Earnings Call Transcript - TH Q2 2021

Operator, Operator

Good day, and welcome to the Target Hospitality Second Quarter 2021 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Mark Schuck, Senior Vice President of Investor Relations. Please go ahead.

Mark Schuck, Senior Vice President, Investor Relations

Thank you. Good morning, everyone, and welcome to Target Hospitality's second quarter 2021 earnings call. The press release we issued this morning outlining our second quarter results can be found in the Investors section of our website. In addition, a replay of this call will be archived on our website for a limited time. Please note the cautionary language regarding forward-looking statements contained in the press release. This same language applies to statements made on today's conference call. This call will contain time-sensitive information, as well as forward-looking statements, which are only accurate as of today, August 11, 2021. Target Hospitality expressly disclaims any obligation to update or amend the information contained in this conference call to reflect events or circumstances that may arise after today's date, except as required by applicable law. For a complete list of risks and uncertainties that may affect future performance, please refer to Target Hospitality's periodic filings with the SEC. We will discuss non-GAAP financial measures on today's call. Please refer to the table in our earnings release posted in the Investors section of our website to find a reconciliation of non-GAAP financial measures referenced in today's call and their corresponding GAAP measures. Leading the call today will be Brad Archer, President and Chief Executive Officer; followed by Eric T. Kalamaras, Executive Vice President and Chief Financial Officer. After their prepared remarks, we will be joined by Troy Schrenk, Chief Commercial Officer, and open the call for questions. I'll now turn the call over to our Chief Executive Officer, Brad Archer.

Brad Archer, President & Chief Executive Officer

Thanks Mark. Good morning, everyone, and thank you for joining us on the call today. As the economic outlook continues to improve supported by post-pandemic re-openings and increasing global economic activity, Target has continued to benefit from consistent increases in demand for its customized hospitality solutions and services. This has supported building momentum and strengthened Target's operating metrics through the first half of 2021. Target's strong second quarter results are a direct reflection of the aggressive actions we took in 2020 to appropriately position the business to take advantage of these improving market fundamentals. Our actions created an efficient operating structure, allowing us to expand our customer reach with highly attractive margins that generate significant cash flow, which allows us to execute on our strategic priorities. The sustained momentum Target has experienced over the past year has provided the basis to both materially accelerate the strengthening of Target’s financial position and grow the end markets we serve. Target continues to see positive momentum in customer demand anchored by our premier first-class customer base. This has supported meaningful increases in occupancy from our Top 10 non-government customers who have increased their utilized beds by over 20% during the first half of 2021. The positive momentum contributed to Target's second quarter utilization of 72% which represented the fourth consecutive increase in quarterly utilization. Additionally, we continue to focus on asset optimization across our network. In March, we reallocated approximately 2,400 beds to our government segment. This reallocation allowed us to fully optimize our assets and resulted in several communities being fully utilized during the quarter. This network optimization creates an ideal operating structure and maximizes the margin contribution from each utilized bed with negligible capital requirements. Our customers find added value in the flexibility of Target’s network of relocatable assets and hospitality solutions, which provides scale and flexibility to meet their needs while delivering superior service offerings. These attributes have supported the addition of more than 50 new customers in the first half of 2021. And while we continue to have plus 90% customer renewal rates—something we have enjoyed for several years—this positive momentum has also supported the continued execution of our strategic objectives. Target has achieved significant debt reduction with no outstanding borrowings under the company's credit facility, which has materially enhanced Target's financial flexibility. Further, the company has meaningfully enhanced its government segment that now represents approximately 60% of second quarter revenue. This marked an important juncture as we believe this more balanced revenue profile creates a strategic inflection point for Target. We have illustrated our ability to appropriately position the company to systematically execute on its strategic objectives. By doing so, we have established a trajectory in which to continue pursuing our growth strategy focused on enhancing value to our diversified portfolio of service offerings. Target’s unique capabilities translate across a range of markets and provide the opportunity to pursue a variety of value-enhancing growth initiatives. Target will pursue these opportunities while simultaneously remaining focused on expanding its reach, providing critical support to the United States government. Target has intentionally increased the concentration of services supporting federal agencies and has established itself as a trusted provider of these critical services. This creates the optimal foundation to continue expanding its strategic long-term partnerships with the U.S. government. Our established platform creates the avenue to utilize our core competencies to support critical service needs across a variety of U.S. government agencies, as well as a broader suite of commercial opportunities. These services extend beyond our legacy accommodation offerings and include facilities management, building operations, asset maintenance, and other critical support services. Additionally, our established position as a proven government service provider enables Target to begin engaging these various agencies as a direct prime contractor, which further validates Target as the premier provider of government services and enhances contract and counterparty strength. Additionally, our increased government scope and the breadth of our services should bode well for additional commercial opportunities across a variety of industries. Target has identified and is currently evaluating a robust pipeline of expansion and diversification initiatives within the government and commercial services markets. This pipeline includes expansion opportunities within our existing service offerings, as well as inorganic growth focused on broadening our reach across government agencies. Target has intentionally enhanced its operational and leadership capabilities to effectively identify and evaluate these growth opportunities, which it believes provides the greatest opportunity to accelerate value creation. We enter 2021 encouraged by the improving economic outlook, supported by sustained progress in post-pandemic reopening, and increasing global commercial activity. We were confident that the deliberate action taken to appropriately position the company would allow us to take advantage of a balancing market. The pace of these improvements has exceeded our expectations and the momentum Target has sustained is impressive. We have utilized this momentum to accelerate our progress, strengthening the financial position of Target while growing our end markets. We anticipate this progress to continue as we progress through 2021 and into 2022 while staying focused on our strategic priorities and creating value for our shareholders. I'll now turn the call over to Eric to discuss our second quarter financial results and ongoing growth initiatives in more detail.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Thank you, Brad, and good morning everyone. In the second quarter, we experienced continuing improvements in our operating metrics and realized a fourth consecutive quarterly improvement in utilization as demand for our premium service offerings increased. This supported our strong second quarter performance with total revenue of $75 million and adjusted EBITDA of approximately $32 million. As we continue to focus our growth strategy on broadening our reach into adjacent end markets, we have changed our reportable segment names to align accordingly, and to highlight Target’s balance of service offerings. Beginning with the second quarter of 2021, the segments formerly known as Permian and Bakken will now be referred to as Hospitality & Facilities Services South and Midwest respectively, or HFS South and HFS Midwest. The assets and revenues within each segment remain the same from prior periods requiring no adjustments. We believe this change more accurately reflects our comprehensive suite of services and solutions. Our Government segment produced quarterly revenue of approximately $45 million, compared to $17 million in the same period last year. The significant increase was a result of a new U.S. government contract award, executed in March of 2021, which contributed approximately $31 million of revenue in the quarter. As a reminder, Target’s Government segment is supported by minimum revenue contracts, which are fully backed by the United States government over their respective contract terms. Our HFS segments delivered second quarter revenue of $29 million, compared to $21 million in the same period last year. This increase was driven by continued improving customer headcount demand, supported by post-pandemic re-openings and strengthening economic demand. As the pace of the improving economic outlook continues to build, we continue to monitor supply chain impacts and inflationary pressures resulting from strengthening economic demand, and any associated impacts on our cost of services. We take an active approach managing our input costs and benefit from our service offering flexibility, which allows us to adjust primary cost components to mitigate pricing pressure. As such, our input costs have remained within our expected ranges and have not impacted margins. Furthermore, inflationary effects that we have seen we expect to abate over the coming months and did not anticipate negative price impacts to meaningfully affect margins for the balance of the year. Recurring corporate expenses for the quarter were approximately $9 million. Despite the significant increases in revenue and EBITDA, we have not had commensurate increases within our corporate costs with the highly scalable business model that allows us to substantially expand growth with minimal incremental costs. As a result, we anticipate recurring corporate expenses to remain around $9 million per quarter through 2021. Total capital expenditures for the quarter were approximately $12 million, including approximately $10 million in growth capital, primarily associated with the new government service award, as well as $2 million in maintenance capital. We ended the quarter with $7 million of cash and $345 million of total debt. As of August 11, Target has reduced year-to-date outstanding borrowings by $70 million and has no outstanding borrowings under the company's $125 million revolving credit facility, providing available liquidity of approximately $179 million, including $54 million in cash on hand. Because we are achieving a high level of cash generation, coupled with minimal capital spending, we have industry-leading return on invested capital, which has significantly enhanced Target’s financial flexibility. Importantly for Target and our investors, we expect this trend to continue for the next several quarters. As a result, the company has made significant progress towards its year-end 2021 target net leverage ratio of below 3.5 times. We're excited by the strengthening commercial activity and associated demand for our service offerings. These elements supported Target’s strong second quarter results and provide confidence and cadence for customer demand for the remainder of 2021. From a contractual perspective, approximately 96% of Target’s 2021 midpoint revenue outlook is under contract, and approximately 73% of contracted revenue has committed payment provisions with 54% of committed revenue related to the government services segment. As a result, we have reiterated our 2021 financial outlook, which consists of revenue between $260 million and $270 million, adjusted EBITDA between $97 million and $107 million and discretionary cash flow between $65 million and $70 million with $15 million to $20 million in capital spending and a Target net leverage ratio below 3.5 times by year-end. We have made significant progress towards our 2021 financial outlook and net leverage with approximately $179 million of net liquidity as of today. We remain focused on preserving and enhancing this financial strength throughout 2021 and into 2022. The positive momentum Target has experienced this year has accelerated our ability to execute on our strategic initiatives. With significant progress made in enhancing our financial flexibility through meaningful debt reduction, we anticipate turning our focus to strategic growth. Target’s growth strategy will focus on utilizing its core competencies to expand its reach within the government services end market as well as select commercial markets, which we believe offers the greatest opportunity to enhance Target’s unique value proposition. The foundation we have created providing a central service offering to United States government creates the optimal scenario to pursue highly economic growth opportunities. The foundation of our existing network and broad reaching capabilities creates a platform to pursue these opportunities with limited capital requirements, creating an impressive return on invested capital profile, while simultaneously preserving the financial flexibility we have created. As part of accomplishing our growth objectives, we have placed significant focus on highly efficient capital allocation and deliberate management of our network that allows for the expansion of accommodation services and associated hospitality solutions with the use of existing assets. As a result, we have achieved this performance with minimal capital spending. And we remain focused on maximizing our discretionary cash flow potential of each new contract award. In addition, as we have substantially increased utilization to fully optimize levels, we're also enacting ADR increases across select HFS markets that will further drive revenue increases. Additionally, as our potential commercial and contract backlog continues to build, so does our acquisition pipeline. We have engaged in an exhaustive acquisition strategy over the past several quarters that are starting to bear fruit. We have been highly selective and any targets will be pursued with the aim of preserving balance sheet strength. Many strategic targets require limited infrastructure capital and tuck into Target’s broad ranging service offering capabilities. These opportunities cater to a variety of government agencies and provide significant revenue visibility through long-term contracts and quantifiable contract backlogs. To add context to the size and scope of this addressable market, federal facility support and management represents an approximate $84 billion per year industry segment. Now we look forward to providing additional information on these opportunities if and when they materialize. These characteristics of our growth strategy meaningfully increase revenue visibility and strengthen economic returns, which we believe create the greatest opportunity to accelerate value creation for our shareholders. With that, I'll turn the call back over to Brad for his closing comments.

Brad Archer, President & Chief Executive Officer

Thanks Eric. We intentionally positioned Target to take advantage of improving market conditions, while systematically continuing to execute on our strategic priorities. Our strong second quarter results reflect this commitment and illustrate our operational strength, which we have leveraged to meet and exceed our customers' varying needs. We have created and sustained a tremendous amount of momentum over the past year, which has been reflected in our impressive results and execution. As we look to the second half of 2021, and into 2022, we will utilize this momentum to focus on our strategic growth initiatives. We have intentionally increased our concentration on services aiding the United States government, and we believe we have established Target as a premier provider of these services. This foundation provides a platform to pursue additional value-added growth opportunities within the government services market. Additionally, we have taken thoughtful steps to enhance our capabilities to effectively identify and evaluate these opportunities, which we believe provides the greatest avenue to accelerate value creation for our shareholders. We have created a structurally sound business and developed a unique set of core competencies, which will allow us to continue executing on our strategic objectives. I appreciate everyone joining us on the call today. And thank you again for your interest in Target Hospitality.

Operator, Operator

Our first question comes from Stephen Gengaro with Stifel. Please go ahead.

Stephen Gengaro, Analyst, Stifel

I think two things. I mean you talked a little bit about this, but so you have the Government business, which is clearly has gone very well, and you renamed the other two segments. Does the renaming of the segments suggest there you're expecting opportunities that are non-oil and gas to fall into those two buckets that are sort of non-government work?

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Eric Kalamaras here. Good to hear from you. So yes, one can certainly think of it that way. I think the way we had thought about it more holistically was that Target Hospitality offers a broad range of services. And what we wanted to do was try to make those segments more encompassing and holistic of the services and the solutions that we provide as opposed to being geographic-specific. And as we look to expand the business both commercially as well as by geography, we've felt that that particular naming convention really didn't exemplify, one, the services we provide; and then two, where we're heading as a business and as an organization and, frankly, how we operate it.

Brad Archer, President & Chief Executive Officer

Yes. Let me just add to that. Stephen, good morning. Kind of in response to your question, maybe just to add a little bit on what Eric is talking about: if you look at our sales pipeline today, which is more robust than I've seen in years, the projects are more actionable, meaning funding is in place. But I think the biggest difference is in the diversity of the projects. So they range from facilities management, energy transition, infrastructure, government-related projects like we're performing today. So very diverse compared to years past where it was heavy oil and gas. Now with our large network built out, we can service our oil and gas customers with much less new capital needed for that with the network built out. So it allows us to go after these other markets, which we've been doing not just for the past few quarters, really for the past few years. It's now the momentum is building in that. So along with this kind of transition, I think the renaming of those sectors really worked out in our favor for that.

Stephen Gengaro, Analyst, Stifel

Okay, thank you. And just two other things. One is a follow-up to that. Would you envision the contracts and the contract terms to be more solid like government contracts in some of these other endeavors or more similar to what you do in the oil and gas business right now?

Brad Archer, President & Chief Executive Officer

Well, I think when you look at the Government business as a whole, when you look at the size of that addressable market, Eric mentioned it in his remarks—$84 billion—so it gives you the ability to scale, which adds a lot more contracts for you. But I think they're very visible when you start to look at the Government business. You can look out many years on these. So I would say, yes, the longevity of them is a big piece of why we're going there.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Yes. I think, Stephen, it's in addition to that also about the potential hit rate opportunities as well. So the structure may look and feel similar at times, but it's also the hit rate in the total addressable market that you're looking at. Whether you're looking at industry or whether you're looking at the government side, what you're really talking about is massively expanding the pie over time. And that level of expectancy around contract availability is really important as is the structure.

Brad Archer, President & Chief Executive Officer

And really capital-light.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

For sure. That's exactly right.

Operator, Operator

And next question comes from Scott Schneeberger with Oppenheimer. Please go ahead.

Daniel Hultberg, Analyst, Oppenheimer (on behalf of Scott Schneeberger)

It's Daniel on for Scott. A couple of questions on the Government segment. If you could please speak to the dynamic at the border where immigration issues persist. Are children still kept temporarily around convention centers? And what are the chances for Target to garner incremental solutions?

Brad Archer, President & Chief Executive Officer

Well, look, let me just kind of talk about that business as a whole. The contract, as it sits today, continues to perform as expected. We continue to receive high marks for the services we perform. More directly, the need for our services has continued to grow. In fact, the need has increased to a point where we're in active discussions with our customer on expansions as well as additional locations. We're not the company to do the more temporary-type structures. As you mentioned, the convention centers were more of those standard-type products. So we believe that is what we do best. Our end user really likes that, and we fully believe there's more business out there to be had. The issues at the border have not stopped. It's actually increased. So the need for our services has done the same.

Daniel Hultberg, Analyst, Oppenheimer (on behalf of Scott Schneeberger)

Got it. Very helpful. Thank you. And if we think about the existing contract, I think you alluded to it, how would we think about the potential for the extension of that contract?

Brad Archer, President & Chief Executive Officer

Again, I touched on our performance to date, how we're ranked on our services. They value our supply, and I think you need to look at that point. We're in active discussions for more expansions in more locations. As it relates to the growth and longevity of this business segment, we view all the things that I just mentioned as positive steps as we move forward throughout the year into 2022.

Daniel Hultberg, Analyst, Oppenheimer (on behalf of Scott Schneeberger)

Got it. Thank you. That's very helpful color. And just a quick one on the other segment. How should we think about the visibility? I mean you're doing well on new customers, so that's great to hear. But how do we think about the visibility going through the back half and also into 2022? Thanks.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Sure. So I think the way we would characterize the business going forward in the back half of 2021 is continuing positive momentum around the energy side. We obviously continue to see stability around the Government Services side. I think the biggest question then is how we foresee growth. And as Brad has mentioned in the prepared remarks and then just a moment ago in the question, the pipeline we have is really extensive. But look, deals aren't done until they're done. And so we feel quite optimistic about the back half of 2021. We expect the business to continue to perform and to continue to progress and hopefully improve even from where it is today. We continue to see positive aspects of that. So we feel great about it. We'll just let the rest of the year play out. We'll adjust accordingly and make the marketplace aware to the extent we have commercial discussions that materialize and result in something with the outlook.

Operator, Operator

The next question comes from Doug Becker with Northland Capital Markets. Please go ahead.

Doug Becker, Analyst, Northland Capital Markets

I want to touch base on the guidance again. It seems like the EBITDA guidance implies that we see a decline in 3Q and 4Q from the second quarter level. Just wanted to see if there was anything you could point to specifically that would cause that.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Hi Doug. Good morning. So look, no, there's nothing specifically we can point to that would cause that. I think what you're seeing in there is we have purposefully been cautious around how we see the business progressing through the back half of the year largely because of pandemic reopenings when we initially set the guidance some months ago. While we're not changing it today, what I think you're hearing us say is we feel quite confident about it going forward. But we want to be thoughtful about how we have the outlook. At this point in time, while we're highly comfortable in our positioning for the outlook, we're just not prepared to change it at this point in time.

Doug Becker, Analyst, Northland Capital Markets

Got it. That makes sense. Do you have any visibility on maybe any seasonal weakness in the fourth quarter based on conversations with your customers?

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

We do see occasionally some seasonal weakness towards the back half of the year, particularly in the December time frame during the holidays. It's not material. It's maybe 1% or 2% on utilization. Beyond that, I don't have any additional color specifically at this point in time around that.

Brad Archer, President & Chief Executive Officer

One thing I would say is our customers are being pretty good about staying within their budget. In years past, they seemed to spend it early, and then in the fourth quarter you've seen them having to cut back. Talking with our customers, it's going to be a more even trajectory throughout the quarters as we move through the back half of the year. So I think that lends well to what Eric's saying—minimal, if any, drop-off in the fourth quarter, other than we always have a drop-off around the Christmas holidays and those types of things, but I don't see anything major.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

That's right. And I want to be clear. We continue to expect the HFS South and particularly that side of the business to continue to show positive trends. We continue to expect that and don't want there to be any mistake around that.

Doug Becker, Analyst, Northland Capital Markets

Got it. And then as you are pursuing the growth opportunities and the diversification, would you expect these to be accretive, dilutive, kind of the same as existing margins? Just trying to think about the margin outlook as you pursue these growth opportunities.

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Sure. It's a great question. We have exceptionally high margins, which we are quite proud of, and we do all we can to protect and have done that consistently for years. As it relates to margin specifically, you have to also contemplate the denominator as part of that equation in terms of return on capital. What we have been very thoughtful about over the past several months and quarters is capital deployment and doing so very thoughtfully to maximize utilization potential within the capital. We have done that, which has made this EBITDA highly accretive. Now as we go forward, what we're looking at are businesses that are intrinsically more capital-light. With that, though, also may come with slightly lower margins. However, we expect the all-in return on invested capital to actually look very similar at the end of the day. At least that's what we're trying to achieve. Ultimately, you can capture a similar return on invested capital even if you have a slightly lower margin, but you're also spending significantly less capital for that.

Operator, Operator

Next, we have a follow-up from Stephen Gengaro from Stifel again. Please go ahead.

Stephen Gengaro, Analyst, Stifel

Thanks. I appreciate you taking that. Just quickly, when you think about capital deployment and you've obviously been reducing debt, you have some targets in mind. As you get to the leverage targets, to the extent there's not something that is brewing on the acquisition side, what do you do with the cash at that point?

Eric T. Kalamaras, Executive Vice President & Chief Financial Officer

Good question. Let me address the balance sheet a little bit. We do have some more work to do on the debt reduction. We are running to a point that the level of prepayable debt is becoming effectively nil. So we have a couple of options at that point. One is we'll look at further optimizing the capital structure, if we need to, as we move through the next couple of quarters. That's certainly an opportunity for us. We haven't historically been pleased with the cost of capital on the debt side, and we'll absolutely take an opportunity to address that in short order. That's point number one. Point number two is as a growth-oriented business and as a business where we have clearly stated our strategic intention to reposition the business and to continue to grow the business, I think our best use of capital is to do what we can to continue to increase the enterprise value of the business. We see opportunities there, and we're going to continue to exploit those. I think the way to do that is to use cash as opposed to trying to do something overly creative on the balance sheet, which is something we absolutely don't want to do. So effectively, that's the use of cash and the goal at this point.

Operator, Operator

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

Brad Archer, President & Chief Executive Officer

Yes, I just want to thank everyone for joining the call today, and we look forward to speaking again in November. Have a good day.

Operator, Operator

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