Earnings Call Transcript - TH Q3 2021

Operator, Operator

Good morning, and welcome to Target Hospitality's Third Quarter 2021 Earnings Call. Please note this event is being recorded. I'd 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 third quarter 2021 earnings call. The press release we issued this morning outlining our third quarter results can be found in the Investor 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. The 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, November 12, 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 Investor 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'll 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 and Chief Executive Officer

Thanks Mark. Good morning, everyone. And thank you for joining us on the call today. Demand fundamentals have strengthened throughout 2021 and have supported consistent increases in demand for Target's premium hospitality service offerings. Since 2020, Target has experienced an over 40% increase in customer demand across its hospitality and facility services segments. This robust demand has resulted in expansion of operating margins and utilization throughout 2021, and it has supported the continued execution of our strategic objectives. Target's exceptional third quarter results are a direct reflection of the intentional action we have taken to appropriately position Target to take advantage of building customer demand. Target's Top 10 HFS customers have increased their labor allocation by over 95% since mid-2020. This demonstrates the value our best-in-class customers find in allocating labor to Target's world-class network and premier holistic service offerings. These attributes continue to support an over 90% customer renewal rate, which we have enjoyed for many years. As Target's utilization increases, we're approaching an ideal level of network optimization and are beginning to benefit from the scale and efficiencies we have created within our operating structure. This network optimization creates an ideal operating environment and maximizes the margin contribution from each utilized bed with negligible capital requirements. This efficient operating structure has resulted in meaningful cash flow generation, which has been directed towards significant debt reduction and accelerated the strengthening of Target's financial position. This intentional focus has resulted in a 52% reduction in Target's net leverage ratio in 2021. These accomplishments have allowed Target to materially enhance its operational flexibility, while simultaneously diversifying its business mix and establishing a robust growth pipeline. Additionally, Target has advanced its diversification focus, with its government segment now representing over 50% of third quarter and anticipated full year revenue. As we continue to focus on network optimization, we recently relocated a number of assets from our HFS Midwest segment to be utilized in service of our existing contracts within our government segment. This illustrates the flexibility of our network and our ability to optimize assets to generate the highest returns. We have illustrated our ability to appropriately position the company to systematically execute on its strategic objectives. By doing so, we have established the trajectory in which to continue pursuing our growth strategy focused on enhancing value through a diversified portfolio of service offerings. Target's unique capabilities translate across a range of end 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. Our established platform creates avenues to utilize our existing core competencies to support critical services, including humanitarian aid efforts across a variety of federal agencies. Additionally, Target's holistic service offerings create a broad suite of commercial opportunities across a range of end markets. These services extend beyond our legacy accommodation offerings and include facilities management, building operation, asset maintenance, and other critical support services. Target has identified and is currently evaluating a robust pipeline of expansion and diversification initiatives within the government and commercial services markets. These multiple growth levers are underpinned by the existing strengths of Target's core offerings, and include both inorganic-focused initiatives and broadening our existing commercial portfolio. As it relates to our government services opportunity set, we continue to have active and productive conversations with various government agencies regarding their continued need for permanent humanitarian solutions. Target's premier and comprehensive service offering is viewed favorably by the U.S. government, providing multiple avenues to expand Target's offering in support of these critical humanitarian solutions. While we can never be sure of a successful contract outcome, we are very encouraged by the frequency and scope of our ongoing dialogue with the U.S. government. We have strategically positioned Target as North America's leader and premier vertically integrated hospitality solutions provider. We have accomplished this by intentionally identifying and transitioning Target's business mix to capture the greatest value creation and expand its long-term growth pipeline. 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 have been encouraged by the sustained momentum experienced throughout 2021. And as our results have illustrated, the benefits of our strategic positioning as North America's premier provider of vertically integrated hospitality solutions are clear. The progress we have made in executing our strategic initiatives is impressive, and has exceeded our expectations. This positive momentum is illustrated in our recently raised 2021 financial outlook, which represents the second increase to our financial outlook this year. We anticipate this progress to continue as we progress through the remainder of 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 third quarter financial results and ongoing growth initiatives in more detail.

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

Thank you, Brad. Good morning, everyone. In the third quarter, we experienced continued improvements in our operating metrics, and realized a fifth consecutive quarterly improvement in demand for premium modular accommodations and value-added hospitality solutions. This supported our exceptional third quarter performance, with total revenue of $89 million and adjusted EBITDA approximately $38 million with discretionary cash flow of $35 million, representing an impressive 39% discretionary cash flow yield to revenue. Our government segment produced quarterly revenue of approximately $46 million compared to $60 million in the same period last year. The significant increase was a result of the U.S. government contract executed in March 2021, which contributed approximately $33 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 $32 million compared to $20 million in the same period last year. This increase was driven by sustained momentum and customer demand for Target's premium service offerings supported by strengthening activity within our commercial service areas. As the pace and momentum of our economic activity continues to build, we continue to monitor the supply chain impacts and inflationary pressure resulting from strengthening economic demand and any associated impacts on our cost of services. We take an active approach to 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 materially impacted margin at this point. And we have reflected our expectation for cost of services within our recently updated financial outlook. The current corporate expenses for the quarter were approximately $10 million. Despite the significant increase in revenue and EBITDA, we have not had commensurate increases within our corporate costs. We have a highly scalable business model that allows us to substantially expand growth with minimal excess costs. As a result, we anticipate recurrent corporate expenses to remain around $10 million per quarter through 2021. Total capital expenditures for the quarter were approximately $9 million, including approximately $6 million directed towards enhancements within our government services segment and the new government services award as well as an additional $3 million in maintenance capital. We remain focused on maximizing return on invested capital and do not anticipate significant non-growth capital requirements for the remainder of 2021. We ended the quarter with $31 million of cash and $340 million of total debt, providing available liquidity of approximately $156 million with a net leverage ratio of 3.1x. 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 in the next several quarters as we remain focused on balance sheet flexibility, so that we can continue to accelerate our growth. As a result, the company has made significant progress towards our year-end 2021 target net leverage ratio being below 3x. We are excited by the strengthening commercial activity and associated demand for service offerings. These elements have supported Target's strong third quarter results and provide confidence in the cadence of our associated demand for the remainder of 2021. From a contractual perspective, approximately 99% of Target's 2021 midpoint revenue outlook is under contract, and approximately 73% of contracted revenue has committed payment provisions with 53% of committed revenue related to government services. As a result, we recently raised our 2021 financial outlook, which now consists of revenue between $280 million and $285 million, adjusted EBITDA between $110 million and $113 million, and discretionary cash flow between $75 million and $80 million with $25 million to $30 million in capital spending, excluding acquisitions, and a target net leverage ratio below 3x per year-end 2021. The sustained momentum Target has experienced throughout 2021 is impressive, and this led to multiple increases to our full year outlook. Our current 2021 financial outlook represents a 25% and 42% increase over full year 2020 revenue and adjusted EBITDA respectively. The positive momentum Target has experienced 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 pursue a balanced portfolio of service offerings, while expanding its reach within the government services end market as well as selected adjacent commercial markets. We believe these opportunity sets offer the greatest potential to enhance Target's value proposition. The foundation of our existing modular solutions network and broad-reaching capabilities creates a platform to add additional growth channels to a portfolio of services and solutions. Target has strategically positioned itself as North America's market leader in providing premier, vertically integrated hospitality solutions. We accomplish this by intentionally focusing on markets and world-class customers that offer the greatest long-term revenue growth potential while optimizing our existing asset fleet and unique capabilities to maximize economic returns. These principles have established a highly attractive financial profile that generates best-in-class margins with substantial cash flow conversion. Additionally, our asset fleet requires little maintenance capital, leading to significant discretionary cash flow. This efficient financial profile allows us to reinvest cash flows into complementary growth markets, aligning with Target's strategic principles and expanding Target's long-term growth pipeline. 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 stakeholders. We look forward to discussing our progress as these opportunities materialize. With that, I'll turn the call back over to Brad for closing comments.

Brad Archer, President and Chief Executive Officer

Thanks Eric. Target's impressive third quarter results illustrate the benefits of Target's unique position as North America's leader in modular accommodation and hospitality solutions, while exemplifying our commitment to executing on our strategic objectives. Target's strategic position and operational strength has allowed us to meet and exceed our customers' varying needs, while significantly enhancing Target's financial position, and supporting our commitment to pursuing our growth strategy. We have created and sustained a tremendous amount of momentum in 2021. And as we look into 2022, we will utilize this momentum to focus on our strategic growth initiatives. We have taken intentional steps to enhance our capabilities to effectively identify and evaluate a range of growth opportunities focused on enhancing value through a balanced portfolio of service offerings. This opportunity set expands across a variety of end markets, including providing additional critical support services to the United States government. Importantly, these growth initiatives utilize Target's existing core competencies, which we believe creates the optimal scenario to accelerate value creation for our shareholders. 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 Scott Schneeberger with Oppenheimer.

Scott Schneeberger, Analyst, Oppenheimer

Thanks very much. Good morning, everyone. I guess I'd like to start by asking: are there any new developments with regard to potential new contracts with the government? And then a follow-up question I'll ask up front as well: has the government contract that was established in March of 2021 — I believe that was a one-year contract — has that been renewed, extended, or are there any discussions with regard to developments there? Thank you all.

Brad Archer, President and Chief Executive Officer

Hey Scott. Good morning, this is Brad. Let me cover expansions and extensions in the government segment. Our existing contract is performing as expected; we continue to receive high marks on the premium services that we offer to the U.S. government. We continue to have access and consistent conversations with the customer on extending the existing contract in West Texas. I think it's important to remember the existing contract term runs through March of 2022, and we feel very confident on a successful extension by the end of the first quarter of 2022. So we've got about 40% left on this contract. Discussions are happening, but it moves further down the road after the first of the year, and comes to a conclusion by the end of the first quarter. Additionally, Target has established itself as the trusted long-term provider of premier comprehensive hospitality solutions throughout the U.S. government. It's also important to remember Target has established its reputation by providing two of the largest permanent hospitality solutions for the U.S. government humanitarian aid efforts — now spanning three different administrations. With this backdrop and more on expansions and new government business, we are having active and productive conversations with various government agencies regarding the growing need for more humanitarian aid solutions. While the outcome can never be certain, we do feel very good about this segment moving forward in 2022. Very active conversations, very mature conversations, and I'll leave it at that; we feel very good about where both of these are headed. Last thing I would say on this: this is very similar to how we approach long-term contracts — we built a great location, and we built a permanent facility. It started out on a year-to-year basis. Now we're seven years on that contract; this is not new to us, and it's not new to the government. They move a little slower than most, but that's normal. So we feel very comfortable with how this is moving along.

Scott Schneeberger, Analyst, Oppenheimer

Great, thanks for that, Brad. And one quick follow-up and then I'll pass it over. I'll keep it in the government segment. This is probably for Eric: the average daily revenue was $78 in the third quarter; I think that was up from $76 in the second quarter. I think you probably had gotten full quarter contribution from the March contract when in the second quarter. So just curious what that increase is. Is that an inflation-based escalator or something else there? Thanks.

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

Sure, Scott. Are you referring to the sequential quarter?

Scott Schneeberger, Analyst, Oppenheimer

Yes, quarter-over-quarter.

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

Good question. The reality is you saw an increase from the pro rata benefit as we moved to the full quarter. That's really all it is. You see that in the number. Recall last quarter, we did have a first-quarter benefit, but as we were moving through that process there were change orders and it was a large project that was still moving into scale and scope. As a result, we got additional benefit this quarter from that. So that's really what you're seeing. It was recognized in Q2, but there were some positive movements as it relates to ADR because of scope and scale in Q3.

Scott Schneeberger, Analyst, Oppenheimer

Got it. Thanks. Has it probably topped off here or might there be a little more, or is it wait and see?

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

The scope and scale question: the government is looking at a lot of things. What we're seeing is an increase in scope and scale, not a decrease. I'm not going to say there won't be positive movement there. I would work with what we have posted right now, but there's always opportunity for that to increase.

Operator, Operator

Our next question comes from Stephen Gengaro with Stifel.

Stephen Gengaro, Analyst, Stifel

Thanks. Good morning, gentlemen. Three things to me: I'll start with just — can you give us your expectations on the bridge to the fourth quarter? Because it feels like you're guided to about $24.5 million to $27.5 million of adjusted EBITDA which is a little down sequentially. I know there's seasonality, but is there anything else in there we should be thinking about?

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

Yes. You're right; we have seasonality that does impact things a couple percent in the quarter, so you need to bear that in mind. I don't think there's anything specific going on there that we haven't already talked about. If you'd like after the call, I'm happy to walk through any specific nuances that you think are of interest, but nothing specific really going on beyond seasonality.

Stephen Gengaro, Analyst, Stifel

Okay, thanks. When we're hearing 20% to 25% upstream spending growth in the U.S. next year, which I think is reasonable, if you get something like that and there's inflation as our cost productivity is probably up mid-teens, will your utilized beds rise at roughly that same rate in the HFS segment?

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

Good question. To the extent our customer capital spending is tied directly to human capital allocation, yes. But it's important to remember we haven't seen those large capital spending numbers coming from integrated providers who are really the bulk of our customers; we've seen the increases from smaller and private companies. So there is a component of the anticipated 2022 capital that is not due to human capital, but from other inflationary pressures as well. I would caution against a direct correlation one-to-one between headline capital spending numbers and our utilized beds. We do expect to continue to see positive momentum in 2022, like throughout 2021, but be cautious about tying a one-to-one correlation until we put our 2022 outlook out. Also, we tend to have about a quarter lag between capital spending and what happens at the account level, so bear that in mind.

Stephen Gengaro, Analyst, Stifel

And I think if I'm correct, you do more work that is directly service-related than directly tied to large capital projects. So does it matter if the private to public spending mix changes, if Liberty and Halliburton and others are just as busy?

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

It matters to the extent the bulk of capital spending comes from those larger integrated companies. If companies like Chevron or Exelon change their capital activity, that can obviously swing nominal capital spend numbers. So be cautious in tying headline capital numbers directly to our business. Also remember the quarter lag I mentioned.

Stephen Gengaro, Analyst, Stifel

Great. One more quick one from me and I'll get back in line: the potential or pending acquisition of FPSI — I'm pretty sure you had an FPS facility. I'm not sure if that's still open. But I imagine you do business with them. Does that impact you at all? Or do you do business with the potential buyer? Just curious if there's anything I should be aware of. And that's what I'm curious — if there was any lost work in the third quarter.

Troy Schrenk, Chief Commercial Officer

Stephen, this is Troy. Good morning. Good question regarding that potential business combination: we definitely are continuing to service that customer and have for a long time. As that transaction moves forward, we anticipate that relationship, which has been intact for a long period of time, will continue. Regarding FPSI's facility, while that specific facility is not open, we are servicing customers throughout the entire Permian Basin and expect that to continue in the future.

Stephen Gengaro, Analyst, Stifel

Can you comment if you're doing business with their potential buyer and whether it could actually be additive if you're not?

Troy Schrenk, Chief Commercial Officer

When we think about mergers and acquisitions and business combinations, it's generally been more favorable than not because of who we're doing business with, the size of the network that we have, and the sheer number of customers we service across that 85,000 square mile piece of Permian Basin real estate. Given our penetration into the marketplace, I fully expect this to continue and that we'll do work with FPSI and other large oilfield service customers regardless of the M&A outcomes.

Operator, Operator

Our next question comes from Doug Becker with Benchmark Research.

Doug Becker, Analyst, Benchmark Research

Thanks. I was looking for a little more color on what drove the sequential decrease in gross margins in government services and HFS South and just a little more detail on what the expectation is going forward given that decline?

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

Good question. On government first: it was similar to the answer given to Scott. That contract had a pretty substantial ramp period when it first started. Similar to many other contracts we do, you may have full minimum revenue commitment, but not full occupancy per the contract initially. When that happens you end up with a higher front-loaded margin due to higher revenue relative to the costs you are spending to facilitate the contract. As the contract matures and occupancy increases toward steady state, that margin starts to normalize, so it's normalizing off a higher comparative number. That's really the driver there. On HFS South, you're seeing increased occupancies, which is good, and a larger portion of minimum revenue commitments, which is also good. When you see a large movement up in utilization in a short period, costs increase to support that growth and margins can come down temporarily. So those are the drivers.

Doug Becker, Analyst, Benchmark Research

Is it fair to say that for government we move back to, say, a 60% gross margin, and then in HFS South go back to the upper 40s? Or should we not assume that?

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

On the government side, I think the leading-edge margin you see this quarter is the number I would guide to for now. When a new contract of that scale hits, it tends to tilt things, and you should use what we have reported as the leading-edge number. When we update the 2022 outlook, we'll provide fresh guidance. On the HFS South side, I think there's continued positive activity in terms of margin over time as the marketplace strengthens and utilization tightens. That positions us to increase prices to some extent, which benefits margin over time.

Doug Becker, Analyst, Benchmark Research

That makes sense. As you look to expand outside your traditional end markets via acquisitions, can you help frame what the potential size of the contracts you're looking at might be, just to help set expectations?

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

Good question. I won't opine specifically on transaction sizes because they can vary. We've looked at tuck-ins that are smaller and things that are larger and potentially transformative. Our bias is to do deals that increase operational scale, maintain a flexible balance sheet, and allow us to continue exploring growth avenues. The goal is to increase enterprise value of the business; we see meaningful operating leverage and commercial opportunity. It could be a multi-step approach rather than one and done, but whatever we do will be thoughtful and focused on materially increasing the business's value.

Brad Archer, President and Chief Executive Officer

And just one thing to add on that: we're talking about inorganic growth, but let's not forget our organic growth. Troy, take a few seconds to speak to our pipeline and what we have organically because it's very robust, actionable, and meaningful, aside from inorganic growth.

Troy Schrenk, Chief Commercial Officer

Doug, good morning. In addition to the inorganic opportunities Eric was talking about, we continue to evaluate a very mature pipeline of organic opportunities across multiple commercial applications. We're very excited about that. The opportunities encompass a variety of commercial applications, including green energy, energy transition and infrastructure projects, and integrated facilities management. I would characterize the pipeline as mature: number one, it's robust; number two, it's actionable; and three, it's diverse. We continue to pursue it and believe it represents exciting growth avenues for the business.

Operator, Operator

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

Brad Archer, President and Chief Executive Officer

Yes, just want to say thanks to all of you for joining us on the call today, and we look forward to speaking again after the New Year.

Operator, Operator

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