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Executives

Jeffery Goldberger - KCSA Strategic Communications

Norbert Sporns - Director, CEO and President

Jean-Pierre Dallaire - Financial Controller and CFO

Analysts

Colin Guheen - Cowen & Company

Tony Brenner - Roth Capital Partners

HQ Sustainable Maritime Industries, Inc. (HQS) Q3 2008 Earnings Call Transcript November 10, 2008 4:30 PM ET

Operator

Good afternoon, my name is Erika and I will be your conference operator. At this time, I would like to welcome everyone to the HQ Sustainable Third Quarter 2008 Earnings Conference Call.

All lines have been placed on mute to prevent any background noise, after the speakers' remarks there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Goldberger, you may begin your conference.

Jeffery Goldberger

Thank you Erika, good day everyone and welcome to HQ Sustainable third quarter conference call. For the period ended September 30, 2008. Again, my name is Jeffery Goldberger and I am KCSA Strategic Communication Investor Relations [consultates] U.S.

With us today are Mr. Norbert Sporns, President and Chief Executive Officer; Mr. Jean-Pierre Dallaire, Chief Financial Officer, and Eugene Hill, Executive Vice President of Finance.

Before, we get started I would like to remind our listeners that managements prepared remarks in this call contained forward-looking statements that are subject to risk and uncertainties and management may make additional forward-looking statements in response to your questions. Therefore the company claims the protection of Safe Harbor for forward-looking statements that has contained in Private Securities Litigation Reform Act of 1995. Actual results may differ from those discussed today due to such risk as but not limited to fluctuation and customer demand, management of rapid growth, intensity of competition from other providers of aqua culture products, general economic conditions, geopolitical events and regulatory changes and other information detailed from time to time in the Company's filings or future filings with the SEC.

Although, the company believes that expectations contained in such forward-looking statements that are reasonable there could be no assurance that these expectations will prove to be correct. Any projections as to the Company’s future performance represents management estimates as of today November 10, 2008 and HQ Sustainable assumes no obligation to update this projection to the future as market conditions change.

With those comments complete, it's now my pleasure to turn the call over to Norbert Sporns.

Norbert Sporns

Thank you, Jeffery, and welcome everyone to HQ Sustainable third quarter conference call. While many of you are familiar with HQS, I would like to also welcome any new investors and prospective investors. Before, Jean-Pierre takes you through a detailed review of our financial results I would like to offer an update on our business and provide some context to I believe both this quarter and last quarter are representative of the strength of our business model.

Based in Seattle Washington HQ Sustainable and integrated agriculture and aquatic product processing company with significant operations based in the Island province of Hainan, in the South China Sea. We sell our agriculture health and bio products in markets around the globe to diverse array of consumers. Before reviewing the highlights of quarter I would like to offer some general comments on the current global financial turmoil and how it affects HQS or may affect us in the future.

Simply put I believe that HQS is in a good position to benefit from the current recessionary conditions, with our tilapia products we offer the market and affordable dietary option high in quality protein.

We strongly believe that savvy consumers will continue to gravitate to worth our products as an alternative to low quality less healthy fast-food and more expensive and less convenient family-style restaurants, we offer an attractive middle ground in an unstable market. I should also note that our customer and vendor relationships remain strong and we are non-experiencing any significant receivables problems.

We attribute this to our strategy to shift majority of our sales directly to the customer and I suppose to working through third party purveyors. We have found to these buyers to be extremely responsive timely payers. We are very closed to having our entire customer base consist of direct sales.

The global financial [atevo] has been especially difficult on consumer oriented companies. We view the situation as an opportunity to separate ourselves from herd. While many companies choose to reduce their marketing expense during these times, HQS is strategically expanding our branding effort and pushing into new regions. We are focusing on what we see as a strong growth opportunity, it could developed a line of ready to eat meals which positions tilapia as the main protein component.

We expect to in produce our ready to eat meals in club stores in U.S. and Canada over the next six months. It's very important role out is being managed by Bryan Gent our recently appointed Vice President of Product Development. Prior to joining us, Brian served as a Regional Sales Manager for Aqua Star Seafood and also served as Senior Vice President of Sales for Club Marketing Services, where he worked directly with the corporate president managing annual divisional sales for its Club stores, with the budget of $125 million.

We are confident that this effort is in very capable hands. We are also making strong strides to improve our communications programs. In addition to being in the process of relaunching our corporate website, we have recently retained KCSA strategic commutations that helps us improve our shareholder communications and expand our shareholder base. We have recognize a need for transparency and even greater -- is even greater during the bearer market as quality investments become few and far between.

With this in mind, we are working diligently to improve the quality of information we provide to the investment community. We have also worked to bolster our finance department to help us more effectively model our business and to provide an additional avenue through which analyst can gain important insight into our business.

To that end, we have recently appointed Eugene Hill, Vice President of Finance. Eugene brings to HQS more than two decades of financial services experience serving in various roles including Interim Chief Financial Officer or Treasurer for several mid to large cap publicly traded companies. We understand and embrace the importance of transparent and consistent communication with investors and our confidence aforementioned actions will go a long way in supporting this effort.

Internal research as well as numerous independent agencies continue to point to a global decline in ocean caught fish, which in turn in causing major retailers and fast food outlets to seek more secure, stable alternative sources. HQS has been working diligently to position itself to meet the inevitable increase in demand. We have taken steps to increase our production and to better control our costs.

As you know, we have recently expanded our capacity at our aquaculture plant to increase production from 20,000 to 30,000 metric tons live weight flow through. Ultimately, we are working to become a vertically integrated protein producer and aim to become the [Tyson Foods] of this niche market.

Presently, we do not see any serious competition in the vertically integrated aquaculture marketplace, partly result of the fragmented nature of the industry, and we intend to exploit this void.

Now, to some quick comments on our quarter and results that, I believe, are a good indication of the strength of our company. This quarter represents the best third quarter in our company’s history, which is the direct result of the expanded capacity at our aquaculture plant.

During the third quarter, we achieved revenues of $22.4 million, up 42% from the third quarter of 2007. Gross profit in the third quarter of 2008 was $9.5 million, up 23% from the third quarter of 2003.

Our net income increased substantially to $5.6 million in the third quarter, up 62% from the same quarter a year ago. Sales of our aquatic remains strong and we have seen a 47% improvement in this quarter when compared to the comparable period in 2007. To add to our already strong sales growth, we made significant progress with regard to establishing solid relationships within the fast food industry during the quarter.

Currently we are selling a new line of organic products to the major retailer in Mexico. But as is the case with some of our major customers we have prohibited from naming the specifics retailers at this time. As these developments will likely hate us in fostering even more solid relationships we are working with these customers to allow us to make these announcements in the near future.

During the third quarters result of the slowing of the economy in China we had to lower the prices on our health and bio products. The volume and price levels in China are not quite what we expected to see. And we were unable to achieve the same level as of profit as we have had in previous year's. That said we expect to see the situation correct itself overtime. As we push to expand our products throughout the region and implement a more aggressive marketing strategy.

While sales of our bio and healthcare products improved by 34% compared to the third quarter of 2007, our gross profit ratio from this ratio fell from 84% in the three months period of 2007 to 80% for the three months ended September 30, 2008.

This reduction in the gross profit ratio is due to a sales mix that occurred in 2008 as higher levels of products carrying lesser gross profit was sold in 2008. We have still been aggressive with our sales efforts and we have actually improved our marketing penetration.

In terms of construction updates, several series wireless systems have come through Hainan which have delayed our feedmill construction, but these delays are in the order of two or three weeks and are not substantial. We are attempting to make up for these days -- our delays, our crews are working day and night wherever possible. But it is likely that we will be slightly delayed in finishing the feedmill with completion expected in the first quarter of 2009.

Once complete, this mill will supply both our cooperative farmers as well as other regional farmers. We are in the process of completing the organic certification of our tilapia to the USDA or US Department of Aquaculture standards, and hope to complete this process by the end of the year. We are, however, cognizant of the fact that the growth of this product may be slower than recession than that of our block and club stores tilapia mill products due to higher prices. Before turning the call over to Jean Pierre for a review of our financials, I would like to provide some additional insights into our operations. It is important that investors understands that we will continue to make strategic investments in our business as we grow. In the short-term as illustrated in the second quarter, these investments make cause a drag on results but ultimately position us to succeed in the long run.

HQS is in a growth mode, and as such, we will not hesitate to make investments that support our long-term prospects and take advantage of the consolidation which is currently under way in the secret products industry. As investors may know, we recently filed the registration statement in order to provide us with the flexibility to make a strategic acquisition should the right situation present itself.

For example, we have seen considerable consolidation throughout the industry and may seek to acquire ponds following positive results from a recently conducted feasibility study.

While we have not yet achieved a level of profitability that we know that we are capable of, we see a number of factors that are in our favor. Some of these factors are out of our control that will very likely work to our advantage, such as reduction in energy and commodity costs.

However, we’re also working to increase the sales of our organic products through the marketing initiatives discussed earlier, and we will reap increase cost savings from our direct sales model.

I would now like to turn things over to Jean-Pierre, who will present more detailed financial results for the third quarter. Jean-Pierre?

Jean-Pierre Dallaire

Thank you, Norbert. I would like to begin by stating that the financial results discussed during our call refer to EBITDA which is a non-GAAP financial measurement. The press release issued earlier today contains reconciliations of EBITDA to net income.

As Norbert comments, we are very pleased with our results from the quarter, having significant growth in our revenues, gross profit and EBITDA. Total sales for the three months period ended September 30th, 2008 increased by 42% from $15.8 million in 2007 to $22.5 million in 2008.

Our Aquaculture Product segment experienced strong sales growth of 47% during the current quarter of 2008, increasing to $15.1 million compared to $10.3 million for the corresponding period of 2007. Our Marine Bio and Healthcare segment realized sales of $7.4 million in the current quarter, compared to $5.5 million in the same period of 2007, an increase of 34%.

Total gross profit for the current quarter increased by 23% to $9.5 million compared to $7.7 million in the same period of 2007. While gross profit increased, the overall gross profit ratio decreased to 42% during the quarter, compared to 49% for the same period last year.

The reduction in the gross profit ratio originates mostly from increased manufacturing costs in the aquatic product segment as a continuation of the same factors at the previous quarter combined with a different sales mix in the healthcare products segment.

The gross profit ratios were 24% and 31% for the aquatic product segment in the three months period of 2008 and 2007, respectively, while the gross profit ratio for the marine bio and healthcare products segments was 80% and 84% for the three months period of 2008 and 2007, respectively.

Operating income for the quarter increased from $5.2 million in 2007 to $6.5 million in 2008, an increase of 25%, mostly due to an increase of sales and related gross profit. Our increased sales also resulted in the substantial increase in net income of $5.6 million or $0.43 per diluted share in the current quarter, compared from net income to $3.5 million or $0.38 per diluted share corresponding period of 2007, after considering an increase of more than 42% in the weighted number of diluted shares in the current period.

The aquatic product segment contributed $2.7 million to our net income in the current quarter compared to net income of $2.2 million for the corresponding period of 2007. The health and bio products segment contributed to $4.5 million to our net income in the current quarter of 2008 compared to $3 million in 2007.

A reduction in financing cost and elimination of tax rate for aquaculture product segment also contributed to the increase in net income in the third quarter of 2008 compared to the corresponding period of 2007.

EBITDA reached $7.1 million in the third quarter of 2008 compared to $5.5 million in the third quarter of 2007. Finance cost decreased to $60,000 from $897,000 for the three months ended September 30th, 2008 compared to 2007, as a result of the phasing out of the amortization effect of conversion of warrants and conversion option on debentures issued in 2006.

For the nine months – for the first nine months of 2008, total sales were $46.2 million, up 24% from $37.2 million in the corresponding period of 2007. About 73% of the increase in sales came from increased sales for the aquaculture products segment.

Gross profit for the first nine months of 2008 increased to $18.4 million compared to $16.9 million in 2007.

The gross profit ratio was 39.7% in 2008, compared to 45.2% for the corresponding period of 2007. Operating income decreased to $7.4 million in 2008 from $8.1 million in 2007, mostly due to an increased contribution to gross profit from both of our business segments, offset by increased general and administrative expenses from all segments.

Net income increased to $3.6 million or $0.29 per diluted share in the first nine months of 2008, compared to $2.7 million or $0.34 per diluted share in the corresponding period of 2007. Although the net income from operations decreased in 2008 compared to 2007, the reduction in financing costs and overall income taxes contributed to increased in net income for the year in 2008.

Now for the balance sheet. As of September 30, 2008, we had cash and cash equivalence of $49.9 million, an increase of $3 million or 6% compared to $46.9 million at December 31, 2007. Our current assets were $79.8 million in September 30, 2008, up from $72.4 million at the end of 2007. Long-term debt consisted of $5.2 million of outstanding convertible promise [renotes] net of discount, which mature in November 2009.

Shareholders equity was $81.2 million at the end of September 2008, showing an increase of 18% from $68.8 million at end of 2007. As of September 30, 2008 working capital was $71 million compared to $61.5 million at December 31, 2007.

The funds generated by the operating activities during 2008 were used mainly to support the increase in our business volume or specifically our receivables and inventories level.

Norbert Sporns

Thank you, Jean-Pierre. In summary, we believe that we are at a crucial point in the growth of our company. When consumer’s examine their spending habits in light of current economic conditions, we will be in a position to reap the rewards of their more selective choices. While China is showing some softness, we are continuing to make in roads with our health products there. These products are still in demand and are certified by the Central Government to the highest standards, which serves to differentiate us from more than 85% of our competitors.

I would like to thank everyone for their participation on today's call. It is our goal to become United States largest vertically integrated aqua culture and aquatic product processing company, and we will continue to innovate and find ways to do business in today’s global marketplace.

With that I, John-Pierre and Eugene will be happy to answer your questions.

Question-and-Answer Session

(Operator Instructions). Your first question comes from the line of Colin Guheen with Cowen & Company.

Colin Guheen - Cowen & Company

Hi, good afternoon gentlemen.

Norbert Sporns

Hi Colin.

Colin Guheen - Cowen & Company

First question, on the pricing environment during quarter, could you characterize it kind of by month and which way -- directionally which way it moved during the quarter and which its moved to first four weeks of the fourth quarter?

Norbert Sporns

Well, the products that the aquaculture products generally the top line sales price has been rising during -- continue to rise during the early part of the third quarter, solidified during the end of the quarter and we are seeing early signs of it coming down as costs come down as a result of reduced feed cost and energy costs the new environment that we are in, there is a bit of a lag in the filter through the system of reduced feed components as the feed mills empty their stock and the farmers are in to new feed which is less expensive, but we are seeing the cost of fish come down as a result of reduced feed and energy cost. Also the Mainland Chinese situation is more normal, the production in Mainland China is fully engaged and is having its effect on the marketplace.

Colin Guheen - Cowen & Company

If I remember the third quarter there is some sort of pricing squeeze almost where you were buying the fish, doing inflationary pricing time where you already locked in price it would be with the buyer, so could this benefit you on the flip side here as we see move down and fill up your prices?

Norbert Sporns

It does. Yes, it was not doing the third it was more in the second quarter we experienced this wave of new buyers who were suddenly available as the results of the absence of product from the places they were traditionally sourcing and Mainland China because of the weather freeze. And we were able to consolidate our hold on these buyers through the second quarter at a certain costs that was mentioned in my prepared remarks. However, this strategy, I think, was a sound one without knowing that the world we go into a recession, we have tremendous group of investors now who are very strong and very interested in our value added products so the new lines additional certified and value added products and -- of course these are excellent payers. There have been anecdotal accounts of failures in other -- of the second tier buyers to be able to honor payments and problems with delivery, and fortunately we are not victim to any of that. So we view the second quarter as an important transition in putting our company in a situation now we are as close to being recession proof, I guess, as we could be.

Colin Guheen - Cowen & Company

I have a -- question on brining on the new processing plant, and it seems to be that, that -- when exactly will that be online from a revenue perspective? Is it fair to assume that late 2009 -- early 2010 is a more of a realistic timeframe?

Norbert Sporns

Yes, that would be an accurate statement. I think the current situation with the new processing plan is that, there are three things which are impacting us regarding that plant. One is, we have seen in the market place because of the consolidation in the world market towards – companies have benefited from all the levels of certification that we have in away from companies that, that don’t have those additional certificate patients that are some of the plants in Hainan, for example, who have been closed at least temporarily as result of problems associated with their clientele payment to Russia and those types of concerns. As result of this, there are some acquisition opportunities which may provide more immediate benefits to the company, should we pursue than building a Greenfield plant.

Secondly, what we are seining -- we are currently in the final stages of dealing with major block buyers -- block tilapia buyers. This is a new product in the marketplace; currently most block is made from ocean caught fish particularly Pollock. Pollock code is -- our looking quite soft, I don’t know the way this forecast for the next -- new ear but everything indicates a further reduction which will bring total Pollock productions far below where the demand is. And as a result the gap needs to be filled by another product preferably an aquaculture product preferably tilapia. As a result of these negotiations, we are expecting this to receive substantial orders in the new year for block production new year and beyond for block production, and if we configure our plan too quickly to the wrong type of future production, we will have a problem that we have to address at later times. So, because we are a matter of couple of weeks -- a few weeks from completing this process we’ve decided to hold off on the construction of that new plant until we know the exact parameters of this new opportunity, which we should receive before years’ end.

The third factor of note is that construction material costs are reducing every week. In China, as generally cost comes down and any delay in fact plays in our favor because we are able to acquire construction materials at lower cost. But all of this is temporary and we expect to be on line to complete within the period you’ve mentioned.

Colin Guheen - Cowen & Company

And then lastly, your comments on the pond ownership, would you actually be buying ponds from current farmers and that the follow up to that -- would you be nervous making acquisition, I guess, on a year where revenues have really peaked for the pond farmers versus the 7-8-year history that they have been in business?

Norbert Sporns

The strategy here would be to build new ponds. We have received a feasibility study which showed a couple of things; one is that it is extremely profitable for us to get in to the farming but not in the way -- it would not be the same profitability if we would simply acquire existing ponds.

What’s important here is that the industrial -- the overview of aquaculture farming approaching as an industry -- from an industrial production approach as oppose to the sort of a cottage industry approach where one farmer has two or three ponds and we are contracting with a group of farmers through these cooperatives organized from -- through various rural groupings in the co-operative structure.

The more industrial approach requires laying out ponds in a larger grid pattern, allowing us the mechanical selection of fish -- small, medium and large fish in different ponds, to provide exactly the size of which required by our large high-end direct buyers. And as a result of this, we were able to introduce efficiencies, which currently are not out there, allowing us to turn ponds over three-times a year as oppose to two-times a year. That’s possible with this more industrial approach, with better feed, better fry breeding techniques as well as this mechanical selection.

So, this is a new approach in Hainan. No one is doing it currently and requires investment in new pond infrastructure, which would build the ponds to this better more industrial configuration. We have begun testing the three months – the three-time per year turnover rate on the new configuration with some ponds that we have selected on a test basis, which will allow us to complete our analysis and provide us with the inside we need to make the final determination.

Colin Guheen - Cowen & Company

Great. Thank you very much.

Jean-Pierre Dallaire

Thanks.

Norbert Sporns

My pleasure.

Operator

Your next question comes from the line of Tony Brenner with Roth Capital Partners.

Tony Brenner - Roth Capital Partners

Hi. And just following up on the ponds’ topic. Now that you have decided in order to pursue that particular method, what sort of timing is involved in the beginning of construction of ponds?

Norbert Sporns

Well, we haven’t completed. I mean, we have the initial feasibility study and we are in the process of doing a test. The results of the test will give us a result within the next three to six months, which will guide us on the opportunity of phasing in direct ownership of ponds. But it certainly is highly profitability for us to do it. In addition to the added revenues from the ponds themselves, there are tremendous synergies. We have buyers currently that are asking for very small fillet or a very large fillet. And the way the ponds are set up currently each part of this has – as although the average weight is about a pound live weight per fish, we are getting fish of varying sizes, not sufficient, looks very smaller or sufficient very large sizes to easily supply very important buyers, who are asking either a for a very large fillet or very small fillet. And without this industrial approach, it’s difficult to service these very important clients.

We also have greater efficiencies at certain sizes that allow us, for example, in a more cost-effective way to assemble blocks using fish coming from ponds that have been harvested three times a year as oppose to two times a year. So, all of this is pushing us in a very positive direction. But, we will not make a final determination for at least another quarter and we’ll share that with you in subsequent conference calls.

Tony Brenner - Roth Capital Partners

You recently filed a shelf registration or an 8-K for a shelf offering up to $12 million. Does that – are those money is your mark for pond construction? And if so, what’s the significance of the $12 million?

Norbert Sporns

Well, the shelf registration is for a block of shares currently with the market value of about $12 million. It’s not our intention to use that in the near future. We have it available, given the opportunities that are out there currently, not only for pond, new ponds building, construction, but also for potential acquisitions of existing processing plants. We see there to be tremendous consolidation going not only in our aquaculture sector but also in the seafood industry.

I just attended in Qingdao Global Aquaculture Alliance Meetings where this was voiced by several speakers that there is a consolidation that’s ongoing. The winners will get stronger and others will fall by the way side. And we consider ourselves in the former category and expect to benefit from the decisions we’ve made, some of which were caused a little bit of a speed bump as we saw in the second quarter, but are very positive for the company’s growth in the longer term.

So, that shelf operating is there as an additional support moving forward, but we will only use it if we see there is an accretive advantage to using it, and we don’t expect to need it for sometime. Certainly we are not planning to use in the current, at the current share price.

Tony Brenner - Roth Capital Partners

Do you have an estimate of what it might cost to construct deposit that you are contemplating?

Norbert Sporns

We do have a -- in order to produce 40,000 metric tons live weight of tilapia, we would require an investment of some US $50 million to US $60 million.

Tony Brenner - Roth Capital Partners

With respect to the club store business that we’ll begin in ‘09 will that be watch it under the tilapia brand?

Norbert Sporns

We have developed a new brand for this -- for these purposes I don’t want to share with you the name right, because we are still in the process of detecting the intellectual property of that. But in line with marketing practices in North America for organic products there we have given it a different name which is closer to the kind of naming framework that the club stores like, and we expect -- we were hoping that we could roll it out before the year-end but in order to do it properly we need to have a range of products and the range has required more in depth testing. We expect there is club stores and large retail stores. I am very anxious to take the product because there is really very little in the way fish filet products available in these meal concepts.

And there are more and more buyers looking for that as the impact of recession -- forces people to look at other options than going to the restaurant or eating out in fast food, joints instead of taking home meals that are prepared with a bit more taste and better for your -- more healthy. We believe that will be a big winner moving through the next few months.

Tony Brenner - Roth Capital Partners

Last question. Finance expense in the quarter was considerably less than I think the earlier guidance is this now a reasonable run rate for finance expense going forward?

Jean-Pierre Dallaire

Actually during the quarter the total amortization and non-cash cost and interest expense is were up about to 200,000 but they were netted against the interest income that we made on the cash that we have on hand, so this is why we are down at 60,000. So the run rate is basically 200,000 a quarter until September minus an interest income that we will make on the cash that we have hand. So, 60,000 is a fair number.

Tony Brenner - Roth Capital Partners

Thank you.

Norbert Sporns

Thank you, Tony.

Operator

(Operator Instructions). There are no further questions at this time. Do you have any closing remarks?

Norbert Sporns

I sure would like to thank everyone. I believe that we always have been on the right track I think that the second quarter was a transition period that we can see now in the third quarter as given us the impetus to move forward. I think we have necessary components to keep the company on track in the months coming forward. And I invite investors to familiarize themselves with the services of Eugene Hill who is here with us today; our new VP Finance who is there to help you understand our Company more fully.

Thank you very much to everyone.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: HQ Sustainable Maritime Industries, Inc. Q3 2008 Earnings Call Transcript

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