DIRTT Environmental Solutions Ltd. (DRTT) CEO Benjamin Urban on Q2 2022 Results – Earnings Call Transcript

DIRTT Environmental Solutions Ltd. (NASDAQ:DRTT) Q2 2022 Earnings Conference Call July 28, 2022 10:00 AM ET

Company Participants

Kim MacEachern – Director of Investor Relations

Benjamin Urban – Chief Executive Officer

Geoff Krause – Chief Financial Officer

Conference Call Participants

Rupert Merer – National Bank

Neil Linsdell – iA Capital Markets

Operator

Good day. And thank you for standing by. Welcome to DIRTT’s Second Quarter 2022 Financial Results Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded.

I would now like to hand the conference over to your speaker today, Kim MacEachern, Director of Investor Relations. Please go ahead.

Kim MacEachern

Thank you, Operator, and good morning, everyone. Welcome to today’s call to discuss DIRTT’s second quarter 2022 results. Joining me on the call today are Benjamin Urban, DIRTT’s newly appointed CEO; and Geoff Krause, CFO.

Today’s prepared remarks are accompanied by presentation slides. To access the slides, please use them from the web page of this webcast or on our Web site. Today’s call will include forward-looking statements within the meaning of applicable Canadian and United States securities laws. These statements are based on the company’s current intent, expectations and projections. They are not guarantees of future performance.

In addition, this call will reference non-GAAP results, excluding special items. Please reference our Form 10-Q filed on July 27, 2022, with the Securities and Exchange Commission, or SEC, and other reports and filings with the SEC for information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results. I will also remind you that this webcast is being recorded, and a replay will be available today at approximately 1:00 p.m. Eastern Time.

I would now like to turn the call over to Benjamin.

Benjamin Urban

Thank you, Kim, and good morning, everyone. Beginning on slide four, it is my pleasure to be joining for the first time today as DIRTT’s CEO. It’s been an exhilarating first few weeks and as to be expected, I hit the ground running. In a short period of time, I’ve worked with the Board and management to execute on some crucial short-term actions while we develop our long-term plan. As you know, I come to this position with a great deal of first-hand knowledge of DIRTT having worked as a DIRTT partner for over 14 years. I believe for many years and more strongly now than ever that the growth opportunity for DIRTT as it was for me as a distribution partner is significant.

There is no one in the market that can do what we can do. I’ve seen how impressed clients are by their completed projects and know this is due to the unique manner in which we deliver our solution. This holistic approach is unmatched, and our largest opportunity for growth is — continues to be displayed in conventional construction.

I also believe that ICE is still our most powerful sales and manufacturing tool, and I’m also a strong proponent of evolving — resolving some of the pain points in getting orders into revenue, which uses up valuable time and resources.

The big picture is encouraging. Notably, we are starting to see demand increase in the industry for — more specifically for DIRTT’s products as we emerge from the pandemic-induced market uncertainty over the past several years. Our 12-month forward pipeline in cleaning needs is up 13% from April 2022 to $359 million, excluding the impacts of the 2022 price increases.

Our partners continue to report that they are quite busy and attendance at our Connext trade show, which we held in June 2022, was about 10% higher than it was in 2019. All of these indicators are forming in the right direction.

It’s especially important to me, however, to ensure that while we consider what we could grow into in the future, we also recognize where we are now, that we are currently facing our escalating costs that are impacting our profitability and manufacturing constraints, which are impeding our ability to scale up with increased demand.

We have and are taking specific steps to address these immediate tactical issues, which I expect will positively impact third quarter results and beyond. First, to combat inflationary efforts on our raw materials and labor, we recently implemented 2 price increases, a 5% increase effective June 1, 2022, and a further 10% increase effective July 21, 2022. We also terminated a pilot price reduction program for Reflect and Inspire.

Furthermore, we have increased our governance around discounts provided. During the pandemic, we used discounts as a means to drive increased volume in a period of low demand. But with demand increasing and in a rising cost market, we recognize that we needed to curtail this activity. We expect the positive profitability impacts of both these items will begin to be realized mid-third quarter.

Second, we are unlocking our physical manufacturing capacity through multiple actions. As Geoff will talk about in a bit, during the quarter, we increased our manufacturing headcount by 9%, mainly in Calgary, and are continuing to work on hiring in Savannah, which has proved more challenging. It takes about 45 days for a new employee to become fully productive, so we will begin to see the effects of this in the third quarter. Given this lead time, we have moved to a proactive hiring stance and have begun to hire in advance of anticipated growth.

Adding headcount though is only part of the solution. Increasing the pace of projects, going through our order engineering process, improving our internal communication by breaking down silos and optimizing our manufacturing processes for new products like Reflect and Inspire is also key. To that end, we have established a cross-functional working group to address these first 2 issues and are seeing immediate improvement. We’re also implementing changes to manufacturing processes for Reflect and Inspire that will reduce manufacturing time and equipment bottlenecks, a portion of which is already in place and the remainder of which will be completed by mid Q3.

Turning to slide five, we are also focused on improving overall productivity across the organization, not simply in our manufacturing facilities. This includes taking a good look at our approach to distribution partner requirement, onboarding, management and accountability. It involves redefining our approach to strategic accounts and market segment management, evaluating how these 2 important components of our commercial function interacts with our partners and drive results. It includes reigniting our culture by bringing our people back together and above all, it means streamlining the overall organization, including our sales organization such that we can be agile and responsive while we grow our market share and establish our market presence.

In this latter component, that has enabled us to implement further fixed cost reductions, including 36 salary positions for a total annual savings of approximately $5 million. This also includes some leadership changes. We announced the departures of Charles Kraus, Senior Vice President and General Counsel; and Colin Blehm, Vice President, Product Development; as well as the promotion of Trevor Didluck to the Vice President, Product Development role. Nandini Somayaji has been promoted to Senior Vice President, Talent and General Counsel and Corporate Secretary of the company. Geoff Krause, DIRTT’s current Chief Financial Officer, has announced his intention to retire from the company effective September 30, 2022. A search for a suitable replacement has commenced, and we are also making good progress on our search for a Chief Operation Officer. I’d like to take the opportunity to thank Chuck, Colin and Geoff for their dedication and service to the company.

As we look forward and complete the aforementioned near-term realignment initiatives, I anticipate prosperity and opportunity ahead for this company. Today, we have a renewed, stronger and altogether different DIRTT. And it is through the efforts of all the passionate individuals here at DIRTT, our distribution partners and our Board that have made this successful.

We will continue to affect great and rapid change by rekindling that culture and dedication that is so uniquely DIRTT. I firmly believe that there isn’t another company that can affect change the way that we can with the people and technology and solutions that we deliver. Our method of construction will continue to change the construction industry, and with it, not only the growth of DIRTT, but also those partners that journey with us.

I’ll now turn it over to Geoff to provide some further financial color on quarter and the items that I discussed. Geoff?

Geoff Krause

Thanks, Benjamin, and good morning, everyone. Turning to slide six, revenues for the quarter were $44.7 million, consistent with our expectations and an increase of 16.8% and 8.8% over the first quarter of 2022 and the second quarter of 2021, respectively.

As a result of the increased activity, we experienced some manufacturing capacity constraints resulting from the need for additional staff at our Calgary and Savannah facilities to handle the increased volumes. It is important to note that between December 31, 2019 and December 31, 2021, and in response to declining demand, we reduced our overall hourly headcount by about 34%. With demand increasing, we are now into a hiring mode to unlock our physical capacity, which is constrained by labor levels.

The challenge of attracting and training manufacturing employees on short notice and in a tight labor market resulted in revenue being delayed — some revenue being delayed into the third quarter. To increase our competitiveness, we have also raised hourly wages in both Calgary and Savannah.

During the quarter, we increased our overall manufacturing headcount by 9%, all of which in Calgary, which has proven easier to staff up than Savannah. We also commenced night shifts for certain operations in Calgary. Manufacturing headcount and productivity continue to be a focus for us, and we will continue to provide add resources as necessary as we see sales continuing to improve.

Turning to slide seven, gross profit margin for the quarter decreased to 14% from 22.4% for the same period in 2021. Similarly, adjusted gross profit margin declined to 18.9% from 27.4% for the same period in 2021. As we’ve discussed in prior quarters, we’ve experienced significant increases in the realized cost of raw materials, transportation and packaging. During the second quarter, material transportation and packaging costs increased by approximately 5.4% as a percentage of revenue compared to the second quarter of 2021.

In response to these inflationary pressures on inputs and in an effort to drive ourselves back to historical margin levels, we have instituted a number of price increases to date. This includes a 5% increase announced in February that was effective June 1, 2022. As a result of honoring price quotes for certain projects in process, there is some degree of lag before we recognize the full benefit of the price increase, and we expect to see the benefits of the June increase in the third quarter.

We also determined that based on current input price increases, an additional 10% price increase was warranted, which we implemented on July 21. We also terminated a pilot price reduction program for Reflect an Inspire and have curtailed the amount of discounting that we’ve been doing, as Benjamin has discussed. We expect to see the benefits of these items beginning in the middle of the third quarter of 2022.

We continue to monitor the trends of our input prices and are ready to take further actions should it warrant. That said, it looks like we are beginning to see some relief in upward pressure. Aluminum commodity prices have recently come off their highs and other input costs appear to have leveled. The current quarter margins were also impacted by additional labor costs and inefficiency associated with adding and training manufacturing employees in Calgary and Savannah following the closure of the Phoenix plant, and in anticipation of continued higher volumes.

Further, compared to the second quarter of 2021, we incurred incremental fixed costs of our manufacturing facility in Rock Hill, South Carolina. These increases were slightly offset by a weakening Canadian dollar this quarter with a $0.8 million benefit of Canadian dollar-denominated manufacturing costs and by marginal fixed cost leverage on account of the 9% increase in revenue compared to the same period last year.

Looking at a breakdown of operating basis on slide eight, sales and marketing expenses increased by $0.2 million to $7.8 million for the 3 months ended June 30, 2022, which was largely related to an increase of $0.9 million in travel, meals and entertainment expenses, offset by a decrease in salaries and benefits costs due to flat headcount reductions as part of the cost savings initiatives announced in February.

I would note that travel was higher this quarter due to both the easing of travel restrictions and increased business activity as well as our Connext trade show in June compared to last year when we did a much scaled-down version of the event in the fourth quarter.

General and administrative expenses decreased by $0.9 million to $6.9 million for the 3 months ended June 30, 2022, approximately $0.3 million of professional fees associated with the contested election of Directors was more than offset by lower salaries and benefits costs. Operations support expenses increased by $0.3 million to $2.5 million for the 3 months ended June 30, 2022. The increase was due to lower cost capitalized on internal projects with the completion of Rock Hill and Dallas DXC last year and an increase in salaries and benefits of $0.2 million. Technology and development expenses were consistent with prior period costs as $0.2 million of lower capitalized costs due to fewer internal projects were offset by reductions in salaries and benefits expense.

For the quarter ended June 30, 2022, we incurred $5.2 million in reorganization costs attributed to the closure of the Phoenix facility, reduction in workforce and change of control of the Board. Actual costs are higher than originally anticipated of $4.4 million due to additional severance arising in June ’22, with the departure of 2 executives and additional costs totaling $3.7 million of director and officer runoff insurance and renewal costs following a change of control of the Board of Directors. That was part of the $4.4 million we announced previously.

On slide nine, adjusted EBITDA and adjusted EBITDA margin for the quarter decreased to a $9.4 million loss or negative 21.1% from $6.8 million loss or 16.3% in the same period of 2021, driven by the reduction of gross margin profit — gross profit margin, as I’ve already discussed.

On slide 10, net loss for the quarter increased to $19.3 million or $0.22 net loss per share in the 3 months ended June 30, 2022, from a net loss of $9.7 million or $0.11 net loss per share for the 3 months ended June 30, 2021. The higher net loss primarily is the result of the lower gross profit margin of — a $4.2 million increase in operating expenses driven by onetime reorganization costs, a $3.4 million reduction in government subsidies and a $0.5 million increase in interest expense, offset by a $1.3 million increase in foreign exchange gains.

Turning to slide 11, we finished the quarter with $19.7 million of unrestricted cash compared to $38.9 million at March 31, 2022. Net working capital at the end of the quarter was $31.6 million, and we used approximately $19.1 million of cash in the second quarter, which included $6 million of onetime restructuring, proxy contest costs and other related payments.

Our cash usage has been at unsustainable levels, and we have taken numerous steps to address the issue. We have lowered our overall fixed cost base in a number of ways, including the closing of the manufacturing facility in the second quarter of 2022, reductions in our hourly headcount in 2021, salary headcount reductions and other fixed cost savings initiatives announced in February ’22 and today, in July 2022.

As I said before, since March of this year, we have experienced a significant increase in demand, particularly within our commercial and education verticals. In response, we entered efforts to increase manufacturing accounts at our Calgary and Savannah facilities in order to meet both immediate demand and anticipate future increase. We believe the manufacturing headcount additions, training and debottlenecking will begin to be realized in the middle of the third quarter of 2023, continuing through the balance of the year. This will support higher revenue levels and mitigate cash usage through anticipated gross profit, including net leverage effects.

We have also implemented two price increases, which I spoke to earlier, to mitigate the inflationary impact on our raw material, transportation and packaging costs and significantly curtail pricing discounts given. This is also expected to drive higher gross profit. We have assessed the company’s liquidity using multiple downside and upside scenarios. Taking into account our sales outlook for the next 12 months and the actions I’ve just described and in combination with existing cash balances and available credit facilities, we believe we have sufficient liquidity for the next 12 months and we expect cash usage to improve throughout the year due to sequentially improving revenues, including the effects of price increases, curtailed discounts, a lower fixed cost base and reduced onetime costs. Available and undrawn borrowing under our asset-backed credit facility with RBC stands at $11.3 million at the end of the quarter.

From a work capital perspective, we continue to experience a buildup in inventory, primarily in aluminum extrusions, reflecting a difficulty in increasing price — productive capacity relative to expectations. Inventory increased by $3.7 million and $3.4 million in the second and first quarter of 2022, respectively. We have taken steps to moderate our supply, and we expect to begin to reduce inventory levels in the third and fourth quarters. Days sales outstanding, net of deposits and income taxes receivable, was 27 days, in line with our targets. Our current ratio at June 30 was 1.8x compared to 2.2x at March 31.

For the full-year 2022, our revenue guidance remains unchanged at between $175 million and $185 million, the midpoint of which represents an approximate 22% increase over 2021 revenue. We expect to see improved adjusted EBITDA and net loss through the balance of 2022, approaching monthly cash flow breakeven in Q4.

Operator, we can now open the call up for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question will come from Rupert Merer from National Bank. And your line is now open.

Rupert Merer

Hi. Good morning, everyone.

Benjamin Urban

Good morning, Rupert.

Geoff Krause

Good morning, Rupert. How are you doing?

Rupert Merer

Doing well. So, Geoff, you’ve talked about headcount reductions and increasing pricing and other actions that you’ve taken to push you towards breakeven. Can you talk about what that walk looks like from where we are today to the year-end? And what the impacts of all the actions you’ve taken should have on your quarterly EBITDA by year-end?

Geoff Krause

Absolutely. Thanks for that question, Rupert. And I’ll reference back to the current quarter as kind of a baseline. So, our current quarter cash burn was $19 million based on $47 million of revenue or $44 million of revenue — $47 million of revenue, sorry. Sorry, $44 million of revenue with nominal impact from the June 1 price increase and no impact of the July 21 price increase that we just did. So, included in that $19 million cash usage was about $6 million of onetime costs, $5.2 million of reorg, including the D&O insurance runoff, $0.3 million contested election and about $0.6 million of DSU payments in cash to the former Directors. So that makes the next year about $13 million a quarter on $44.7 million of revenue.

Accounting for response, first, since June 1, and including the July 21 increase, we’ve raised prices by about 15%. We expect to see the impact of that mid-third quarter. Second, we have significantly curtailed our discount activities and that should benefit us to the tune of 3% to 5% revenue increase. So the combination of that is anywhere between 18% and 20%. We expect to see the impacts of those mid-third quarter. Third, we’ve reduced our cost base at the end of July by about $5 million per annum, that’s about $1.25 million per quarter. We have the effect of the Phoenix closure, which is about $0.25 million per quarter since we staffed up some of our variable labor offsetting some of the previously announced savings. So there’s — in total, there’s about $1.5 million of quarterly savings there. All of those things that I’ve talked about go directly to the bottom line and it gets you close.

With the debottlenecking in the plants that Benjamin and I discussed, the increased revenue and demand that we’ve seen, our new hires getting trained and productive, that increases our overall labor efficiency and that gets us to the rest of the way. And I think the other thing which is important is a large part of our gross margin compression has come with the inflationary impacts that we’ve seen, which is why we’ve done the price increases. We’re setting those input costs come back down, and I think that will also benefit, although we haven’t taken that into account. Does that help you?

Rupert Merer

Yes. That’s great, Geoff. Thank you.

Operator

Thank you. [Operator Instructions] Our next question will come from Neil Linsdell from iA Capital Markets. Your line is now open.

Neil Linsdell

Yes, hi, good morning, guys.

Benjamin Urban

Good morning, Neil.

Geoff Krause

Good morning, Neil.

Neil Linsdell

Good morning. For Benjamin, I’m really curious about your perspective being — recently being a distribution partner now moving up to DIRTT. From working with clients, how have you seen client requirements, decision-making processes changed and specifically in the last couple of — last few years, like — and how are they dealing with the macro environment? Because I’m really curious as to how you look at DIRTT as far as not having addressed that before or trying to put some processes in place that help respond to some of these changes.

Benjamin Urban

Thanks, Neil. Yes, that is a great question. And having come from the distribution partner directly, I can say with certainty that their requirements and decision-making processes have changed significantly in the last few years by both the pandemic as well as uncertainty in the economy. I think that the pandemic has shown, with the limitation in raw materials and resources, including labor, that our clients’ needs for cost certainty and rapid construction with the ability to also have change have proven more difficult for them to obtain through conventional construction now as well as in the immediate future. And that is where our sweet spot is with DIRTT, to be honest. We’re also seeing some additional needs from them or requests for sustainability more so than we’ve seen previously.

And to your question about what we can do better to respond to that, I would say that we can continue to improve our response to these types of changes through improved communication from our distribution partners as well as our direct sales force. But beyond that, I think where our opportunity is to effect more change is even further decreasing the lead times on our products as well as innovation from our product development team to respond to probably needs that come out. I’d say, in closing, all of that really — this is the perfect time for DIRTT, Neil. The way that we deliver construction is perfectly in line with what our customers are looking for even more so than previously.

Neil Linsdell

Okay, fair enough. Thanks.

Benjamin Urban

You are welcome.

Operator

Thank you. And that does conclude our Q&A session for today’s conference. I’d now like to turn the call back over to Benjamin Urban for any closing remarks.

Benjamin Urban

Thank you so much. I’d like to thank you all for joining us today, and I look forward to speaking more with you in the coming months. To reiterate my earlier comments, I anticipate prosperity and opportunity ahead for this company and that is what inspired me to take the role of CEO. We have decisively made changes to the organization that will result in a renewed stronger and altogether different DIRTT. The big picture demand environment is improving, and we are addressing our immediate inflationary and manufacturing challenges. We continue to see 2022 as a year of revenue growth over 2021 with our guidance of between $175 million and $185 million.

I want to thank all of the passionate individuals here at DIRTT, our distribution partners and our Board for their tremendous efforts to set us up. Thank you.

Operator

Thank you. This concludes today’s conference call. Thank you for your participation. You may now disconnect. Everyone, have a great day.

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