NAT Stock

From humble beginnings. When Jason Finnis, a music student at The University of Victoria, began selling hemp t-shirts from the back of a Volkswagon van in 1998, he surely couldn't have known the effect it would ultimately have. After a scientist at the National Research Council of Canada took an interest, Finnis' passion ultimately evolved in Naturally Advanced Technologies (TSXV:NAT), a company that has partnered with apparel giants Levi-Strauss and Hanes. Multinationals see Naturally Advanced's technology as a way to reduce their "cotton footprint" with a cleaner, more reliable flax based alternative. Ken Barker, a textile lifer and executive at Adidas North America, knew the industry's problems from the inside and recognized the significance of what the company had. When Barker decided to leave the safety of corporate America for this Canadian-based startup it received an instant injection of credibility. Now on the verge of commercialization, Barker has assembled a hand-picked team of industry execs to take Naturally Advanced to the next level. Cantech Letter's Nick Waddell sat down with Barker and they were joined by Jay Nalbach, whom Barker recently lured from Adidas, for an in-depth look at where Naturally Advanced is in late 2011, five years after Barker's arrival. Ken, can you take us back to how Naturally Advanced began? Sure, Nick. The company was founded in 1998 as an organic apparel company. Our founders were Jason Finnis and his wife, Larisa Harrison. They started selling hemp t-shirts out of the back of a Volkswagen van when they were at the University of Victoria, studying music. Jason was way ahead if his time, firmly behind the green initiative. We were in that industry before it became fashionable to some of the other big vertical retailers who decided to get in. This was called Hemptown Clothing? Yep, Hemptown Clothing. The National Research Council of Canada were looking at an enzyme process they had developed for the pulp and paper industry and they were wondering what other feed stocks might be applicable to their science. Their lead scientist, Dr. Wing Sun, was firmly of the opinion that hemp was a super crop and besides its phenomenal food value could truly be a fibre that could satisfy a lot of the deficiencies in the natural fibre industry. So, the first work that was done around our patented technology was done towards hemp. When they were looking for commercialization partners what the NRC does is develop technologies and then look for partners to help commercialize them. This is a process that is unheard of, at least from my experience, around the world. So they were looking for partners that had experience in hemp clothing and up pops this little company from Victoria, BC. Wing phoned Jason, they agreed to get together and Jason flew out to meet him in Ottawa. Dr. Sun suggested they should sign a master services agreement that would help fund research on a quarterly basis. If this came to fruition and there was a patent to be had from this technology we would be a beneficiary. So this was how the technology came to be privy to Naturally Advanced Technologies. Interesting. So when did you get involved Ken? I got involved in 2006, I left Adidas America in 2005. My background is in textiles, I have been in apparel my entire career. The latest job I had was the Head of Apparel for Adidas North America. I joined a very good friend who I had met at Adidas, David Howitt, in a business that started helping Adidas licensees understand the brand. During the course of that first year, by chance, we had three startups come to us and say "Can you help us with a business plan? Can you help us with an executive summary, executive placement, can you help us raise capital?" At the end of the first year we realized we had raised $2.5 million dollars. At that point David said to me "We're crazy, we should be doing this formally, why don't we start a small fund and invest where this gap is?" because back then you couldn't get a VC company to write you a cheque if it was for less than $5 million. And there were so many of these little companies that were looking for $300K or $500K, enough to get them over that first hurdle, get revenue started and then value themselves properly. So we raised a small fund with friends and extensions of friends and family and we invested in six companies, and one of them was Naturally Advanced Technologies. We met the CEO and he had met with someone that Jay and I had both worked with at Adidas, Peter Moore. Peter is an industry veteran in the sporting goods industry out of Portland, he is one of the original creative geniuses behind the Air Jordan brand for Nike. Is Portland a mecca for the apparel business because of Nike? Yes. Nike is headquartered there and it attracted everybody into that business. So, Peter suggested that Jerry, the CEO of Naturally Advanced at the time, come and meet with David. After a while I turned to David and said "If this thing is halfway as good as what it could be then it's the Holy Grail." I had just come out of Adidas and we had been looking at bamboo, we had looked at seaweed, we had looked at coconut, we had looked at banana. We had looked at every alternative fibre that we could find that was more sustainable than cotton was, because cotton was starting to rear its head as being publicly known as the most destructive crop that we grow on this planet. That was how I got involved. We invested and I was asked to join the board, given my experience and my background. And after a while I said "You know what guys? I think I'd be up for running the company". I could see what the potential was, I could see it so clearly. So I took over as CEO in the middle of 2006, and I have been running it ever since then. Where is the push coming from financially to explore the potential uses of alternative fibres? Two places. Natural fibres, or cotton, constitute 43% of the apparel business. 57% is polyester. The first push is coming from the consumer. Consumers have been pushing for a sustainable choice as it relates to cotton fabrics. Organic cotton has done some part of satisfying that need up until now, but unfortunately organic cotton is really difficult to grow and you cannot scale it very quickly. Because it is so difficult to grow and is so labour intensive, it grows in most of the third world countries out there, so much so that it is now referred to as "the poverty crop". There is nothing out there that can scale to the level that cotton is currently at in order to be a true alternative. The second push, which is coming from the manufacturing sector, is the volatility in cotton. We saw last year when the supply/demand imbalance went the wrong way and cotton jumped to $2.30 a pound from an average benchmark price of $.65 cents a pound. So if you`re a company like Levi Strauss or Hanes Brands, where virtually all of their production is cotton, well you are exposed. They have no alternative. If you go back and look at The Gap's earnings for the last quarter they reported for the first time that the cascading effect of the increase in cotton prices had affected their margins, and it had affected their margins substantially. They dropped twenty points in value immediately as a result of that. So there is no viable alternative for them to turn to? All the alternatives are man made fibres like polyester and rayon and you can feel the difference straight away. You put 10% of those fibres in a cotton garment and you will know that something is not the same. So for brands that have built their relationship with the feel and the wearability of cotton, it's really difficult to think you could change without upsetting the entire platform that you have built your brand on. Sounds like there are huge motivating factors to find an alternative... Massive. Never mind the sustainability play, just purely from the perspective of minimizing risk. Naturally Advanced is not simply a benefactor of these trends, you have taken a leadership role. Can you tell you a bit about the technology that has gotten you in the door with these giants? Sure. The technology, very simply, is an enzyme process that takes bast fibres such as hemp, flax, jute and kenaf. That's the stalk of vegetable fibres. The lignan that binds those fibres together, just like lignan binds wood fibres together is the source of the problem. In Asia, they have manufactured hemp for centuries, but it goes through a highly caustic soda bath before and then is hand separated and hung before you can start spinning it. And it doesn't spin on regular cotton equipment. Linen is the same. Linen is made from flax, but it is mechanically separated, and then it is spun on special equipment so that you end up with a garment that looks somewhat like a natural fibre, but it has problems. It creases terribly, it shrinks terribly and it has that uneven feel to it because the fibres aren't separate to the individual fibre strands. Our enzyme process removes that lignan completely, and what we end up with is a pure, separate white fibre that spins on existing cotton equipment. That was the first threshold that we had to overcome. You aren't asking the industry to change its infrastructure... Nothing. That was a key requirement of this. Otherwise we would have been a niche industry that sat on the fringes and never got to commercialization scale. It would never be anything that could rival cotton. Frankly, when we started this, we didn't think that we would get down to cotton pricing for probably ten years. And that was why we started with hemp, because hemp was the easiest fibre in the world to grow organically. Hemp grows voraciously, it grows without any pesticides and herbicides, it grows with regular rainfall. It will grow throughout the Canadian Prairies. You can't get cotton to grow any further north than Texas or Georgia, maybe Alabama. So that was a huge advantage. In March of last year, we were running trials for Hanes Brands in Germany with the equipment supplier that was going to supply us with our bulk equipment. At the end of the trial there was some flax lying there from the European harvest and we decided we would run a couple of tons of flax to see what kind of results we got, and the results were unbelievable. It spun better than hemp did because it is finer than hemp. Now keep in mind that we can grow flax all the way down to Georgia and South Carolina, so the issues that we had in the United States with regard to growing hemp were overcome. But most importantly, flax processes twice as efficiently as hemp does. It has a different lignan content to hemp. So we were twice as efficient processing it. We went back with those results and we were given the mandate to see if we could get anywhere close to where the projected price was for cotton going into this year, because cotton was already beginning to show that it was becoming unstable. The benchmark we were given was ninety cents a pound. We never thought cotton would go to over two dollars. I know that partly because of the rise of biofuels, farmland is at a premium. How can the price of flax be more reliable than the price of cotton? Flax grows with regular rainfall, it grows with minimal pesticide or herbicide. The biggest problem is with weeds as it starts to germinate. Cotton is extremely hard to grow. We can grow flax in the winter months in South Carolina. Cotton has too grow in summer months, it needs hot temperatures to germinate. The only thing flax is up against is winter wheat. We're totally counterbalanced to all of the heavy summer crops. For farmers that don't grow winter wheat or don't grow anything, we're an alternative for them to increase the yield on the farmland during the winter months. The other thing is that the yield from flax is so much better than cotton. We can get approximately three tons per acre, where cotton would come in at 500 or 600 pounds per acre. So from that perspective we're more efficient. Another factor is that we grow almost two-million acres of flax for oilseed use between Manitoba, Saskatchewan, and North and South Dakota. The stalk from the process is a byproduct that has no value, it's burnt or it's put in landfills. We can take it, run it through our enzyme processing unit and use it for everything from denim to cotton trouser weights, woven industrial cloth, a multitude of applications. So we're out of the big agricultural cycles, the big crops like corn, cotton , tobacco and soy and canola. Does cotton blend well with flax? Yes, perfectly in fact. It's interesting that you ask that question. We have had discussions with the major brands, and we're talking to every major brand out there. The phrase that they are using is "reduce my cotton footprint" similar to the terminology we heard about carbon around the cleantech movement. What we are giving the industry is a sustainable alternative to cotton with performance advantages. For instance there is an 8% efficiency in dying the fabric because flax uses dye more efficiently. Flax also reduces shrinkage in cotton garments. The fibre is different; cotton has elasticity, flax doesn't, so it binds up the fabric. If someone were to ask me what the single bottom line message that comes through as a result of our technology, funnily enough, it comes down to something as simple as hand feel. For brands that have built their business on cotton, their biggest concern has been that everything they have tried to date, we can tell the difference. How on earth can they get away from cotton when they have built their business on this feel? Clothing can be so much more personal than other purchases. So Ken, how do you start to turn a profit from all this technology and all these partnerships? We have commissioned a 650,000 pound per week facility in Kingstree, South Carolina . We are receiving phenomenal support from local government as well as regional government there. That facility will be ready to start operating in the first quarter of next year, it will hit full scale production in the second quarter and that will start feeding all of the partnerships arrangements that you are seeing starting to come to fruition now. We have signed joint development agreements that simply set the guidelines for how we protect intellectual property and how we would structure commercialization upon successful completion of the development program. There are other companies that we are working with in other individual product categories where we are going straight to sampling and straight to commercialization but what we are doing now is a list of joint development agreements with big brands. We signed a ten year agreement with Hanes Brands in March. We signed an agreement with Georgia-Pacific this month. So we have a succession of these agreements going through the development process, confirming the development potential and then evolving into commercialization. You`ll see that taking place throughout the rest of this year and maybe into the first quarter of next year when that first facility comes onstream. And after that? The second facility should go into one of the Canadian Prairie provinces, either Manitoba or Saskatchewan, by the end of 2012 to take advantage of the crop that is available to us from the oilseed industry there. We then anticipate that if we are to continue on that growth path, which is an organic growth path, one that we can self-manage, we would repeat that every year for the next three years. And that would put us at approximately 3.5 million pounds per week by the end of 2014. We have already run our technology at scale for days on end. Hanes wouldn't sign an agreement with us until we could prove that we could. So we think we have reduced a lot of that technology scale up risk that exists for many companies in our space. Clothing is the first market for your technology, but it`s not the only one. Can you talk about how your technology applies to other areas? Well I should talk about Georgia-Pacific. Georgia-Pacific, as you know, is one of the largest pulp and paper manufacturers in North America. Here we enter the field of non-woven fibres, which are created without spinning, you are weaving it, for example. These are hydro-entangled or needle punched, similar to what you would see in an industrial wipe or a personal care wipe, such as those that remove makeup or baby wipes. These are all part of a fourteen-billion dollar category. That's the first category that we have entered with Georgia-Pacific. Following from that we have been approached by industries that we had no idea we would be applicable to. The first was in the medical industry for disposable gowns and face masks and booties in the OR and in the ER. The second market was as a replacement for cotton in wound dressing, because the key factor to wound healing is keeping the wound dry. This fibre wicks moisture, cotton doesn't. You`ll be able to buy a CRAILAR-cotton blend golf shirt next year that will have better performance characteristics because the CRAILAR will wick sweat. Another industry we have been contacted by is the mattress industry. There are new flame-retardant rules for the mattress industry. They can't use synthetic fibres anymore. There's also the bed and bath market, bath towels, shower curtains, bath mats, sheets and pillow cases. That's a massive category. In the summer months you'd be cooler with sheets that aren't 100% cotton. But, to circle back, I knew as soon as we signed our commercialization agreement with Hanes Brands it would be absolute validation of the technology and confirmation of our ability to satisfy one of the biggest consumers of cotton in the world. Since then it has just been an inundation of calls and inquiries for what we are doing. I guess this is a very important time for you to manage the scale and the scope of what you are doing. Is executing on a lot on these partnerships you have developed, is that something you think about a lot? Constantly. It's my single biggest concern. Under promising and over delivering is the path we have chosen. We have chosen our partners very, very carefully. We make sure that they are partners that satisfy a particular positioning within the category, partners that we can tell an ingredient branding story with. So ours is the Gortex or Intel Inside model. By law, fibre content will be called out but we want to see it called out on the hang tag and, to the best of our ability, to have it transferred either into point of sale, above the line, below the line. There's a great opportunity to tell a brand story here using the strength of our partner's brand messaging. On that basis, given our scale up and given the number of brands we are talking to right now we're happy to provide them with an ability to get out into the marketplace ahead of their competitor in support of an ingredient branding story. There's a balance between what we're able to deliver in terms of volume, which we recognize. We're happy to restrict it, but in return that ingredient branding strategy is key for us, because if done correctly we could be a household word in three to five years time, and that would be 50% of the value on our balance sheet. So that's our key focus. How many employees do you have now? I was just counting coming up on the plane. We`re at twenty-one. Wow, lean. We've been leaner than that! We were at twelve right up until three months ago. We ran this on a shoestring. It sounds by the size of the market you are addressing that if handled correctly you could scale up quite quickly and become a larger company. There is certainly not much about the size of the market that would limit you. .. Yep, I used to be kept awake at night wondering if we would be successful at commercial scale or wondering if there was anything lurking out there that might trip us up. I've seen enough evidence of our product running, not only in our facilities where we`re running the tests as it relates to what it looks like, but now we're having these commercialization partners come in and tell our story back to us without any prompting. So now, what we worry about is making sure we don't over promise anything, make sure we can fulfill the requirements of our partners, and let's do it in a manner that's strategic, so we can get the story out there and position it in the marketplace so that we can create that branding and that halo effect that can pull it through thereafter. And then the execution of the model from a production standpoint is really a plug and play one. Twenty-five to thirty thousand acres will feed one facility, we can put in a facility every six months. Typically these are going into spinning facilities located within thirty to forty miles of our plants. You've just finished a big financing in which you raised $13 million, you have a cash position of just over $12 million. What is your burn rate and when can investors expect to see profits? We're burning about a quarter-million a month right now. We`re about to put in a facility that`s about $13 million in capital expenditures, 70% of that is covered by a local agricultural bank. As soon as that facility comes online we will go cash-flow positive, instantly. We expect that to happen around Q2 of next year. We have a pilot facility down there currently that's capable of doing about 40,000 lbs a week, that will start producing fibre for Hanes, this month. That's not enough to offset our cash burn, but it certainly starts contributing. If we are to grow at the rate I expect, we can service everything on our plate internally. The only question is will the market come at as faster than that. So I keep coming back in my mind to issues of scale, because some of the categories you are entering are gigantic. Could you handle a massive order right now? Some of the analysts that cover us have asked me, "In ten years time, what is your blue-sky figure?" I tell them I categorically believe we could be a five-hundred million dollar company. It's perfectly logical that we could be a billion dollar company. The other discussion that we have had with all of our partners has been around vendor-financed facilities. All these large companies see just how much of a percentage of their business we could be and how do they know that the production in the facility is dedicated for them and that there is no interruption in their supply chain? Because if we are going to be above 20% of anybody's supply chain they want some guarantees. On that basis we have told them we are quite happy if they want to put up the production facility we'll run the technology through it and it will be dedicated to them. And those discussions have been very well received. So I think that if we were to see volumes come at us in excess of what we're able to manage, the first default would be to vendor financing. I think that is a logical way to handle growth beyond what we can currently handle. At that point we would go from being a supply chain partner to a partner, that large company would now be vested in our business. We are very fond of that model and we think it would be worth giving up a couple of margin points in order to not have to finance the facility ourselves.

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