Star Equity Holdings, Inc. Q1 FY2021 Earnings Call

Greetings, ladies and gentlemen, and welcome to the Star Equity Holdings, Inc. First Quarter 2021 Results Conference Call. As a reminder, certain statements made during this conference call including the question-and-answer period are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. These forward-looking statements include, but are not limited to, statements about the company's revenues, costs and expenses, margin, operations, financial results, acquisitions and other topics related to Star's business strategy and outlook. These forward-looking statements are based on current assumptions and expectations and involve risks and uncertainties that could cause actual events and financial performance to differ materially. Risks and uncertainties include, but are not limited to, business and economic conditions, technological change, industry change, trends and changes in the company's market and competition. More information about risks and uncertainties is available in the company's filings with the United States Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K as well as today's press release. The information discussed on this morning's conference call as well as today's press release should be used in conjunction with consolidated financial statements and notes included in those reports and speak only as of the date of this call. The company undertakes no obligation to update these forward-looking statements. In the earnings release today and its comments, management makes reference to both GAAP results as well as adjusted results. The adjusted results are non-GAAP and do not include nonrecurring charges; also adjusted EBITDA, which is a non-GAAP measure that further excludes depreciation, amortization, interest, taxes and stock-based compensation. Management believes the presentation of these non-GAAP measures, along with GAAP financial statements and reconciliations, provide a more thorough analysis of ongoing financial performance. Investors can find the reconciliation of results on a non-GAAP versus GAAP basis in the earnings release. If you did not receive a copy of the press release and would like one, please contact Star at (203) 489-9500 after the call or its Investor Relations representative, Lena Cati, of the Equity Group at (212) 836 9611. Also, this call is being broadcast live over the Internet and may be accessed at Star's website via www.starequity.com. Shortly after the call, a replay will be available on the company's website. It is now my pleasure to introduce Jeff Eberwein, Executive Chairman of Star.

Thank you, operator. Good morning, and thank you all for joining us today for our first quarter 2021 results conference call. On the call with me today are Matt Molchan, CEO of Digirad Health; and our CFO and Chief Operating Officer, David Noble. In the first quarter of 2021, our Healthcare division continued to be impacted by the COVID-19 pandemic with revenue declining slightly versus the prior year quarter. However, we continue to see activity levels rebounding steadily towards normal levels. Our Construction division grew revenue 65% with much of the growth attributable to significantly increased output at KBS. Gross margin percentage in our Construction division declined as a consequence of rising raw material prices, but is expected to return to more normal levels in the coming quarters. During the first quarter of 2021, the company completed the sale of the DMS Health Technologies business unit for $18.75 million, and we completed another small sale for $1.4 million. The asset sales in Q1 substantially improved our balance sheet and liquidity position with net debt decreasing from $20.4 million a year ago to $13.5 million at the end of Q1. We are now better positioned to fund high return internal growth investments and pursue acquisitions, which could be bolt-ons in Healthcare or Construction or entry into a new business sector. We continue to execute on our holdco growth strategy and value enhancement initiatives to maximize shareholder value. Our holdco structure allows division CEOs to focus on operations and organic growth, while holdco management focuses on corporate strategy and capital allocation. In addition to looking for attractive bolt-on acquisitions for existing operating businesses, we're also looking to create new business divisions in the future through the disciplined acquisition of businesses complementary to our holdco structure. With that, I'll turn it over to our Healthcare CEO, Matt Molchan. Matt, please go ahead.

Thanks, Jeff. Revenue from our Healthcare division in Q1 2021 fell by 2.7% to $13.3 million over the same period in the prior year. Although Q1 2021 revenues for the Healthcare division decreased slightly from Q1 2020, this division has largely recovered from the COVID-19 pandemic related downturn, and is now performing at near pre-pandemic levels. However, even though doctor offices have reopened, they are not yet operating at full capacity. But as state-by-state vaccination levels increase, we expect to see our operations fully return to normal levels later this year. Gross profit for Q1 2021 reporting period decreased by 9.6% and gross profit margin decreased by 1.5% over the same period last year. Although revenues only decreased by 2.7%, gross profit declined by a higher percentage due to certain fixed costs related to employees, insurance, rent, utilities, and repairs and maintenance expenses. In Diagnostic Services, revenue and gross margin percentage for the first quarter of 2021 were $10.2 million and 15.7% compared to $10.8 million and 18.5% in last year's first quarter. The decrease in Diagnostic Services revenue and gross margin percentage compared to the prior year was primarily due to a decrease in testing days and scans resulting from the continuing impact of the COVID-19 pandemic. In our Diagnostic Imaging business, we did see early signs of improvement. Revenue and gross margin percentage for the first quarter of 2021 was $3 million and 32.3% respectively compared to $2.9 million and 30.4% respectively in the prior year first quarter. The increase in Diagnostic Imaging revenue and gross margin is a good indication that the slowdown of camera sales associated with capital funding delays and uncertainty due to the COVID-19 pandemic is easing up. Now I'll turn the call over to David Noble, our CFO, who will provide additional financial highlights for the first quarter. Dave, please go ahead.

Thank you, Matt, and good morning. I'll first mention results for our Construction business, which now accounts for 40% of our consolidated revenues. For the first quarter of 2021, the Construction division revenue and gross margin were $9 million and 6% respectively compared to $5.5 million and 7.3% in the prior year first quarter. Much of this increase in revenue was due to the increased utilization at our primary production facility at KBS in Maine, and that was due to our re-entry into the commercial scale residential modular market during 2020. The slight decrease in gross margin percentage was due to the adverse effects of higher raw material prices, which offset the benefit of higher output levels. For Q1 2021, on a company wide basis, SG&A increased by 3.9% compared to Q1 2020. This was due to a $0.3 million increase at the Construction business as a result of increased commissions and headcount, offset by a $0.1 million in reduced travel expense in the Healthcare division. Moving on to consolidated bottom line results for the first quarter of 2021. We had a net loss from continuing operations of $0.6 million compared to a net loss from continuing operations of $2.4 million in the same period in 2020. Non-GAAP adjusted net loss from continuing operations in the first quarter of 2021 was $1.7 million or $0.35 a share compared to adjusted net income of $1.3 million or $0.65 per share in the first quarter last year. Non-GAAP adjusted EBITDA decreased slightly to negative $0.9 million for the first quarter of 2021 compared to negative $0.5 million in the first quarter of last year, and this was driven by the continued COVID-19 impact, particularly on our Healthcare operations as well as some increased raw materials prices that affected the Construction side. For the first quarter of 2021, we registered an operating cash outflow of $2.2 million compared to an operating cash inflow of $0.6 million in the first quarter of last year. As of March 31, 2021, the outstanding balance on our credit facilities was $16.8 million, which includes $3 million in PPP funds and we fully anticipate that they will be completely forgiven in coming months. Therefore, our overall net debt position, including $13.3 million in cash and cash equivalents, was $3.5 million. Now I'd like to turn the call over to the operator for questions.

Our first question comes from Tate Sullivan with Maxim.

You mentioned that the pressures from raw material prices will ease in terms of being reflected in prices later this year. Could you provide another update? Is most of the pressure coming from the structural wall panel business or the larger modular construction projects? Any additional details you can share about raw material prices would be appreciated.

I mean it affects both of the Construction businesses on the edge builder side in the Midwest, where we do the wall panels that you mentioned. It has a more serious impact in a way because most of the value of those panels is in the wood commodity that goes into it. The labor value add is relatively small. So we've seen quite an increase there and it really affects margins. But what I would say is we're working through those projects that we had agreed to at lower commodity prices, and we're still continuing to win large projects at current prices. So we're locking in normalized margins with the activity that we're pitching for now. On the modular side, it also has an impact, but there's a lot more that goes into a modular unit than just the commodity. There's other building materials, bathtubs, and windows and doors. And although there's been some price increase there, it's not so dramatic as what we've seen on the commodity side. But the same thing goes for that business. The business that we are signing today takes into account the current commodities prices. So we've pretty well worked through anything where the prices that we agreed to were far lower at the time. In fact, the large project that we did in Natick, Massachusetts, last year, we bought those materials almost a year ago at much lower prices than today. So we were pretty well shielded on that project.

I would just add that we have been significantly increasing our pricing, similar to the whole industry. We can and do pass those higher input costs onto our client base, and as I mentioned, everyone in the industry is doing that. However, it takes a few quarters to reflect this in our financials during periods of volatility. The accounting method used by companies affects short-term results; we use average cost, whereas other companies might use LIFO or FIFO. Over the long term, these factors balance out, but in the short term, discrepancies can arise based on the accounting method.

Looking at the gross profit in Building & Construction, it is returning to more normalized levels for the rest of the year. What do you consider a normalized level of margins for that business—perhaps around 19% or above 15%?

I think we'd say, I mean, there's still a lot of uncertainty in our Healthcare business and Construction business, and recovering from COVID and input prices, so we haven't given guidance for the year. But I guess the short version to answer your question is we have a goal of significantly increasing our margins in the second half of the year. And the price increases that we have put through have been significant, and it just takes a few quarters for those to filter through. And then long term when we think about the plan for this business, it's to have a Construction business that can generate 20% gross margins and an EBITDA margin of at least 10%. That's the long term plan and that's very achievable, and it's what we're working hard to deliver. And we've talked previously about our growth plan for this division and at least on a top line basis, that's definitely coming through. We've been ramping up output and our sales pipeline is stronger than I've ever seen it. So the end customer demand is very, very strong. I mean the higher prices give them some pause, but the outlook is really strong for this division. It just takes a few quarters to pass through these higher input prices.

And just last one for me before I turn it over. I think the last call, you mentioned efforts to get more into affordable Housing and in Building and Construction. Is that underway, or have you secured orders in that segment of your Construction business?

I mean that is a very interesting space. As you can imagine, some of the themes that go along with modular construction, such as reduced waste and more sustainability and cheaper prices, et cetera, to quicker delivery than doing it on site. That all makes sense for the affordable housing market. So yes, that is one of the segments we're pursuing, but there's other segments. There's student housing, there's passive homes, apartment buildings, et cetera. But definitely, affordable housing is one area that we are pitching a lot. I can't speak to things that may or may not be signed, but that is an area we expect to be doing more and more in the medium term for sure.

Our next question comes from the line of Theodore O'Neill with Litchfield Hills Research.

Jeff, here in the prepared statements, you talked about pursuing acquisitions that could be in the Construction business, and it seems to me there must be plenty of undercapitalized construction companies that would be targets. But could you talk about how you might think about that compared to expanding in the existing square footage that you've got already?

We're guided by wanting to increase value per share that’s our guiding metric; everything else is a means to that end in many businesses. And I think this is an example. Scale is really helpful. The more scale you have, the higher margins that you make, and higher return on investment and the more durable, sustainable business model. And so we're open minded to both, and they're not mutually exclusive. So we do think there are some undercapitalized construction businesses that we could add on to our existing business, and we're looking for one plus one equals three type of opportunities. And we are also looking to increase output at both businesses, but particularly KBS, where we have a very significant factory just a few miles away from our existing factory. And I think it's just a matter of time before we do open that factory. And in the meantime, we're continuing to debottleneck and reengineer our existing factory to improve output.

I don't keep track of lumber prices very well. However, regarding the wall panels and their impact on margins, is the pricing particularly higher or rising faster in that segment? Is it because it involves specially treated lumber, or is every type of lumber experiencing similar inflation?

Yes, it's the second one. If you look at what people refer to when they mention lumber or the futures market, that points to a specific grade and location. The low price a year ago was around $250, and a more typical long-term price ranges from $300 million to $400 million. By the end of last year, it had closed at $1,000 million, which means it quadrupled from the lowest point. So far this year, even though we are only in May, the price of lumber has increased by 70%. This price serves as a proxy for various lumber products as well as OSB, which is a significant input. There's no futures market for OSB, making it more challenging to track its daily price. Additionally, it can be difficult to obtain these materials due to supply shortages, leading to price increases. However, prices tend to stabilize over time. We are not basing our business decisions on hope; instead, we are pricing projects based on current commodity prices and engaging in discussions with clients about purchasing materials and managing the risks related to the volatility we are witnessing in import prices.

Our next question comes from the line of Adam Waldo with Lismore Partners.

I know there are a lot of different moving parts on the commodity side and construction. But as you think about the enterprise overall, it seems as if the leading and coincident indicators are all pretty much hitting in the right direction, recovering from COVID, which is great to see. So as you put it all together at the enterprise level, what's your best sense now for when we'll return to being sustainably operating cash flow positive?

So I would say, EBITDA isn't the same as cash flow but it is a leading indicator. And strongly, we think we will be EBITDA positive in the second half of this year and see very substantial growth in EBITDA over time as things recover to normal and as we get back to more normal margins in the Construction business and continue to grow the top line in Construction. And converting that into positive cash flow generation, we have interest expense, which is now going to be much, much lower because we have paid off the vast majority of our debt and working capital investments. And we've made a tremendous investment in working capital, particularly in the Construction business over the last year to fund that growth. But we think if we continue to grow revenue, our margins improve to more normal levels, EBITDA will have a significant increase over time and our cash flow generation will have a significant increase over time. And even though our businesses are different, one common theme throughout all of our businesses is very low maintenance CapEx, and you can see that on our cash flow statement. And the business that we sold was a much heavier CapEx business, and that's one characteristic that we do like in looking at acquisitions and looking at different growth prospects is businesses that have low maintenance CapEx, and we want to find businesses that generate earnings and cash flow.

And I know it's a little hard, but are we feeling pretty confident that by the end of this calendar year, early next year, we continue to be in a more normal post-COVID operating environment given the current scale of the business post the divestitures completed in the first and early second quarters here that we're in good shape to be sustainably free cash flow positive?

We think so; we should be. There's a lot of unknowns out there. And at the beginning of last year, I don't think anyone was predicting that we'd have a global pandemic that would shut down the global economy for a period of time. So there's a lot of unknowns out there in the world, but there's no structural reason why preventing us from returning to more normal levels in all of our businesses.

And then one more, if I may, and this is related to the preferred stock. So prospectively, I presume that preferred stock is probably going to be a component of compensation for future acquisitions in terms of what's given to the sellers of acquired companies. And obviously, we have a preferred out there that is now more than six quarters in arrears on its preferred dividends payments that are accrued and unpaid. And I think technically in default of a couple of the provisions related to that six quarters in arrears. So with the balance sheet substantially cleaned up post the divestitures completed earlier this year, are we now at a point where we expect to be able to clean up the accrued and unpaid dividends and resume dividend payments on the preferred?

That's a good question, and we anticipated it might come up. I want to clarify that this is a decision for the board rather than management. We completed the sale of these businesses just over a month ago, and our immediate priority was to reduce debt. The significant sale of DMS concluded at the end of the day on the 31st, providing us with cash to pay down the credit line tied to the Healthcare business. Since the end of the quarter, we've also reduced even more debt. This was our primary focus. The Board is actively evaluating all available options and the advantages and disadvantages of various capital allocation strategies. We are looking into it and plan to make an announcement at a future date.

Our next question comes from the line of Jeff Kobylarz with Diamond Bridge Capital.

Jeff, I heard you mention earlier that the sales pipeline at KBS is stronger than ever. Can you provide any numbers related to that?

We actually have our Head of Business Development and Sales with us today. So I'm going to turn this over to Dave, our COO; and Matt Sullivan, our Head of Business Development for KBS. But we've publicly talked about a sales pipeline of over $50 million. And just a reminder, that's just for the KBS business. And so that doesn't even include the business that we have in the Midwest. If you include that, our sales pipeline is higher. And so just a couple of quick things I would say is we maintain that pipeline even after winning several large projects last year. And if you think about how mechanically that works, if you win a project, your pipeline actually goes down because you're putting that large project into production. So the fact that our pipeline stayed around the $50 million level after winning those large projects is an indicator that we have other large projects that got put into our sales pipeline, enabling it to stay around that $50 million level. So that was kind of accomplishment number one. And accomplishment number two is, I think our sales pipeline today is at least 20% higher than that level. But I'll turn it over to Dave and Matt Sullivan to just talk about what they're seeing in the market and potential projects that are coming down the road, and they can talk about those at a high level.

You summarized it well. I’ll hand it over to Matt shortly. We are seeing strong demand for single-family homes, especially in northern New England, which is entering a busy season. Additionally, our initiative to expand into larger commercial projects is showing promise, despite the longer lead time needed for these endeavors. We have many more opportunities now than we did six to nine months ago, which makes us optimistic. While commodity prices have caused some delays in certain projects, the overall impact has not been significant, and many projects continue to advance as planned. I'll let Matt Sullivan, who is with us today, share more insights on the projects, although we can't discuss too many details yet as they haven't been publicly announced.

Matt Sullivan here, Vice President of Business Development for KBS. So demand continues to grow in all sectors that we're focused on. As Dave mentioned, the seasonal business is picking up in the residential markets. But we're seeing greater opportunities in the multifamily space, both on the affordable housing, workforce housing and just multifamily opportunities throughout New England. So demand continues to grow, and opportunities are significant. So our space that we focus on is kind of that under $5 million in terms of project revenue, and there seems to be a tremendous amount of growth in that area specifically. So we're also getting more traction in the passive home and net zero space. KBS has sort of differentiated itself from other manufacturers by being able to provide that type of construction. So it's something that has gained momentum and interest, not only in the affordable housing space but also in the kind of for-profit opportunities. And as Jeff mentioned, we're in that $50 million pipeline, early-stage opportunities kind of mirror that as well. So we've got some things that are projected out to 2022 that would be in that same level, another $50 million of business that we project further out. So pandemic aside, the opportunities are significant, and interest continues to grow for KBS.

And just for clarification, can I just ask about when you mentioned pipeline, it sounds like it blurs over a little bit into a backlog type of term. It sounds like some of your pipeline is a backlog. And can you comment about that, how much of the $50 million is, say, contracted and agreed to?

Yes, that's the total sales pipeline. We talk about it internally as sort of like our lead times, our assigned backlog. Matt, would you maybe comment on what is our lead time?

Currently, we're running at about 10 weeks, 10 to 12 weeks for backlog opportunities, that's contracted work currently. The $50 million that we're forecasted is for business that has not officially been contracted. So different stages of the sales cycle.

So we do a variety of different things. And the sales pipeline or projects that were in active discussions on, and those numbers are all the gross numbers that we gave you. We also put a probability next to each one of those. And so we have a probability weighted pipeline and that's a pretty good number. And it probably more closely mirrors future sales, and that number has also been growing. And then what Matt was talking about was pre-pipeline, some people would call it a funnel or pre-pipeline, that's probably another $50 million of opportunities. So all those are really great leading indicators. And the point is there's a lot of projects out there for us to do. So as we debottleneck the plant, increase plant at the existing plant, and then eventually open a second plant, our production has a tremendous amount of upside. I think we have a slide in our investor deck that talks about having a goal of getting to 750 to 1,000 boxes a year. And when we bought the business, it was doing less than 300, and we've already significantly increased that number. I think last year, it was around 400. Is that…

We did 280 last year and would be around 400 this year…

Yes, we produced 280 last year. The goal for this year is to reach 400. However, the long-term vision is to be able to produce between 750 and 1,000 boxes a year.

Yes, the only thing I'd add, the other piece of our pipeline that's hard to measure is the single family business. A lot of that comes in through a dealer network that we've established over many years. And you have very little sort of knowledge of what's coming in. We just know that that's busy, but we might get a house, and that's on the line two weeks later, and it never hits our pipeline because they're bidding it out to two or three different manufacturers, and we win it and produce it pretty quickly. So there's sort of a shadow pipeline that we're not even aware of, and you can really price yourself to get as much of that business as you want. But obviously, we want to price projects at gross margins that are attractive to us. But that's kind of a spigot that can turn on and off in addition to the longer lead-time commercial business.

And so the dealer network, do you know what percentage of your volume it was last year?

I'd say in 2019, it was pretty much all of it, a large percentage of it, around 80%. Last year, probably about half of that or less.

A little less than half.

A little less than half last year. And just to put into context what this is, these are local home building companies that build anywhere from 10 to 50 homes a year. A lot of them have been around for a really long time. So they'll have a retail center that people can go to sometimes with some model homes on it, and a client can design their own home, customize it, and then that dealer gives the order to us. And we're by far the biggest manufacturer in New England and we've improved our quality. We've improved our product. And it is, we think, a very high-quality product. And there's just not many other factories in the New England market. And bigger manufacturing centers are in Canada or Pennsylvania, which are a long way away to ship, which gives us a natural shipping advantage for the New England market. So we really like our position, but your question was on dealer network and pipeline. And I guess the point is that we know the dealer network is going to give us orders of XYZ, but we don't know specifically what month or what exact client, but it's just kind of year-in, year-out, some of these dealers will give us 20, 30, 40 boxes to build. And it is business we can kind of count on year-in, year-out.

Our next question comes from the line of Zach Liggett with Desmon Liggett Wealth Advisors.

The first question I had was on the preferred, but it sounds like that's to be decided here a little bit later. As far as the M&A front goes, could you give us a little more color on how advanced your pipeline is, what the funding strategy is going to be given the ideas you're looking at, or at least some of the ideas there? And outside of the current segments, could you share what areas of focus you're looking at?

It's difficult to generalize, but I can share a few insights. We have been focusing internally for quite a while. We acquired the Construction business in late 2019, and since then, we've been enhancing operations, overhauling the sales team under Matt Sullivan's direction, and re-entering the commercial market. Everyone is aware that we recently completed the sale of about 40% of our healthcare business, which was announced last fall and finalized on March 31st. These efforts have occupied much of our attention, and now that we have completed that process, we are turning our attention outward. We have always maintained a target list and had discussions, and it seems more likely that we will pursue a bolt-on acquisition in either the Construction or Healthcare sectors. However, in the long term, we want to explore additional avenues for growth. Any potential acquisition must align with our existing structure, and we need to be confident that the target will be significantly more profitable and valuable within our organization. The construction acquisition we made serves as a strong example of this; it was a company listed on the OTC pink sheets when we acquired it using preferred stock, avoiding cash or common stock in the transaction. Our goal has been to increase revenues from $25 million to $30 million and greatly enhance profitability and value. We are looking for similar opportunities, and at a broader level, we are interested in sectors like industrials, materials, financial services, and business services—anything where we can add value. However, we are unlikely to engage in venture capital-type investments in pre-revenue companies that do not align with our strategy.

Regarding the funding strategy, do you plan to reintroduce leverage to the balance sheet, or will you focus on maintaining minimal debt in the near term?

I think it all depends on the opportunity and the sellers. There's private companies out there. There are other micro caps out there that are already publicly traded. So a lot of it is just going to depend on the preferences of the seller, what it takes to get a deal done. But what we like about the company we've created and the structure we've created is that we have a lot of tools in the toolkit. So bank debt is very, very cheap. That's a tool in the toolkit. Nonbank debt is more expensive, but is available. We also have our preferred stock, which could be an acquisition currency. And then the bar is high to issue common stock. But it is possible sometimes to do acquisitions and increase NAV per share even if common stock is a component of the acquisition consideration.

Our next question comes from the line of Robert Strougo with RIS Investments.

Concerning our preferred stock, my understanding is that if you're six quarters behind, we as shareholders of both your common and your preferred, we understand we could put people on the Board if you're six quarters behind. Why don't we just clean up this preferred? I think it's accruing at over 10% a year, so we could sell another preferred and/or have an exchange offer for this preferred and pay some of it off and clean up our balance sheet now that we have the cash. Can we do something like that to make it more attractive? Our stock went up to $4.5 a share. It's back down at $2 and change. So we like to see that stock go back up, because it should be a lot higher, even though you sold stock here at around the same price.

So I own common and preferred stock as well. So I share your sentiment and in the same situation. I would just say we're studying all of those options, and all those options are on the table. And I would just tell you to stay tuned. But your comments, thoughts, and observations are not lost on the Board and it's top of mind.

We have no further questions at this time. I would like to turn the floor back over to management for closing comments.

Thank you very much for your interest in our company and really good questions today. And I'd just like to note that David, our CFO, COO, is always available to answer questions, as am I and Matt Molchan on the Healthcare side. Happy to take your call and discuss any questions you have. So feel free to reach out to us if you have questions and want to do a call. And we're going to continue to meet with investors and share our story in the coming weeks and months. We're scheduled to present at the Sidoti conference next week, on May 20th, for example. And I just want to say we appreciate all of our shareholders and thanks for your feedback and your support. Have a great day.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.