Star Equity Holdings, Inc. Q2 FY2022 Earnings Call

Greetings, ladies and gentlemen, and welcome to Star Equity Holdings Inc. Second Quarter 2022 Results Conference Call. Please be advised that the discussion on today's call may include forward-looking statements. Such forward-looking statements involve certain risks and uncertainties that may cause actual results to differ materially from those contained in the forward-looking statements. Please refer to Star Equity's most recent 10-K and 10-Q filings for a more complete discussion of risk factors that could affect these projections and assumptions. The company assumes no obligation to update forward-looking statements as a result of new information, future events, or otherwise. Please also note that on this call management will reference non-GAAP financial measures including EBITDA, adjusted EBITDA, adjusted net income, and adjusted earnings per share, which are all financial measures not recognized under US 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 did not receive a copy of the earnings release and would like one after the call, please contact Star Equity at 203-489-9500 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 Equity's website at 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, Rick Coleman, Chief Executive Officer of Star Equity. Thank you. You may begin.

Thank you, operator. Good morning and thank you all for joining us today for our second quarter 2022 results conference call. On the call today are our Executive Chairman, Jeff Eberwein; and our Chief Financial Officer, David Noble. On a technical aspect and operational performance, we saw a 19% revenue increase, as well as a significant improvement in gross margins. On a segment basis compared to the second quarter of 2021, our Healthcare division revenue decreased by 6.4% to $13.9 million, predominantly driven by a decrease in revenue from fewer total scanning days due to the national shortage of nuclear medicine technologists. However, our gross margin improved by 3.5 percentage points to 26.4% and gross profit for the quarter increased by 7.9%, both due to a better mix of products and services sold. Our Construction division's second quarter revenue grew by 53.7%, driven by large commercial projects at KBS and pricing increases that we implemented to mitigate the impact of higher raw materials costs. Gross margin improved substantially due to increased pricing, improved operations, and commodity price risk mitigation. We believe this quarter's performance shows continued progress toward our construction goal of generating a gross margin over 20%. Finally, our January equity offering strengthened our cash position, which remains strong and leaves us well-positioned to fund high-return internal growth investments and to pursue acquisitions, which could be either bolt-ons for our existing divisions or entry into a new business sector. Now I'll turn the call over to David Noble, our CFO, to highlight additional Construction division and consolidated second quarter financial results. Dave, please go ahead.

Thank you, Rick, and good morning. Let me first touch again on the performance of our Construction division as it was a major driver for the turnaround in our financial results. Q2 construction revenue was $16.8 million versus $10.9 million in Q2 of 2021, marking a 53.7% year-over-year increase. Gross margin was a positive 14.8% versus a negative 16.9% in Q2 of 2021. The modular business specifically reported even higher gross margins. The increase in revenues for the Construction division was driven mainly by multifamily and commercial scale modular projects at our KBS modular business. In Q2, our Construction segment accounted for 54.7% of Star Equity's total consolidated revenues. The increase in gross margin percentage resulted from significantly increased pricing levels to offset higher input costs in both residential and commercial projects, along with much better risk management around building materials price volatility. Our construction backlog and sales pipeline remained very strong. Now, turning to Star Equity's consolidated results. In Q2 2022, SG&A increased by 23% compared to Q2 2021, primarily driven by one-time litigation costs, and secondarily by severance expense associated with executive management change, both of which are related to the Digirad Health business. Consequently, SG&A as a percentage of revenue increased slightly in Q2 2022 to 22.4% versus 21.6% of revenues in Q2 2021. Moving on to Q2 bottom line results for Star Equity, we had a net loss from continuing operations of $1.6 million, compared to a net loss from continuing operations of $1.8 million in Q2 2021. Non-GAAP adjusted net income from continuing operations in Q2 was a positive $0.5 million, which compares favorably to the adjusted net loss of $3.7 million in Q2 2021. Non-GAAP adjusted EBITDA increased to a positive $1.3 million in Q2, compared to a negative $2.9 million in Q2 2021. This substantial improvement in consolidated adjusted EBITDA was due to operational improvements and a bottom line turnaround in our Construction division, where segment non-GAAP adjusted EBITDA swung from a negative $2.8 million in Q2 2021 to a positive $1.3 million in Q2 this year. Importantly, consolidated operating cash flow for Q2 was a positive $3.6 million versus a negative $5.4 million in Q2 2021. As of June 30, 2022, our balance and liquidity were very strong. The outstanding balance in our interest-bearing credit facilities was $11.6 million, while our cash balance was $13.7 million, leaving us with an overall net debt position of negative $2.1 million. Now, I'd like to turn the call over to the operator for any questions. Operator?

Thank you. Our first question comes from the line of an unidentified analyst with Litchfield Hills Research.

Yes. Thank you. First of all, congratulations on these tough times. You guys are putting up tremendous results. My first question is you have been making steady improvements in construction gross margins. What is the upper limit for construction margins? Do you have a specific target?

I don’t think that we've identified an upper limit. Rather, we’ve really taken a top-down approach to reengineering that business. This started over a year ago and continues today under new leadership that we brought in at the beginning of the first quarter of this year. What that means is examining the business from contracts to materials, tools, and processes that we're using. So we're making steady improvement. We feel like we have the right team in place today, and they're taking all the right steps to move the business forward. Dave, I don't know if you want to add to that, but I feel like we don't want to set an upper limit. We just want to continue making steady improvement.

Yeah, I think that's right, Rick. I mean we used to look at 20% as somewhat of a benchmark number. We like to see something well into the 20s, even mid-20s. But as Rick said, there's no real upper limit to that. I would suggest that there are certain projects we do that are over 30% gross margin. Some of the more complex work, especially in the passive, energy-efficient space. But we're definitely driving to push gross margins up, and we've been very successful. Our ASPs are double what they were a year ago. Obviously, there's some increase in material prices over the last couple of years, although they've been coming down for much of this year. So I wouldn't set an upper target, but projects in the mid-20s are good projects and some of them are higher.

Okay. Great. And my second question is in your prepared remarks you noted a shortage of nuclear medicine technologists for the reason for a decrease in healthcare revenue. Is the shortage in this specialty different from the shortfalls in other areas of healthcare personnel? And if so, what are the dynamics there?

I think there are some common elements across the healthcare industry. But with regard to nuclear medicine techs specifically, during COVID, a lot of colleges that offered nuclear medicine technology programs really weren't able to get the students on-site to get the necessary clinical hours to fully graduate. During that same time, older nuclear medicine techs in the market were moving on to other positions or retiring. That's what created the shortage of technicians affecting us. However, we feel like now that the pandemic is mostly behind us, we're starting to see some improvement in the availability of technicians, and we believe that things will mostly self-correct in the next 12 to 18 months.

Great. Thank you.

Our next question comes from the line of Tate Sullivan with Maxim Group. Please proceed with your question.

Thank you. Good morning. Rick, following up on the nuclear medicine technicians, were the margins higher for healthcare in the quarter due to more camera sales, or does it imply that the nuclear medicine technician business is lower margin?

No. The margins were higher mainly due to a product mix. In addition to the scanning work that our technicians do, we also sell cameras. We have a range of cameras that we sell, some new and some refurbished. Depending on the mix of cameras that come through the pipeline in a quarter can affect the margin significantly.

Okay. Thank you. Regarding modular construction, are the trends in New England that you're seeing stronger than other areas in the U.S. for modular construction, or are there special considerations in New England for demand for your modular construction business?

Dave, you've done some work on that. Do you want to comment on that one?

Yeah. I don't know that it's any different. I mean, on the modular side, there is a secular trend that modular is taking up a higher share of housing starts, both single-family and multifamily. So I don't know that New England is different in that way. We have a relatively strong position, especially in multifamily commercial scale modulars. We are based in New England. There's nobody else really in New England that provides the same product. We do have some competition from Canada and Pennsylvania, but we're able to service those projects a lot better given our proximity to those projects, which tend to be in the Boston area or down on the Cape and islands. So I think obviously, everybody is wondering about interest rates rising and housing starts coming off a bit. We feel that we have some secular trends in our favor such as the increase of modular as a percentage of housing starts. We also have a diversified business that includes single-family residential, both second homes and starter homes, but we have pushed aggressively into the multifamily space where there is a significant housing shortage. You can read in the news every day that governments are getting involved in encouraging multifamily housing, and rentals are very strong right now. So we believe we have some very positive factors considering our location and expertise.

And David, you mentioned the Nantucket affordable housing project earlier and then with the energy efficiency element to it. Will that help you win future projects in affordable housing with that, or can you talk about energy efficiency and modular construction? And how might it be better than on-site construction in terms of integrating energy efficiency work?

Yeah. You can implement energy efficiency whether you're building on-site or building in a factory, but I would suggest that the quality is better when done in a factory, as it's a controlled environment. Not every public housing project or every municipal project will necessarily have an energy-efficient element, but those are two themes: servicing workforce and affordable housing and servicing projects that have an energy efficiency element. Often those are the same project, but both themes are essential to our ability to execute that type of work, which I believe is a real strength of our business.

I would say, Dave, those are very distinct pipelines for our business. We're indeed pursuing those opportunities, and more are presenting themselves as we develop a reputation for being able to deliver.

Okay. Thank you, and a couple more on the financials if I may. David, $3.6 million in cash flow from operations in the quarter is a great number. However, it looks like CapEx did increase. Can you remind us what the CapEx requirements are? And is it mostly for KBS in the next couple of quarters as well?

I don't have that number at my fingertips, but across the group as a whole, we spend about $1 million a year in cash CapEx. We do add leases here and there on the healthcare business particularly, but CapEx is not a major component. Overall, we are a relatively capital-light business, so that's not a huge factor.

Okay. Last question; the preferred, I think you recategorized the preferred into equity. Can you go over the accounting treatment for that? Was it a change from Q1 to Q2?

Yes. There was a provision in that preferred that in a change of control, the owners of the preferred could elect to have that redeemed, and we changed that provision. We held a vote that allowed us to change that provision so that in the case of a change of control, only the Board can decide whether to redeem that preferred. Thus, it receives equity treatment based on the current form of that preferred. So we dropped that into stockholders' equity.

Okay. All right. Thank you all. Thank you, Rick and David.

Thank you.

Our next question comes from Adam Waldo with Lismore Partners. Please go ahead with your question.

Hi. Good day, Rick and Dave. Thanks very much for taking my questions. I wonder if you can hear me okay?

Yes, we can.

Okay. Can you speak to the new business pipeline on both principal division sides? Additionally, can you provide some quantification as to what the new business pipeline and backlog look like at the end of the quarter?

Sure, which businesses particularly?

I'm particularly interested in the construction business, but any directional quantification on the healthcare business side would also be helpful.

Sure. We have two companies in that Construction division. The first is the modular business in Maine called KBS. They have a very strong pipeline, which I believe is in the range of around $50 million of identified opportunities. As mentioned before, they have single-family homes, both energy-efficient and regular homes, as well as second homes and the commercial scale multifamily business. Both of those pipelines remain very strong. In fact, our production schedule is fully booked into early next year, ensuring we remain busy for the rest of the year at very high ASPs, like we've been experiencing all year. So that business remains robust. We're currently monitoring for signs of slowdown with interest rates, but so far, that business has held strong. I believe that there was a real shortage of capacity, and it will take time for that to turn around if things slow down at all. On the other side, in Minneapolis, we have the Edge Builder business, which serves as both a retail lumberyard and a professionally focused lumberyard, in addition to a wall panel business. Both of those sectors remain strong. We recently had a few projects get delayed into the third quarter that we had hoped would be completed in the second quarter, but our pipeline continues to be as strong as ever, especially in the upper Midwest housing segment, which we serve with wall panels. So we remain cautiously optimistic. Those businesses are incredibly strong at this moment.

Oh, sorry.

I'm sorry. Go ahead.

No, I'm sorry.

I was just going to say the same is true for our Healthcare business. We have a strong pipeline that will carry us forward, at least through the remainder of the year. The healthcare business is somewhat different, as it's typically a doctor's office considering purchasing a $250,000 camera and changing their operating methodology to allow us to do scanning on their behalf is a big decision. Our pipeline of opportunities is strong, and we are seeing improvements in those scanning customers who may have deferred some business and slowed down during COVID, who are now ramping up.

So given the positive commentary surrounding the new business pipeline backlog in both divisions, are you comfortable that you have good visibility into posting similar revenues for each division by the end of the year or perhaps even somewhat better than what you posted during the second quarter?

We're not going to forecast the revenues, but I would say that we do feel very comfortable with the health of the business and the backlog for the remainder of the year.

Very helpful. Thank you. With respect to margin structures, you've obviously made numerous adjustments on the pricing side and somewhat on the hedging side in the construction business. What timeline do you think is reasonable for trying to meet or exceed your intermediate-term target for over 20% gross margin on the consolidated construction business?

Yeah. I'm not sure how much we can say on that. What I would say is we're achieving that on the KBS side already. There’s some fluctuation in the other business, but essentially, we are there. We are pricing projects at our target gross margin level, and we do not have any lower-margin projects still in the pipeline. Our year-over-year results are dramatically improved. We had some projects last year that were negatively affected when commodity prices escalated quickly and led to sub-par gross margin projects, but we do not have that work in progress. Therefore, everything going forward is priced at our target gross margin level, and everything currently in production is aligned with that target gross margin level.

Terrific. Lastly, you’ve incurred litigation expenses in the first half of the year that you continue to classify as one-time in nature. What sort of timeline should we anticipate regarding these litigation expenses, and how might they influence the free cash flow profile of the business through the second half of the year?

We share that same inquiry. We have one case that has been quite costly over the past couple of years, and we're currently awaiting a judge's determination. Consequently, it's difficult to forecast that with certainty. However, we are hopeful that we will be able to conclude that matter soon.

Okay. That’s fair. It seems reasonable to think that we should see operating and free cash flow in the second half of the year similar to or possibly even slightly better than what you posted in the second quarter, based on your current understanding. Is that a reasonable estimate?

Certainly, that is our hope as well.

There are no further questions in the queue. I'd like to hand the call back to management for closing remarks.

Thank you, operator. Before concluding, I'd like to note that we're always available to take your calls. Please don't hesitate to contact us to discuss any additional questions you might have. We will continue to share our story with existing and potential investors in the coming weeks and months. As always, we appreciate all of our shareholders and your continued feedback and support. Thank you.

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