Earnings Call Transcript - CTOS Q3 2022

Operator, Operator

Greetings. And welcome to the Custom Truck One Source Inc. Third Quarter 2022 Earnings Conference Call. It is now my pleasure to introduce your host, Brian Perman. Thank you, Mr. Perman. You may begin.

Brian Perman, Host

Thank you, and good afternoon. Before we begin, we would like to remind you that management’s commentary and responses to questions on today’s call may include forward-looking statements, which, by their nature, are uncertain and outside of the company’s control. Although these forward-looking statements are based on management’s current expectations and beliefs, actual results may differ materially. For a discussion of some of the factors that could cause actual results to differ, please refer to the Risk Factors section of the company’s filings with the SEC. Additionally, please note that you can find reconciliations of the historical non-GAAP financial measures discussed during the call in the press release issued today. The press release we issued this afternoon, and the presentation for today’s call are posted on the Investor Relations section of our website. We will be filing our third quarter 2022 10-Q with the SEC this evening. Today’s discussion of our results of operations for Custom Truck One Source Inc., or Custom Truck, is presented on a historical basis as of or for the 3 months ended September 30, 2022, and prior periods. While our reported results can only include Custom Truck One Source LP for the period since the April 1, 2021 merger date, we have presented and will be discussing today pro forma combined results as if Nesco and Custom Truck had operated together for all periods. We believe such combined information is useful to compare how the combined company has performed over time. Joining me today are Fred Ross, CEO; Ryan McMonagle, President and COO; and Chris Eperjesy, CFO. I will now turn the call over to Fred.

Fred Ross, CEO

Thanks, Brian, and welcome, everyone, on today’s call. I’d like to begin by thanking all of our employees, customers, and suppliers who support our business and are helping us navigate the challenges our industry continues to face. The entire team continues to work tirelessly to maintain record levels of production so we can fulfill our goals of providing unrivaled service to our customers, growing our market share, and creating value for our shareholders. Compared to the prior year quarter, we delivered strong gross profits and adjusted EBITDA gains as well as modest revenue growth. We delivered $91.6 million of adjusted EBITDA, which is up 9% versus the prior year, while at the same time, Q3 revenue was up slightly versus Q3 of 2021. Supply chain issues continued to impact us in the third quarter, but we were able to deploy $97 million into our rental fleet in the quarter, which is the most since the merger. Supply chain challenges impacted new equipment sales, which unfortunately did not see the sequential growth that we expected. While our supply chain continues to improve, issues remain, and we are working diligently to end the year ahead into 2023 on improved footing. Our ERS business continues to perform very well, with utilization increased by 100 basis points for the quarter and by 250 basis points compared to Q3 of 2021. Our TES business continues to see very strong demand, with backlog growing to a record of $709 million, more than 2x what it was a year ago. Strong demand for both rental and new sales provides us the opportunity to focus on improving profitability through margin expansion. Finally, we remain well-capitalized, and our focus is on reducing our net leverage, which Chris will discuss later. Our third quarter results provide continued momentum for us for Q4 and a very solid foundation as we look forward towards next year. They reflect the realization of the benefits of our one-stop-shop business model and our focus on end markets that consistently exhibit strong underlying fundamentals and are less susceptible to cyclicality. While our outlook for the rest of the year is tempered by the continued impact of global supply chain issues and inflation, we are confident that our team will continue to navigate these effectively. During the last quarter of the year, we expect to see continued strong revenue and adjusted EBITDA margin growth across business segments. With that, I will turn it over to Ryan.

Ryan McMonagle, President and COO

Thanks, Fred, and good afternoon, everyone. First, I want to echo Fred’s comments regarding the tremendous efforts of our employees who helped us deliver another solid quarter. Demand remains very strong in each of our strategically selected four primary end markets: T&D, telecom, rail, and infrastructure. We continue to believe that these markets offer compelling long-term growth opportunities well in excess of GDP and should for the foreseeable future. This can be seen in the reported backlogs of the utility and telecom contractors, our largest customer base, which continue to be extremely strong and at or near record levels. We see this reflected in both our TES backlog, which grew by more than $45 million or 7% in Q3, and in the performance of our rental fleet as well. As Fred mentioned, we added $97 million to our rental fleet in the quarter, the most we’ve added since the merger in early 2021. We are seeing utilization continue to improve. For the quarter, utilization averaged 83.8%, but we ended the quarter north of 87%. Additionally, we are experiencing very strong demand from our customers to purchase assets in the rental fleet, which we see as a positive indicator for sustained strong demand. Given the level of assets we added to the rental fleet in Q3, which has continued in Q4, we anticipate being able to sell more of the aged equipment in the rental fleet during the fourth quarter. Pricing across our end markets continues to hold steady, reflecting strong demand and our focus on driving margin expansion across our largest segments. We continue to put new assets out on rent at higher rates than our fleet average. Continued industry supply chain issues remain the only significant headwind to our ability to meet customer demand. We continue to experience intermittent issues receiving adequate supply of major inputs for our trucks, which impacted our ability to deliver product to our customers during Q3. However, as Fred already mentioned, production in the third quarter remained near historically high levels. Overall, our inventory increased by $20 million versus Q2, which we see as a positive indicator and positions us well as we finish the year. Through the strong vendor management efforts of our team, we continue to experience an increase in inventory flows from our suppliers, with deliveries up more than 28% during Q3 compared to Q3 last year and up 40% year-to-date versus last year. We remain on target to add more gross CapEx to the rental fleet in the second half of this year than we did in the first half. Despite the improvement in the supply chain challenges we’ve been discussing over the past several quarters, we fell short of our goal of continued quarter-over-quarter revenue growth in TES. We remain dedicated to returning to both sequential quarterly and year-over-year revenue growth in TES in the fourth quarter. We continue to experience wage inflation consistent with the rest of the market as well as higher costs for some of our production inputs. We are passing through certain input cost increases to our customers and implementing reasonable price increases where possible. From a strategic perspective, we remain focused on optimizing our production and how we deliver service to our customers. Our goal of producing continued strong revenue, gross margin, and adjusted EBITDA growth, and increasing shareholder value now define how we run our business. As we look ahead to the fourth quarter and to next year, we believe that favorable end market tailwinds, robust customer demand, improving supply chain, and continued solid execution by our team all position us to achieve these goals. While supply chain challenges and inflation remain obstacles, we look to fully take advantage of these growth opportunities. We currently have unprecedented demand for rental asset purchases that we will benefit from in the fourth quarter, and we expect this to continue into fiscal 2023. We know our employees are the key to delivering financial results and unmatched customer service as demonstrated in the third quarter, and I’d like to extend a sincere thank you to them. I will now turn it over to Chris.

Chris Eperjesy, CFO

Thanks, Ryan. As Fred and Ryan have indicated, Q3 was another strong quarter despite the supply chain challenges we continue to face. Total revenue of $358 million was up slightly compared to Q3 2021 despite these issues. Total revenue in Q3 decreased by 1% sequentially compared to Q2. Adjusted EBITDA was $92 million, a 9% improvement compared to pro-forma Q3 2021 results. Year-to-date, 2022 adjusted EBITDA is up 18% compared to the pro forma year-to-date period in 2021. Net loss for the quarter was $2.4 million. Gross profit, excluding rental depreciation, was $131 million, representing an adjusted gross margin for the quarter of 36.6%, up 220 basis points from 34.4% for Q3 2021 and up 175 basis points from last quarter. The gross margin improvement continues to be driven by favorable segment mix and our strategic focus on pricing across all of our revenue segments. SG&A was $50 million for Q3 or 13.9% of revenues, which is up slightly versus Q2, but in line with the expectations we set forth earlier in the year. Turning to our segment results. Fred referenced our continued strong utilization within our ERS segment for the quarter, which was 84%, up from 81% for Q3 2021 and up 100 basis points compared to last quarter. Despite the supply chain challenges, average OEC on rent increased by more than $32 million compared to the previous quarter. On-rent yield was just under 39% for the quarter, which was slightly lower than Q2, mainly as a result of mix and up from 38% for Q3 2021. Our OEC ended Q3 at $1.43 billion, up by more than $29 million in the quarter. We will continue to invest heavily in the fleet in the fourth quarter. For Q3, ERS rental revenue was $112 million, a 3.6% increase versus Q2. ERS equipment sales for the quarter were $37 million, essentially flat from Q2. In ERS gross profit, excluding rental depreciation was $95 million for Q3, up 9% from Q2, and adjusted gross margin improved to 63.6%. Disappointingly, TES revenues of $174 million were down 4% sequentially from $181 million in Q2 as this segment continues to take the brunt of the impact from supply chain issues. Despite the lower revenues in the quarter, gross profit increased marginally in Q3, resulting in a gross margin of 15.7%, up from 15% in Q2. Our sales activity continues to be extremely strong, with backlog growing by 7% sequentially from Q2 to $709 million, and this strength was very broad-based across our product portfolio. While supply chain issues are resulting in near-term headwinds to our ability to fully take advantage of the strong demand, we believe the continued growth in the TES sales backlog reflects growing demand for equipment, indicative of our strong market share gains and our pricing discipline. We have been successful in countering inflationary pressures through the implementation of ongoing production efficiency initiatives in addition to gaining favorable price increases with our customers. As this quarter’s TES results show, we are confident we will be able to hold or improve margins over the coming quarters, even with elevated levels of inflation. Our APS business posted revenue of $35 million, down 2% compared to Q2. Gross profit margin in the segment was negatively impacted by higher labor and facility costs as well as shifts in product mix. Maintaining a strong liquidity position and improving leverage remains priorities for us, as do investing in the rental fleet and pursuing selective strategic growth through M&A. Pursuant to our previously announced stock repurchase program, we purchased $2.4 million of our stock in the open market during the quarter. During the quarter, we increased the borrowings under our ABL by $12 million, with the outstanding balance ending at $447 million, mainly to fund a portion of our working capital investments. At September 30th, we had $300 million available and $127 million of suppressed availability under the ABL with the ability to upsize the facility. With the LTM adjusted EBITDA of $364 million, we finished Q3 with net leverage of 3.77x, which is an improvement of almost 1 turn since the close of the transaction and down slightly from last quarter. Approximately 3x leverage remains our goal and the one we will likely achieve later in 2023. We will continue to seek to make incremental investments and prudent acquisitions when we believe they create long-term shareholder value. With respect to our 2022 outlook, based on year-to-date results, current backlog, and our outlook for the rental fleet, we are adjusting our guidance as follows: we expect ERS revenue of $650 million to $690 million, TES revenue of $720 million to $750 million, and APS revenue of $135 million to $145 million. This results in total revenue of $1.505 billion to $1.585 billion. We are projecting adjusted EBITDA of $385 million to $395 million, which is within our previously provided guidance range. And as Ryan noted previously, we will benefit from strong demand in the fourth quarter for rental asset purchases, particularly of older equipment in the rental fleet that will favorably impact our results and partially offset the supply chain headwinds that continue to impact the TES segment. In closing, I want to echo Fred’s and Ryan’s comments regarding our strong performance. Despite ongoing challenges, we have executed a transformational integration with Nesco, delivered double-digit adjusted EBITDA growth, expanded margins in an inflationary environment, reduced leverage, and continue to deliver the highest levels of customer service. With that, I will turn it over to the operator to open the line for questions.

Operator, Operator

Our first question is from Nicole DeBlase of Deutsche Bank.

Nicole DeBlase, Analyst

So I guess maybe just starting with utilization comment that you made saying that you exited the quarter, you exited the quarter around 87%. Is the assumption that, that 87% can sustain through 4Q? Or could you talk a little bit about the utilization that’s baked into the 4Q outlook?

Chris Eperjesy, CFO

Yes, that’s a great question. We ended September with 87%, and it has remained strong so far in the fourth quarter. Typically, utilization peaks around October or early November, then tends to decline slightly after Thanksgiving and during the holidays. Therefore, we expect it to return to a more historically normal average for the fourth quarter, which would be in the low to mid-80s.

Nicole DeBlase, Analyst

Okay. Got it. And then regarding the CapEx outlook, I wanted to clarify if you are actually increasing the amount of CapEx you expect to spend, or if it's just that the second half will be stronger than the first half compared to your previous expectations?

Chris Eperjesy, CFO

It’s the latter. Yes, the second half is stronger than the first half. So I think Q4 will probably come a little lighter than where Q3 came in from a gross CapEx perspective, but it will still be strong. So the second half will be meaningfully more than the first half of this year.

Operator, Operator

Next question is from Justin Hauke of Baird.

Justin Hauke, Analyst

Yes, I apologize for the background noise here. My question is about the TES business. The revenue has been consistently in the $170 million to $180 million range for the past year. The guidance suggests that at the midpoint, we are looking at around $215 million for the fourth quarter, indicating 20% growth. While the backlog and demand are evident, it would be helpful to understand what visibility you have regarding deliveries on the sales side as we are almost halfway through the quarter.

Ryan McMonagle, President and COO

Yes, you’re right on historical performance, but things are trending well so far in the fourth quarter. And that’s why that’s the number that we’ve had to bring guidance down today and on the last call. So it is where the risk is of just what are we able to put out. But we’re trying to share the best information we have with how the supply chain allows us to deliver. But you’re right, demand is continues to build and is strong. You saw the backlog build in the third quarter, and it’s even building still in October. So we’re seeing really good demand trends. It’s just what we’re able to get out.

Justin Hauke, Analyst

Okay. I guess the second question is on the positive side, the margins were strong here, particularly in the rental business. I know previously you were talking about the price contribution on new fleet that was going out was up in the 10% range. I’m just curious if that’s trended higher. It seems like it’s offsetting maybe your cost inputs here, and you’re able to recover some margins. So maybe just some commentary there.

Ryan McMonagle, President and COO

Sure. Yes, new rates on new things going out are still in that range, Justin. So it’s still trending double digits above where the overall fleet is averaging. So we’re seeing that trend. When utilization is increasing, we’re putting a lot of assets out. What is happening, though, is we’re also seeing the duration of assets increase. And so some of the assets that have been out are not churning as much. But yes, we’re still seeing good opportunity when it comes to rate. And obviously, as the market dictates, we’re trying to add as many assets as we can into the rental fleet.

Operator, Operator

Our next question is from Stefanos Crist of CJS Securities.

Stefanos Crist, Analyst

Could you just talk about free cash flow expectations for the year and just in terms of working capital as well?

Chris Eperjesy, CFO

Yes, this is Chris. I will focus on levered free cash flow. Looking at the first three quarters, year-to-date, after adjusting for the high rail acquisition, we’re close to zero. While our levered free cash flow is at zero, we have successfully covered a substantial investment in the rental fleet. In the third quarter alone, there was a net investment of $60 million in CapEx after considering any proceeds. For the year, we anticipate achieving positive levered free cash flow, which should reflect in Q4. Regarding net working capital, we have made significant investments, especially in inventory. This is partially balanced by some inventory being on floor plan. Aligning with some of Ryan’s comments, we believe this positions us well for Q1 and Q2 next year. Last year, our inventory levels were quite low, which created constraints as we entered the year. We expect to carry over some of that investment as we close out this year, setting us up favorably for the first half of next year.

Stefanos Crist, Analyst

Got it. And another one for you, Chris. I think on the timing of the last call, you were just getting started. Can you just talk about your time so far at Custom Truck, anything you’re seeing that you’d like to improve on? Or any changes you’d like to make?

Chris Eperjesy, CFO

I'm now counting months instead of days, so I've been here for 2.5 months. I did a lot of research before joining, and everything I loved about the company has turned out to be true. I really appreciate the end markets and the company's positioning. I admire what Fred has built and am grateful for the opportunity to be part of it. Like any business, there are always areas for improvement, particularly when you've grown quickly and faced the challenges of being public, which is where I can contribute. The story and strategy you’ve heard are exactly what attracted me here. I don’t have any great insights to share today, but I want to reassure you that the aspects of the business you appreciate are the same reasons I'm here, and I’m pleased with what I’ve experienced so far.

Operator, Operator

Our next question is from Noelle Dilts of Stifel.

Noelle Dilts, Analyst

I wanted to dig into ERS a little bit looking at implied fourth-quarter guidance that I think suggests about a 38% increase to over revenue levels and average revenue levels in the first three quarters. So I’m assuming most of that is coming from rental equipment sales. But could you just help us understand again what’s giving you the confidence in that strong fourth-quarter jump?

Ryan McMonagle, President and COO

Sure. Yes. This is Ryan. I’ll start and Fred or Chris can certainly add-in. But you’re right. We think, and we mentioned it in some of our prepared remarks about the demand we’re seeing about fourth-quarter buyouts. So two things are going on. One, we’ve got really strong demand from the customer for that equipment, which we see as just a really good indicator of sustained demand heading into next year. And then two, as we’ve been able to increase what we’ve been able to deploy into the rental fleet, so the $97 million of gross CapEx that we talked about this quarter, we’re comfortable being able to take out some of the older equipment that we’ve talked about for the last several quarters. So we’re seeing really strong demand for it, and we think it makes sense with the amount of CapEx we’re able to put into the fleet last quarter in Q3 and the plans we have for this quarter and Q4.

Noelle Dilts, Analyst

Sorry, go ahead.

Fred Ross, CEO

No, I was going to say, and then again, it’s just an indication that our customer base won’t spend CapEx if they don’t believe that they’re in a good position to get the return on it. And so it’s mostly distribution, and we don’t see any end in sight to that business. And again, we like selling our older equipment off to get into the newer equipment.

Noelle Dilts, Analyst

Okay. Yes, I understand those dynamics. I guess, I don’t know if you can give us any guidance here, but I’m assuming you’re paying more for the newer equipment than you would have been in the past. Can you give us a sense of where rental fleet units you think will wind up heading into ‘23? I’m just trying to get a sense of how we should think about the fleet size and growth potential heading into next year.

Ryan McMonagle, President and COO

There are a few points to highlight. We’ve mentioned the rate increases on rental units, which will help balance out the rise in input costs. Currently, the cost of the units is mid-single digits higher than in previous years due to inflation and our OEM partners' pricing. However, we believe that the price adjustments can counteract this. Additionally, as we acquire new assets, we are launching them at the higher rates, which creates a favorable trade-off. For the fourth quarter, I can't provide an exact figure, but we anticipate a significant outflow of equipment, which relates to your initial question. Moreover, we expect that gross capital expenditures will be lower than in the third quarter, but still substantial. It should be roughly balanced in the fourth quarter, considering what's going out versus what's coming in, though some details will only be clear in December as we finalize what equipment is being removed. It's also important to note that the costs associated with repairs and maintenance decrease significantly with new equipment, while older units require more investment to maintain. It's much easier to replace older equipment with new that doesn't require the same level of upkeep.

Operator, Operator

Our last question is from Scott Schneeberger of Oppenheimer.

Scott Schneeberger, Analyst

I'm interested in discussing the supply chain issues further. Can you provide insights on how these challenges are affecting each of the segments, especially since it's having the most significant impact on TES? There have been some hopeful signs from you this year regarding improvements, but it seems those have not materialized. Has the situation improved, or are we likely to remain in this situation for a while longer?

Ryan McMonagle, President and COO

Yes, I’ll share a few numbers, and then Fred can provide additional insights. The flow has improved, but it hasn't picked up as quickly as we hoped this time last year. However, there are improvements. Our inventory is up $140 million at the end of the third quarter compared to the beginning of the year, indicating more inflows. For the quarter, inflows increased by nearly 30% in Q3 compared to Q3 last year, and year-to-date inflows have risen about 40%. This increase in product intake makes us optimistic about how it will position us for next year. The ongoing challenge is sourcing all the components needed to complete units. Currently, we have chassis available and are seeing better inflows of them, but in some cases, we have attachments while waiting for the appropriate chassis to pair with them. This variability complicates our ability to project exactly how many units we can build in the quarter. Overall, the situation is improving, and we believe it positions us reasonably well as we head into Q1 next year in 2023.

Fred Ross, CEO

The truck side has gotten quite a bit better. It’s really exciting on where we’re at in the product that we’re getting now. And it’s more small parts that are holding us back versus the big parts, which is a big deal because a lot of times, we can flex on the small parts or come up with different ideas that can work instead. But I’m super excited about where we’re at and how we’re set up to go into the first quarter of next year. But this is the most trucks I’ve seen in a while and the most attachments. So I’m really bullish on it. I feel really good about it. And it is getting here. Do we wish it would have gotten here a month earlier or two months earlier? Sure. But we are getting it, and it is coming in now.

Scott Schneeberger, Analyst

It seems like there are multiple issues rather than just one or two. However, things appear to be improving for you. Are there any specific areas that lack clarity and remain uncertain? I have one more follow-up question after that.

Fred Ross, CEO

It’s really smaller pieces. Maybe it’s a cylinder or pumps or valving versus the major components that you really can’t change. If the digger or dump body doesn’t arrive, there’s nothing you can do about it. So these are smaller parts that are still needed to put the truck together. That’s why our inventory has grown; those larger components are now arriving, which will allow us to complete the trucks. So this is happening. I wish it had happened earlier, but I’m happy with where we are today, and I’m excited about it.

Scott Schneeberger, Analyst

Great. And then just on in ERS, it sounds like you’ll be selling a lot of aged units in the fourth quarter. And I think I just heard you say a lot of that will be determined in December. So it sounds like it’s still on the come. How do you anticipate pricing to be and margin on those used fleet sales? You sound confident but any commentary there? And this was discussed before, but is there a concern maybe if you can’t get the CapEx you have on order and you sell too much that you might be very capacity-constrained heading into the new year? Just thoughts on that as well. And that’s all for me.

Ryan McMonagle, President and COO

Sure. Yes, I’ll start, Scott, it’s a good question. We’re currently seeing high residual values, so we believe it’s a favorable time to sell some of the used equipment from our fleet. The strong demand environment is contributing to these good values, and I’m confident in our margin expectations. Additionally, we are satisfied with our capital expenditure plans as we move into the next year or two. We share the optimism that Fred mentioned and feel positive about what we can achieve this quarter and the fleet additions we can make for next year.

Operator, Operator

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would now like to turn the call back over to Fred Ross for closing comments. Please go ahead, sir.

Fred Ross, CEO

Thanks. Thanks, everyone, for the time today and your interest in Custom Truck. We look forward to speaking with you on our next quarterly earnings call. And in the meantime, please don’t hesitate to reach out with any questions. Thank you again. Good night.

Operator, Operator

That concludes our conference. Thank you for joining us. You may now disconnect your lines.