Quarterhill Inc

TSX:QTRH

Earnings Call Transcript 2023-Q1

[Operator]

Good morning, and welcome to Quarterhill's Q1 Fiscal 2023 Financial Results Conference Call. On this morning's call, we have John Gillberry, Interim CEO; and John Karnes, Chief Financial Officer. [Operator Instructions]

Earlier this morning, Quarterhill issued a news release announcing its financial results for the 3-month period ended March 31, 2023. This news release, along with the company's MD&A and financial statements, are available on Quarterhill's website and on SEDAR.

Certain matters discussed during today's conference call or answers that may be given to questions could constitute forward-looking statements. Actual results could differ materially from those anticipated. Risk factors that could affect results are detailed in the company's annual information form and other public filings that are available on SEDAR.

During this conference call, Quarterhill will refer to adjusted EBITDA. Adjusted EBITDA does not have any standardized meaning prescribed by IFRS. Please refer to the company's Q1 2023 MD&A for full cautionary notes regarding the use of forward-looking statements and non-IFRS measures.

Finally, please note that all financial information provided is in Canadian dollars, unless otherwise specified.

I will now turn the meeting over to Mr. Gillberry. Please go ahead, sir.

[John Gillberry, Interim CEO]

Thank you, and good morning, everyone, and thank you for joining us on today's call. In terms of the agenda, I'll start with a look at Q1 consolidated and segment highlights as well as some important developments subsequent to quarter end, after which John Karnes will take a look at key financial results, and then we will open it up for questions.

Quarterhill's consolidated revenue in Q1 was $44 million, consolidated adjusted EBITDA was a negative $6.9 million, and cash and equivalents was $51.7 million at quarter-end. Revenue in the ITS segment was up slightly year-over-year, while the segment generated an adjusted EBITDA loss in Q1.

Within ITS, IRD had another strong quarter, exceeding our top line and margin expectations. This was done in what is generally a slower seasonal period for their business. IRD continues to execute well and is adding to its backlog, as recent wins in Illinois and Indiana attest to.

IRD is an ITS leader in enforcement system solutions such as Weigh-in-Motion, vehicle data capture, tire classification, speed and red light cameras and radar and camera technology. These types of solutions are in high demand as they improve road safety and vehicle mobility, and they can be a source of revenue for cash-strapped governments who face widening funding gaps. Overall, IRD is off to a good start in 2023, and we expect this to continue throughout the year.

At ETC, our tolling operations, we made some progress operationally in Q1 and took necessary steps in the quarter to lay the foundation for improved financial performance throughout the remainder of 2023 and beyond. Since assuming the Interim CEO role late in March, along with Rusty Lewis, our new Chair of the Board, we've done a deep dive into this business' ongoing projects and sales pipeline, and we've made good progress in doing so.

As you know, we have several tolling projects in the implementation stage right now, and it's important to note that these projects are moving forward in a constructive way, and our customer relationships are strong.

At a high level, we've had some challenges and are going to have challenges with some of our fixed -- sorry, we've had some challenges and with some of our fixed price arrangements and the contracts that didn't leave enough breathing space when the economy ran into a period of wage and material inflation post pandemic.

We've learned from this experience, and with Rusty's help, we've implemented processes and procedures to avoid these types of situations going forward. To protect our P&L against any further hiccups in the near term, we have taken cost contingencies in the quarter, which John will discuss in more detail in his section.

In 2023, some of our tolling projects and implementation will begin to transition to the operational phase and will be a steady, reliable, higher-margin revenue generator for years to come. Revenue generated in the operations phase of our project has gross margin percentages of approximately double that of the implementation phase. The first of these projects is expected to transition into operations late summer, with another one expected later this year -- late in the year, probably Q4.

These are long-term infrastructure projects with stable and reliable customers that are only in their very early stages. These projects have the potential for significant expansion over the lifespan, and we expect that they will contribute to the health of the business for years to come.

As far as our 2023 financial outlook is concerned, we said in our call in March that we expect the ITS segment to generate a positive adjusted EBITDA in 2023, inclusive of all of Quarterhill's corporate segmented costs. As a reminder, in 2022, that would have resulted in an $11.5 million EBITDA loss, so we are expecting a significant improvement in turnaround here in 2023. And we do expect further improvements in adjusted EBITDA to take place in 2024 as well.

Integrating the ITS business remains a focus of ours and an important part of improving the financial profile of this segment. Our goals are to reduce the expenses without impacting our ability to sell and to deliver, and to better assimilate the teams in order to generate more cross-selling and align the tech world and the IRD in process.

Subsequent to quarter end, we completed a new series of cost savings initiatives, which will provide the company with additional savings beyond those we announced in Q4 and the Q4 restructuring.

Regarding WiLAN and the strategic review, the process remains ongoing, and we continue to engage with interested parties on our options to surface value. In the meantime, it's business as usual for the team as they seek to build their pipeline and execute on their various licensing programs. We will continue to keep shareholders abreast of any material developments with the business and with the strategic review.

With the release of our Q1 results today, we announced that Quarterhill will be suspending indefinitely the payment of dividends. This decision is based on discussion between the Board and management on determining the optimal capital allocation strategy to support growth of the company.

This decision creates financial flexibility and best positions the business to generate value through our capital allocation strategy focused on supporting the growth of its ITS business. The dividend is a legacy of the IP licensing business, and dividends are not common among publicly traded companies and the ITS sector.

Companies in the ITS sector tend to follow more traditional growth-orientated model, which requires ongoing adjustment in areas such as R&D, along with organic and nonorganic growth initiatives.

This morning, we also announced the appointment of Chuck Myers to the Board of Directors. Chuck is a seasoned entrepreneur with CEO level experience and is an ITS industry veteran who helped cofound Transcore and part of its leadership group until its sale to a private equity investor.

Chuck is a great fit for Quarterhill given his ITS experience as well as his leadership and operational experience. He has been a CEO and a Board member of several public companies and has a track record for delivering growth and -- with multiple companies in the tech sector. More than once, he has been instrumental in helping companies overcome significant obstacles to realize their full potential and deliver significant growth.

In closing, I want to reiterate our commitment to the ITS business and our view of the compelling opportunity in this industry. The industry is growing at a CAGR north of 10% and the 2 verticals we focus on, tolling and enforcement, are growing above the sector average. We've previously spoken about multiple tailwinds propelling this growth, which suggests the growth trend could remain in place for years to come.

In this favorable environment, we have 2 strong ITS platform businesses in ETC and IRD. Both have talented teams, strong reputations in their respective fields, solid revenue backlog and growing prospects for new business. This outlook for the segment is positive for '23 and well into 2024 and beyond.

They are with good visibility in the near-term -- future. One -- our goals are: One, to improve financial performance in 2023 and achieve positive EBITDA for the ITS business; two, to maintain progress on ITS integration moving forward a shared services model and further integration regarding the technology roadmap and sales synergies; three, hire a new CEO, a search firm has been selected and that process is well underway; and four, complete the WiLAN strategic review process, an essential step for becoming a pure-play ITS business.

With that, I will pass it over to John Karnes for a closer look at the Q1 numbers.

[John Karnes, CFO]

Thank you, John. Good morning, everyone. As an initial matter, as you may have seen in the Q1 MD&A we filed this morning, we are no longer breaking out corporate costs in our segment note. We have now assimilated all corporate costs 100% into the ITS segment comprised of tolling and enforcement.

As such, going forward, we will only present 2 columns in our segment reporting, licensing and ITS. This will provide a much more accurate view of the standalone financial profile of each segment on a go-forward basis and align our pub co Board of Directors, executive and other corporate costs with our go-forward ITS focus.

Now looking at our new segment presentation. Revenue in Q1, consolidating both the ITS and licensing segments, was down year-over-year relative to the strong performance in licensing in Q1 last year. Q1 revenue for the ITS segment was $38.3 million, up year-over-year only slightly. However, Q1 ITS revenue was negatively impacted by approximately $3 million of delayed revenue recognition under our percentage of completion rev rec methodology. This delay was associated with project re-estimations during the quarter, all of which impacts gross margin.

Separately, we also saw $2.5 million of committed Q1 ITS revenue push out in the future periods, owing to shifting time lines that are characteristic of the complex construction projects that ITS, in particular, engages in.

Taking these 2 revenue items together, we actually had visibility into Q1 ITS revenue closer to $44 million, which would have represented a more in-line increase of, say, 12% year-over-year versus the slight increase reported.

So consolidated gross margin for Q1, again, ITS and licensing, was 11% compared to 55% in Q1 2022. As I mentioned earlier, this is largely a reflection of the high level of licensing activity this time last year with its associated higher margins.

Gross margin in the ITS segment was 13% as reported for Q1. This compares to 28% in Q1 last year. Notably, however, the Q1 ITS gross margin includes the negative impact of the $3 million resulting from our Q1 project re-estimations, plus another $2 million of cost contingencies and project overruns during the quarter.

These contingencies were set up as part of a thorough project review and represent management's reserve to address identified risks remaining in our ongoing roadside and back-office project implementations. Excluding the contingency and overruns, Q1 ITS gross margin would have been closer to 23% in Q1.

Moreover, we also effected a change in our SG&A reporting in Q1 that had the effect of increasing our cost of sales about 5%. So in this regard, consolidated sales, general and administrative expenses, SG&A, in Q1 '23 were about $10.7 million compared to $13.6 million in Q1 last year, representing a $3 million year-over-year increase for progress in ITS SG&A -- reduction in SG&A.

This decrease in ITS SG&A is a result of a $1.7 million reclass to cost of sales, which I mentioned, and a $1.3 million savings realized from our integration reorganization.

With all this factored in, consolidated adjusted EBITDA was down year-over-year in Q1 due, of course, to the impact from licensing. Q1 adjusted EBITDA for ITS was a $5.2 million loss, which, as a reminder, is inclusive of all ITS corporate costs that were previously broken out in our segment analysis.

Q1 adjusted EBITDA was impacted by the project re-estimations, cost contingencies and overruns I discussed earlier. But for these items, the ITS segment would have been essentially breakeven on an EBITDA basis for the quarter.

In this regard, as John Gillberry just mentioned, looking forward, we are targeting achieving positive adjusted EBITDA for the ITS segment in 2023, including all corporate costs. Apples-to-apples with last year, this would be an improvement from a loss of around $11.5 million.

Turning to the balance sheet and cash. Cash used in operations in Q1 was $10.2 million compared to $8.8 million of cash used in operations in Q1 last year. Cash used in operations is expected to decline, that has improved as we move through 2023, with cash starting to rebuild in 2024.

We ended Q1 with cash, cash equivalents and short-term investments of $51.7 million compared to $67.9 million at the end of 2022. In addition, we also had $6.5 million in restricted short-term investments at the end of Q1.

Factors impacting the change in cash from year-end included debt scheduled repayments, the Q4 dividend and severance charges, among other working capital fluctuations. At quarter-end, the company was offside its ratio covenants under its credit facility. We are currently in discussion with our lender group to negotiate a covenant relief period. In the interim, the remaining $28.4 million outstanding of our long-term debt under our credit facility is being classified as a current liability.

In summary, we've made good progress in the past months to set the business on a clearer path towards a stronger operational and financial performance level. This should become evident as we continue to move through 2023, particularly the second half of 2023, and we expect that the momentum we gather this year will carry us into 2024.

This concludes my comments, and I'll now turn the call back to the operator for Q&A.

[Operator]

[Operator Instructions] We have your first question coming from the line of Todd Coupland from CIBC.

[Todd Coupland, CIBC]

I wanted to ask about the outlook comments about improving revenue and operating performance. I guess, you've taken the reserves, so you feel like you provided for the losses in the contracts.

How much of the business that you expect to come in, in the second half of the year to drive that higher revenue is already booked and scheduled to be delivered as we go through the year? Just give us some color on that.

[John Gillberry, Interim CEO]

I think I understand the question, Todd. But if you're asking about the revenue in the ITS segment that's going to drive margin percentages up, it is all in implementation stage at this point in time, and that implementation moves over to operations and maintenance, which -- and that is the trigger point in which margins move up significantly.

There's 2 key sort of, I would say, date milestones as it relates to the -- the first, we have visibility on. And one is sort of, I'm going to say, late summer and one is early fall next year. If that's too broad of an answer and to vague of an answer, maybe I can get John Karnes to give you a little bit more color on that.

[John Karnes, CFO]

Yes. Thanks, John. I might come at a different angle and not sure if this is where you're going, Todd, but it's 100%. I mean, the revenue we have in the last 3 quarters of the year that we're planning on when we say we're going to be -- we're targeting cash flow profitability, that's all contract committed revenue.

So there is no new logo. There's no new business on top of that. This is executing the projects that we have today, getting them through implementation, into operations and getting them into that higher-margin phase of their contract life.

[Todd Coupland, CIBC]

Yes, that's what I was asking. And how much flexibility -- I mean, I guess, this is with the state and municipalities would be the customer. How much flexibility do they have to actually take that business over the next 3 quarters?

[John Gillberry, Interim CEO]

How much flexibility do they have to take that business? I'm sorry, Todd, I just don't understand your question.

[Todd Coupland, CIBC]

So how much -- I understand the contracts are 100% booked. You don't have to go out and win it.

[John Gillberry, Interim CEO]

Right.

[Todd Coupland, CIBC]

But is there any flexibility in terms of how it's scheduled and build and you work on it with the state and municipal customers?

[John Gillberry, Interim CEO]

Yes. If you're asking about what's the risk of slippage on our debt and...

[Todd Coupland, CIBC]

Yes.

[John Gillberry, Interim CEO]

Yes. Okay. So there's a big inducement for the state and agencies to get these projects into implementation because it's revenue generating for them. So there's an inducement for them to get them live absolutely, and there's actually penalties if we don't get them live.

So we're all aligned and on the same page in terms of getting them up and running on target dates. And I would say that there's no incentive -- it would be a big disincentive for them to try to push them back in any way, shape or form. The pressure goes to the other direction.

[Todd Coupland, CIBC]

Okay. And then sort of last question, I apologize if this is an uninformed question. But the cost overruns and project expenses that you took in Q1, does that cover your -- what you might face for the next 3 quarters? Or is it possible that some of these contracted programs also could face cost overruns?

[John Gillberry, Interim CEO]

Yes, that's -- actually, that's a good question, Todd. What we did in the quarter is, I would say, probably at a level that hasn't ever been done before if we grubbed these projects hard. And we look to find out what is the real cost of completing these projects and doing the estimation on the [cusp] of these projects. And John's team got way, way, way down into the weed.

So the high-level answer is that we think that we've captured the cost and cost overruns to deliver these projects that we have in the implementation phase right now. So I would not expect to see another contingency like we took in this quarter come back up again this year. I mean, we did a lot of work on this in the quarter. John Karnes, do you have any color to that?

[John Karnes, CFO]

No, I echo everything that you said. What we did was went through the entire project, caught up where we're at inception to date, looked at estimate to complete the project, where are the risks, the software project, handing over software. Acceptance testing sometimes is where you see cost balloon.

We assess that risk where we thought it might relate to more hours. We built a cushion in for more hours. Where we saw hardware risk in a construction project, we put it in. So this should be everything, inception to date, everything that we see today on the projects that we have outstanding.

[Todd Coupland, CIBC]

Okay. Sorry last question -- sorry, 2 quick questions. First on this, so your adjusted breakeven roughly in the quarter. What should margins look like as you start to work through these programs over the next year or 2?

[John Gillberry, Interim CEO]

Yes, that's a fair question. And I think we've indicated in the past that we feel that this industry sector can deliver an adjusted EBITDA number of double digits, for sure, and approaching sort of that mid-double-digit level. And I think we have pretty good line of sight to know how we get there, Todd.

[Todd Coupland, CIBC]

Okay. And then sort of last question. I know you're looking for a CEO replacement. Can you just talk about time line and the type of person that would make sense, internal, external considerations that kind of thing? Any additional color would be appreciated.

[John Gillberry, Interim CEO]

Yes, sure. So we -- as I mentioned, we have engaged a search firm. They are fully engaged. As a matter of fact, just yesterday, I saw like a list of -- I think it was someplace around 20 profile-type candidates that they initially had kind of come back to us and said "We're starting to sand this down a little bit, but we've got some candidates that we think would be interesting for you."

We are looking for somebody who has got very, very deep operational experience, like, and somebody who can actually work with state and local governments on these big, big contracts. Whether it's an internal or external candidate, I think all of that is open.

Most of our business, even on IRD side of it, is in the U.S. So my speculation is that the candidate will either come from the U.S. or will have to relocate to the U.S., if it happens to be somebody who's not actually in the U.S.

But I'm hopeful that as we move through to the late summer, we'll be on a short list of a couple of people. I think it's moving quickly, to be honest with you. But we're -- as I've said before, we're in no hurry to make a mistake, and we do have a lot of eyes looking at this candidate process right now, a lot.

[Operator]

[Operator Instructions] As we have no further questions at this time, I will turn the call over to Mr. Gillberry for closing comments.

[John Gillberry, Interim CEO]

Okay. Thank you, and thanks, everybody, who dialed in to listen to the call this morning. I want to thank everyone who participated in today's call, and I look forward to speaking with you and keeping you abreast on our developments in the coming months, coming weeks. And just thank you for staying with us. Goodbye.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines. Have a lovely day.