Quarterhill Inc

TSX:QTRH

Earnings Call Transcript 2022-Q3

[Operator]

Good morning, and welcome to Quarterhill's Q3 Fiscal 2022 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 parties are in 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 9-month periods ended September 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 the 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 Q3 2022 management's discussion and analysis for full cautionary notes regarding the use of forward-looking statements and nonIFRS measures. Finally, please note that all financial information provided is in Canadian dollars unless otherwise specified.

I'll now turn the meeting over to Mr. Kidd, please go ahead sir.

[Bret Kidd, executive]

Thank you very much. Good morning, every one -- that's quite an intro. Good morning, everyone. Thank you for joining us on today's call. In terms of the agenda for today, I'll start with a look at the ITS business highlights for Q3 followed by WiLAN, after which John will take a look at the key financial results. Then we'll open it up for questions.

The primary story of the quarter was the operational improvement in the ITS business. This was driven by the pickup in implementation activity, which led to 8% sequential revenue growth from Q2. This also produced $1.9 million of adjusted EBITDA, up from negative $4.5 million in Q2. Year-over-year, ITS revenue grew significantly as Q3 2021 included just 1 month of ETC operations following the acquisition by Quarterhill on September 1, 2021.

ITS backlog remains high at USD 581 million, that's over CAD 770 million and we continue to have a strong balance sheet underpinning our operations with cash and equivalents of $76 million and working capital of more than $110 million.

Looking more closely at the ITS business. We have 7 implementations underway at ETC, following a strong period for new business wins in 2021 and 2022. In fact, in just the past 12 months alone, we have announced more than $235 million in new business in the ITS segment. Since 2021, we have closed over $0.5 billion in total contract value.

Implementation progress improved in Q3 from Q2, though we do continue to see some delays with certain projects. The reasons are similar to those we discussed on our Q2 call, labor scarcity, timely access to materials and/or shift in customer priorities are the most common. Also sometimes our work is dependent on tasks being completed by other parties who may be encountering similar labor or supply chain delays, which then pushes back our work.

That said, the environment is showing signs of improvement in these areas, and we continue to work to mitigate the impacts from inflation and tight labor markets. We're optimistic the broader trends will continue in a favorable direction, and we are expecting and planning for a stronger 2023 in terms of revenue and margins.

New opportunities are being added to ETC sales pipeline and in total, it remains well into the billions in value. As we spoke about last quarter, new contract awards in 2022 have been slower to materialize throughout the industry. Despite that, we have won our share of new business in 2022 including the announcement in Q3 of Alameda County, California's intent to award ETC a contract for electronic toll systems integration. As of today, this is past the protest phase, and we are now in the final stages of negotiating the contract, which we'll announce upon completion.

In 2023, we plan to increase our bidding activity over 2022 to lay a further foundation for future growth. We have a history of strong win rates, differentiated technology, and we consistently get the highest technical scores in the bids we pursue.

As we mentioned previously, to recognize both supply chain and labor cost, we're aligning our proposals and our pricing to reflect new realities.

IRD performed well in Q3, which is 1 of its 2 seasonally strong quarters. IRD had a share of wins in the quarter, including a $13.8 million contract in New York State. Just last week, IRD announced 2 contracts for both its e-screening and tire anomaly classification solutions. These were following contracts in Nebraska and South Dakota, expanding the company's footprint in those states.

Those solutions provide waste stations with advanced notice of information for commercial vehicles that are traveling on the state highways. They increase the efficiency of vehicle processing for the state, improve safety for drivers and enhance productivity for motor carriers. further, from an environmental perspective by improving the efficiency of inspection, the use of these systems often result in reduced delay in idling and therefore lower vehicle emissions.

IRD has also encountered some supply chain disruptions, wage and material inflation in the quarter, and its results reflect minor project delays along with some higher cost. However, it's managing through these factors and is experiencing improvements in the supply chain.

IRD Europe continues to build its sales pipeline, and we are starting to see some larger opportunities there, along with opportunities to sell certain of their recently acquired products here in North America. As we've said previously, we continue to work towards integrating our ITS businesses. The goal of this process is to focus on revenue, cost, technological and operational synergies while maintaining our growth mode at both businesses.

On the cost front, by the end of 2023, we believe the integration efforts will generate annual run rate savings of approximately $3 million as we consolidate the support functions from ETC and IRD into a single corporate entity. This will provide greater efficiency and effectiveness from these functions while enabling the operating units to focus on sales and delivery.

Statements will occur in a step function fashion during 2023 as initiatives and new processes are implemented.

On the M&A front, we continue to manage our M&A pipeline while focusing primarily on our ongoing implementations and the significant organic growth opportunities in our sales pipeline. 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 companies with both good operational and financial profiles.

Turning now to our outlook for the ITS business. For Q4, we look to see some modest improvement in revenue from Q3 but inflationary pressures will have some impact on the related growth to adjusted EBITDA. We see a stronger picture emerging for 2023 with revenue growth and adjusted EBITDA margin expansion. Supporting this outlook, we have a solid base of contracted revenue for 2023, a significant sales pipeline for new customer wins and the potential for change orders and expansions from our existing customers.

2022 and 2023 are both broadly characterized by implementations. And towards the end of 2023, some of the 7 implementations will begin to transition to the maintenance and operations phase with the remainder expected to convert to the maintenance phase in 2024. As we've said before, revenue from projects in the maintenance and operations space is higher margin than implementation-based revenue. So the ITS margin profile should improve as these transitions occur.

Given this, we maintain our view that we can achieve an adjusted EBITDA margin of 15% for that segment in 2 to 3 years' time. This will be achieved through revenue expansion, a greater percentage of higher margin revenues as projects move into the operations phase and through cost savings.

Looking at our licensing business. WiLAN's results in Q3 reflect the variability in the ban licensing business model. When viewed over a longer time horizon, the business has a track record for generating strong cash flows and its very positive results year-to-date in 2022 for the reinforce that track record.

Subsequent to quarter end, WiLAN signed a license agreement with Micron, which will be reflected in its Q4 results. The strategic review for WiLAN continues to make progress and follow the customary steps in such a process. We're obviously very limited in what we can say at this time, and we will update shareholders accordingly as material developments occur.

In closing, we have an exciting opportunity in front of us today, and we are well positioned to execute on our growth plan. ITS industry tailwinds are significant and recession-resistant as projects tend to be long term in nature and therefore, less prone to cyclical effects with solutions like tolling often viewed as an useful tool in helping governments pull out of a recessionary period.

We have a significant organic sales pipeline in ITS. We have significant revenue backlog, providing stability and visibility into future periods. We have a leadership team and a Board experience in ITS and M&A, and we have a strong balance sheet to support organic and M&A growth.

With the significant contract wins we have completed in the past several years with our differentiated technology, the progress we are seeing in certain of our implementation 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. These are long-term smart infrastructure projects with stable customers and important public policy objectives, designed to deliver a valuable set of services and outcomes literally for decades.

Now I'll turn it over to John to discuss the financials.

[John Karnes, executive]

Thank you, Bret. Good morning, everyone. I'll start with revenue and take a look at key consolidated numbers as well as some select results from our ITS and licensing segments.

So consolidated Q3 revenue was up 17%. This was driven primarily by the addition of the ETC business, which, as Bret mentioned, we acquired in September 2020. Contracted backlog at the end of Q3, as Bret mentioned, was USD 581 million. This includes only base term and renewals, but with no change order or order enhancement projects, which often can be counted on for substantial additional revenue over time.

ITS revenue at $42.2 million was up 8% sequentially from Q2 and 69% from Q3 2021, which included only one month of contribution from ETC. Q3 revenue improved sequentially over Q2 of this year and based on scheduled implementation activities and sales order book so far this quarter, we believe Q4 will generally continue on trend along the lines of our discussion last quarter.

While some delays persist in both implementations and new contract awards in our tolling business, as Bret mentioned, our projects are, by and large, progressing towards completion and new project opportunities that we hope might bolster 2022 revenues remain viable and prospective to contribute to next year's prospects for growth.

While we continue to migrate our projects beyond their implementation phases through 2023, our next year's plan will be predicated on methodically higher revenues from both our base projects and higher-margin tangential opportunities that combined can be expected in ITS to lend themselves to improving margins and overall profitability.

So gross margins for Q3 2022 was 21% compared to 42% in Q3 last year, which benefited from unusually strong licensing activity that biased up the comparable. Likewise, year-to-date gross income was higher in the same period last year due to the exceptional first -- exceptionally strong first quarter performance this year in our licensing business. As I just mentioned, we generally look for the ITS gross margins to continue to improve modestly over the course of the next year or so as revenue ramps for our implementation activities.

This, of course, with the prospect of even higher margins heading into 2024 once our current wave of implementations are handed over to operations, where we target margins that are materially higher yet. As a reminder, we generally think about gross margins for projects in the implementation phase as being between 10% and 15%, rising to between 30% and 50% during the operations and changeover phases. This step-up in gross margin, which is embedded in our fee schedules under our long-term contracts is the profitability lever that gives us confidence in our targeted 15% adjusted EBITDA margin target for ITS in the future over time.

Operating expenses for Q3 2022 were up year-over-year in absolute terms due to last year's ETC acquisition and inflationary pressures impacting labor and certain services and supplies. Notwithstanding these labor pressures, we still think, as Bret mentioned, $3 million of integration savings are achievable once we conclude our current programs of system and organizational efforts in early 2023, and we expect to provide more specifics around our cost savings initiatives when we're back laying out our 2023 plan in our next call.

Consolidated adjusted EBITDA was negative $2.7 million in Q3, but of course, still positive, a robust $67 million year-to-date bolstered by a very strong licensing activity in the first quarter of the year. Q3 adjusted EBITDA for the ITS segment was $1.9 million, a significant sequential increase from the negative $4.5 million in Q2 of this year, which reflected our recording of a loss on a singular project and marks a step in the trend we mentioned last quarter toward double-digit EBITDA margins as we execute on our current implementation portfolio and reload our stable of projects and what we expect to be a very busy big year in 2023.

That said, for ITS, we do see next year shaping up as a year of measured EBITDA improvement, main stayed by projects that we already have under contract with upside coming from the potential for enhancement and change order work. To capitalize on the opportunity, we plan to continue to maintain a strong cash and liquidity position.

Cash used in operations was $26.9 million for Q3, which included a $14.6 million settlement payout from our ongoing VIZIYA arbitration. Year-to-date cash from operations was $41.3 million. Cash, cash equivalents, short-term investments were $76 million at quarter end compared to $72.6 million last year. In addition, we also had $7 million in restricted short-term investments at the end of Q3. Working capital was $112.8 million, up from $105 million last year.

Lastly, Quarterhill paid off $20.8 million of debt in Q3, bringing to $35.3 million, the amount of debt is paid down this year from the ETC acquisition. As a result of these paydowns, senior debt outstanding stood at $30.2 million at quarter end, down from $62 million last year.

Consistent with prior quarters, we continued our dividend payments in Q3. And on November 9, the Board of Directors declared a dividend of [ $0.0125 ] per share to be payable on January 9, 2023, to shareholders of record on December 9, 2022.

In closing, Q3 saw a sequential improvement in the ITS business returning to profitability, notwithstanding slower-than-planned ramp in its implementation portfolio and notwithstanding a nagging inflationary and labor backdrop. Although we don't expect the cost and labor climate to be resolved overnight. We do continue to feel good about our ability to shepherd our early-stage projects into their higher-margin cash flow phase in 2024 to capitalize on our opportunity set of potential high-margin enhancement awards next year and compete successfully for new long-term projects, leveraging our excellent technical and operational reputation in the tolling and commercial vehicle enforcement space, all the while progressing toward an attractive double-digit EBITDA margin as we move through the next year or so.

That concludes my remarks. And I'll turn the call back over to the operator.

[Operator]

So we have a first question here from Andy Nguyen from Raymond James.

[Andy Nguyen, analyst]

Guys, my first question will be on the WiLAN sell process. Could you give us some update on the sale process?

[Bret Kidd, executive]

Thanks for joining the question. Yes, as we noted, the process is continuing in a positive direction, but unfortunately given the stages that we're at, there's not a lot more that we can say about it at this time. Sorry, I wish we could.

[Operator]

Question is coming from Gavin Fairweather from Cormark.

[Gavin Fairweather, analyst]

On ETC and some of the bottlenecks that you're seeing on the implementation side. I'm curious whether those are coming from kind of the clients themselves, getting hardware or labor and whether those factors were generally kind of improving in Q3 relative to what you saw in Q2?

[Bret Kidd, executive]

Yes, Gavin, great question, and you're exactly right. The nature of the delays that we've seen this year have come from multiple directions and the ones you listed are actually really the most common. On the ramp-up of signed business, so the work that we've already signed, that's in backlog. There's been a blend of things, some of around customer priorities. So the priorities can shift and that can be related to physical construction and some issues that may be having there, which could then have an impact on us. And we've also had in various programs, both at ETC and IRD issues around labor scarcity in particular, and then also some supply chain impacts affecting the materials that we need at a given point in time.

That can be especially impactful in these implementation phases, especially with the roadside deals where there's a fair amount of equipment involved in those implementations. So there are a range of items like that, that can impact the timing and the ramp. There's also the other side that we've talked about on the new business that's still unsigned and then some of the delays around those decisions as well.

Actually can be some similarities too and that the agencies themselves and getting RFPs out [indiscernible] can be impacted by upstream projects, either technical or physical that they're dealing with. But the good news is that we are seeing improvement. We saw improvement in Q3 in the ramp of the sign business and the work that we're doing on the current implementation program. So we are seeing improvement there.

And I think both R&D and ETC are getting better and better at managing the labor scarcity, finding better talent, getting folks in and utilizing different sources in order to meet those needs and then also managing the supply chain, cultivating alternative sources and getting some additional redundancy and resiliency built into those supply chains. So I think those improvements, you saw some in Q3, and we expect to continue to see those into Q4 and on into 2023 as well.

[Gavin Fairweather, analyst]

That's very helpful. And then just on the macro environment, I mean, you kind of discussed your expectation that your ITS segment should be fairly resilient. I'm curious if that statement applies kind of equally to IRD and ETC. And maybe we can just discuss kind of the IRD backlog and pipeline and momentum that you're seeing in that business, which doesn't have the big flashy projects that we talk about on the ETC side, but curious for an update there.

[Bret Kidd, executive]

Yes. Another great question. And yes, there's a lot to be excited about with the IRD business as well. I do believe that both are generally recession-resistant. IRD has performed well through -- it's got a 40-year history, and it's performed well through prior recessionary environments. You do have -- because both organizations provide services to public sector. Public sector itself, it tends to be less recession-prone, if you will. And there can be that countercyclical effect where dollars are actually released by the government in order to help offset. We already had some of that stimulus, you could call it, in the form of the Biden Infrastructure Bill, which already is moving money into the states, U.S. states.

Four things lie for high-priority projects like safety and sustainability solutions, which we address and IRD is benefiting from. So we see a strong position in both companies relative to recessionary pressures. The ETC business, they are our long-term contracts. And so you don't tend to get that fluctuation. So we see good position on both organizations as even as we look into a tougher market broadly. Does that -- did I get you the whole part question?

[Gavin Fairweather, analyst]

No, that was great. And then maybe just on kind of M&A deal landscape, obviously, we've seen the public comps coming under some multiple compression here given what's going on in the market. Curious if that's kind of filtering through into the private market side as your corp dev team is looking at potential additions to your platform there?

[Bret Kidd, executive]

Yes. We are continuing to see deal flow, and I will say the private valuations continue to be uneven. I think that some are better at recognizing the broader fundamentals of the market and the valuation is getting a bit better. And others that we've seen haven't been. We have -- we continue to engage with opportunities that we think could be interesting for us. And for those that we think can bring the technology or operational capabilities and also can provide enhanced -- enhancements in the way of our financial returns as well. But we're continuing to be selective and due to some valuations, which we believe are too high. We have disengaged from a number of different processes as well.

I think our focus on M&A at this point, again, as I mentioned, our primary focus really is around the implementations we have and just a tremendous amount of organic opportunities. But we do believe that tactical M&A tuck-in type businesses that support those organic objectives continue to be interesting, we'll continue to look at them.

[Gavin Fairweather, analyst]

Great. And then just lastly for me on WiLAN. Obviously, it's hard to pinpoint the timing of a conclusion to your view. We're looking at this quarter kind of a minimal production quarter. I know it is volatile kind of quarter-to-quarter, but maybe you can just give us a sense of the underlying level of activity around license negotiations and any kind of upcoming trials just to give us a sense of the level of kind of underlying activity within that business?

[Bret Kidd, executive]

Yes. So the business continues to perform well as not only Q1 is illustrated, but even this recent agreement that was announced with Micron. There's over 20 programs in flight with WiLAN as we speak. And so the business continues to perform well. One thing that I believe we've mentioned before and I referred to it in my comments is that if you look at WiLAN over time, performs extremely well. The average over the past 5 years in terms of EBITDA is nearly CAD 30 million. And so that very strong team that we have with -- I think it's over 4,500 assets that they've got focused on these 20 programs continue to perform well. And so we're excited about what WiLAN's doing, what it's achieving in the market. And again, you'll see some more of those results here in Q4 and those things contributed, obviously, to the nature of the strategic review as well.

And I guess one thing I should have mentioned after the first call, too, is that these sorts of processes. They have varying time lines depending on the nature of the asset involved. In the case of WiLAN, as you might imagine, the diligence there is going to be on the longer end of that spectrum given the nature of the business and the underlying assets and what the prospective buyers or interested parties would need to understand. So hopefully, that helps explain the overall time line.

[Operator]

There are no further questions now. Please proceed, sir. You can close the call now. There's no further questions. Go ahead.

[Bret Kidd, executive]

Okay. All right. Well, very good. Thank you, everyone, for participating this morning. I appreciate the questions. And look forward to continuing engagement with everyone going forward. Again, we're pleased with where things are headed and excited about the future. So thank you all. Have a good day and a good luck on a busy season this time of year. Thanks so much.

[Operator]

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