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Edited Transcript of DRT.TO earnings conference call or presentation 9-May-19 2:00pm GMT

Q1 2019 DIRTT Environmental Solutions Ltd Earnings Call

CALGARY May 20, 2019 (Thomson StreetEvents) -- Edited Transcript of DIRTT Environmental Solutions Ltd earnings conference call or presentation Thursday, May 9, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Geoffrey D. Krause

DIRTT Environmental Solutions Ltd. - CFO

* Kevin P. O'Meara

DIRTT Environmental Solutions Ltd. - CEO & Director

* Kim MacEachern

DIRTT Environmental Solutions Ltd. - IR Executive

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Conference Call Participants

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* Adnan Waheed

National Bank Financial, Inc., Research Division - Associate

* David Quezada

Raymond James Ltd., Research Division - Equity Analyst

* Elizabeth Johnston

Laurentian Bank Securities, Inc., Research Division - Analyst

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Presentation

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Operator [1]

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Good morning, and thank you for standing by. I am the operator on today's call. Welcome to the DIRTT Environmental Solutions 2019 First Quarter Financial Results Conference Call. (Operator Instructions) I will now turn the call over to Ms. Kim MacEachern, Director of Investor Relations for DIRTT. Ms. MacEachern, please go ahead.

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Kim MacEachern, DIRTT Environmental Solutions Ltd. - IR Executive [2]

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Thank you. Good morning, everyone, and welcome to today's call to discuss DIRTT's Q1 results. Joining me on the call are DIRTT's Chief Executive Officer, Kevin O'Meara; and Chief Financial Officer, Geoff Krause.

Management's prepared remarks today are accompanied by presentation slides. To access the slides, if you've not already done so, please view them from the web page of this webcast or go to the Investors section of DIRTT's website. The earnings press release that was issued yesterday afternoon can also be found on our website.

We will begin with opening remarks from Kevin on Slide 4, followed by Geoff providing a review of our results and our current outlook. We will then move to the Q&A portion of the call.

Today's call will include forward-looking statements, and because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially. In addition, as this call will include references to non-IFRS results, excluding special items, please reference the company's management discussion and analysis available in the Investors section of dirtt.net or on sedar.com for further information regarding forward-looking statements and reconciliations of non-IFRS results to IFRS results.

I will also remind you that this webcast is being recorded, and a replay will be available today at approximately 1 p.m. Eastern Time.

I now turn the call over to Kevin.

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [3]

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Thank you, Kim. We're pleased to review the results of our first quarter with you today and to update you on DIRTT's continued progress.

On our last call together in March, I shared 2 significant observations about our business as they shaped my view of the years to come and the strategy that will sustainably drive DIRTT's long-term success. For today's call, I will start with updates connected to those observations.

The first observation was, it's a testament to the strength of DIRTT solutions that the company has achieved levels of growth it has despite an underdeveloped approach to sales and marketing. By way of update, we're making progress in our strategic business review, particularly in sales and marketing. We're setting out to define a long-term and data-driven marketing strategy. This process began with DIRTT's management team outlining the data and analysis needed to devise that strategy. Accordingly, through our comprehensive and competitive process, we engaged an internationally recognized management consulting firm to provide an in-depth analysis of DIRTT's markets. We expect the engagement to be completed by the end of this year's third quarter and to support the development and execution of our long-term marketing strategy, with the goal of strategically positioning us for increased market penetration and sales growth. Our search for a Chief Commercial Officer, which is a new role for DIRTT, remains in progress. We continue to evaluate candidates and are taking care not to rush this critically important decision.

Second observation I shared was that DIRTT's prior approach to manufacturing led to reactive versus proactive management of its operations, and that we had to address it in order to effectively scale our business, achieve significant revenue growth and enhance operational performance. As we discussed, the first step was to recruit a new Chief Operating Officer, Jeff Calkins. Under Jeff's leadership, the operations team has made tremendous strides forward regarding the continuous improvement of DIRTT's manufacturing operations. We've implemented daily and long-term performance tracking and measurement boards in all DIRTT plant locations, consistent with lean manufacturing principles. These boards aggressively track safety, quality, delivery, inventory and productivity and promote a culture of rapid and efficient problem-solving that drives improved performance. We're also developing standard manufacturing operating baselines to ensure best practices are followed in all operations. Finally, we're conducting an in depth analysis of our capacity to ensure we are able to serve future sales growth.

Now turning our attention to the post-delivery tile warping challenges that we discussed on our last quarterly call. As you will recall, this was caused by regulatory-driven changes to the resin within the MDF substrate that we use for our tiles. We are in the midst of determining a permanent solution to eliminate the potential warping of tiles due to humidity in transit and on job sites. We're rigorously testing several options, including the potential use of higher-resin-content substrates and/or the application of a pre-finishing sealant. While the testing shows positive early results, it's too early to unequivocally say the problem has been solved until our demanding testing and analysis protocols are complete. The occurrence of warping was partially attributable to humidity in storage and installation environments, and accordingly, we're working closely with our partners to mitigate this. Obviously, we're firmly committed to a resolution that will eliminate all occurrences going forward, and we'll update you as we progress.

Elsewhere in the organization. I'm pleased to share progress made by our talent team, led by Senior Vice President of Talent, Krista Pell. The talent team has successfully implemented employee incentive programs based on financial and manufacturing performance metrics. These nondiscretionary, self-funding programs recognize and reward the immense value and importance of our people and ultimately motivate behaviors aligned with business growth, boost employee morale and operating efficiencies. The programs were enthusiastically received by our employees.

I will now turn the call over to Geoff for his review of the financials.

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [4]

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Thank you, Kevin. Before we get into our first quarter results, I'd first like to talk about the accounting impacts of the new IFRS lease accounting standard that was prospectively adopted on January 1, 2019, and how it affects comparability between 2018 and 2019. I refer you to Slide 5.

Because it was adopted prospectively, 2018 numbers have not been restated. This new standard effectively does 2 things to our statements. First, on the balance sheet, the present value of our leases, comprised mainly of facility and office rents, is brought on to the balance sheet as a right-of-use asset with a corresponding liability. Second, on the income statement, the right-of-use asset is now depreciated over its life, while the right-of-use liability is increased for the year's interest cost and decreased by cash payments. The net impact between 2018 and 2019 first quarter income statements is that rent expense in 2018 is replaced by about $1.4 million of depreciation and $300,000 of interest expense in the quarter. This results in an accounting-driven $1.7 million decrease in adjusted operating costs and a corresponding increase in adjusted EBITDA, both of which have been fully disclosed in the MD&A.

Now let's talk about the business. Moving to Slide 6. Revenue in the quarter of 2019 increased by $5.6 million or 6.9% over the first quarter of 2018 to $86.3 million. It is important to note that, by comparison, we had an unusually strong quarter in 2018 when $5 million to $10 million of revenue moved into the quarter from 2017 due to the impact of hurricanes on project timing. We continue to see an increase in the prominence of our health care sales in the first quarter, which increased as a percentage of quarterly revenue to 20% from 16% in 2018. Compared to Q1 2018, we saw $7.6 million or 10% increase in overall product and associated transportation revenues. Revenue was buoyed by a 5% increase in the U.S. dollar, vis-à-vis, the Canadian dollar, which contributed approximately $4.5 million to the quarter. These increases were offset by a $2 million reduction in installation revenues, reflecting the timing of projects. As we have noted previously, and except under certain circumstances, our approach is to have the distribution partner undertake the installation services as opposed to DIRTT. Accordingly, we do not see or anticipate significant growth in this revenue stream.

Turning to Slide 7. Adjusted gross profit percentage for the quarter decreased to 41.6% of revenue from 46.1% in the first quarter of 2018. As shown on this slide, to put the first quarter of 2018 in perspective, last year's gross profit percentage is at the top end of our historical range and the highest of our last 8 quarters. In Q1 of 2018, sales increased 8% over the previous quarter without a corresponding increase in headcount. While this caused a favorable direct labor variance for the quarter, the plants were operated at an unsustainable labor utilization rate. Headcount was subsequently increased in anticipation of continued sales growth for the balance of the year, bringing adjusted gross profit back in line with historical norms for the remainder of 2018. But comparing the first quarter of 2019 with that of 2018, this accounted for approximately 2% of the difference in gross profit percentage.

I want to emphasize that our current quarter gross profit percentage is in line with the previous 3 quarters after removing the impact of higher material costs related to tile deficiencies in Q4 of 2018 and Q1 of 2019. It is important to note that gross profit percentage will move with our revenue levels due to some fixed cost nature of about 20% to 30% of our cost of sales.

As we discussed in our year-end conference call, we expected downward pressure on our gross profit margins in the first half of 2019. This is mainly associated with the use of higher cost MDF substrate as a temporary solution to our isolated incidents of warping. As Kevin noted, we are working diligently on a resolution. In the quarter, approximately $2 million of additional material costs were incurred and attributable to this, equating to a 2.3% decline in adjusted gross profit as a percentage of sales. We do expect our work in the plant to partially mitigate the downward pressure in the first half.

Turning to Slide 8. You'll see a waterfall chart displaying the adjusted EBITDA variance. Adjusted EBITDA for the quarter was $11 million or 12.8% of revenue in the first quarter compared to $12.7 million or 15.7% of revenue in 2018. After removing the $1.7 million positive impact of the new leasing standard, adjusted EBITDA was $3.4 million lower than 2018. This is explained almost entirely by the lower gross profit percentage, combined with about $1.4 million of FX losses and $900,000 in onetime professional fees related to our planned NASDAQ listing.

Turning to Slide 9. Adjusted operating expenses were $23.9 million for the first quarter compared to $25 million last year. These expenses exclude the impact of stock-based compensation, depreciation and reorganization costs. After removing the $1.7 million positive impact of the new leasing standard, adjusted operating expenses would have been $25.6 million or $600,000 higher than last year. This $600,000 increase in adjusted operating expense reflects a few moving and offsetting parts as well as some onetime costs. In sales and marketing, we saw a $2.4 million reduction in spending, reflecting ongoing and targeted reductions of nonrevenue-generating costs. In the first quarter of 2019, we spent $1.9 million less on travel, meals and entertainment and reductions related to a specific trade show, which we did attend. In general and administration, we incurred onetime professional fees associated with our planned NASDAQ listing. In operation support, we incurred $400,000 in consulting costs to assist in the evaluation of our current operations, including tile warping. We continue to see the impacts of improved discipline on our core administrative costs.

Our technology and development expense increased by $1.8 million, reflecting the reduced capitalization of internal salaries. This was mainly in our software development group, where there was an increase in business process improvement activities. While not capitalizable from an accounting perspective, we expect to benefit from this work in the future. As a result, you will note a corresponding $1.5 million reduction in capitalized intangible assets on the cash flow statements. On a total cash basis, though, including both capitalized and expensed amounts, our total spending on technology and development was comparable to the first quarter of 2018.

Turning to Slide 10. First quarter 2019 net loss was $7.8 million or $0.09 per share versus net income of $3.6 million or $0.04 per share last year. Net loss for the quarter was impacted by significantly higher stock-based compensation and $3.5 million of reorganization costs. Stock-based compensation was $9.1 million in the quarter. As you will recall, in 2018, DIRTT ceased to qualify as a foreign private investor or issuer or FPI under the rules of the SEC. As a result, equity issuances are subject to a 1-year hold period, including those under incentive stock option plans. To minimize any potential undue impacts to our employees, DIRTT's Board of Directors approved a cash surrender feature for certain options until our FPI status is returned or our registration statement is filed and accepted by the SEC. Accordingly, we account for the intrinsic value of outstanding stock options at the end of the reporting period. A significant appreciation in the stock price since year-end resulted in an $8 million charge this quarter. Reorganization costs included severance and other costs as we rounded out our executive team, with no further material expenditures expected in the remainder of 2019.

Working capital decreased from $96 million at December 31, 2018 to $88 million at March 31, 2019, including cash and cash equivalents of $72.2 million. I am pleased to note that our emphasis on working capital efficiency is beginning to show benefits. Net cash flows provided by operating activities was $11.7 million, a $20 million improvement over the same quarter of 2018. Cash conversion of working capital was almost $4 million in the quarter. Of note, this is after cash payments of $1 million to settle stock options but excludes $1.9 million of rent payments that are now shown as financing activities under the new standard. We expect this cash settlement of options to cease upon listing our shares on NASDAQ.

During this fortunate -- in the fortunate position of being a high cash-generating, low CapEx business, excluding major expansions, with substantial cash balances, our capital expenditures were $2 million lower than last year mainly due to decreased software developments that we discussed previously. Looking forward, we expect CapEx to be consistent with last year, excluding these lower software development costs.

With our continued high cash balances, we cleaned up our balance sheet in the quarter and repaid all of our outstanding debt in January. We are now completely debt-free.

We continue working through the requirements of listing DIRTT shares on NASDAQ. We met a major milestone at the end of April. We completed the conversion and audit of 3 years of historical statements to U.S. GAAP and U.S. currency. We continue to make good progress on the related listing and governments documents. We are on track to list in the second half of 2019, and total expected costs to complete have increased by $1 million to about $2 million. This is a significant undertaking, and the effort to complete is higher than previously anticipated, mainly in the form of increased audit and legal work. This includes the necessary inclusion of an additional year of historical audited financial statements as well as assessments of required disclosures and revisions to corporate charters and policies to meet U.S. standards.

We reaffirm our prior guidance of between 5% and 10% revenue growth for 2019, but we note that adjusted net income and adjusted EBITDA, which we had previously forecasted to increase commensurately with revenue, will now reflect the impacts of the sales and marketing consulting engagement in the amount of $2.6 million and $2 million of onetime U.S. listing costs.

Now turning it back to Kevin.

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [5]

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Thank you, Geoff. I want to reiterate that 2019 is a transitional year. It's something we spoke about on our last call. And despite some short-term and addressable challenges, our first quarter demonstrates the operational strategic progress we're making in building a platform for scalable and replicable growth. We're satisfied the Q1 revenue fell within our stated guidance, and we reaffirm 5% to 10% revenue growth for 2019.

Our robust leadership team is driving positive change within their areas of expertise. We're bringing increased focus and attention to safety, quality, delivery, inventory and productivity within our operations. We've introduced performance-driven compensation programs for employees. We're developing a long-term, data-driven marketing strategy to drive sales growth. We also remain on track to list our shares on NASDAQ in the second half of 2019. These efforts have been and continue to be fundamental to achieving our goals in this transitional year.

We've now completed our prepared remarks for today's call. I'll turn it over to the operator for questions. Operator, please go ahead.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from David Quezada from Raymond James.

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David Quezada, Raymond James Ltd., Research Division - Equity Analyst [2]

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My first question here, just on the tile warping issue. I guess it definitely sounds like it has continued on into the second quarter. Is that something that you anticipate having an effect as we get into the third quarter? Or do you feel like a solution is kind of imminent here?

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [3]

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David, it's too early to tell. By way of background, we have followed a 3-step process in resolving the situation. The first step was to do a root cause analysis to see what was driving the issue, which we completed. The second is to isolate potential solutions to the issue, which we have done, as we had mentioned before. And then the third piece is to test the solutions to see do they work and do they have any unintended consequences. The third phase is the phase that we're currently in and well into. We are optimists by nature and are optimistic that the test will be successful and that the situation will be resolved. But you test for a reason, and there's always a chance that what happens in the test is that, for some reason, it fails and then we have to take a step back. So we have no reason to think that now, but again, we are in the testing phase. It'd be premature to try to predict exactly when that will be completed and we'll be in a position to say that the problem is behind us.

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David Quezada, Raymond James Ltd., Research Division - Equity Analyst [4]

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Okay. Fair enough. That's good color. And I guess just one follow-up question on that topic. As you get the permanent solution in place, do you anticipate that, that will be -- there will be no change in the long run to your cost structure? Or will you have to start using, I guess, a higher-quality input?

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [5]

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It's a little bit too early to tell exactly what the impact would be on our cost structure until we know exactly what the solution is going to be.

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [6]

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Just to add some color. Wood is about 10% of our overall material cost, and so -- and because these are isolated pieces, it's not a -- it wouldn't be any massive changes.

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David Quezada, Raymond James Ltd., Research Division - Equity Analyst [7]

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Okay. Fair enough. Great. And then just one other question. You obviously saw really good growth again in the health care vertical. Just wondering if there's any color you can provide on nature of the jobs you saw there during the quarter. Yes. Just any color on that vertical in general.

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [8]

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We continue to be very optimistic about that vertical. There were 2 fairly sizeable jobs that completed during the quarter, but we have a nice, attractive pipeline, and we think that, that vertical will continue to grow going forward.

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Operator [9]

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(Operator Instructions) Your next question comes from Elizabeth Johnston from Laurentian Bank.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [10]

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Just a follow-up question regarding the impact of the tiles. I'm trying to think of the best way to think about this headwind. Would you say that it would -- the impact in terms of additional cost to repair would be a function of revenue in the period? Or should I think of it more in terms of absolute dollars?

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [11]

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I think you should -- Elizabeth, it's Geoff here. I think you should think about it in terms of more of absolute dollars. We are -- as we're working through our cost of sales piece, it does relate to direct material costs. And I think it's important to note that we are not seeing a lot of deficiencies now. In fact, our overall warping rate has dropped to around 1%. So it's considerably less than what we saw previously. It's isolated. We are into the less humid part of the season. So it's more in the underlying material costs as we work our way through this.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [12]

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Okay. So given that there's this variability quarter-to-quarter in terms of overall level of revenue, I should still think about that in terms of the absolute dollar impact on gross margin.

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [13]

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Yes. That's probably right.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [14]

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Okay. Okay, that's great. And just turning over to talk about revenue a bit. In Canada, revenue of $9.4 million was a material decline year-over-year. And we know that sales in this segment can be -- or this region, rather, can be fairly variable. But if there was anything you could say with respect to this particular quarter that led to the decline year-over-year?

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [15]

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There wasn't anything that's really big that jumps out. As you know, the Canadian side of the business is 10% to 15% of the overall business as a whole. That means that the timing of projects has a magnified impact of that relative to what you would see in the U.S. side. So it's really a timing of projects. It's not an indication of anything beyond that.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [16]

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And when it comes to your commentary in the MD&A regarding government work and how that was lower having lapped a contract -- or, rather, a contract that was -- did not repeat this year, was that a contract in Canada?

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [17]

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No. That was a U.S. contract.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [18]

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Okay. And so is there anything you can say as we look forward in terms of Canada? I know overall, you've given indication of 5% to 10% revenue growth, but should we therefore expect maybe Canada under-index that? And how -- or how should we think about it on a regional basis?

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [19]

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No. We are busy. We continue to be busy in Canada. We are seeing a robust pipeline up north here. And so I think we would stay within our normal 15% range, but it will have inter-quarter variability, as you have seen.

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Elizabeth Johnston, Laurentian Bank Securities, Inc., Research Division - Analyst [20]

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Okay, great. And as maybe in terms of gross margin, longer term here, excluding the tile impact, which we've already discussed, are you able to talk about where you see this gross margin moving to in the medium to longer term? In other words, I'm trying to see where -- how much expansion could there be as the company improves efficiencies and grows top line.

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [21]

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There's a couple places to look at. The first piece that -- to look at is certainly the leverage off of the fixed cost base, and you would have seen that in Q3 of last year, where we did see a margin expansion primarily associated with that. The second piece is related to the work that Jeff Calkins is doing in the plant, combined with our -- with the incentive programs that we've put in place for employees. We've introduced a significant amount of rigor and measures within the facilities. And in fact, when we were walking through the facilities with our Board of Directors yesterday, we saw an example of that throughout the plant, where targets were there, where numbers were being put up on the board that were actually looking better than the targets are. And it's kind of that what gets measured is what gets done kind of thing.

We expect to see increases of productivity. We expect, as we look at the material costs -- putting increased rigor around our material costs, we should see some benefit off of that. But I think as we also have discussed previously, we will look at what we do with some of those savings and where we apply some of those savings. But we do see significant opportunity there.

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Operator [22]

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(Operator Instructions) Your next question comes from Adnan Waheed from National Bank.

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Adnan Waheed, National Bank Financial, Inc., Research Division - Associate [23]

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I'll be speaking on behalf of Rupert. Just trying to get a little more color on the fiberboard issues. I was wondering, was the $2 million incremental cost that you incurred in the quarter, was that related to the replacement of panels using different materials? Or was it for building new panels altogether?

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Geoffrey D. Krause, DIRTT Environmental Solutions Ltd. - CFO [24]

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No. It's Geoff. It related to -- actually, to step back a bit and give some color is, as we talked about in prior calls, the initial step that the previous operations group did to react to the tile issue was to utilize a higher-cost substrate without going through the appropriate testing protocol. We're continuing to use that because we had commitments with our supplier to use that higher-cost substrate, and that's really what is driving this. That's what's causing the downward pressure. It is not the replacement of tiles.

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Adnan Waheed, National Bank Financial, Inc., Research Division - Associate [25]

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Okay. And I appreciate the color. And then moving on, could you tell us about how your sales pipeline is developing? Geographically speaking, nice to see businesses from North America. Are you observing any behavior in other markets that could be driving demand?

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [26]

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Not really. On a geographic basis, it's roughly consistent, as Geoff indicated, between Canada and United States, and it tends to relate to various projects. And so where we might be particularly active with a handful of projects, that can be a specific state or province where we're busy from one quarter to the next. But there's no underlying trends to where we can say a particular region is significantly over-indexing other regions from a systemic basis.

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Operator [27]

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We have no further questions in queue. I turn the call back over to Kevin O'Meara for closing remarks.

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Kevin P. O'Meara, DIRTT Environmental Solutions Ltd. - CEO & Director [28]

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Thanks, everyone, for joining us today. We appreciate the opportunity to provide you with additional insights into our progress transforming DIRTT into a company that can rapidly and sustainably grow. We look forward to updating you further in our second quarter call. This concludes today's call.

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Operator [29]

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Thank you everyone. This will conclude today's conference call. You may now disconnect.