Star Equity Holdings, Inc. Q1 FY2023 Earnings Call

Greetings, ladies and gentlemen, and welcome to Star Equity Holdings, Inc. First Quarter 2023 Results Conference Call. Please be advised that the discussions 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 description 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 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 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 via www.starequity.com. Please note, this event is being recorded. 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. Please go ahead.

Thank you, Gary. Good morning, everyone. We appreciate you joining us for our first quarter 2023 conference call. On the call with me today are Executive Chairman, Jeff Eberwein; and Chief Financial Officer, Dave Noble. It's a pleasure to update you on our first quarter results and to report strong overall performance. In our Healthcare division, I'm especially proud of the team effort that began with the reinvigoration of our business in early 2022 and culminated in the sale we completed on May 4. This has been a transformational quarter and has positioned us well for the future. Our operating plan assumed a strong start to 2023, and I'm pleased to report that our teams exceeded those expectations. We achieved first quarter adjusted EBITDA of $1.7 million versus $0.1 million in the first quarter of last year, primarily due to continued strong top and bottom line growth at our Construction division. This exceptional improvement was driven by better operational efficiency as well as disciplined pricing and expense control. Although Healthcare division revenue was roughly flat versus the prior year quarter, gross margin improved by 1.2 percentage points to 24.9%, again reflecting our focus on higher-margin products and services stemming from our 2022 reorganization. With the sale of Digirad Health, we've significantly strengthened our balance sheet and are well positioned to pursue accretive acquisitions as well as other strategic opportunities. I'll first focus on our Healthcare division. In the first quarter, our Healthcare division revenue decreased by 0.4% versus the prior year quarter. Discontinuing unprofitable services and initiatives and focusing on higher profitability business helped drive 4.8% higher gross profit. Our Healthcare division was able to deliver these strong results despite the continuing labor market headwinds. On behalf of the Star Equity management team, I thank all Digirad employees for their contributions over the years and wish them the best under TTG's leadership. We believe the scale and synergies created from this partnership will result in a stronger, more valuable business, and we're excited to continue as equity partners. Let me next touch on the results of our Construction division. Q1 Construction revenue increased 6.1% to $12.3 million versus $11.6 million in Q1 of 2022, and gross margin percentage was 35.1% versus 13.6% in the same period last year. Increased output was the primary driver for the revenue improvements at both our EdgeBuilder and KBS businesses. The increase in gross margin percentage was due to better pricing management relative to changing input costs as well as better risk management around building materials price volatility. Despite macroeconomic uncertainty across the construction space at large, we're a relatively small specialized player with a unique position in the markets we serve. KBS in particular is experiencing continued growth in the areas of workforce and affordable housing, educational dormitories and school buildings and environmentally sustainable housing. Both of our Construction businesses have a robust pipeline heading into the summer, and we're working on some exciting new business initiatives that we expect will continue to fuel our future growth. Now I'll turn the call over to Dave Noble, our CFO, to provide additional first quarter consolidated financial highlights. Dave, go ahead.

Thank you, Rick, and good morning. Let's now turn to Star Equity's consolidated financial results. In Q1 of 2023, SG&A decreased by 5% versus Q1 of 2022. SG&A as a percentage of revenue decreased meaningfully in Q1 to 25.0% versus 27.1% in Q1 of 2022. This demonstrates both effective cost control and good operating leverage embedded in our businesses, particularly on the Construction side. Moving on to the bottom line results for Star Equity. We generated a positive net income of $0.4 million in Q1 compared to a net loss of $3.7 million in Q1 of 2022. Non-GAAP adjusted net income from continuing operations in Q1 was a positive $0.9 million. This also compares favorably to an adjusted net loss of $0.7 million in Q1 of 2022. Non-GAAP adjusted EBITDA increased to $1.7 million in Q1 from just $0.1 million in Q1 of 2022. The substantial improvement in consolidated adjusted EBITDA was driven primarily by our continued bottom line focused turnaround at our Construction division, particularly at KBS, where it began to materialize in mid-2022. Construction non-GAAP adjusted EBITDA extended its upward trend, generating $2.2 million in Q1 this year, up from $0.4 million in Q1 of 2022. Consolidated operating cash flow for Q1 was a positive $5.1 million versus a negative $0.6 million in Q1 of 2022. Q1's strong positive operating cash flow was driven by both a strong performance and also monetization of the accounts receivable buildup we experienced in Q4 of 2022 at our Construction division. As of March 31, 2023, our consolidated balance sheet and liquidity were strong. The outstanding balance in our interest-bearing credit facilities was $8.4 million, while our cash balance stood at $5.7 million, leaving us with an overall net debt position of just $2.7 million. Along with the filing of our 10-Q this morning, we also disclosed that following the sale of our Healthcare division on May 4, we have paid off the entirety of our outstanding interest-bearing debt. This debt was in the form of a revolver with Webster Bank and two revolvers and a term loan with eCapital. We are now 100% debt-free. Our pro forma financial statements filed via 8-K/A last week disclosed our pro forma cash balance at $23.1 million. I would also like to note that the company was able to use its accumulated net operating losses to completely offset federal gains associated with the substantial gain on sale that we realized with the sale of Digirad Health on May 4. Now I'd like to turn the call back over to Rick for some additional remarks.

Thanks, Dave. The Digirad sale was certainly a major change to our business. Our team had been working diligently towards closing this deal for several months, but I don't want to overlook the exceptional work that's been done in both our Construction businesses. Strong leadership, along with disciplined planning and execution, gives us confidence in the potential for continued strong performance and growth. In the coming weeks, the Star Equity Board and management team will continue to assess and prioritize the elements of our growth strategy. These could be acquisitions, including Construction bolt-ons or entries into new business sectors as well as thoughtfully expanding activity at our Investments division. We plan to provide shareholders updates on these and other initiatives as they occur. I'll now turn the call over to the operator for questions.

Our first question is from Theodore O'Neill with Litchfield Hills Research.

Congratulations on the good quarter and the sale of the Healthcare division. My first question here is about KBS. So I have seen that you've had some success here making buildings for asylum seekers and emergency shelters and supporting buildings. And that looks like a sort of a universal problem that the states are having right now. Can you comment on the outlook in that area?

Yes. Let me just say that there are a number of sectors that I would consider very specialized. Those are a couple of them. But as I mentioned, we're getting a reputation primarily through word of mouth among educational institutions, local governments who have short-term needs for different types of affordable and workforce housing and things like that. So we've got a growing strength and a growing reputation for quality and flexibility. So we feel like we've done a pretty good job of strengthening the business and positioning it for growth.

Okay. And can you comment on any sort of acquisition opportunity in the Construction business? Because it seems to me, the last time we had a rising interest rate environment, there were plenty of struggling construction companies on the verge of going under. Are you seeing that yet? Or is it too soon?

I think it's too soon to see a lot of them that are struggling. But there are... it's a pretty fragmented industry still. There are a number of family-owned businesses and specialized companies that build everything from trusses to windows and cabinets and things of that nature. All of those are good potential business partners for us and are part of our input stream today but could become part of our business in the future.

The next question is from Tate Sullivan with the Maxim Group.

And on the sale of Digirad, I think you mentioned a couple or at least 2 months working on the sale, maybe longer. Can you talk about the conditions in the medical imaging industry in general that led to the timing of the sale? And was this a particularly high point in terms of valuations, if you can comment.

I'll say, first of all, thank you for the question. Our 2022 operating plan did not take into account any thought that we were planning to sell the Healthcare division, though we had a number of initiatives underway to strengthen it and we were working hard towards growing the business and doing the things that we would do as a continued owner. We were approached during the year and began discussions about the possibility of selling the business. The more we looked at it, the more we realized the benefits of scale and the opportunities available to us at the sale price. So we moved forward from that position. It took a little bit longer than we expected, to be honest, but we're very pleased with the result.

In terms of retaining some interest in the combined company, I believe it's TTG. How will you and David account for that? Will it be through equity and investment? Is there any history of TTG paying dividends? What might your retained interest in the combined company look like?

Dave, do you want to address that one? Go ahead, David, yes.

Yes. The retained interest will be in the sort of 5% to 6% range. We don't anticipate any distributions. The acquirer is a private equity company who combined Digirad with an existing platform company that they had, combining... the company is called TTG. So I would expect over the next few years, they will grow this company and then attempt to sell it.

This is Jeff, Tate. Our current plan is to account for it using the cost method. The equity interest and the note will remain on our balance sheet while we recognize the interest income as it accrues. Additionally, this business is quite similar to Digirad; the two have collaborated for many years, with Digirad being a supplier to TTG. Their compatibility creates many synergies, which is why we are pleased to retain a stake. The private equity firm invested in TTG in late 2021, and typically, they hold onto their investments for around five years. By that logic, we can expect to maintain this position for a few years before an eventual sale, as is customary for private equity firms. At that time, our debt would be repaid, and our equity would be converted into cash. Our investment is on equal footing with the private equity firm, which is another aspect of the deal’s structure that we appreciate.

I have a follow-up question. I noticed some pro forma financial statements. The implied overhead for Digirad seems to be around $13 million, based on the transaction adjustments I reviewed. Will this overhead disappear immediately, or will it take time to distinguish your overhead related to Digirad? How will this affect your forecasts for overhead expenses?

Yes, this is Jeff. I don't know the exact number, but every single employee of Digirad was part of the transaction. It should be fairly immediate. There is a transition services agreement in place, so we will continue to assist each other with some matters. While we are not fully separated, the impact on financials will be minimal, especially after we get through Q2. Q2 will be complicated since we only own the business for about five weeks, and that will be reflected as discontinued operations.

Okay. And sorry, one more, if I may. For Construction, gross profit margins have been consistent over the past two quarters at 28% and 31% in Q4 '22. This quarter has also shown solid performance in Construction gross profit margins. Is this a result of the previous hedging strategy for lumber, or does it reflect your current pricing approach for the future? How should we anticipate margins in Construction for the remainder of the year?

Why don't you take that one, Dave?

Yes. Well, I'll speak first. So it really is a fundamental change in that business in the sense that we've dramatically increased pricing and probably tiered up in terms of the type of projects that we're pursuing. So I can't promise you're going to see 35% every quarter, but the hedging definitely helps. We only hedge actually at the EdgeBuilder side of the business, that's about half of the business. We don't hedge at KBS for a number of reasons. But lumber, the hedgeable part of our inputs, is only a smaller piece of what we purchase to build modules at KBS. So hedging is not the best strategy. But I'd say it's really just cost control. And also, you've seen lumber prices have generally declined in the last 6 months while we are able to maintain our higher pricing levels. So I'd just say better business management all around.

And this is Jeff. I would add that we have made a deliberate investment in our sales teams. We are increasing our spending on sales and marketing within our construction businesses and exploring new verticals. The construction market is quite large, and we are a small niche player. We've noticed a decline in the residential market, but it now represents a much smaller portion of our overall business. Our entry into the education vertical is new for us; last year, we secured a $9 million project to build four dormitories for a college in New England, which established our presence in the education sector. Completing that project on time and within budget has left the client very satisfied, and they serve as a positive reference for us. People can visit the completed project to see what we've accomplished, which was instrumental in securing our recent $2 million project in Vermont. We anticipate potential opportunities in education and other sectors as well. There are always construction projects happening somewhere, and our team has improved significantly in identifying the right projects and positioning ourselves to engage.

This concludes our question-and-answer session. I would like to turn the conference back over to Rick Coleman for any closing remarks.

Thanks, Gary. Before concluding the call, I just want to note that we're always available to take your call and to discuss any questions you might have. Please don't hesitate to contact us. We'll continue to share our story with existing and potential investors in the coming weeks and months. And as always, we appreciate all of our shareholders and your continued feedback and support. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.