Input Capital is an agricultural streaming company dedicated to farmers in western Canada. The company has 81M shares outstanding and 7.9M options with current market cap of $155M. The company had $28M cash and $6.8M in current liabilities as of December 31, 2016. The company generated $11.7M in cash from streaming sales with an 84% cash operating margin in the recent quarter, announced yesterday. You can find more on company’s website.

The accounting standards imposed by IFRS on Input Capital use some very involved and complicated derivative accounting that sometimes obscures the economic reality of the company. I am keen to understand it better, so I had a conversation with Mr. Brad Farquhar, CFO and Director, about the results. As always, I picked up on some interesting comments that I am happy to share with you below. 

PB: Hello Brad, thanks for taking my call today. Let’s talk about those first quarter results for fiscal 2017.

BF: In a way, there are no surprises here since we provide operational updates at the beginning of each quarter. That is, 10 days into the quarter, we provide an update on the prior quarter. From that initial release to now, we tend to see minor adjustments. There could be a change from an accounting rule or more tonnes coming in after the quarterly operation update deadline. Usually, we see a few more things added to the final results.  

BF: For this quarter, we initially announced $12M in deployment. The final number came in at $12.5M. We announced 15 contracts, and the number is actually 17. We announced canola sales of 22,500 tonnes, and the number is almost 25,000 tonnes. All slight revisions upwards from the numbers that were previously put out.

BF: We are quite pleased with the results. We had adjusted streaming sales of $11.7M and deployment of $12.5M. We are at a point where canola sales are close to funding deployment. It’s not going to happen every quarter, but it is getting close.

BF: We are, however, at a point where our existing resources -- our cash flow and our revolver -- will certainly fund our growth plan. That's an exciting stage for any company to be at, where you can grow at 25% or so with internally-generated resources. To not have to go back to the market and face the potential of selling equity at prices you don’t like or not being able to get any capital at all. We really like the spot we are in now and are preparing for a great period of growth here.  

BF: One thing that investors have been wondering about for some time is progress on collections associated with bad accounts. There is not really much news to report from Q1. We continue to deal with prospective buyers of the land that we previously received as part of a foreclosure process and are working to get a sale in place by this spring. That's an ongoing project. You will notice that, in this announcement, we do have an agreement for sale of land that we previously got last fall from a farmer as part of a partial buy-down of a streaming contract. That's still subject to the removal of some conditions, but it is scheduled to close on April 1st and will mark some good progress on land sales. Moving those assets held for sale off the balance sheet and turning them into cash.

BF: All in all, good quarter. My focus, as CFO, is often on a number of non-IFRS measures that get summarized in the second part of the news release. Across the board, I am happy with how things are going. We have increased the number of streams from 77 to 121. That is a good, solid increase in the number of streams.

BF: The streams we have done in the last 18 months or 2 years are just rock solid -- low levels of counterparty risk, high levels of security, and no production or delivery issues. We are really happy with the evolution that has taken place in the portfolio with this move to what we often call “smaller contracts”. 

BF: Sometimes the contracts are smaller in nominal terms, but other times it just means they are smaller in relative terms to the size of the farm. If you were a banker, you would know what I mean when I say the "canola stream servicing ratio" as something similar to a debt service ratio on a loan. Those sort of ratios are all nicely in hand on the contracts we have done in the last two years. We are very pleased with that as we think it sets a good trajectory for us, going forward.

PB: I noticed average size of streams, based on total canola reserves versus number of streams, has come down significantly.

BF: Think back to the first year or two -- the average deal size was over $2M. Today, that number is well below $1M and continues to decline. That doesn’t mean we won't do any more multi-million dollar deals, we will just do them with fewer farmers. The farmer must have the scale to really support a large deal like that.

PB: There are so many ratios and ways to come at the data you have here.

BF: It's true, you can slice and dice 'till the cows come home.

BF: One of the things that I am sure I will get questions about, because the other Directors asked me about it, is the appearance of a decline in sales and other figures when you compare this quarter to the one last year. As you and I have talked about, this business does not lend itself well to quarter-quarter comparisons. Harvest delays in October, as we saw this year, can easily push some tonnes into the next quarter. It doesn’t mean we won’t receive those tonnes, it just means that they will come in on a slightly different time frame.

BF: We are very pleased with how our sales have gone. Last year was so extraordinary that it basically inflated our numbers and made us look amazing at that time. Now, it makes us look a little worse today, but this year is far more typical of the pace at which canola will get sold; probably half of expected volume will come through from harvest to Christmas period, and the other half in the after-Christmas period.

PB: There were some numbers that seemed to suggest to me that the costs are getting better for you. Looking at the trailing 12 month numbers --$24M in sales this quarter against $5M in purchase and direct expenses is significantly more efficient than the year before where you had $50M in sales and almost $20M in expenses. Any comment on all that?

BF: Some of the purchase and other direct expenses are crop payments. So, part of that line is a function of the line above it. The more sales we do, the higher are the expenses. Part of that expense also comes down to a mix of which tonnes we have sold from which contract and whether they had a big crop payment or a small payment associated with it. As we discussed before, those numbers do move around a bit from deal to deal with different farmers.

BF: We are starting to get some good scale. We have talked before about how there is little need to add more people. Part of my report to the Board covered our G&A budget. We are nicely under where we thought we would be. Keep in mind, we are often doing things for the first time or the second time. We can't look back at 5 years of data and predict a trajectory from that experience. I'm happy to see that expenses are coming in below where we estimated -- it makes me feel good about how we can plan, going forward.

PB: I noticed a line item that corporate expenses around $1.5M, whereas prior quarters were around $1.0M. Note #12 in the financial statements.

BF: Part of that was driven by collection costs and an increase in office expenses. We hired a significant number of people in the quarter ended March 31, 2016. In the next quarter, you will see that gap between last year and this year start to close for salaries and office expenses.

PB: And that $200,000 for collection seemed pretty clear.

BF: Yes. If we had an employee number in here, then you would see that we were a lot smaller a year ago. We have added five or six new people in 2016.

PB: I noticed the contract renewals is a significant number this year.

BF: Yes, and I think that is going to continue. I appreciate the fact that farmers are willing to come back and do more business with us. It means they are having a good experience, which has always been a question: people have asked, "Are you going to be one and done?" Well, it sure doesn’t look like it.

PB: Can we expect any additional info around the farmers who did renew?

BF: No, we cannot provide a lot of colour around that. It is usually a combination of expansion opportunities or a farmer who started with a really small deal and now sees the benefit of a streaming contract. Some farmers find that the deal they had with Input has worked well and they figure that they can do a bit more with us, for a variety of reasons. It may be that fertilizer is on sale and they need to act now, or it could be that their tractor blew up. A streaming contract provides farmers a way to pay for their tractor with canola. For farmers, Input is just a way to pay for things with canola

PB: As you mentioned in our last interview, no grain trader will underwrite five years of production.

BF: And then pay you in advance! That's really what is getting farmer's attention. They say "You're going to give me a deposit for that, too?" It's pretty unique from their perspective.

PB: There seemed to be a few points where I was curious about what was going on with the upfront payments versus the delivery payments. We have discussed that before and you said how you are seeing variety from contract to contract as farmers want different amounts upfront versus at delivery. 

BF: Page 3 of the MD&A is a good reference for the upfront payment per tonne. It used to be called 'cost per tonne acquired' but we have renamed it and think this is more user-friendly. That has gone down from $310 to $217. I think that trajectory is going to continue. We see a growing demand for deals from farmers with smaller upfront payments and larger crop payments. We like that. We think, ultimately, that is a better place for both the client and us. Frankly, it is a lot closer to the way a metal stream works.

BF: The way a metal stream is designed -- the philosophy of how that number is established for payment at delivery -- is such that the payment is approximately the cash cost for producing that marginal ounce. The streaming company is effectively reimbursing the operator of the mine for producing that ounce and then keeping the profit from that ounce.

BF: As we move to larger crop payments, from $60 or $70/tonne to something that could be over $100, we start to get a lot closer to the farmer's cash cost of production. That means the rest of their farm does not have to subsidize the production of anything they provide to us in the year of production. That sets us up for good sustainability.

PB: That is a very interesting development. I always wondered how the farmers would feel about selling at a loss, relative to their costs.

BF: Well, it could become an issue. Especially if the farmer was unable to use the upfront payment to generate other returns by buying fertilizer cheap or helping increase yield on other crops. That stuff should work, but it will not work every year. The farmer may be better off over the entire lifecycle of the deal, but may end up worse off in one particular year. We want to move farmers away from that circumstance towards a place where they will be equally or better off in all years. We want them to be at least as well off in each year and paying them the cost of production helps achieve that.

PB: My sense was that it is hard for farmers to endure the year where they are worse off, especially because they may still have to pay you out of proceeds from other crops.  Designing the contract to ensure that farmers always cover their costs just makes the deals all the more bulletproof.

BF: Yes.

PB: Very exciting. Pretty sure you just mentioned the idea of a Pareto improvement there, Brad. That's a first and I certainly look forward to talking more about that another time. I noticed the figures included $8M of upfront payments in two streaming contracts that are not yet finalized. Any comments on that?

BF: There are some closing conditions in those deals that haven't been satisfied yet, but we had announced the deployment and wanted to reflect the deployment number here.

PB: It would seem to me that if you didn’t have that capital deployment, then the total deployment number for the quarter would look pretty low.

BF: Yes, it would be a lot lower.

PB: And those are fairly big contracts, as well.

BF: Yes. In particular, there is one that is quite large and the other is more typical. I can't get into a lot of details because there are few farms of that size and we want to respect their privacy. I can't give you a lot of detail there right now, but hope to be able to give more info in due course.

PB: I wonder what the analysts might do with that.I suspect that some might exclude that amount from their calculations and how that may throw things off.

BF: Well, that would be up to them. Of course, if they don’t count it now, then they will have to count it next time. This is the prime-time quarter, right now.

PB: The quarter that we are in now, which we don’t have results for yet.

BF: Yes. There are still almost two months to go until the end of this quarter and a lot of things happen for us in February, March, and even April. It will be interesting to see what comes across the line by March 31st.

PB: We've talked about this stuff before -- how an analyst might look at these numbers and whether they should expect to see half of the $50M deployment complete so far.

BF: The way we look at it is as follows. If our deployment is roughly 3 quarters, running from October to June, then we would expect do about 25% in the first quarter, 50% in the second quarter, and 25% in the third quarter. Considering our objective of $50M, 25% of that is $12.5M, which is about where we are. We are tracking nicely for our objective.

BF: When we look back to a year ago, our deployment was $6.6M. We are roughly double where we were last year. Last year our total deployment was $25M and we are trying to deploy twice that this year. So far, we are double where we were and are on track with our plans for where we want to get to this fiscal year. We think it is fully achievable.

PB: I see it in the MD&A that it has $4.5M in deployment. It doesn’t have that extra $7.9M.

BF: Everything you see in those tables ties back to the accounting, rather than the extra $8M of deployment that was announced but not formally in the accounting. The way I see that, with the extra conditions that need to be removed, the number is large enough that it is material, so it needed to be announced. If we were buying an office tower as a public company -- you would have to announce that, even if it didn’t close for 6 months. We've done this deal and now we are going to work to close it.

PB: There was one mention of liabilities in the news release of $7.3M. That's not the revolver -- curious what that is.

BF: That is accounts payable -- it includes upfront payments to farmers where the deal is done and closed, but the monies haven't advanced as of December 31st. It also includes any crop payments payable on deliveries that took place in December where the payment hasn’t yet been made.

PB: There are a variety of ways to look at profitability here, too. The revenue was lower this year at $10M versus $22M last year, but the purchase and direct expenses were even lower and the company seemed to be in a better position. Then, the net income number came in much lower. Any comments?

BF: Part of that goes back to last year, when we had a large percentage of revenue from canola trading. Canola trading doesn’t add much to the bottom line. Note #10 in the financial statements breaks down the revenue from streaming contracts versus canola trading. You can see that we had $7M of revenue from canola trading last year, but it only added $27,000 to the bottom line. We did a lot less of that in this quarter, but made three-times as much money on it.

BF: Of course, we also lost canola sales in October because harvest ground to a halt after we had that foot of snow on Thanksgiving weekend. 

PB: I sent out a couple tweets right away, but deleted them because I didn’t have the comments quite right. The dividend announcement was very easy for me to wrap my head around, but these financial statements requires me to put on my thinking cap a bit more.

BF: My recommendation for you or any analyst is to know that the income statement is complicated by the mark-to-market and revenue-recognition policies under IFRS. The non-IFRS measures in the MD&A are more simple and clear. We try to do a good summary of those in the front part and then give the reconciliation in the back part.

PB: Bottom line -- my sense was that the cash flow situation bore out the reality of the dividend starting up recently.

BF: Follow the money!

BF: Here's the interesting thing from the cash flow statement: net increase in cash was $11.5M, but revenue was $10.6M. Our cash flow was better than our revenue this quarter. That's partly because of the strange ways revenue is recognized.

PB: How much of that is attributable to grain trading?

BF: To some extent. The revenue number includes $1.5M in trading that added only $75,000 to the bottom line. There was a bunch of stuff that any farmer would call revenue and we would, colloquially, call revenue that certainly adds to cash flow, but is not recognized by IFRS as revenue -- it's treated as negative expense and gets buried in the net cash settlement of canola interest in Note 11. There is $2.7M of flows that most people would call revenue, but is not considered revenue by the accounting standard. That's what causes cash flow to be greater than revenue, which doesn’t sound normal.

PB: I saw something weird like that and I tried to tweet it, but I couldn’t quite get it right.

BF: It's the reason why the income statement is not terribly helpful to truly understand the business. From a management perspective, what we use to track our business is our non-IFRS measures, not the income statement. Read pages 3 and then 17+ of the MD&A.

PB: The MD&A was very comprehensive, I was happy to see that.

BF: There are lots of great numbers there that are expressed and understood in the ways that normal people think.

PB: Yes, but there will still be volatility in these numbers.

BF: We will always have challenges with comparisons one quarter at a time. The twelve month trailing numbers on page five of the MD&A help a bit. As we get more size, each contract's uniqueness will contribute less and less to lumpiness, overall. That will help our numbers normalize within some standard ranges that people will get used to.

PB: The heterogeneity among contracts must be an analyst's nightmare when there is a small set of contracts.

BF: I expect to see things like cash operating margin per tonne, cash margin per tonne, upfront payment per tonne all come down as we see more contracts with smaller upfront payments. Then, crop payments will go up as a result.

BF: The beauty of that is we end up with less cash at risk, the same or better IRR returns, and better security.

PB: And it occurs to me that you don’t have to pay for tonnes that aren't delivered.

BF: Correct. It will all help keep more farmers current and greatly reduce the risks to us from a default perspective.

PB: You've had individual defaults, but isn’t there still the risk of a regional collapse in production?

BF: That's the beauty of crop insurance. Crop insurance steps in and keeps the farmer whole. We get paid first because we have an assignment of those crop insurance payments. We settle-out what the farmer owes us, send any excess crop insurance on to the farmer, and we are ready for next year. Show me a mining stream with insurance.

PB: Doesn't happen! I’ve never heard of mine insurance, at least not with government subsidies. That effectively means that you will get your forecast production levels in years where there is some catastrophic decline in production.

BF: Yes. Even today, we saw some crop insurance cheques come in where the farmer had already delivered all of his obligation to us. So, we just sent the money along to them. It just passes through our books and doesn’t have any impact, but it shows that we are standing ahead of the farmer on those crop insurance payouts.

PB: Quite literally. I would imagine that it engenders some goodwill on their part to you. The magic of financial engineering that they could have paid their obligations to you, and still see some payments from the government.

PB: Well, thanks again for taking the time to chat with me, Brad. I look forward to an even more detailed discussion of the financials someday and picking your brain about contract design to make farmers better in every year. Great stuff, thank you.

BF: You’re welcome, Peter.