Covalon Technologies Ltd.

Thank you, Mariana. My name is Danny Brannagan and as Covalon’s Chief Financial Officer, I would like to thank everyone for taking the time this morning to attend our conference call.

We will be discussing the financial statements, MD&A and press release related to Covalon's third quarter ended June 30, 2019. There will be an opportunity for you to ask questions at the end of our call.

Before we begin the discussion, I would like to remind participants that this call is covered by Covalon's Safe Harbor statement. Certain statements included on this conference call may be considered forward-looking.

Such statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements, to be materially different from those implied by our statements. And therefore, these statements should not be taken as guarantees of future performance or results.

All forward-looking statements are based on management's current beliefs, assumptions and information currently available to us and related to anticipated financial performance, business prospects, partnership opportunities, strategies, regulatory developments, market acceptance and future commitments among other things. Participants on this conference call are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this conference call.

Due to risks and uncertainties, including those identified by Covalon in its public security filings, actual events may differ materially from current expectations. Covalon disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

For the third quarter ended June 30, 2019, Covalon's total revenue was $6.9 million, the net loss of approximately $3.5 million or $0.16 per share. This compares to the prior year's third quarter, which saw total revenue of approximately $7.9 million and a net income of approximately $2.2 million or $0.09 per share.

Operating expenses increased for the third quarter to 7.3 million, compared to 4.3 million for the same period of the prior year. The overall gross margin for the third quarter was 59%, compared to 82% in the third quarter of the prior year.

The increase in expenses during the quarter, mainly related to the AquaGuard acquisition and costs associated with running that business which were not included in the comparative period. For the nine months ended June 30, 2019, Covalon's total revenue was 27.4 million for the net loss of approximately 5.6 million or $0.25 per share.

This compares to the prior year's comparative period, which saw a total revenue of 20 million and a net income of 2.2 million or $0.10 per share. Operating expenses increased to 22.8 million, compared to 13.1 million in 2018.

The overall gross margin for the nine months decreased to 65% compared to 77% in 2018. The revenue and gross margin in the comparative periods included an upfront payment of US$3.5 million related to a licensing agreement with a major medical device company.

And there was no similar license fee in the quarter ended June 30, 2019. I would now like to turn the call over to Covalon's CEO, Brian Pedlar.

Thanks Danny, for the review of our third quarter results and good morning fellow investors. Thank you for joining Danny and I on this call.

So last night, we released our third quarter results. We also issued a press release in July, that discussed a number of business items, in an attempt to keep investors up to date.

And we issued a press release recently about a private placement. So I'm going to try and provide some insight into our business and our results to-date.

The first area I'm going to address under that is revenue. But before I dive into that, I want to make some comments about the overall state of our business because I think it's very important for investors to understand the bigger picture.

Now I talked to a lot of investors every week, and without exception, they asked me to share my views on Covalon's business prospects, both as CEO and a fellow investor. And in my opinion, the overall state of our business is strong.

Why do I say that? Well, we have diversified our revenue, which was part of our goals over the last 12 months.

So we are no longer reliant on a single market for success, as we were in the past. We've begun to open up new lucrative channels for our world class products in new markets like Latin America.

And I believe that the intrinsic value or underlying value of our business today is massively stronger than it was 12 or 24 months ago. And it's my view that the true value of Covalon is not at all fairly reflected in our current market gap.

And I know many shareholders I talked to feel the same way. Many companies like us have lumpy revenue and thinly traded stocks, and they suffer from market exaggerations, and that is what I think is happening to us at present.

In my view, our share price is volatile, and is influenced based on events that really do not reflect the underlying value of the company. This is difficult for some investors to accept, and others see this as a great opportunity.

As is typical with many companies, including many in the healthcare field, our lumpy revenue model makes it difficult to accurately estimate revenue in any given quarter or even between quarters. This is very typical to businesses like ours.

And this also means that bottom line profits and losses are lumpy as is cash flow. Outside of our direct sales channel to hospitals in the United States, almost all of our product revenue consists of distributing bulk shipments.

And these result in uneven revenue recognition quarter-to-quarter and depending on when the orders are placed, when they're shipped to distributors and when they're delivered to hospitals, they impact our revenue recognition. Even as Danny pointed out our license revenues, from our own OEM business, which is thriving and very strong are lumpy.

And we are not always able to control the timing of shipments or the resulting revenue recognition under license deals. As a result, looking at Covalon from quarter-to-quarter and trying to project our future performance is quite frankly difficult.

As we disclosed in our press release of July 25th, and in our Q3 press release and MD&A, our Q3 results were affected by the timing of shipments related to our contracted Saudi Arabian business. This largely drove our bottom-line loss and a lower than anticipated revenue this quarter.

There have been a number of developments in the Middle East since we were awarded the latest set of competitive contracts. Several developments are external to Covalon and we all read the papers and know the ongoing political issues between Canada and Saudi Arabia.

But Saudi Arabia is a market that operates differently than North America. And as a result, we are required to engage a local agent to deal directly with customers and the health authorities.

This removes us from the direct and daily contact with the ultimate customers, unlike in the United States, where our sales team are in hospitals on a daily basis. The situation in Saudi Arabia makes it difficult for us to monitor product usage in hospitals, which is a key component in understanding product volumes in the market.

It also means that we are reliant on our local agent's insights into the market. And there are also other countries and markets in addition to Saudi Arabia that fall under these set of contracts, and they have a completely different ordering system.

So that combined with the fact that we've had some personnel changes on our team focused on the Middle East, that particular change has given us the opportunity to have some fresh eyes on the market. So in the past, we provided future estimates into the value of contracts, supporting our Middle East business.

Given everything that has occurred in the Middle East, going forward, we've decided to discontinue providing any estimates on our future business in Saudi Arabia, and simply report revenue as it is recognized on the contracts. These contracts are in place until at least 2021 and they allow the health authorities the right to order Covalon products under the contract, basically when they want and in the volume quantities that they want.

Now, I know a number of investors would like us to provide exact forecast and each future quarter's performance. And many investors I talked to are focused only on the immediate quarter-to-quarter performance.

The result is, I think, that when people do this and look at two back-to-back quarters and try to draw a straight line, it's a very limited and flawed way to look at a business like Covalon, that happens to be lumpy and each quarter is not necessarily reflective of the next. This means a lot of people miss the big picture.

There's a number of -- an overwhelming number actually of investors that have a different view of providing exact forecast and have said to me, I wish you would just let your year-over-year progress and performance speak for itself. So despite our lumpy revenue, our product revenue is actually tracking significantly ahead of last year's third quarter and year-end results.

This was driven by both organic growth within our existing channels and the contribution of our AquaGuard product line. Our sales efforts in the United States through our direct sales force and wound care distribution channels have been growing according to plan.

Our AquaGuard product sales continue to grow and our U.S. team continues to look for opportunities to launch several new products into our direct-to-hospital and our third-party distribution networks.

Year-to-date, approximately 65% of our revenue is from the United States markets. And that covers -- that's across our product sales, our development and consulting and our license and royalty revenue sources.

I think this demonstrates the strength of Covalon's diversification efforts. Couple of years ago, it was tilted much more heavily than 65% into the Middle East.

And so I think we're in much better shape. I think we have a stronger more diverse business than we had in the past.

Now, in one of the press releases recently, we talked about the launch of distribution in Mexico. And we talked about additional products that we had cleared for sale in Chile and Argentina.

And as a result, I anticipate that our Latin American business will begin to materially contribute to revenue over the next year. I got to tell you, we have a very strong distribution channels into several key markets in Latin America and our brand awareness in these key markets is growing rapidly.

We recently received clearance ahead of schedule on our first two products in Brazil and we're working on clearance of 15 other families of products in that country. We also received regulatory clearance on our seventh product family in Mexico, and we've been awarded our first competitive contract in Mexico.

That's a big step for us, although it is a small contract. We recently were awarded our fourth contract in Panama and that was with our ColActive Plus product.

And we've developed a very strong brand awareness in that country. Why do I bring up Panama, it's not the largest market?

Well, there's a market where 18 months ago we had less than 0.5% market share. And I'd say, we're probably pushing close to 50% market share in Panama in wound care today.

There's an example of what can happen when we focus on the market and begin to grow within those markets with really good distribution partners. So as our expanding portfolio products obtains the equivalent regulatory clearance in those Latin American countries.

We believe we can replicate our success that we've had in other markets in Mexico, Brazil, Argentina, Chile and other countries as we compete for contracts. Now, in order to shelter us from the impacts of our lumpy business and the resulting lumpy cash flow that comes as a result, we announced that we were going to close a private placement of up to $6.2 million.

The private placement is proceeding very well and there's actually a significant interest by shareholders in participating. I expect the private placement to close over the next several weeks and we will obviously announce and update shareholders on the close when it happens.

Proceeds of the offering are intended to be used for general working capital to expand our international distribution channels and to develop and commercialize some of the new products in our pipeline. Now our intellectual property knowhow and experience within the four walls of Covalon is truly a strength.

This is something that as an organization, we're very proud of but we protect it vigorously and that we are constantly adding to and improving. We reported that a former sales executive attempted to use confidential information and intellectual property of Covalon for personal gain.

We were successful in obtaining a legal injunction to prohibit that former executive from competing with Covalon, from using our proprietary information and from interfering with our customers and distributors. And we take the protection of our intellectual property very seriously.

And we will always vigorously and aggressively pursue anyone, who we believe is trying to take advantage of Covalon. This isn't just my view, this is a view shared across the company.

And I can assure you that our team is working harder than ever to build our company into a strong player in all of our markets. I am continually amazed and impressed with Covalon's team's ability to innovate, to commercialize and engage with customers and educate them about our world class products and our technology.

I believe the fundamentals of Covalon are very strong. I've said this before on calls and I'll say it again, I can't think of very many examples of companies that have what Covalon has.

We have more FDA cleared products and regulatory cleared products than almost any other company of our size. I think we have more depth of patents and intellectual property across broad platforms that we're leveraging in our business channels.

We have a world class lab, and that lab has the ability to drive new products into the market. Now we have very strong distribution channels, whether we're talking about the United States, Latin America or internationally.

And those channels I believe are poised to scale and grow. So, with that, I'd like to open the line for questions.

I ask that you try to keep your questions to one or two questions. There'll be lots of time to get back into the queue.

So I'll now turn it back over to Mariana to start the question-and-answer period.

Not to harp on the Saudi contracts, it's a big -- it's potentially a big part of the business. And I absolutely understand, I've been doing this long time.

I understand the difficulty of giving guidance and then not having a whole lot of control necessarily over whether you'd hit the guidance. And personally I have experience of dealing with international customers, but I can certainly relate to in a sense.

So, but I'm just trying to get a better sense of where the contract stand. In particular the language that's in the press release this morning, that says these contracts give the health authorities the rights to order Covalon products, they want when they want.

Does that imply that they're under no obligation to buy up to $100 million?

Brian, thanks for your comments. And I know you're very experienced at this.

Look, the contracts, they are in place, nothing has changed from that perspective. I think what we've determined is that we are not given all the moving parts in a position to accurately be able to forecast revenue recognition under these contracts.

And they are supply contracts for consumable medical products that are used within facilities. And as I talked about the way we tend to evaluate these contracts is to, is past history, but also looking at volumes of product use through the channels and we're finding it very difficult in Saudi to do that.

When they were one-year contracts, lot easier. When they were three year, it’s a little more difficult, because product moves year-to-year within the contract.

So, we just -- these contracts are always written in a way where they're never ironclad, no government signs up to contracts for supplies of products that are 100% ironclad. Our change in no longer providing future forecasts is driven simply by the moving parts in the market that are making it more difficult for us to predict when shipments and when revenues recognized.

Okay. So, just if we can think about a sort of a worst case scenario, with the Saudi contracts, if they -- if you just didn't get any more orders at all, the way the rest of your business is structured, and it sounds like for the most part the rest of your business is performing well and I guess as planned, can you reach profitability you think, if you didn't see another dollar from the Saudi contracts?

Absolutely.

Okay. All right, great.

Thanks. I'll jump back in queue.

Thanks, Brian.

Hi, Brian. A follow-up question on the Saudi contract.

Your quarter ended June, into June, have you delivered anything -- any product to the Middle East, since -- in the last two quarters, July-August?

Good questions. But, I think, we're going to wait until we announce our results, to talk about the revenue from those contracts.

I think, we just want to ensure that -- what I said about us no longer providing forecasts, I would view that as a forecast. And we continue to satisfy business in the Middle East under those contracts.

And, as much as the weekend when I was over there, we are continuing to look at new business opportunities. So, we're just not in a position to comment about forecasting future revenue, which if I answered the question you asked would be me doing what I just said, we're no longer doing, so.

Okay. Fair enough.

Second question is really on the PP. Your current stock price is 25%, roughly.

Outside the PP price, has there been any discussions on bringing that closer to the current price?

Dave, a good question. I can tell you, we are very well advised by experts in the capital markets.

And we're following that advice to do the best for all shareholders. Repricing the private placement is not on the table at this point.

But, we're going to continue to follow the advice of our advisors and experts in capital markets on how best to close the private placement.

Okay. Thank you.

Thanks, Dave.

Everybody's always talking so politely. I'm going to speak plainly, Brian.

There seems to be a lot of I and I about this Middle East contract. We had [indiscernible] which was a bust, we had this Middle East, which doesn't sound very promising.

It is to be transformative for Covalon. Phone is ringing off the hook.

And I hear a lot of I and I, a lot of verbal meandering, a lot of this lumpy talk all the time. I’ve held the stock for 19 years, Brian, 9 of which were under your leadership.

I heard three to five years a $1 billion company. Last year, I couldn't make it to your meeting, but I'm sure you didn't mention it.

And this year -- I'm sorry, last year you didn't mention it. This year, I’m sure you didn’t mention, I couldn't make it to the meeting.

So, this is year three, if not year four. What's happening, Brian?

We're not going to live forever. It's taking time.

There's never any really good news. It's always negative news on these announcements.

Your technology is getting older, like people are catching up. I don't understand, like your times must be running out.

Sorry. I don't know what to say.

I'm very, very frustrated. Let's put it that way.

Okay. John, do you want me to comment?

Sure, please.

Okay. So, John, I know you've been long time investor in Covalon.

And you've seen the ups and downs in the business. I think, we've been very clear on the trajectory and path that we're following.

I think, we've been very clear on the progress we've made. When you first invested in Covalon, there was no revenue in the business.

We are now -- have distribution in a number of countries around the world. We have a very strong product set.

We have a very strong set of intellectual property. We have transformed the Company from completely reliant on other people sales channels to have our own through our direct sales within the United States.

We were fortunate enough to beat out huge medical companies for very lucrative contracts and continue to do that, as I’ve talked about, in our new markets in Latin America. And yes, I’m continuously surprised about investors like yourself that look at Covalon and see the glass half empty.

And…

Sorry. Last year -- I'm calling from Middle East right now.

Last year at this time, I was in Middle East, and I like I say, having my espresso. And I happened to look at the stock price, it was $9.40.

This year, same place. I'm looking at it, it's under $2.

So, I'm not looking from quarter-to-quarter…

Hi, guys. Couple on the expense lines.

Relative to G&A, on the Q2 call, I think, you mentioned there were about $1.5 million worth of expenses that were -- I can't remember exactly, what they were attributed to, but they were, I believe, nonrecurring. And I think you mentioned most of those were in G&A.

So, it’s my assumption that we would have seen G&A come down sequentially from Q2 to Q3, it actually went up by about 10%. And then, I'll just lump in the second question here too.

Given that the Saudi contracts are at a lower margin than the rest of your business, with the possibility that the Saudi contracts don't generate as much revenue as we had previously thought, should that improve your margins? I think, you guided to about 65% to 70% margins back on the Q1 call?

Should we now expect to see those margins exceed that guidance?

So, let me answer the first one -- or the second one first. I think, again, our margins are very impacted by product mix and in any given quarter, including -- and that's the -- it happens when you get a lumpy business as well.

But, I think, we've -- we're comfortable with margins in the range that you've mentioned. We -- as far as G&A, we did incur some significant legal expenses and trying to protect our intellectual property, and those came through in the quarter, this particular quarter.

And there's no question, we look at our business, we try to plan, we try to time when our revenue shipments are coming in. And we know that in order to get Covalon to the next rung one of the ladder of success, we need to invest in opening up some markets.

And that means that we get expenses that are sometimes in our operations without -- that are not necessarily tied to today's revenues, but are there to help us build tomorrow's revenues. And so, from a G&A perspective, and sales and marketing, and operations, we -- going forward, we certainly are very cost conscious.

I can tell you, I do not believe in losing money as a business. That's not our intention, that is some business models where it's invest, invest, invest.

That's not ours. And anyone who's followed us for a very long time knows that we're very prudent with what we look at and what we invest in.

And I think, our expenses, we’ll continue to monitor over time to -- and reduce if necessary. But, I think again, one our quarter does not necessarily reflect the go forward views of where I think the business is going.

Okay, great. I appreciate it, Brian.

We didn't talk too much, I didn't ask too much about AquaGuard. And I just wanted to get one question in there.

Can you talk about that business? How it stands today relative to what you were, I guess, anticipating when you were -- when you closed the acquisition?

Has that performed as you had hoped, better, maybe worse? And do you see that improving in terms of the profitability over the next, say 6 to 12 months?

Look, the AquaGuard acquisition, I think was done in bringing an organization and a channel together with Covalon that I find very exciting. I think, it has great synergies with the Covalon product set.

But, we got to remember this was selling into hospitals. And I was speaking with an investor who had a lot of experience selling into hospitals the other day.

And we were commiserating on the fact that, it doesn't matter which business you're in, if you're selling into the hospital market, it just takes a long time. But, once you're in, it scales rapidly.

And once you get going, it scales rapidly. So, with the AquaGuard business, we brought that organization together with Covalon with the intention of creating a very strong channel for ourselves into acute care, into hospitals in the United States.

And I think that’s mission accomplished. Could we do better?

Absolutely. Could it have gone a lot worse?

Absolutely. Overall, I think, it's going very much to plan.

Revenue is growing with the AquaGuard Group, and I see it continuing to grow. And I'm very encouraged with the progress we've made.

And we've done a lot to set that business you, so we can grow with additional products and cover more territory, have more time with clinicians in hospitals, and really be set up to grow that channel and get to the point where the AquaGuard team is now fully part of Covalon. And, not everything operates ever 100% perfectly.

But, I'm really impressed with the team's ability to adapt, and in the position that we're in. So, I'm very, very bullish on our opportunities within the U.S.

market.

All right, great. Thank you.

Great. So, thank you, everyone.

At this point, I’d just like to close with saying that I want to repeat what I said earlier at the beginning. I think, the overall state of Covalon's business is massively stronger than we were 12 and 24 months ago.

I think, from a top-line perspective, very diversified. We have very strong channels.

We're beginning to see some of the returns from our very, very hard work of our team over the past year, and two years actually or more in some of these markets. We're opening up these new markets.

We're seeing traction, we're seeing our brand and our brand recognition climb and improve. And I think it's very true that the value -- the underlying value of Covalon when you look under the covers, is yet to be realized in our market cap.

I'm very excited with where we are. I know, we have some work to do on the bottom-line to return the Company to profitability quarter in, quarter out.

That's Danny’s and my goal. And based on what I see in front of us, it’s absolutely our focus going forward.

And we will get there as soon as we can. So, I'm very encouraged with where we are.

And I like to thank you all for attending the call and having some great questions. Thank you.