022, reduced demand from certain markets more closely correlated to the economic conditions and the residual effect on sales and inefficiencies from consolidating the folding carton operations in Lachine while integrating Paragraph and Graf-Pak.
Moving on to Slide 41. Consolidated EBITDA was $9.4 million in the second quarter of 2023 versus $13.9 million last year, while adjusted EBITDA amounted to $9.6 million compared to $13.9 million a year ago. As a percentage of revenue, the adjusted EBITDA margin was 13.3%, down from 22.3% last year. Envelope segment adjusted EBITDA totaled $9.7 million compared to $11.6 million last year. This decrease is mainly due to the effect of lower volume and the absorption of fixed costs.
As a percentage of revenue, the adjusted EBITDA margin was 19.6% compared to 25.3% last year. Now in the Packaging and Specialty Products segment, adjusted EBITDA was $1.7 million versus $3.3 million last year. The decrease reflects lower demand from sectors more closely related to the economy that affects fixed cost absorption and the residual effect of inefficiencies from consolidating folding carton activities into Lachine, while integrating acquisitions. As a result, adjusted EBITDA was 7.4% compared to 19.6% for the same period in 2022.
Corporate and unallocated costs were $1.8 million in the second quarter of 2023 compared to $900,000 in 2022. The increase is mainly due to foreign exchange loss and an unfavorable adjustment to stock-based remuneration expenses. Turning to Slide 42. Net earnings reached $2.1 million or $0.08 per share versus $7.4 million or $0.22 [ph] per share last year.
Adjusted net earnings amounted to $2.2 million or $0.09 per share in the second quarter of 2023 versus $7.4 million or $0.28 per share a year ago. Moving on to cash flow on Slide 43. Despite lower profitability, net cash flows from operating activities remained solid, amounting to $10 million in Q2 2023 compared to $10.4 million last year, mainly due to a positive cash stream from working capital. For the same reason, free cash flow held relatively steady at $9.8 million in Q2 2023 compared to $10.2 million a year ago.
In the quarter, we used our cash flow to finance the acquisition of Graf-Pak and proceed with net repayments of $3.1 million on our revolving credit facility. We also returned an aggregate of $2.1 million to shareholders through dividend payments and the repurchase of 56,700 common shares.
Looking at our financial position on Slide 44. Total debt was reduced to $78.2 million as of June 30, 2023, from $81.4 million as of March 31, reflecting the aforementioned debt repayment. Net debt which excludes deferred financing costs and cash, stood at $76.9 million. As a result, our net debt to trailing 12-month adjusted EBITDA ratio was 1.3x as of June 30, 2023, versus 1.2x 3 months earlier. At the end of the quarter, we had $43 million in available liquidity under our senior secured revolving credit facility of $120 million, leaving us sufficient flexibility to finance our investments and operations.
Finally, the Board of Directors declared a dividend — a quarterly dividend of $0.035 per common share payable on September 22, 2023 to shareholders of record at the close of business on September 7.
I turn the call back to Stewart for the outlook. Stewart?
Thank you, Francois. Although disappointed with the Q2 results, we remain bullish with what the future holds for Supremex as we methodically build the business for the long term. Our strategy is simple: leverage our capacity, know-how and cash flow in Envelope to fund the pivot to packaging. We are both product and geographically diversified and we operate in 2 segments that we have positioned for sustainable success. In envelope, we are the second largest manufacturer in North America, yet our market share is only about 7% to 8% in the U.S. market.
After developing our brand in stock and bolton [ph] statement envelopes, we positioned ourselves as a leader in the vast U.S. direct mail market with the Royal Envelope acquisition. We now stand firmly in all 3 of the major segments in the envelope market, offering a broader than ever product portfolio to meet market demand. In Packaging, paper-based solutions have market favor as CPG companies are increasingly turning to sustainable, eco-friendly packaging. In this segment, we are solidly rooted in the high value-added verticals of pharma, health and beauty, food and e-commerce.
We are very pleased with the integration progress of our 3 most recent acquisitions. The softness in Q2 was definitely not related to integration issues. With the seamless transition of Graf-Pak’s operations, our short-term priority is to leverage the now even greater potential from Lachine’s impressive platform. As the adage goes, potential is a great thing to have but a bad thing to keep. And be assured, we have added resources and refocused management’s attention to Lachine with a mandate and a sense of urgency to quickly evaluate and execute on optimization initiatives and capture all available benefits.
In parallel, our continued solid financial position despite the soft quarter allows us to consider further expanding our scope in packaging. Having reached an optimal size in Quebec, our eyes are set on new territories, either in Ontario or in the U.S. regions, where we already have a presence to continue and grow and benefit from natural synergies. With a current run rate of 70% and 30%, we are still aiming to achieve a 50-50 balance between envelope and packaging. That said and in keeping with our conservative nature, while the acquired companies are performing well and in line with expectations in the current market conditions, in acquiring 5 locations in less than 7 months, we’ve bit off a substantial amount and our first priority is to have all operations performing to our standards. In a nutshell and I want to be clear on this point, the fundamentals of our 2 segments have not changed but we expect the current market reset and conditions to ebb later in the quarter. Our solid reputation and diversification should allow us to emerge from this demand reset ahead of the market in general and our strong management team will have the Lachine facility at stronger operating efficiency levels in Q3.
Meanwhile, on the cost side, we have repeatedly proven that we can tightly manage our expenses. In closing, despite the results, I want to thank the entire Supremex team for providing superior service no matter what the market conditions are. Their talent and dedication will bring us success as we carry out the strategy.
This concludes our prepared remarks. We’d now be pleased to answer any questions you may have.
[Operator Instructions] Our first question is from Matthew Lee from Canaccord Genuity.
So just on the envelope side here, it looks like volumes are down about 35% on an organic basis. Can you maybe just help us break down between the inflation impact on mailing and the impact of destocking, how that kind of splits? And then how much of that you expect to unwind in Q3?
Yes, sure, Matt. We appreciate it. I think one thing with the envelope business, we look at the 6 months. We had an incredible — the year-to-date numbers. We had an incredible Q1 on the envelope side that surprised a lot of people. We signaled that the market had started to turn in late Q4 and into Q1. And on that basis, I mean, we are ahead of the market decline. I think it’s really a temporary ebb. The fundamentals of the market haven’t changed. And for all of 2022 and the beginning of 2023, the envelope market had a voracious appetite as the industry and we just couldn’t make enough envelopes. And to our point earlier, the overstocking and — was a result of panic buying, paper supply was tight. So people bought more to ensure they had enough. This made supply even tighter and so on and so forth. Small businesses that buy their envelopes through printers, weren’t mailing more and USPS didn’t see a spike, yet demand was through the roof for the envelope manufacturers.
And I often say, nobody cares about envelopes until they don’t have any. And it was the fear of not having any that really drove the market. I guess the most succinct which is not my strong point, way of saying it is, our situation on resell envelopes was exactly what happened in toilet paper in Covid. At some point, people realized they weren’t using more and the supply was way more consistent than they thought it was going to be. So they just stopped buying until their linen closets were empty. And then they just — they restocked stuff. So that’s exactly what happened and about as succinct as I can be on this destocking. But any — the interest in inflation, like a lot of companies, there are a lot of industries, we were impacted by it. We’re susceptible to macroeconomic conditions. And while most people or the casual observer wouldn’t naturally equate elasticity between envelopes and interest rates and inflation. But I hope I did a decent job explaining sort of the nuances of charitable giving and that — in my comments but — and I tried to provide some real-life examples.
And the not-for-profit solicitation business is massive in the U.S. and really drives a lot of that, what we classify as direct mail. And when they sneeze, the industry catches a cold. And they sneezed in Q1 as inflation sort of took hold and the residual effects through Q2. And the envelopes used in not-for-profit solicitations are made on the exact same equipment that those in statements are made on. So if that market dries up, the manufacturers naturally turn their attention to other markets and you’ve got more capacity chasing the same or less volume. So that’s kind of the dynamics of it. And the 3 of them, the confluence of the 3 of them and coming off a super hot 2022, makes the comp a bugger. And you got the 3 things play [ph] at once. If we didn’t have destocking and we just had the economic conditions, nobody would have noticed. Nobody would have known. But the combination of the macroeconomics, inflation and interest rates, sort of squeeze in direct mail and others, along with the destocking, it was just something that we couldn’t overcome from a volume standpoint.
Great. That’s great color. And then maybe when I think about Q3, I think Q1 volumes were up 3%, Q2 volumes were down 20% in terms of reported. Is Q3 double-digit decline? Or is that going to improve from the Q2 number?
Yes. So I mean, I tried to provide a little bit of color with the comments. But the short answer is yes and we have tangible evidence that it’s improving. Going back to my toilet paper analogy, as long as you continue to use it, eventually you’ll have to start to rebuy. And that’s something — unless something has fundamentally changed, you’ll start buying at the same rate with the same cadence. And we have no evidence that the small business that buys 5,000 envelopes from their local printers have changed their mailing patterns. And as a result, the printers have to continue to buy from the resellers and the resellers will have to start to buy from us. We expect the resellers start work to reorder as they work through their inventories. And in fact, the backlogs for stock envelopes have improved considerably.
And anecdotally, just last night, the Senior VP responsible for envelopes at our largest U.S. customer sent an e-mail to myself and Joe Baglione, who’s the President of the Envelope division. And the subject line simply said, replenishment orders are coming tomorrow. He knows we’ve been anxious and it’s really hurt us. I was with him 3 weeks ago and said we dedicate a sizable portion of our capacity to you. You were clamoring for more all of 2022. We delivered more to you in all of 2022 and into the beginning of 2023. You want us there for you when the industry bounces back. What are we supposed to do when you bought less than 50% in the first half of the year while you destocked? And it was a rhetorical question, because I knew you couldn’t really do anything about it. But we were buoyed just last night, literally last night, replenishment stock orders are coming today — or tomorrow, sorry, meaning today.
And on the direct mail side, as I said in my comments, not-for-profits and credit card solicitations, they just can’t stay out of the mail forever. Mail is a proven effective mode to attract new customers and attract donations. It’s the heartbeat of the revenue streams and may have overheads. I mean there is evidence that they’re sort of awakening from a 3- to 4-month slumber. And again, anecdotally, on the direct mail side, our largest customer went from 20 million units a month roughly, for about 3 years, $20 million a month, $20 million a month, $20 million a month to just over half of that in Q2. But in July, we produced $27 million for them and mailing plan for August is $25 million. So it doesn’t mean we’re out of it but the signs are all there. It’s positive. The market just can’t stay — the market didn’t drop 25% fundamentally for overnight. And as I said, it really hurts when you get destocking and the macroeconomic conditions in the same quarter. I hope that helps.
The next question is from Ahmad Shaath with Beacon Securities.
Stewart and team. I guess maybe switching gears on the packaging side, maybe give us a little bit of a color of how the demand environment is looking there. And what can you attribute relatively this in the quarter had there not been any duration issues or challenges in Lachine.
Yes, Ahmad. I don’t want to jump ahead on the question but I do think it’s important and maybe I’m splitting hairs a little bit here but I would like to distinguish between integration and commissioning. They’re 2 different things. It’s Royal, Paragraph and Graf-Pak to a lesser extent. They were affected by the macroeconomic conditions but becoming part of Supremex wasn’t any of the challenges that they faced. So the acquisition, I mean, the synergies we pulled out of Royal in just 3 or 4 months has been incredible. It’s hard to see on the EBITDA line because of all of the other things that are going on. But that integration has gone fantastic. And then Paragraph, it’s — we’ve moved some orders around.
We’ve taken advantage of more efficient equipment, the people have been good but there’s a lot that goes into buying a $30 million 2-facility operation and that created some distraction for the management team on the packaging side. So the integrations themselves are going well. What’s bumpy and way bumpier than sort of I expected and that I think it should have been, is the — just this commissioning of the new facility. So — and then on the demand side in packaging, everything I talked about on the envelope side is virtually the same in packaging. The destocking to a lower degree but we do have customers that are overstocked, either they bought too much or their sales have slowed, so they’re taking it less.
We do a lot of make and ship and we have no visibility on what the customers — how their inventory is depleting and they just replenish later, a month later, 2 months later or at a lower quantity. And the order intake slowed in that regard. We do a lot of vendor management for customers as well and this will maybe talk about what happened in the quarter but more importantly, what’s — what the future looks like. We have forecasts, we plan around those forecasts. We get approvals to produce off of their forecast before we go to press. And they started to, they started to cut back on the call-off quantities in Q1. We ship just in time.
We know in real time what’s happening and have some visibility and we could see what was coming in some of those segments. Like envelope, we’re seeing the same dynamics, customers are coming out of slumber so they’re becoming more bullish for Q3 and Q4. And the relationship between overstocking and — in the Health and Beauty segment, our products are purchased with our customers’ products that we serve are purchased with discretionary dollars. Our largest — second largest customer, I guess now, in the health and beauty side and I think you know who it is. Our main product with them is professional hair salon products that go to professional hair salons. So, now you’ve got $8 butter and you’ve got $6 milk and you got your mortgage rate is going up.
I think people are waiting longer before they go back to the professional salon. Instead of monthly, maybe they’re going every 6 weeks or instead of every couple of months, they go quarterly. And we’re just a bit of a victim of that and we didn’t have enough time to sort of reconstitute or to develop enough new business to backfill that. And those customers expect us to be there when things swing back. So — and then — so we didn’t have enough absorption in the plant and labor is another problem. Again, we all know how tough labor is and customers expect us to be able to turn on the tap when they want us to. Our shareholders expect us to be able to drive revenue and we need labor to make those products. And we had a dip in demand, we generally bring orders forward from inventory and produce to inventory but our warehouses are full.
So we kept people employed and maintained productivity and get absorption but our warehouses were full and we just, we did maintenance and we forced vacations but there was very little relief for the P&L in the quarter. Yes, we believe it’s temporary and we’re reengaging and talking to customers. But in Q2, we just didn’t have enough levers to pull to overcome destocking and sort of a general slowing economy for discretionary items. Does that help?
No, that’s great color, Stewart. So is it fair to say from what I just heard from your comments, looking into Q3, Q4, second half of the year, the dynamic in the Packaging is similar to what we’ve heard from you earlier on the envelope side? Or are customers still more gun shy in terms of orders for the second half?
No. So our backlog in Lachine is extremely strong right now for August and into September. A month or 2 doesn’t make a quarter or a trend. But yes, we’re seeing more activity. We know that those vendor-managed inventories, the forecasts are stronger for Q3 and Q4 than they were in Q1 and Q2. So the aggregate effect of that is — should be helpful. And just triggering ahead to that, looking at the inefficiencies in the Lachine facility, I mean, as I said, it’s not really integration. It’s move-related and it’s no one thing. It’s been a bit of a confluence of things. And it’s generally the same people running the same equipment and they’ll get there. We took management with other facilities and to evaluate equipment and spread them pretty thin. And just the combination of weak backlogs, new environment, equipment not running quite as efficiently as it was. We know from experience that whether you move a machine halfway around the globe or you move it 6 kilometers, it’s going to take time before it functions like it did in the previous facility, whether it’s the same people running it or not. And that’s exactly what we’re experiencing.
But we sort of see every day that it’s better and we’ve now hired people at Paragraph that allows the sort of a local management team to spend more time in the Lachine facility and being there to help troubleshoot issues or make decisions or frankly, push the guys a little bit harder. I mean it’s not hard to imagine that if backlogs are weak, taking a little bit longer to set up every job. It’s kind of human nature and it requires management to be Johnny on the spot and to be pushing that and they just — they weren’t there.
[Operator Instructions] This concludes the question-and-answer session. I’d like to turn the conference back over to Stewart Emerson for any closing remarks.
Thank you very much, Operator and thank you to everybody that’s on the call this morning. We really appreciate your interest in Supremex. And while we were disappointed with the quarter, we’re still very bullish on where we are, what we are and we look forward to speaking to you at our next quarterly call. Thank you very much.
This concludes today’s conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.