Quarterhill Inc

TSX:QTRH

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, and welcome to Quarterhill's Second Quarter Fiscal 2020 Financial Results Conference Call. On this morning's call, we have Bret Kidd, President and CEO; and John Karnes, Chief Financial Officer. At this time, all participants are in a listen-only mode. Following management's presentation, we will conduct a question-and-answer session, during which analysts are invited to ask questions. [Operator Instructions] Earlier this morning, Quarterhill issued a news release announcing its financial results for the 3 and 6 months period ended June 30, 2022. 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 the company's Q2 2020 management 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. Kidd. Please go ahead, sir.

[Bret Kidd, executive]

Good morning, everyone, and thank you for joining us on today's call. In terms of the agenda for today's call, I'll start with a look at the ITS business highlights for Q2, followed by WiLAN, after which John will take a look at key financial results. Then we'll open it up for questions. To start things off, I'd like to welcome John to his first call as the company's CFO. John joined us in June and comes to us with more than 20 years experience in CFO roles at both public companies and private equity enterprises. In several of those roles, he led during periods of transformation characterized by acquisition and integration, while ensuring regulatory compliance and operational efficiency. Overall, John's leadership, extensive capital markets experience, and lengthy M&A track record make him the ideal person for the role at Quarterhill. And it's my pleasure to introduce them to you today. Looking at our results. Q2 was a mixed quarter with revenue more than doubling to $43.9 million. Revenue backlog in the ITS segment reaching a record level of $573 million and our cash on the balance sheet growing to more than $120 million. At the same time, a slower ramp with certain ITS project implementations and delays with new contract awards impacted the quarter's overall level of revenue growth and margin performance. In our ITS segment, IRD had a good quarter that was relatively in line with our expectations, and they had several new contract wins, including a large contract in the state of New York announced subsequent to quarter end. Q2 and Q3 are seasonally stronger quarters for IRD and accordingly, we saw an improvement in IRD from Q1 of this year. IRD isn't immune to supply chain disruptions and wage and material inflation and labor scarcity issues and its results in the quarter reflected some minor project delays along with some higher costs. IRD's 2 tuck-in acquisitions from 2021, sensor line, and DBS are being successfully integrated within IRD Europe. Both acquisitions when combined, grew revenue as well as EBITDA in the first half of 2022 in comparison to the same period last year. Overall, the fundamentals in IRD remained strong with significant backlog, a robust sales pipeline, and the potential for additional tuck-in acquisitions to broaden its systems capabilities and drive its growth. At ETC, we have signed a significant amount of new business in the past 18 months, and some of these projects are now in the implementation phase. As discussed on our Q1 call, the ramp for several of these projects has been slower than expected, and this persisted into Q2. The contributing factors were primarily shifts in customer priorities or preferences that can occur in the early stage of a large infrastructure project along with some supply chain disruptions and labor scarcity. Fortunately, we saw some of these factors begin to abate during the quarter, with resulting progress seen with certain key implementations. In particular, we did have one implementation where we experienced higher than initially planned costs as well as some impact on revenue. The net of it is that working closely with the customer, we adjusted certain elements of the project, resulting in some one-time costs incurred in Q2. The upside of the relationship remains strong. The project is now moving along according to the revised plan, and we believe the issue is now behind us. To provide some context, our ITS business has signed contracts totaling more than $345 million in just the past 18 months. And what we've seen here so far in 2022 are some of the challenges of launching a significant level of activity and to be doing so in an economic environment characterized by tight access to materials and labor. Again, we believe the worst of these impacts on our Q2 results are behind us and expect our top line and margin performance to improve. These are long-term infrastructure projects with stable customers and important public policy objectives designed to deliver a valuable set of services and outcomes for decades to come. Further, these are projects that will continue to move forward should the economy enter in a prolonged recession. As an important aside, that $345 million of new contracts is largely comprised of long-term ETC tolling projects and that dollar amount does not include change or follow-on orders, which are commonly associated with contract to ETC and which can have a multiplier effect on the total contract value. There are several factors that give us confidence in our stronger outlook. First, we'll be moving beyond Q2's one-time items. Plus, we are seeing better ramp-up on our implementations right now, which begin to pick up pace during the quarter and continue to perform well today. We believe the revenue curve on these projects has simply shifted to the right. On the supply chain side, there are still some disruptions in terms of timely access to materials and equipment, but we have adjusted our purchasing habits to allocate for longer lead times. On the labor side, it's still a competitive and increasingly expensive market for personnel where we're getting more creative and are hiring to mitigate these costs, and we have made significant hires in Q2, which have helped from both the leadership and horsepower perspective in order to drive these implementations forward. As mentioned on our last call, to accommodate both supply chain and labor costs, we are aligning our new proposals and pricing to reflect new realities. I should note that along these lines, our sales pipeline remains robust and our win rates remain very high. There are a number of near-term opportunities that we are focused on. Several of these opportunities were expected to have been decided earlier in the year, but the decisions have been pushed out. We still expect these opportunities to materialize. And in fact, in addition to IRD’s new contract in New York State, subsequent to quarter end, ETC was selected as under of choice for a large electronic toll system integration contract, which is now in the customary protest phase. Regarding the 2022 financial outlook for the ITS business. Previously, we had expected that revenue for the year would grow from our annualized Q4 2021 ITS revenue run rate and that adjusted EBITDA margin for the year would also be in line with that generated in Q4. However, given our results in the first half of the year, we have adjusted our expectations for the year downward from those targets. We do see improvements in the second half, and we believe we will end the year at a run rate approaching our original outlook for the year. This outlook does assume that work on our 7 ongoing implementations continues to progress along their current trajectory and the challenges related to supply chain and labor market developments begin to ease. We are maintaining our view that we can achieve an adjusted EBITDA margin of 15% in 2 to 3 years. This will be achieved through revenue expansion and a greater percentage of higher-margin revenue as projects move into the maintenance operations and change order bases as well as through cost savings at the corporate and segment level. My top priority today is making sure that the ITS businesses are well positioned to execute on new contract mandates and to continue to build the funnel for future contract wins. On the last call, I spoke with several other priorities for the ITS business, with one of them being greater integration of IRD and ETC and the corporate function at Quarterhill all as we move towards being a pure-play ITS company. As part of this plan, I've appointed Bruce Kramer, ETC's Chief Operating Officer to lead the integration process. Bruce is a veteran operations executive, who joined ETC as COO in 2020. [ First of all ] will work closely with John Karnes on the cost-saving side and across the broader integration. The goal of the integration between IRD and ETC is to focus on revenue, technological and operational synergies. Overall, by the end of 2023, we believe the integration efforts could generate annual run rate cost savings of approximately $3 million as we consolidate the support functions from ETC and IRD into a single corporate entity. This would provide greater efficiency and effectiveness from those functions while enabling the operating units to focus on sales and delivery. Savings would occur in a step function during 2023 as initiatives and new processes are implemented. Another priority I spoke of on the Q1 call is M&A. We are in the enviable position of having considerable resources to pursue M&A, but we'll continue to be patient and disciplined buyers looking to pay reasonable valuations for opportunities with both good operational and financial profiles. We are seeing some easing evaluations in our target areas and are looking at opportunities in a range of sizes that could help us accelerate our growth and achieve other strategic objectives. Looking now at WiLAN in our licensing business. WiLAN underwent a leadership transition in the quarter and completed several licensing agreements, building on its very strong Q1 results. On a year-to-date basis, WiLAN's results reflected cash flow generating potential and build on its long-term track record for doing so. In December last year, we announced a strategic review for the WiLAN business and the process continues to move along in accordance with our expectations. We will announce material developments related to the process in due course. As we have said previously, while it was a difficult decision to launch a process for WiLAN, it was recognized that there may be better alternatives for that business than as part of a public company structure, especially given Quarterhill's strategic focus on the ITS business. In closing, we remain very excited with the opportunity in front of us today and are very well positioned on our organic and M&A growth plan. ITS industry tailwinds are significant and will remain even in a recessionary environment. We have a significant organic sales pipeline in ETS and also very high win rates. We have access to strong M&A deal flow, and we have a leadership team and Board experience in ITS and M&A. And finally, we have a very strong balance sheet, giving us great flexibility to grow. While we have experienced some growth pains related to the Ram for certain new projects, with the significant contract wins we have completed in the past 2 years, the lift-up we're now seeing uncertain of our implementation stage projects and the new project awards that are on the horizon, we believe that our ITS model for revenue growth and margin expansion remains firmly in place. With that, at this point, I will hand it over to John to talk through the financials.

[John Karnes, executive]

Thanks, Bret. Good morning, everyone. I will start with revenue and take a look at the key consolidated numbers as well as select numbers from our ITS and licensing segments. Revenue more than doubled for the quarter, driven by the addition of the ETC business, which was acquired last September as well as revenue growth from the licensing business. As Bret mentioned, backlog at the end of Q2 stood at a record $573 million, with the potential for enhancements and scope expansions to have a multiplier effect on that number. ITS revenue at $39.2 million was negatively affected by approximately $12 million of customer scheduling complications on newly won implementations, delays in new contract awards, supply chain, and installation slowdowns, and the one-time implementation project we adjusted during the quarter. But given that these are long-term contracts, slower ramp-ups nearly shift revenue to the right and don't otherwise impact the contract value. The value proposition of Quarterhill is its raft of newly awarded long-term contracts with prime governmental agencies, some of which we expect to last for decades. And of course, the company's new project opportunities remain in the pipeline, where we believe they will ultimately be awarded in due course, like the 2 [ breadth ] Bret mentioned in his remarks. Looking forward, we view our backlog as providing a source of built-in growth. And while we expect it to be a few quarters further down the timeline by now, which has made 2022 a bit of a transition year. As Bret mentioned, things are finally moving forward, and we are forecasting revenue to now start tracking as we continue to ramp up and deliver our portfolio of implementation projects. Gross margin for Q2 2022 was 13% for Quarterhill as a whole compared to 18% last year. Gross margin for the year-to-date period was higher than in the same period of 2021 due to the strong first quarter of '22 from our licensing business. Going forward, we expect gross margins to naturally increase as we move through our wave of newly won ITS projects through the implementation phase, typically at a lower gross margin, and into operations and enhancement phases where the gross margins are structured to be significantly higher. Operating expenses for Q2 2022 were up on a dollar basis due to the addition of expenses from the acquired ETC business and lesser extent, inflationary pressures related to personnel and sourcing certain equipment and materials. Operating expenses for Q2 include $15.1 million of other charges, of which $14.6 million is a one-time charge to settle litigation and arbitration disputes with the former owners of VIZIYA. The expense was incurred in Q2 and the payment was subsequently made in the third quarter. Consolidated adjusted EBITDA for Q2 was negative $9 million and positive $70.1 million to date. The significant year-to-date number is due to the strong licensing activity last quarter. The Q2 adjusted EBITDA for the ITS segment was negative 4.5% and was negatively impacted by approximately $2 million of project award timing, $3 million of supply chain installation delays, $3.5 million from the project we adjusted as discussed earlier, and almost $1 million of out-of-period costs. Tracking gross margin, we expect adjusted EBITDA in the ITS segment to improve in the future as we get beyond the period's one-time items and our implementations continue to ramp. And longer term as our slew of new ITS projects mature into their higher-margin sustaining operation and maintenance phases. Quarterhill continues to maintain a strong cash and liquidity position. Cash generated from operations was $77.8 million in Q2, and cash, cash equivalents, and short-term investments were $122.9 million at quarter end compared to $72.6 million at the end of 2021. Working capital was $138 million at quarter end, up from $105 million at year-end. And long-term debt stood at $48.6 million and recall with a debt repayment of $13.7 million being made in Q2. Regarding the return to capital -- to return of capital to shareholders, we continued our quarterly dividend payments in Q2. And on August 10th, the board declared the next eligible dividend of $0.0125 per share payable on October 7, 2022. That would be for stockholders of record on September 9, 2022. So in closing, as Bret mentioned upfront, Q2 was a mixed quarter impacted by delays and a one-time item, none of which undermine Quarterhill's licensing business or the long-term value of its ITS project portfolio. We have organic drivers in place, a healthy M&A pipeline, good business fundamentals, both in our ITS and licensing segments, and a very strong financial foundation to support our continued growth initiatives. This continues my review of the financial results, and I'll now turn the call over to the operator for question and answer.

[Operator]

[Operator Instructions] Our first question comes from the line of Nicholas Cortellucci of M Partners.

[Nicholas Cortellucci, analyst]

Just had a question about M&A. With the war chest, you guys have accumulated here with collecting the Apple money. What are you guys seeing in terms of private market valuations for ITS firms? Has things pulled back a little bit? Are you seeing a lot of opportunities out there?

[John Karnes, executive]

Yes, we are seeing some moderating valuations. I wouldn't say that it's uniform. And I think it depends. Certainly, the public valuations have come down, and I think that is putting some pressure on some of the available assets that we're seeing. But it's moderating it, but I wouldn't say that it's in a uniform way.

[Nicholas Cortellucci, analyst]

Okay. And then is there any timeline to get something done when it comes to a tuck-in or a bolt-on that you guys are working on?

[John Karnes, executive]

It's probably, as we talked about before, it's very difficult to predict timing with any specificity. But what I can say is that we do remain active M&A, we are looking at a range of different companies at various sizes that all help us with our M&A strategy that we've talked about before, those that will increase scale in the core businesses that would bring specific capabilities to our core business to help maintain technological or other leadership advantages or the third around diversification. So we are looking at a number that I would say, again, range in size and are continuing to move ahead even in the tumultuous market environment. So I think that there's certainly the opportunity for near-term results in that regard.

[Operator]

Our next question comes from the line of Todd Coupland from CIBC.

[Thomas Ingham, analyst]

I was wondering -- I think I took these numbers down right, the various adjustments to the adjusted EBITDA totaled, I think, just under $10 million, $9.5 million. Is it appropriate to add all of those back? So you more or less would have been plus 5% on an adjusted basis, assuming these are non-recurring events. Is that your message on that?

[John Karnes, executive]

What I was trying to do is communicate…

[Bret Kidd, executive]

No, go ahead, John. I was going to throw it to you.

[John Karnes, executive]

I'm sorry. What I was trying to do is communicate the impact of the non-recurring item, which was the project we adjusted, that was $3.5, and then also lay out sort of our contract base and what the company was poised to deliver [ but ] with the delays. So not to say that technically what should be added back in terms of EBITDA, but to make sure everybody understood the value pieces that were out there and what the company was actually poised to do for the quarter, but for delays in contracts that largely are not in the company's control.

[Thomas Ingham, analyst]

Okay. That's helpful. And certainly, not surprising given the nature of the business and the current environment. How much of that, let's say, $10 million is likely to carry over as an expense or item drawdown on EBITDA, however, you want to describe it in the second half of the year?

[Bret Kidd, executive]

John, I'll let you continue on with that one.

[John Karnes, executive]

Apologies. Yes. So again, these are long-term contracts, but with contracted revenue streams that we're ramping up. So what Bret mentioned was we are projects are moving forward again, and we are tracking to get back to where the company or the run rate that was spoken about in Q4 of 2021, moving into 2022. And we expect to see improvement in the future. And we forecast that we'll be back moving closer to where we thought we would be in Q4 by the end of the year. So not to say that any of this is going to reverse next quarter or the quarter after, this is a flow of projects that are improving over time. But that is the magnitude of the EBITDA that the contracts were poised to deliver in Q2, but for the fact that they weren't moving forward as forecast.

[Bret Kidd, executive]

Yes. So if -- yes, if I understood the question correctly I think the -- as John had talked about, really, it's just a shifting to the right of the revenue and the resulting EBITDA that comes with it. Some of this, we just expected to be ramped a little bit faster this year. And so if I understand the question right, that's the way I would.

[Thomas Ingham, analyst]

Yes. No, that's right. And then, sorry, my last question is, as you think about the backlog and then these various puts and takes, hoping to get back to the Q4 2022 or get back to the run rate by the end of the year of '21. What -- should you grow from that in 2023? Or do these headwinds drag into next year as well? Is there any comfort on looking out that far at this point?

[Bret Kidd, executive]

I guess what I'll say, not speaking to specifics for '23, but what I would say is that this massive backlog that we have, again, which is the contracted piece and doesn't include the other extensions, expansions that historically, ETC has gotten throughout its 20-year history. So it doesn't include those. But when you think about that amount, the additional awards that we anticipate, I think we would definitely expect to see a continued upward trajectory on both revenue and EBITDA on a consistent basis going forward. So hopefully, that helps a little bit.

[Thomas Ingham, analyst]

And then just last question for me. You've added a lot to your backlog, obviously. But I think you implied that closing in new businesses, it seems like it's taking a bit longer as well. Could you just give us a bit more detail on current conditions and ability to build on the backlog from here? And that's it for me.

[Bret Kidd, executive]

Okay. Thanks, Todd. Yes, first of all, the pipeline remains enormous. We've been talking about that being in the billions, and it continues to be in the billions. There have been a number of delays in awards. And I will say for various reasons, sometimes it's related to some sort of an upstream project that the agency may be experiencing some delays with. Other times, it's just the interworkings of some of these government organizations where there's a lot of different stakeholders involved in the decisions. I will say what we really anticipated this year was a bit more of a speed up to pre-COVID level, call it, decision-making, and award timing. And instead what we're seeing is just something that's a bit more like the delays or the longer sales cycles that we saw during COVID. I would anticipate, again, that that would speed up, but perhaps just it's not doing so as quickly as we anticipated. But the pipeline remains, again, enormous, and I continue to be proud of the team and the win rates that we are achieving on those that we're bidding on. We consistently get the highest technical scores. We have very differentiated technology the solutions we have in the field, our customers are very happy with. So I remain proud of the teams and very confident about those awards, and it's, again, just have to track to the timing of the customer.

[Operator]

[Operator Instructions] We will pause a moment to allow you to signal. [Operator Instructions] If there are no further questions in the queue, that will conclude today's Q&A session. And now I'd like to turn the call back over to Mr. Kidd for closing comments. Please go ahead.

[Bret Kidd, executive]

Okay. Well, thank you, Sri. Thank you again for those that attended today. Appreciate the time and the discussion and look forward to speaking with you all again in the near future and staying in touch in the coming months. Thank you very much.

[Operator]

This will conclude today’s conference call. Thank you for your participation. You may now disconnect.