Welcome to the EcoSynthetix 2022 third quarter results conference call. At this time, all participants are in a listen only mode. Following the presentation, we will conduct a question and answer session. Instructions will be provided for you at that time for questions. If anyone has any difficulty hearing the conference, you may press star zero for operator assistance at any time. Listeners are reminded that portions of today's discussion may contain forward-looking statements that reflect current views in respect to future events. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. For more information on EcoSynthetix risks and uncertainties related to these forward-looking statements, please refer to the company's annual information form dated February 24, 2022, which is posted on SEDAR.
This morning's call is being recorded on Thursday, November third, 2022 at 8:30 A.M. Eastern Time. I would now like to turn the call over to Mr. Jeff MacDonald, Chief Executive Officer of EcoSynthetix. Please go ahead, sir.
Thank you. Good morning, and thank you for joining us today. Yesterday afternoon, we released our 2022 third quarter results, which you can find on our website at ecosynthetix.com. You can also download a copy of the slides that accompany today's call from our website or alternatively access them on the webcast. There are positive signs coming out of Q3 with CAD 5 million in revenue or 7% growth compared to Q3 2021, and a new account win in our wet end vertical, which I'll touch on in a moment. At the same time, we're also experiencing unprecedented supply constraints on our primary raw material, corn starch, which continued to impact our results during the quarter.
This morning, I'll run through the highlights of the positive developments, including the progress we've made to diversify our revenue streams beyond the legacy graphic paper vertical and into wood composites, wet end strength aids in paper and paperboard, and personal care applications. I'll also address the drivers behind the raw material supply constraints and the proactive strategies we're using to mitigate that issue to ensure our long-standing customers and key strategic accounts continue to receive our bio-based binders that are an important ingredient in their manufacturing processes. We continue to make progress with our new wet end strength aid. We won a new account with a leading European packaging and paper group during the quarter. This account represents our third win and our largest account in this new vertical. We're marketing our wet end application under the name SurfLock.
One of the key demands it addresses for paper and paper board manufacturers is an economical and effective method to strengthen the fiber at the front end of the manufacturing process. Our polymer has shown its ability to add strength across a range of fiber-based applications. This is particularly important when working with recycled fiber. As fiber is recycled, it becomes shorter and the end product weakens. By restoring strength to these fibers, it allows the paper product manufacturer to use more recycled content, which represents both a sustainability and a cost advantage. Our testing and our experience now with multiple accounts demonstrates that SurfLock consistently improves the strength of the fiber matrix in paper products. Another important attribute is that we have seen no negative effects from SurfLock on the existing chemistries used in the manufacturing process. This enhances the adoption profile for prospects.
SurfLock also minimizes sheet breaks and tissue applications during processing. Finally, we deliver processing speed benefits and reduce energy costs to operate the lines. We continue to demonstrate very strong trial results. Based on my experience with industrial change as well as feedback from our technical partners in Europe, it's rare to see the introduction of a new chemistry yield such strong results across a broad range of applications. Typically, you'd see a new chemistry work in specific target applications and maybe see mixed results in other applications. That hasn't been the case with SurfLock. Our test results have been universally positive. The wet end strength aid vertical opens up a much larger market opportunity to us than the legacy graphic paper application, which continues to face declining demand.
With our SurfLock application, we can now access paper and paperboard verticals that are larger than graphic paper and are growing. These include specialty packaging, so think paper food packaging, container packaging, think corrugated board, as well as sanitary and household applications, so think tissue. These new applications represent more than 45 million tons of annual consumption or approximately 60% of the entire pulp and paper industry, compared to coated graphic paper that represents approximately 6 million tons or 8% of the industry. The wet end strength aid vertical opens up a much larger addressable market for us. In many cases, it's with paper and paperboard accounts where we already have relationships, thanks to our work in the graphic paper vertical.
Transitioning to graphic paper, the accounts that use EcoSphere continue to see value in our offering and continue to buy, although we did see volume declines in the quarter due to the macroeconomic climate. These declines were offset in the quarter by pricing. Our ability to take price and pass through the cost increases related to raw material in the quarter was a result of the pricing dynamics in the market for the petroleum-based binder we replace, SB Latex. SB Latex pricing was running above its historical norms, but more recently, SB Latex pricing has softened. As the market normalizes, we expect to retain our legacy graphic paper business. Over time, we do expect this vertical to represent a smaller and smaller proportion of our overall revenue, given the lack of growth in this vertical.
On the raw materials front, the market is dealing with a perfect storm of a number of issues converging to create supply shortages. The macro challenges impacting broader markets play a role, including inflation and general supply chain challenges. Ukraine is a major producer of corn, and the war has disrupted their ability to contribute their normal volumes to the market. In addition to these issues, Europe's growing season was severely impacted by drought conditions, which led the European Commission to cut its forecast for corn. Finally, a labor strike at a major U.S. Midwest mill has been ongoing for more than two months. As a result of these issues, corn starch markets are very tight, with production below expectations, which is leading to availability issues. Consequently, the price of starch, which usually tracks the price of corn as the primary ingredient, has become disconnected from corn.
Roquette, a global food company and a major producer and user of starch, estimates it is facing 30% lower volumes versus last year, and that it will have no choice but to reduce supply to its customers. When asked about the primary hurdle facing our company, my answer has generally been the pace of change or the rate of adoption in the market. Driving change in well-established markets that use chemistries entrenched for 50+ years is difficult. What we're seeing today is the market moving to us. Major manufacturers and marketers in wood composites, personal care, packaging, and tissue recognize the value our all-natural bio-based resins bring to their supply chains. Today, the primary hurdle is raw material supply. We have managed through these supply issues to date on a hand-to-mouth basis.
During the quarter, supply became available from a primary long-standing supplier, and we've been successful securing supply from a broader range of vendors than in the past. We built inventory during the quarter, investing almost CAD 2 million since the end of Q2. It's expensive inventory and supply lines are long, but we believe it's necessary in the current market. Securing this inventory provided us with sufficient confidence to initiate our first shipments to the new wet end account late in the quarter. Make no mistake, at this stage, we are managing raw material supply, monitoring our margin profile to ensure it remains positive, and balancing the growth opportunities in front of us. In my experience, it's extremely difficult as a commercial operator to recapture margin once you've given price breaks to customers due to higher input pricing. We're not going to write checks with product. It's not responsible.
Instead, we're going to retain customers and grow with new prospects that recognize the value we bring to them while earning a fair margin through this difficult cycle. We have seen some positive developments recently. There were conflicting reports in October that more supply may be available. It's unclear at this point if suppliers are sitting on inventory to retain price. What is certain is that the market is fluid. We will continue to work to secure sufficient supply for our key strategic accounts in new verticals and our long-standing accounts in the legacy paper vertical. As part of a long-term strategy to improve the flexibility of our platform, we are also trialing alternative feedstocks beyond corn starch to give us greater optionality in difficult markets.
As Rob will address in a moment, you can see the impact of the current raw material supply shortages on our margin and the use of cash to build inventory. On the wood composites front, our key strategic account that is backward integrated into a major retailer continues to run steady production volumes. They are working hard and close to their goals to have us fully implemented on the first line by the end of the year, although that may move to the right by a couple of months. Our ability to ramp with them on the first line and expand across other lines they operate and into other suppliers they use is a key component of our growth strategy. Their commitment to our bio-based binder as a path to reduce their reliance on fossil-based binders remains intact.
Sustainability and safety are core to their management philosophy, and their work with our bio-based binder is completely aligned with those goals. Our first major account in wood composites, SWISS KRONO, continues to invest marketing and sales support in their BE.YOND Particle Board. They market BE.YOND as the most environmentally friendly particle board available that delivers the highest indoor air quality. Their leadership team is committed to the product line as a premium offering in the market. We continue to work with their team to expand at other mills as they build demand for their no added formaldehyde offering. On the personal care front, our marketing and development partner, Dow, announced that MaizeCare Clarity Polymer won two prestigious innovation awards. R&D World named it a 2022 R&D 100 Award winner, and Business Intelligence Group, BIG, named it the Sustainability Product of the Year.
These award wins demonstrate the innovation that we and Dow are bringing to the market. Dow is optimistic that 2023 will be another step forward for the product line as they continue to build awareness with formulators and brands. They've had a number of small wins in the market and believe there are larger opportunities ahead. They remain very active in the haircare vertical. At the same time, they're doing more and more development work in new applications where our all-natural film former has performance and consumer preference benefits. This level of activity demonstrates their commitment to making the product successful. Our diversification strategy with multiple shots on goal is working. Wood composites, the wet end strength aids vertical, and personal care are key to our long-term growth. The technology's performance capabilities, value, and its impact on reducing a manufacturer's carbon footprint position us for sustainable success.
With that, I'll turn it over to Rob to review the financials. Rob?
Thanks, Jeff, and good morning. Net sales were CAD 5 million in Q3 2022, up 7% compared to the same period in 2021. The change in net sales was due to higher average selling price, which impacted sales CAD 1.3 million or 28%, which was partially offset by lower volumes, which impacted sales by CAD 1 million or 21%. The higher average selling price this quarter was due to offsetting of significant inflationary pressures with price increases, as well as the continued diversification of the company's product mix. The decrease in volumes during the quarter was due to unfavorable market conditions, primarily in graphic paper and limited feedstock availability due to the challenging supply chain conditions. Gross profit was CAD 1 million in the quarter, a decrease of CAD 70,000 from the prior year period.
The higher average selling price was offset by decrease in sales volumes and higher manufacturing costs. Net of manufacturing depreciation, gross profit as a percentage of sales was 23% in the quarter, compared to 27.8% for the same period in 2021. The impact of higher cost raw materials and logistics impacted margin profile in the quarter. We expect this impact will continue into the fourth quarter and into 2023 based on what we're seeing in the market today. SG&A expenses were CAD 1.1 million in the quarter, a decrease of CAD 250 thousand compared to the same period in 2021. This improvement is primarily due to a reduction in variable compensation compared to the prior year.
R&D expenses were CAD 430 thousand in the quarter, relatively in line with the CAD 480 thousand from the corresponding period in 2021. R&D expense as a percentage of sales was 9% in the quarter, compared to 10% in the same period in 2021. We continue to invest in innovation to improve our value proposition and expand our addressable market opportunities. Adjusted EBITDA loss was CAD 130 thousand in the quarter, which was flat to the same period in 2021. Cash used in operating activities was CAD 2.1 million, compared to cash provided by operating activities of CAD 50 thousand in the prior year period. Our cash used in operating activities changed significantly in the quarter as we invested CAD 1.9 million in additional inventory given the current market dynamics.
As of September thirtieth, 2020, we had CAD 36.9 million in cash and term deposits, compared to CAD 42.2 million as of December thirty-first, 2021. The CAD 5.3 million change was primarily due to an increase in inventory of CAD 2.6 million, an increase in accounts receivable of CAD 600,000, and CAD 1.4 million of cash used to purchase shares through the NCIB since January first, 2022. During the quarter, we invested CAD 440,000 in the NCIB share buybacks for the purchase and cancellation of 133,600 common shares. We have demonstrated our ability to responsibly manage our cash reserves through multiple cycles while continuing to invest in our long-term growth strategy. With that, I'll turn it back to Jeff for closing comments.
Thanks, Rob. The top-line opportunities in front of us remain as strong as ever, especially as we win new wet end accounts like we did in Q3. Our strategy of diversification to achieve greater contributions from our wood composites, personal care, and wet end verticals is working. The diversification is helping to make up for lost ground in graphic paper, with wood composites and the wet end applications poised to be the primary drivers of top-line growth. While the challenges we face on the availability of raw materials and supplying constraints are difficult, we have managed them effectively to date. We're actively engaged in risk mitigation strategies now, should they persist in 2023, including building inventory and broadening our supply base. Our customers rely on us.
They recognize the value proposition, performance, and carbon footprint benefits of our all-natural bio-based binders within their production processes, supply chains, and end products. We are in a great position to deliver long-term sustainable growth. We appreciate the trust and the patience that our shareholders have shown, and I look forward to updating you further on our progress. With that, I'll turn it back to the operator to open up the call for questions.
Thank you.
Thank you. Ladies and gentlemen, we will now begin the question and answer session. Should you have a question, please press star followed by the one on your touch-tone phone. You will hear a three-tone prompt acknowledging your request, and your questions will be pulled in the order they are received. Should you wish to decline from the polling process, please press star followed by the two. If you are using a speakerphone, please lift the handset up before pressing any key. One moment please for your first question. Your first question comes from Meaghen Annett of TD. Please go ahead.
Thank you. Good morning. A nice step-up in revenue here sequentially in the quarter, but the gross margin performance was lower than I would have expected. Assume part of the revenue step-up there is related to the new wet end account. Just on the gross margin, so would that represent a reasonable level for Q4 and 2023? Just any more detail you can provide there would be great.
Good morning, Megan. Thanks for the question. From a gross margin perspective, we definitely had, as we talked about, a lot of supply chain issues, which have continued throughout the year, and also impacted the quarter. Product mix also played a part in the margin decrease during the quarter. As we talked last quarter, we did have a fair bit of backlog built up and the timing of when we accepted some of those orders to the point of when we shipped them, we did see some cost escalation that we were unable to pass on to our customers. You know, as we've moved into the fourth quarter here, we are continuing to see incremental cost escalations.
We're actively trying to address that through some pricing actions, but there are some lags with that. We do expect to potentially see a similar gross margin pressure in Q4, similar to what we've seen in the gross margin in Q3. 2023 is a bit challenging right now to estimate. You know, overall our goal is to have a higher margin than what we saw in the quarter. You know, that's the inflationary pressure that we're still seeing on the starch side in particular right now is making it challenging. You know, we're hoping to see improvement in that market in 2023, which should allow us to restore some of our margins closer to our targets.
On the composition of the inventory balance, is there anything to read into there in terms of forthcoming volumes? Or how much of that is just being driven by higher raw material costs?
It's a mix of, for sure, higher raw materials playing into our inventory balance. We did also receive. It's a lot of timing of inventory. We received access to a fair bit of inventory late in the quarter. In a large, I shouldn't say a large part, but there is a larger percentage than we typically have allocated towards our new account to ensure that we can supply them on a consistent basis, moving into 2023. That inventory in that new customer was started at shipments late in the quarter. We definitely are hoping to see a fair bit of growth from that account. Predicting of which quarter that'll be realized is probably a bit challenging right now for us.
We definitely from a full year perspective expect to see a fair bit of growth from that account. Like I said, a fair bit of our inventory is on the balance sheet at quarter end for that account.
Just a last question here with regards to securing raw materials. So the securing raw materials, so are there any investments you could make with the suppliers maybe to have a more direct relationship going forward? Or anything that you could do in-house within your own facilities in the more near term that might help to mitigate some challenges in accessing raw materials? Thank you.
Thanks, Megan. We've explored, I would say, all possible strategic angles with the raw material suppliers. I think the biggest things that we can do to mitigate this going forward are really on the R&D side to ensure that we have as much optionality as possible across different input materials. That opens up, you know, not only other feedstocks, but a very different supply base in some cases, that we could rely on for at least some of our products. That's where most of our attention has been. I have to say, I guess, unfortunately, the suppliers of the agricultural products that we rely on, it's been very much a commodity relationship so far. We will continue to explore what other strategic angles there may be to collaborate more in the future.
So far, there really aren't any paths there that we see that could help us in the near term.
Thank you.
Yep.
Ladies and gentlemen, once again, if you do have a question, please press star one at this time. The next question comes from Dan Marks of Stonehouse Capital. Please go ahead.
Good morning, gentlemen. Jeff, I wonder, can you give us a little more flavor about this big new wet end account? I think on last quarter's call, you said that it could provide substantial uptick in your volumes and allow you to get pretty close to the targets you set at the beginning of the year. Is that still possible for Q4? Can you give us a little more flavor about that account?
Yeah. Good morning, Dan. Thanks. I think we're pretty late in the year to see a full recovery to our expectations from the start of the year, just given some of the constraints that we faced for the last couple of quarters here. We're really pleased to have a start with this account. If I can characterize it in fairly general terms, 'cause it is, I mean, it's sensitive to both them and us in terms of the advantage that we're offering to them. When we look at an opportunity like them, we consider it's by coincidence only, and I'll explain what I mean there, but an account is an account.
An account at one of these large packaging board mills, and we'll call it a line, represents a very similar revenue opportunity to us as a line in wood composites. It's very different application rates, and it's very different pricing in the two verticals. It just happens to end up being in that sort of CAD 3-5 million range of opportunity. We do see that through our early work with them panning out to be true. That account, again, I don't wanna give away too much of their advantage or who they are, but let's just say that within that account, which is one of the larger ones in the packaging board field, there's somewhere between 10 and 50 lines like this.
I would say that's representative of other large players like them. It's a multiple line opportunity once we get started with an account like this. The thing that's got me and our team, I think, most excited is just the profile of adoption here, given the results that we see early on from trials and the limited impact we have on other parameters within the manufacturing line, and then ultimately their ability to use our product and hopefully now ramp up quite quickly with it. We think this can have quicker results than some of the other markets that simply take longer.
This account could be the same or perhaps greater order of magnitude than your key wood composites account?
Yeah. I would say each one of these packaging board type accounts could be similar in scale for us to the large opportunities we see in wood composites.
Yet it could be you. Obviously, that account, your wood composite account, has been ongoing for, I think, a year since you've press released that you were moving forward. The pace at which this, these accounts, the wood, the wet end accounts can grow is substantially faster than that?
Yeah, for sure. I mean, keep in mind that the journey prior to us announcing that account as commercial in wood composites was quite long in terms of getting to that point, and then even subsequent to continuing to ship to them commercially on an ongoing basis, there's still steps into full implementation with them. It continues to be a step-by-step approach. The implementation of the wet end strength aids by all accounts so far just goes faster. There's less downstream testing required across a range of applications. I mean, that's one factor. I think upstream, just the fact that so far it seems to go into these mills quite easily and work quite quickly.
I think the economic driver, just in that it's offering such substantial savings, has caused it to definitely move faster than what we've seen in wood composites.
Okay. I heard you right in that CAD 3 million-CAD 5 million per line, this entity has somewhere between 10 and 50 lines, and implementation is much faster. Is there any reason why they, with a successful first line, they wouldn't wanna add more lines very quickly?
I can't see any. I think they're very focused on successful implementation on the first line first, and I do think that they're working to maintain their strategic advantage and not saying much more than they need to. Given what's been accomplished, I can't see any reasons why. I guess maybe just to clarify why I used 10-50, that's kind of what we see as a large player in this field. Anybody who's sort of in that range, and they definitely fall within that range. Those obviously are very interesting accounts for us.
Got it. On the last call as well, you told us in addition to this account and the two existing tissue accounts, there were eight more that were in various stages of trialing. Can you tell us what to expect from those accounts over the next quarter or two?
Yeah, we've seen good progress there. I will say that given supply constraints, progress did not go as quickly as we would like. We definitely have had to hold back on some of them. We have advanced some of those trials, though, in the last bit. Going commercial with them, I think is almost entirely reliant on our ability to acquire our raw materials. The table's set for more. I would say the table could have been set for even more if we had greater confidence through the middle of the year on what the raw material supply would look like. It can be a really bad reflection on us as a company if we're seen as, you know, maybe a little R&D entity that's seen on trials, but then has an inability to.
We're pretty careful in, managing, I'll say, our image and how we can work with a customer to get to commercialization quickly. We've been pretty selective here.
Got it. Just reflecting back to the decline of CAD 1 million of volume in Q3, that is attributed. How much of that would be because of your legacy paper, you know, wasn't as just as economical? How much would be you just didn't have enough supply to meet demand?
There's a lot of puts and takes there, and it's influenced, I would say, first and foremost by the two factors you mentioned, but there are more puts and takes to that. I think suffice it to say that through the course of 2022 so far, about 80% we could attribute to a decline in graphic paper demand. Then beyond that, other puts and takes related to supply chain or other smaller opportunities, let's say.
Okay. Last question. I think you mentioned briefly that you're looking at alternative inputs. Are any of those advancing in trials? What can you give us on that?
Yeah. Again, I think I've characterized it this way before, but these are longer term R&D activities that are focused on ensuring that we have optionality for the future. We've done a lot of work, that said. What I just said is true. That said, we did a lot of work in Q3 to advance some of those. Some of those wins are going quite well. But I would say, like, that's not going to change our fortunes next quarter or the quarter after. These are longer term programs that we hope to give us more security of supply in the future.
Gotcha. Sorry, one last item. You had CAD 2.7 million of finished goods inventory, substantially higher than you would normally carry. Is that a case of you just got product at the end of the quarter, and just couldn't get it to customers in time? Should we expect to see that flow into Q4?
Yeah. It's a bit of what you said. Finished product destined, let's say more imminently for existing customers. As Rob mentioned, there's a fair bit of that we have put in place to ensure our ability to supply to this new wet end account. We're a little bit ahead of the curve with them. I think we needed to do that to show them confidence that this wasn't gonna turn on in November and turn off again in December.
Got it. Thanks very much.
Thanks, Dan.
Thank you. Once again, ladies and gentlemen, if you do have a question, please press star one at this time. The next question comes from Gerry Wimmer of Investor File. Please go ahead.
Hi, Jeff.
Hi, Jerry.
Just wanted to pick up on the previous caller's questions in the wet end market. You mentioned now you have three accounts. I assume two of the accounts. Are all three accounts deemed commercial? I guess the most recent account announcement is a much larger mill than the other two.
Yeah. As I mentioned, we've done quite a bit of work across several verticals that use fiber in their production process. Where we got started was in tissue, where we saw a very interesting value proposition on smaller mills. These tissue lines are inherently smaller than these large packaging lines, which is the most recent account we won. The early wins were in tissue, and those have continued to be smaller going concern accounts for us through most of 2022.
Okay. Back to the most recent account, the previous caller, you said they're about anywhere for a large player like them, anywhere from 10 to 50 lines. I guess when you announced that this is a customer, you're comfortable to deliver product them to