Star Equity Holdings, Inc. Q3 FY2021 Earnings Call

Greetings, ladies and gentlemen, and welcome to the Star Equity Holdings, Inc. Third Quarter 2021 Results Conference Call. Some discussions made today may include forward-looking statements. Actual results could differ materially from the statements made today. Please refer to Star’s most recent 10-K and 10-Q filings for a complete description of risk factors that could affect these projections and assumptions. The Company assumes no obligations to update forward-looking statements as a result of new information, future events or otherwise. Please also note that on this call management may reference non-GAAP financial measures, including EBITDA, adjusted EBITDA, adjusted net income or adjusted earnings per share, which are all financial measures not recognized under U.S. GAAP. As required by SEC rules and regulations, these non-GAAP financial measures are reconciled to their most comparable GAAP financial measures in our earnings release issued this morning. If you didn’t 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 broadcasted live on the internet and may be accessed on Star’s website via www.starequity.com. Shortly after the call, a replay will also be available on the Company’s website. It is now my pleasure to introduce Jeff Eberwein, Executive Chairman of Star Equity.

Thank you, operator. Good morning and thank you all for joining us today for our third quarter 2021 results conference call. On the call with me today are Matt Molchan, CEO of Digirad Health; and David Noble, Chief Financial Officer and Chief Operating Officer. In Q3 2021, our Healthcare division continued to rebound to more normal levels, with revenue increasing 16% versus the prior year quarter. Our Construction division grew revenue about 65% due to higher output at both KBS and EdgeBuilder, and pricing increases we implemented to mitigate the impact of higher raw material costs. Although the gross margin percentage at our Construction division remained below normal levels in Q3, it did improve versus the first half of 2021 and is expected to continue to improve in the fourth quarter of 2021, due to steps we’ve taken to increase pricing and improve operations. With the asset sales completed at the end of Q1 2021, we substantially improved our balance sheet by reducing net debt from $18.9 million a year ago to $8.3 million at the end of Q3 2021. We’re now better positioned to fund high-return internal growth investments and pursue acquisitions, which we have previously discussed, could be either bolt-ons for our Healthcare or Construction division or entry into a new business sector. 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 Q3 2021 increased by 16.1% to $14.8 million over the same period in the prior year. This division has largely recovered from the COVID-19 pandemic-related downturn and is now operating at full capacity. Gross profit for the Q3 2021 reporting period increased by 31.6% and gross profit margin increased by 2.6% over the same period last year. In diagnostic services, revenue and gross margin percentage for the third quarter of 2021 were $11.1 million and 17.3% compared to $10.7 million and 19.4% in last year’s third quarter. The increase in diagnostic services revenue compared to the prior year was primarily due to several new service contracts. The decrease in diagnostic services gross margin percentage was mainly due to an increase in material costs and the mix of our services. In diagnostic imaging business, we did see significant improvement in the quarter. Revenue and gross margin percentage for the third quarter of 2021 was $3.7 million and 35.9%, respectively, compared to $2 million and 19.5%, respectively, in the prior year third quarter. The increase in diagnostic imaging revenue is related to increased camera sales, which is a good indication that hospitals and physician practices are recovering from the initial impact of COVID-19. Now, I’m turning the call to David Noble, our CFO and COO, who will provide additional financial highlights for the third quarter. Dave, please go ahead.

Thank you, Matt, and good morning. Firstly, I’ll briefly discuss the performance of the Construction division. I’ll then move on to our consolidated results. Third quarter Construction division revenue was $14.1 million. This compares to $8.5 million in the third quarter of last year, which is about a 65% increase, as Jeff mentioned at the beginning of the call. Gross margin was 3.8% in the past quarter compared to 14.7% in the prior year third quarter. The significant increase in revenues for the Construction division on a year-over-year basis was due to both higher production levels and increased pricing on both residential and commercial projects at both our KBS and EdgeBuilder businesses. The decrease in gross margin percentage was due to the lingering adverse effects of a rapid rise in raw materials costs in the first half, which reached historic levels. Despite implementing price increases, higher input prices affected some of our contracted work produced in the third quarter. We expect gross margin percentages in our Construction division to gradually return to more normal levels by the end of this year. Turning to companywide results. For Q3 2021, SG&A increased by $0.7 million compared to Q3 2020. This was due in part to a $0.3 million increase at the Construction businesses as a result of increased sales commissions and higher headcount, as we bolstered our senior team at both KBS and EdgeBuilder. Also, we experienced a $0.3 million increase in corporate administrative expenses due to additional headcount and a $0.1 million increase in IT and outside service fees. Moving on to consolidated bottom line results for the third quarter, we incurred a net loss from continuing operations of $2.1 million compared to a net loss from continuing operations of $1.6 million in the same period of 2020. Non-GAAP adjusted net loss from continuing operations in the third quarter of 2021 was $1.5 million or $0.29 per share, compared to an adjusted net loss of $1 million or $0.21 per share in the third quarter of last year. Non-GAAP adjusted EBITDA was a negative $0.6 million for the third quarter, compared to negative $0.1 million in the third quarter of last year. The single largest driver of losses in the quarter continued to be the lingering impact of the rapid rise in raw materials cost during the first half, which impacted our COGS on the construction side of the business. This was partially offset by an increase in adjusted EBITDA from the Healthcare division. For the third quarter of 2021, we registered an operating cash outflow of $0.6 million compared to an operating cash outflow of $1.9 million in the third quarter 2020. As of September 30, 2021, the outstanding balance on our credit facilities was $14 million. Our overall net debt position, taking into account the $5.7 million we hold in cash and cash equivalents, was $8.3 million at the end of September 2021. This compares to $18.9 million in net debt at the end of September 30, 2020. We’ve been able to reduce our overall debt significantly year-over-year. Now, I’d like to turn the call back to the operator for questions.

Thank you. Our first question comes from Tate Sullivan with Maxim Group. Please proceed with your question.

Hi. Thank you. Good day everyone. I’d like to start with the Construction division, which reported $34 million in revenue for the first nine months, compared to about $9 million from the key contract wins in 2020. Can you discuss whether you have completed most of those wins from the U.S. Army’s facilities and mixed-use buildings? Are those now cleared from the backlog for the Construction business?

Yes. Those two contracts you’re referring to that we signed in 2020 did lead into this year, but we are fully delivered on all of those projects. We have a little bit of onsite work that we are still doing at Tachi, but we expect to wrap that up within the next couple of weeks. But essentially, we’ve very delivered on those contracts.

Did you complete all the phases outlined in those contracts, or was there a possibility to increase the size of those deals? Are those customers repeat clients as well, or could they be in the future?

Well, we hope they will be repeat going forward. I mean, Tachi is a very large construction manager, and we are definitely talking to them about other projects that they’re working on. But all phases were completed. If you remember during 2020 towards the end, they announced an increase in that contract awarded from the government and then they did give us that additional work, which we did produce and complete during this year.

And Tate, this is Jeff. One thing I’d say we’re excited about is our demand is really strong, and we have a lot of other projects that are in the works. So, even though those projects are completed, our backlog and our sales pipeline remain really, really strong. So, we’ve replaced those projects with other projects, that’s what makes us excited. When you have a large project like that, there’s a risk that your backlog will decline as you get those produced and our backlog has stayed constant, which speaks to strong demand.

Great. I noticed that inventory decreased slightly from $12 million in June to $10 million. Can you explain if this was related to construction and a strategic decision to hold off on purchasing inventory for construction due to higher prices? Also, should I not interpret this decrease as a sign of a decline in project backlog or opportunities?

No, I wouldn't say that. I'm looking at our accounts receivable, and I see that it has increased and we're collecting. It's not that we're not collecting; we just have higher business levels across the board from Healthcare to Construction. However, some of that decrease is likely in the Construction division for a couple of reasons. We've completed some large projects for which we had accumulated materials, and the price of materials has decreased a bit since the peak in June. So, those two factors have contributed to the decrease, but that does not indicate a decline in business levels. We are currently operating at elevated business levels overall.

Can you clarify the difference between medical imaging service contracts and camera sales? Are these completely separate sales processes? I thought a sale would also involve signing a service contract. Could you provide a bit more background on this?

Yes. I’ll let Matt get into detail on that. Yes.

Yes. So, there are two different divisions, right? The diagnostic services business is the business where we use our camera to go out to different doctors’ offices and provide that as a service compared to providing post-warranty support on a sold camera. So, my comment was related to our diagnostic services and the growth, and bringing in more of those types of what we call mobile imaging contracts.

Our next question comes from the line of Theodore O’Neill with Litchfield Hills Research. Please proceed with your question.

I want to delve deeper into the construction aspect. While my sample size is small, I have spoken with several builders in New England and their clients. I'm hearing about significant shortages in materials and labor, and prices for materials continue to rise. Additionally, some high-end residential clients are postponing construction projects until the spring. I believe we may face the same challenges in the spring as they are experiencing now. Could you provide more details on the labor and material issues you're encountering? Are you also hearing from potential clients in construction that they plan to wait and see what happens in the spring? Thank you.

Yes, that’s a lot. Let me see if I can start to address that. On the labor issue, labor has been challenging for on-site construction for some time, particularly in obtaining enough crews for framing and other on-site tasks. We operate a factory in Maine where there are likely fewer alternatives. While labor can be difficult at times, we have a workforce that comes to the same plant every day to perform the same job. This consistency is actually a benefit for us when labor is limited in conventional construction. So, it has not been a significant issue. It is somewhat tougher to build the labor force today compared to a year ago, but we are still able to bring in new workforce participants as needed. On the material side, there are some supply chain disruptions, particularly in value-added areas. We are facing challenges in getting windows and cabinets on time, but we are not having problems sourcing them; they simply have longer lead times, affecting our production schedule. Material prices have generally increased over the last year and remain elevated, although we have seen commodity prices drop significantly from their peak in mid-June. As for our project pipeline, it is as large as it has ever been. Though there might be some project postponements, we haven’t experienced that, and the market share of modular in the new home market continues to grow. Our pipeline remains robust, and while there was some potential for delays during COVID, we are currently pursuing several large projects without feeling the impact you are suggesting.

Our next question comes from the line of Adam Waldo with Lismore Partners, LLC. Please proceed with your question.

Good day, Jeff, Dave and Matt. Thanks very much for taking my questions. I hope you can hear me okay?

Yes, we can.

Yes.

Okay, great. So, thank you. Look, when we talked last quarter, the lynchpin obviously of getting the whole enterprise back to being moderately free cash flow generative and improving the margin structure, the Construction business at the risk of stating the obvious. And you made some progress here in the third quarter, just under a 4% gross margin a year ago. We were around 14%, 15%. As you’re seeing the monthly close for October here in the fourth quarter, can you comment on what the gross margin structure is looking like so far in the fourth quarter? And do you remain confident as you were last quarter that you thought you could get gross margins back to that sort of target, 15% to 20% range by early 2022 on the Construction business?

We can't provide detailed information about October, but we are optimistic that gross margins are moving closer to normal levels. We have cleared our backlog of projects that were priced prior to the surge in material costs, so we do not foresee any loss-making projects in our pipeline currently. As you know, we typically sign a deal for a project and then produce it four to five months later, which exposes us unless we secure materials upfront, something we are beginning to do. We believe margins will keep improving for two main reasons: our production levels are increasing, allowing us to better manage fixed costs, and we have introduced several price increases. Moreover, as material costs have slightly decreased, we have not encountered significant resistance to our pricing. We are optimistic about a strong fourth quarter. It's important to highlight that our construction division consists of two businesses—one in Maine focused on modular construction, which is relatively complex, and the other in the Midwest specializing in wall panels. The recovery rate varies between these two. While we are cautious about KBS returning to profitability due to the larger and more intricate nature of its projects, EdgeBuilder has shown significant positive performance in the second half. Overall, we are quite confident that our situation will continue to improve. While unforeseen events can occur, we believe the third quarter marked a significant turning point for the Construction division, and we expect the fourth quarter to outperform the third.

That’s really helpful. Yes, that’s really helpful perspective, Dave. I don’t know whether this question really is for Dave or Jeff. But, you have a pretty good-sized accounts receivable balance. Do you have a factoring or some sort of, let’s call it Main Street because you’re a little bit too small to securitize, but let’s call it a factoring structure in place for your receivables so that you could have in some fashion for working capital as needed?

We have two asset-based revolving credit facilities. One is at KBS, which is a $4 million line, and we typically borrow between $2 million and $3 million on that, possibly a bit more right now due to our increased accounts receivable. We borrow against accounts receivable with Gerber Finance in New York, a nonbank lender. We also have a $4 million facility at EdgeBuilder in the Midwest, which was originally $3 million but was increased to $4 million. We are borrowing a little less on that one because it has turned a bit quicker. These facilities also allow us to borrow against our inventory at a slightly lower rate, not up to the full $4 million. Overall, we believe these two facilities provide us with the flexibility to scale our borrowing in response to our business needs.

And then, on the healthcare business, we had a revolving credit line with Sterling National Bank. And there’s a table in our press release that shows the balances and the interest rate. And that one has been a very attractive rate, it’s below 3%. But, as Dave said, those are all asset-based lending facilities, and so AR is collateral. And we feel like that’s a cheaper way to finance the business than factoring would be.

That was really, really helpful. Thank you, both, Dave and Jeff. Final one for Jeff, I think, as Executive Chairman. Obviously, you’ve reinstated the preferred stock dividend at the Board level the last couple of quarters. Construction business is improving at a moderate pace in terms of the margin structure sequentially, here things are looking even better for the fourth quarter. Is it reasonable to think that we’ll be continuing to pay the preferred stock dividend here as we go into 2022, especially as that part of the capital stack is a key component of potential future acquisition currency?

Yes. I think that’s a reasonable assumption. The Board sets that policy, not management. But, the Board wouldn’t have started paying dividends on the preferred stock if it wasn’t comfortable that that was a prudent thing to do. And we do see the Construction business returning to more normal levels in the fourth quarter and into 2022, we’ve invested significantly in the Construction business. And now we’re looking forward to seeing that business perform and generate positive income and positive cash flow.

Well, thank you very much. And best of luck for a strong start to 2022.

Thank you.

Our next question comes from Jeff Kobylarz with Diamond Bridge Capital. Please go ahead with your question.

Hi. Good morning. Curious about what you just said, Jeff, about investing in the Construction segment and seeing good results from that. Can you elaborate on what those investments have been?

Sure. When we merged together the thesis, the vision was that the Construction business was doing something like $30 million in revenue, maybe less than that, and we had a vision of investing in it and doubling the revenue to getting it up to more like a $60 million rate with the goal of also having 10% EBITDA margins in that business. And we have injected working capital to fund the growth, and that was one of the primary reasons for the equity offering we did last year was to really fund the growth in the Construction business. And so, a lot of it was a working capital investment that was needed to grow the business. We’ve also added a significant amount of talent in the sales and marketing side of the business, grown our sales pipeline, and grown our backlog. And we’ve also added management personnel to match or help manage the higher production levels. So, we think we’re really seeing that on the revenue side with revenue growing 65% year-over-year. We weren’t planning for lumber to go from, I think, $300 at the lows to $1,800 in such a short period of time. And with the six-month backlog, it’s taken us a while to kind of work that through the system. But, we have increased our prices significantly this year. Those price increases have stuck, which really speaks to strong demand. And as Dave talked about raw material, the more commodity items, raw material prices have declined. And so, we do see that business recovering strongly. We do think that’s going to be an important growth engine for the Company. So, that’s what I meant when I talked about seeing the benefits of the investments we’ve made in that segment.

Sure. Okay. That’s very clear. Thank you. And the volume at KBS, can you say what kind of output per week or so? I think 8% to 10% was the hope for a target.

Yes. We’re not there yet, and part of that is due to internal operational challenges, which, as Jeff mentioned, we’ve addressed by hiring additional management to assist us. Another factor is the supply chain disruption, particularly the longer lead times for certain items, which complicates our assembly line. Currently, we’re averaging around 7%, although it has been higher in recent weeks. I believe we will achieve higher levels as external challenges ease and our internal processes improve. Revenues have exceeded our original budget for the year, largely because of elevated average selling prices. These higher prices are a result of both our price increases and our pursuit of higher-level business opportunities, which we believe offer improved margins. While we are not yet where we want to be in unit production, we are focusing on producing more complex units. This means that no two units are identical, and producing more complex units requires additional labor input, allowing us to charge more. We are placing greater emphasis on the value generated each week rather than just counting units produced. We are satisfied with the revenue growth, production levels, and nature of the work we are undertaking, all while aiming to enhance profitability.

Sure. Regarding the Healthcare side, you've changed your accounting by segment and also sold one of the Healthcare assets. Can you provide some insight into the profitability of the Healthcare businesses now compared to 2019? Is there any way to make a comparison?

Yes, this is Jeff. We’ve returned to more normal levels on the revenue side. What might be confusing is that we’ve separated corporate costs between the public company and those associated with the Healthcare business. On a pro forma basis, revenue has returned to pre-COVID levels, which is about $60 million a year or $15 million a quarter. That’s about where we were in Q3. We expect this business to have a gross profit in the 20% range, which aligns with where it was in 2019, and in Q3 it was 22%. That’s how we define normal levels. Matt, do you have anything to add?

No, I would say you’re correctly identifying the situation. We’re seeing a recovery on the services side in terms of revenue, but there has been a slight decline in gross margin, partly due to labor costs. However, camera sales have rebounded strongly, which is particularly beneficial compared to 2020 and resembles what we experienced in 2019 when adjusting for one-time events.

For the two continuing businesses from 2019 to now, can you provide the EBITDA for those two businesses in 2019? I know it was $1.3 million before corporate allocations, with $1.3 million in the third quarter and the second quarter. I just wanted to get some kind of comparison.

Yes. What Jeff mentioned is that it was challenging due to the differences, and that $1.3 million is after accounting for Digirad Health corporate but does not include Star Equity corporate. In 2019, we didn’t have those separations, which complicates a direct comparison. However, the performance of those two divisions, DI and DIS, in 2019 is expected to be quite similar to 2021.

Okay. And then, just lastly, about acquisitions. Jeff, can you say just where you stand, are you getting any closer? Do you think sometime in the next 6 months, you may announce an acquisition, or are you just going to be patient and just wait for the really the right one?

Yes. No, it’s a good question. We see a lot of benefit from being in the market and looking at things. But, at the same time, we don’t feel forced to do anything. Both of our businesses are growing, and we do have some pretty adding internal growth opportunities. And so, we are looking at all those things, the internal growth opportunities as well as acquisitions. And I think the most likely would be something that’s more of a bolt-on type of acquisition for one of our two business segments, either Construction or Healthcare, with Construction maybe being the more likely of the two. But over time, we would like to add more legs to the stool. And we do think there’s a lot of benefits from combining several other companies that aren’t really big enough to be standalone public companies by combining with us, we can obviously reduce all the public company costs on day one, like we did with the Construction business that we acquired, but we can also reduce the corporate costs or said another way, spread them over a much bigger base. And another very significant benefit that’s hard to quantify is that a lot of these small companies, you really want the management team 100% focused on the operations of the business and maximizing the business, looking at organic growth projects, bolt-on acquisitions, and you really don’t want them distracted by all of the things involved in running a public company. And that’s a real benefit with another business or a company joining with us and becoming another leg to the stool.

And it looks like we have reached the end of the question-and-answer session. I’ll now turn the call over to Jeff Eberwein for closing remarks.

Thank you, operator. Before concluding the call, I just want to note that David, Matt and I are always available to take your questions. So, give us a call or send us an email if you do have any more questions. And we appreciate all of our stockholders and your feedback and your support. So, thank you for your time today.

And this concludes today’s conference, and you may disconnect your lines at this time. Thank you for your participation.

Thank you.