Quarterhill Inc

TSX:QTRH

Earnings Call Transcript 2021-Q2

[Operator]

Good morning, and welcome to Quarterhill's Q2 Fiscal 2021 Financial Results Conference Call. On this morning's call, we have Paul Hill, President, and CEO; and John Rim, Chief Financial Officer. [Operator Instructions] Earlier this morning, Quarterhill issued a news release announcing its financial results for the 3 and 6-month periods ended June 30, 2021. This news release, along with the company's MD&A and financial statements, will be available on Quarterhill's website and will be filed 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 Page 3 of the company's Q2 2021 Management's Discussion and Analysis 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. Hill. Please go ahead, sir.

[Paul L. Hill, President, CEO & Director]

Good morning, everyone, and thanks for joining us on today's call. In terms of agenda, I'll start with a look at the business highlights, followed by John, who will take a look at financial results, then we'll open it up for questions. Q2 consolidated revenue was $18.9 million. Consolidated adjusted EBITDA was negative $3 million, and we generated $1.7 million of positive cash from operations. We ended the quarter with a strong balance sheet with $122.7 million of cash and working capital of $138.5 million. In Q2, we continue to make progress on our M&A strategy, completing our second acquisition of the year, VDS. We've made considerable progress integrating both acquisitions, generating new revenue opportunities, realizing cost synergies, and laying the groundwork for IRD's further expansion into Europe. I'll touch on these developments in more detail shortly. WiLAN completed license agreements in Q2, but COVID-19 continues to be a headwind for some licensing discussions and litigations where in-person meetings or court schedules are being delayed. As a result, Q2, some agreements that we had planned on closing in the quarter got pushed out to future periods. Earlier this week, WiLAN announced patent portfolio acquisitions and a license agreement on patents that relate to wireless technologies used in the automotive industry. So they're off to a good start in Q3.The automotive industry is a promising new market segment for our wireless patents, and we have a number of new opportunities in the pipeline. Those who have followed us for a long time know the episodic nature of WiLAN's revenue. Despite the quarter variability on a relatively consistent basis, WiLAN delivers significant annual cash flow. We expect that to be the case again in 2021. This means that we're looking for a strong second half from the business, and we remain encouraged by the pipeline of agreements the team is working on.Regarding our litigation in the U.S. with Apple, all preliminary briefings have been completed, and we're waiting for the oral hearing date from the Federal Court of Appeals, which could be released any day. We believe the hearing will likely take place this fall or early in the spring of 2022. In addition, WiLAN has upcoming trials with Amazon this November and with Micron in August 2022. The business is also evaluating several interesting patent portfolios for acquisition in the coming quarters. IRD had a good quarter with solid financial performance, integration of 2 acquisitions, and growth in its pipeline. So far in Q1 and Q2, Sensor Line has performed to our expectations, and the integration is going well. In North America, IRD is leading all sales efforts for Sensor Line products and has already closed deals in New York and Indiana. IRD is currently conducting trials in other states, which could result in much larger multimillion-dollar opportunities that wouldn't have been accessible to Sensor Line on its own.With VDS, Q2 reflected a contribution only for May and June. So far, the business is on track, and the integration is going very well. VDS develops and manufactures and sells traffic monitoring devices that record driver speed and red light infractions. There are currently the only radar-based product certified under new regulations in Germany that enable direct enforcement of traffic violations. This is an area of enforcement that we really like and think has significant growth potential. For example, here in Toronto, the city has installed more than 150 red light cameras along with 50 speed cameras and is in the process of rolling out 50 more. I can tell you from personal experience, these cameras are working.In terms of revenue synergies, IRD and VDS are working together on several opportunities in Germany. VDS is leveraging IRD's European footprint to bid on new business in countries where they have no previous sales coverage. Together, these 2 acquisitions demonstrate the global platform of the IRD business and the ability to identify, acquire and grow acquired companies. IRD has initiated a further integration of its 3 EU subsidiaries, Sensor Line, VDS, and iCOMS, to establish a more substantial beachhead in Europe. The company has opened a search for a European general manager who will oversee the acquired companies and lead the expansion of IRD in Europe. We are pleased so far with the progress of the 2 acquisitions, and we intend to complete more transactions this year. We think we can get a couple done -- a couple more done in 2021. We have a solid pipeline, and we'd like to get some larger deals on the Board this year. These could be businesses that are similar in size and scope to IRD with well-established brands and with their own M&A strategy. With attractive market tailwinds in place, we believe the outlook for IRD and the ITS industry in general is very positive.With that, I'll turn it over to John for a look at the financial highlights.

[John Rim, Chief Financial Officer]

Thank you, Paul, and good morning, everyone. I'll take a look at key consolidated numbers as well as the numbers from our ITS and Licensing segment separately. Starting with revenue. Consolidated revenue in Q2 was 18.9 and $38.2 million year-to-date. Revenue was up year-over-year in Q2 as both the ITS and licensing segments grew revenue, but slightly lower year-to-date due to a more moderate value of agreements completed in the licensing business in Q1 this year. ITS revenue was higher for both Q2 and the year-to-date period, primarily due to the inclusion of revenue from the acquired companies as well as resilience and its core business despite the COVID-19 pandemic, still remaining a challenge in most parts of the world. As Paul mentioned, we are already seeing revenue synergies from the acquisitions and expect this to continue as the businesses become more integrated. Licensing revenue was up in Q2 compared to the same period last year, but down slightly year-to-date. Despite the headwinds related to COVID-19, WiLAN continues to show complete agreements in a challenging environment. And as Paul mentioned, WiLAN is off to a great start in Q3 with a license agreement completed on patents that relate to the LTE wireless tech in the automotive sector, which is a new business. We expect a stronger second half of the year for WiLAN going forward.From a gross margin perspective, consolidated gross margin in Q2 was 18% and 26% for the year-to-date period. Gross margin in the 2 periods was lower than last year, primarily due to lower litigation expenses at WiLAN in the respective 2020 periods. Litigation payments do fluctuate based on the level of activity in the particular period. For example, in Q2 last year, litigation activity was low as the courts reacted to the initial onset of the COVID-19 pandemic. ITS margin -- gross margin was 37% in Q2 and 42% year-to-date. The decrease in Q2 compared to last year was primarily due to the activity and nature of projects underway in the quarter and their specific margin profiles. The increase in year-to-date gross margin was primarily due to there being a higher proportion of product sales, which tend to carry a higher margin than in the same period last year.In terms of operating expenses, total consolidated operating expenses were slightly lower in both Q2 2021 and the year-to-date period. ITS operating expenses were up modestly in Q2 with the addition of the Sensor Line and VDS acquisitions. Overall, as always, we continue to keep a close eye on expenses at our corporate level and our portfolio of companies. In terms of adjusted EBITDA, the ITS segment had positive adjusted EBITDA in Q2 of $2.7 million, which was down from Q2 last year and $4.1 million for the year-to-date period, which was up from the same period last year. For both Q2 and the year-to-date period, the ITS adjusted EBITDA margin was around 15%. Adjusted EBITDA margin for ITS can, as I mentioned before, fluctuate depending on the nature of projects underway in the quarter, the revenue mix, and the seasonality that is inherent in the ITS industry. And as we've mentioned before, Q1 is typically a slower period just due to the weather.Adjusted EBITDA for the licensing business was lower in Q2 and the year-to-date period, primarily due to the higher contingent legal and partner costs in 2021. On a consolidated basis, adjusted EBITDA was negative $3 million after corporate expenses, which generally include all of our public company costs. In terms of cash flow and the balance sheet. So cash generated from operations was $1.7 million in the second quarter and cash used in operations for the year-to-date period was $4.1 million. The balance sheet remains very, very strong with $122.7 million in cash and $138.5 million in working capital, again, with no debt. We continued our quarterly dividend payments in Q2, along with our share buyback, spending a combined $3.2 million on both activities. And this morning, in our earnings release, we announced details of our next dividend. The Board has declared an eligible dividend of $0.0125 per share on October 8, 2021 for shareholders of record on September 10, 2021.So in closing, we remain very well-positioned financially to continue to execute on our M&A strategy. We still have a very strong balance sheet with significant cash from working capital as well as the ability to support leverage. And we have 2 operating segments that we continue to believe in and continue to generate cash annually on a consolidated basis to help support our acquisition strategy. As we've talked about before, our plan is to deploy $400 million on our strategy over the next 5 years. We've already made 2 smaller acquisitions. And as discussed on our last call, we believe that doing so could add an incremental $300 million plus of revenue to our ITS business, along with $50 million of adjusted EBITDA over the next 5 years on top of what we're doing already. ITS revenue, in line with our strategy comes with a more steady and predictable profile. And we believe that should result in Quarterhill receiving a valuation that's consistent with other public ITS and IoT telematics companies that have achieved similar scale. So the net result of our strategy is to unlock that shareholder value over the next 5 years and very -- we remain very optimistic that we're going to execute on that.So that concludes my review of the financial results, and I'll now turn the call over to the operator for Q&A.

[Operator]

Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Doug Taylor, Canaccord.

[Douglas Taylor, Director]

One area I just want to flesh out a little bit is -- I mean, you're -- looking for a little help with what gives you the confidence in the inflection in the WiLAN business. You're kind of -- you're telegraphing here for the second half of this year. Is this some of these signings we've seen post-quarter? Is it the pipeline? And I just want to understand how you're handicapping the risk that court openings or would slip further? Because I think many of the jurisdictions you typically are litigating in are in areas that seem to be in the midst of a third wave right now?

[Paul L. Hill, President, CEO & Director]

Yes, the courts -- hey, Doug, it's Paul. Yes, the courts isn't really, the issue it was a year ago. They were closed for, in some cases, over a month. We're not seeing that at the moment. What gives me confidence is just the pipeline, the level of activity, the fact that we're off to a better start in Q3 than we were in Q2. We've announced a couple of deals already. So yes, there's just a lot to work with. And it's starting to look like the year is going to shape up in a similar fashion to last year, not exactly probably, but it's back-end loaded, is fair to say. But there's just enough to work on. And we spend a lot of time on the pipeline and working with the WiLAN team to understand that.

[Douglas Taylor, Director]

Okay. And the other thing that I want to drill down on that you mentioned in your prepared remarks is, I think, talking about the potential for more sizable deals, at least a little more constructively than we've heard recently. And I think, in particular, you said deals of the same size and scale as the IRD transaction. And so I just want to understand, with deals like that, are we going to be looking at things that are potentially accretive on a multiples basis, which has kind of been challenging given the multiple that has been afforded to the WiLAN business. Is it going to be about cost synergies, combining these with IRD? Are these going to represent kind of new platforms that you're going to be layering on additional tuck-ins to get cost synergies down the road? Just help us think about what we should expect from those first couple of transactions of size that you're talking about?

[Paul L. Hill, President, CEO & Director]

I would say the most likely scenario is more of a platform acquisition that would take us into adjacencies to IRD companies with their own brand, their own M&A strategy that would have sort of similar scale and scope as IRD, but in an adjacent, ITS market would be something that's quite possible. And though you're -- in the meantime, I mean, we have a pipeline that has varying sizes of acquisition targets. And it has -- I've been here 1 year. John has been here since last fall, and that M&A pipeline has matured a lot over that period of time. And it's not surprising that the first couple of acquisitions were smaller in nature, right? As you would imagine, those are easier to get done, take less time, easier to integrate. And so as the pipeline matures, as our time in the seat, is longer then we can contemplate larger acquisitions.

[John Rim, Chief Financial Officer]

Yes. I think Doug to add to that. I mean you mentioned sort of IRD, that type of size. We certainly have the financial means to do it. As I mentioned before, we're carrying no debt. So we have opportunities for leverage in this very low-cost interest environment. And then secondly, as Paul mentioned, it's a pipeline. So those kinds of companies are out there. Obviously, we have to come together and make sure it's good for us. It's good for the seller. But what we can say is that we're definitely exploring those kinds of opportunities.

[Douglas Taylor, Director]

Last question for me. I mean are you comfortable with more sizable acquisitions doing these fully with, I guess, virtually? Or are you waiting for travel restrictions to ease? I mean, particularly for transactions that might be in Europe of size or elsewhere in the world? Or are you going to be waiting to meet and visit site visit, and all that before pulling the trigger on something of size?

[Paul L. Hill, President, CEO & Director]

I'm traveling. So it's an acquisition of that sort of scope. Obviously, you want to spend some time with the teams, getting to know the teams, seeing the facilities, et cetera. So I am traveling.

[John Rim, Chief Financial Officer]

And on the financial diligence side, I mean, even before COVID you're getting information from a data room and scheduling calls. The in-person stuff is very important, obviously and so.

[Paul L. Hill, President, CEO & Director]

Yes. We got the first 2 done without going in person, although we had people on the ground in Europe because we do own a Belgian company called iCOMS, and that was helpful, and we have some staff on the ground in Europe. So we were able to do the smaller acquisitions remotely, that wouldn't be possible with a large acquisition. And I am personally traveling and some of my team is down travel.

[Douglas Taylor, Director]

Just wanting to confirm that COVID restrictions or travel restrictions don't seem to be a gating factor here in the rollout of your M&A program, and it sounds like it isn't. I'll pass the line.

[Operator]

Your next question comes from Maxim Barron Cormark.

[Maxim Barron, Associate]

I just had a couple of questions regarding the strength in WiLAN in the second half of the year. So my first question is, does the strength come from several large deals? Or is it more broad-based across the type of deals that you're getting? And just my second question would be the strength, is it split evenly between license agreements and litigation? Or how is that split look?

[Paul L. Hill, President, CEO & Director]

Yes. I would say it's a number of deals. So the pipeline, the way we get to our numbers in the second half, there are many paths and many combinations that will get us there. So I think you can assume that it's a number of transactions of different sizes as opposed to a couple of very large deals that kind of swing one way or the other more dramatically. So that would be my comment on that. Did you want to comment, John?

[John Rim, Chief Financial Officer]

No. Yes, I'd echo that. There's many pathways, and they're all the...

[Paul L. Hill, President, CEO & Director]

The litigation -- I mean I did mention Amazon. We are -- there is a trial date in November. It's a hard question to answer because sometimes cases are settled before it gets to trial, right? So I don't know how you would categorize that. Is that a licensing deal or is that a litigation, right? So I would say that is also a mix.

[John Rim, Chief Financial Officer]

Yes. Like the very -- if you look at the history, the very few have actually calling gone full all the way through the court process. It's really negotiated beforehand.

[Paul L. Hill, President, CEO & Director]

That's right.

[John Rim, Chief Financial Officer]

So what I was going to say is they're all varying sizes. It's just timing and you've got to come together to get something that's comfortable for both parties.

[Paul L. Hill, President, CEO & Director]

Yes. And I would just point out, we are off to a good start in Q3. We've announced a couple of deals already. So already, we're headed in the right direction in Q3.

[Operator]

Your next question comes from Todd Coupland, CIBC.

[Todd Adair Coupland]

I wanted to first ask about, I guess, it's IRD plus the acquisitions, so ITS in total. Is that the $17 million in the quarter, is that a pretty good run rate for all the businesses now that have been acquired?

[Paul L. Hill, President, CEO & Director]

So with -- well, VDS wasn't fully integrated in the financial results, right? It's only half a quarter roughly.

[John Rim, Chief Financial Officer]

Yes. We acquired VDS in April. So -- but that's relatively small. I would say, obviously, Q3 has been the largest quarter always for IRD. In terms of the other 2 acquisitions, what I can tell you is that they're tracking towards our business case and -- which basically forms our budget for the year. The other thing to take note too, is we report in Canadian dollars. And as you're familiar with, IRD's business, half of it is in the U.S. And so last year with the onset of COVID, the exchange rate was quite high. I think it was in and around the 1.39.

[Paul L. Hill, President, CEO & Director]

It's quite a big FX headwind right now with the U.S. dollar, so we gave.

[John Rim, Chief Financial Officer]

Now it is changing, and I think that's one reason for optimism as well, too as that flips and sort of normalizes back to sort of at least the last 5-year average. But this year, we're looking at 1.25 in the quarter. So that's a big difference. I would say on a constant currency basis, the businesses are tracking. But because we report in Canadian dollars and the difference in exchange rate, that hit us a little bit. But we're optimistic that, that's going to normalize, and you'll start to see the run rate numbers pretty soon.

[Todd Adair Coupland]

Okay. And then is there any way to think about sort of organic constant currency growth in ITS with the acquired businesses in IRD? I mean, is it mid-single digits? Is it low double digits? How are you thinking about the market or those combined businesses?

[Paul L. Hill, President, CEO & Director]

We track, the IRD business organically tracks more or less to the market. Historically, the market CAGR is somewhere in the 5%, 6% range. There's some recent market studies that are predicting more like a doubling of that number over the next number of years as all of this new infrastructure spending comes into the market. So that's what -- when I talk about the tailwinds, that's what I'm referring to, is that, for example, in the U.S., the infrastructure spending bill, right, that money will eventually flow down to the state level and show up as new opportunities for ITS vendors like ourselves. So that's more in the kind of 13% to 15% CAGR. But it's going to take a bit of time for that cash to flow down to that level, probably a few quarters. So we think we'll start seeing that CAGR improve somewhere in 2022. So you won't see necessarily a lot of organic growth beyond kind of that 5%, 6% range, probably until that money starts flowing.

[John Rim, Chief Financial Officer]

The other aspect is, and we have talked about sales synergies. Now Sensor Line and VDS are smaller acquisitions. But again, they are very much limited to sort of the European market. And they didn't have the sales channels and the same infrastructure related to sales as we did. And so we're already seeing opportunities. now those take time to flush out the nature of RFP cycles in the ITS industry are longer, let's say, relatively to maybe some other industries, but we're already starting to see those. And Paul, do you want to talk about a few?

[Paul L. Hill, President, CEO & Director]

Yes. I mean we landed a couple of deals already. I mentioned in my remarks, Indiana and New York. Those are deals that probably Sensor Line wouldn't have seen on their own. We have coverage in those markets. We have existing relationships. So we can bring those products. If you look at VDS, they're a German -- their product that sells primarily in the German and Austrian market. I mean that's also very, very -- it's great technology that's being adopted all over the world now. As I mentioned, if you look at photo radar, red-light cameras, there's a lot of investment in those areas to drive new sources of revenue to government. So we think we can take those products into IRD, which operates in over 50 countries right now.

[John Rim, Chief Financial Officer]

Yes. And Paul also mentioned our integration efforts. I mean they're pretty much, from an operational perspective, we're going to start unlocking those synergies, but they're already integrated. Obviously, they're integrated on the sort of back-office financial reporting. And we also expect to achieve cost synergies as well, too, whether it's global insurance policies or redundancies and management and staff. We're starting to unlock those after a transitionary period as well, too. So we'll hit synergies on both sides. It just takes a few quarters to kind of see them roll through the results. And hopefully, we get some cooperation on the FX as well, too.

[Todd Adair Coupland]

Okay. That's super helpful. And then I think -- I thought you said EBITDA margin was 15% in ITS. Is that the right number to think about in this business on a run-rate basis? Or do you think -- what's the range with synergies, I guess, is maybe a more direct question?

[John Rim, Chief Financial Officer]

So a couple of things. One is in our ITS business, and ITS is such a big tent. We're in commercial vehicle operations. We do dabble in other areas, obviously, as well, too. And we do projects, services and we sell some products as well, too, right? Products tend to be higher margin. So they're going to -- that's going to flow all the way down to your EBITDA margin. But other areas in ITS could have a different margin profile. I would say for our current ITS business right now, I mean we can go back to previous financial reporting, and you can do the math, but they were around 11% to 13%. So getting to 15% already. I think that's a reflection of some of the acquisitions we've made as well as some of the synergies.

[Paul L. Hill, President, CEO & Director]

Yes, the gross margin has improved with some of the more product-centric acquisition.

[John Rim, Chief Financial Officer]

Exactly. Yes. The products are anywhere from 50% to 65% gross margin. So 15% is actually kind of the bar that we try to get to.

[Paul L. Hill, President, CEO & Director]

It's a pretty good working number.

[John Rim, Chief Financial Officer]

Yes. For IRD, but other businesses that we acquire going forward in the industry could be higher or it could be slightly less, but still very cash generative, depending on the type of business that it is.

[Todd Adair Coupland]

Okay. That's helpful. And then on Amazon, can you just remind us what is actually the infringement that they've been taking advantage of? Yes, just to help us understand which patents you put forward?

[Paul L. Hill, President, CEO & Director]

Just at a very high level without attempting to get into lots of detail around it. It's essentially the voice-activated assistant technology. So you think of Siri as an example of that. So it's some of the underlying technologies related to voice-activated assistance.

[Todd Adair Coupland]

Okay. I mean -- I mean, you're taking it to trial. So it's -- your opportunity is not sort of single digits of millions. This is like a material infringement, and you'll just see where you get to, I guess, is the read on going all the way to trial, right?

[Paul L. Hill, President, CEO & Director]

I can't comment on that, the size or scope. But yes, I mean, that is the area that we're focused on with them.

[Todd Adair Coupland]

And then just what you got asked about WiLAN a little bit. But if I could just -- you said you do the catch-up and sort of get back to sort of averages in terms of WiLAN. I mean that's how I've always thought about that business. So it's not a big surprise to hear that. Is the catch-up, though I guess if you're going to catch up in the second half of the year, for the full year, get you back to averages, it probably is actually going to be potentially quite a bit higher in the second half. And is there scenarios where you sort of have an outsized year with everything that's in the pipeline? Or is it just getting you back into the average of the things that you think is going to close, end up closing?

[Paul L. Hill, President, CEO & Director]

Yes. No, I think that the year is shaping up in many ways like last year. Except I think last year, we had the one really large WiLAN quarter. It may not be that kind of scenario, but it is definitely -- the similarity is that it's a back-end loaded year. But in terms of order of magnitude, that would be kind of the range. But I would say the wildcard is there are some large projects that could settle at any point, right? So that's the part that you just can't predict at all. We have an Apple case. We have hearings happening in the fall, right? So it's hard to predict that kind of scenario, and I wouldn't factor that into my comments, really. Yes.

[Todd Adair Coupland]

Okay. That's helpful. Thanks a lot, guys. Appreciate it.

[Operator]

There are no further questions at this time. I will now turn the call back to Mr. Hill for closing remarks.

[Paul L. Hill, President, CEO & Director]

Okay. Well, thanks, operator, and thanks, everyone, for participating in today's call, and we look forward to speaking to you again in the coming months. Thank you.

[Operator]

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