Earnings Call Transcript - TH Q3 2022

Mark Schuck, Senior Vice President of Investor Relations

Good morning, everyone, and welcome to Target Hospitality's Third Quarter 2022 Earnings Call. The press release we issued this morning, outlining our third 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, November 9, 2022. 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 tables 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 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.

Brad Archer, President and Chief Executive Officer

Thanks, Mark. Good morning, everyone, and thank you for joining us on the call today. Target's record-setting third quarter results are a direct reflection of our ongoing commitment to improve operational flexibility while enhancing financial strength and maximizing asset utilization. We generated record operating cash flow, entered into multiple long-term contracts, and achieved our strategic goal of significantly strengthening our financial position, resulting in over $220 million of cumulative debt reduction since 2020, with over $300 million of liquidity. These achievements provided an excellent platform to continue pursuing value-enhancing initiatives across our operating segments. Our HFS segments are continuously witnessing positive trends in customer activity, leading to three consecutive quarterly increases in customer demand. Target's HFS customers are benefiting from the size and scale of our network, which delivers premium hospitality solutions and logistical flexibility for their dynamic labor allocation needs. The inherent value of Target's network has maintained an over 90% customer renewal rate for seven years and has led to a 14% increase in utilization compared to the third quarter of 2021. This strong momentum facilitated multiple extensions to significant HFS contracts during the quarter for customers that accounted for over 20% of Target's third quarter HFS revenue. We expect these contracts to generate over $75 million of cumulative revenue through 2025, underscoring our long-standing partnership with these world-class customers. These significant contract extensions demonstrate our dedication to maintaining the premier customer base that we have been committed to serving for over a decade while also expanding and diversifying the business. In the Government segment, our focus during the quarter was to substantially complete the infrastructure needed to support the Expanded Humanitarian Community, which we announced in July. To ensure the timely completion of these crucial enhancements, enhance Target's network position, and significantly increase project returns, we intentionally maximized the use of existing assets. This choice has improved our operational efficiencies by creating a more fully utilized network, especially in the HFS Midwest region. In recent years, we have explored various scenarios to rationalize a portion of the HFS Midwest assets, but have not achieved the desired economic returns. We have now realized that goal. Ultimately, reallocating these assets to the Government segment proved to be the perfect solution, resulting in a significantly better return on assets than we had anticipated. We are pleased with the progress of the Expanded Humanitarian Community and believe it is set to meet or exceed Target's medium- and long-term objectives while continuing to support the critical humanitarian mission it was designed for. In connection with completing the necessary infrastructure enhancements, we established an 11-year partnership with our national nonprofit partner. This long-term agreement reinforces our joint commitment to continue providing vital humanitarian services to the United States government at this specially designed campus. Additionally, we believe this strengthens our shared conviction that this purpose-built community will play an ongoing role in supporting domestic humanitarian aid missions. Target's Government segment accounted for over 77% of third quarter 2022 revenue and is anticipated to account for over 70% of full year 2022 revenue. This clearly illustrates our commitment to diversifying and expanding Target's end markets while improving counterparty exposure and contract structures. These achievements have supported our strategic goal of significantly strengthening Target's financial position and establishing the ideal foundation to continue pursuing strategic initiatives focused on accelerating value creation for our shareholders. I'll now turn the call over to Eric to discuss our third quarter financial results, financial outlook, and capital allocation in more detail.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Thank you, Brad. In the third quarter, we experienced continued strong demand fundamentals and positive momentum in customer activity, predominantly driven by the materially Expanded Humanitarian Community we announced earlier this year. Third quarter total revenue was $160 million, and adjusted EBITDA was approximately $84 million. Our Government segment produced quarterly revenue of approximately $123 million compared to $46 million in the same period last year. The significant increase was attributed to the Expanded Humanitarian Community we announced in July. As a reminder, Target's Government segment, including the Expanded Humanitarian Community, centered around annual minimum revenue commitments. Additionally, the Expanded Humanitarian Community includes variable services revenue that aligns with monthly changes to community population. Our HFS segment delivered third quarter revenue of $36 million compared to $33 million in the same period last year. This increase was driven by sustained momentum in customer demand for Target's premium service offerings, supported by constructive economic demand fundamentals. Recurring corporate expenses for the quarter were approximately $10 million and illustrate our ability to significantly grow the business while incurring minimal incremental costs. As a result of the scalable business model, we anticipate recurring corporate expenses to remain around $10 million per quarter for the remainder of the year. Total capital expenditures for the quarter were approximately $74 million, with $70 million related to the substantial infrastructure enhancements required at the Expanded Humanitarian Community. With the completion of the community enhancements by year-end 2022, we expect a more moderate pace of capital expenditures into 2023. We ended the quarter with $177 million of cash and over $300 million of available liquidity, with zero borrowings under the company's $125 million revolving credit facility and a net leverage ratio of 0.8x. Further, Target anticipates additional balance sheet strengthening continuing into next year with the expectation of having zero net debt by the second half of 2023. Now turning to our financial outlook and capital allocation initiatives. To complete the Expanded Humanitarian Community in the most efficient way, we deliberately chose to utilize a larger portion of existing assets versus acquiring new equipment. This decision has significantly enhanced asset optimization and created a more balanced operating structure. In addition, the use of existing assets resulted in a substantial increase in project returns than originally anticipated. However, this decision modified the accounting treatment for previously anticipated capitalized costs and resulted in one-time mobilization expenses in 2022. These expenses will not impact subsequent periods. As a result, we have updated our full year 2022 financial outlook, which now consists of revenue between $495 million and $500 million; adjusted EBITDA between $263 million and $268 million; discretionary cash flow between $255 million and $260 million; and capital spending between $130 million and $135 million. While Target has experienced a significant increase in consolidated revenue and associated net income, it intends to utilize a significant portion of its remaining net operating loss carryforwards to offset its 2022 cash tax obligations. As such, Target anticipates 2022 cash tax payments of between $6 million and $8 million, resulting in an effective cash tax rate between 7% and 9%. Target's enhanced end market portfolio and contract structure have supported increased minimum revenue commitments and provided greater visibility on long-term revenue and cash flow. As a result, the company is providing a preliminary 2023 financial outlook, which includes minimum revenue of $525 million and maximum revenue of $710 million with minimum adjusted EBITDA of $365 million. Turning to acquisitions, 2023 capital spending should approach more normal levels between $10 million and $20 million per year, with approximately 70% allocated towards growth capital. The range of preliminary 2023 revenue reflects the possible contribution of variable service revenue associated with the Expanded Humanitarian Community. Target anticipates variable service revenue will contribute between $50 million and $185 million of additional 2023 revenue, above the anticipated minimum revenue of $525 million. The amount of variable service revenue will depend on the scale and timing of U.S. government nominations. Target's enhanced balance sheet will allow the company to continue evaluating a range of capital allocation initiatives focused on maximizing long-term shareholder value while simultaneously expanding long-term growth opportunities. These growth opportunities include continuing to pursue diversifying adjacent end market acquisitions as well as select opportunities to strengthen our existing end market portfolio. In addition to broaden the range of potential value-enhancing capital allocation initiatives, Target's Board of Directors has authorized a stock repurchase program for up to $100 million. This plan will allow the company to evaluate a more holistic capital allocation opportunity set while focusing on maximizing value creation through all available means. We believe Target's enhanced financial position and balance sheet strength creates the ideal platform to continue pursuing these value-enhancing opportunities into 2023.

Brad Archer, President and Chief Executive Officer

Thanks, Eric. Our record-setting third quarter results illustrate our commitment to enhance operational flexibility, maximize asset utilization, and provide unmatched value to our customers, which has supported the achievement of our strategic objectives. We are well positioned entering 2023 and will utilize this momentum to continue pursuing initiatives focused on accelerating value creation for our shareholders. I appreciate everyone joining us on the call today, and thank you again for your interest in Target Hospitality.

Scott Schneeberger, Analyst

I guess I'll start out with the West Texas government contract, the expansion of the facility. Could you provide an update? It was mentioned in the press release, completed by the end of the year. It sounds like you're on track, but just want to get an update on the status of that and how complete that is. And then a couple of follow-ups on that theme.

Brad Archer, President and Chief Executive Officer

Yes, Scott, this is Brad. Nice speaking with you this morning. But to answer your question, look, we're substantially complete. We're tying up a few loose ends on site. And other than that, we're on track to finish up pretty quickly here in the fourth quarter.

Scott Schneeberger, Analyst

Good. I have a couple of things to ask. First, are you able to provide any indication from the government customer about the utilization levels you might expect in the West Texas facility moving forward since the expansion is mostly complete? If you don't have that information yet, when do you expect to receive it?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Scott, it's Eric. Thanks for joining this morning. So the question regarding the occupancy levels and the variability there in, as we talked about a couple of times in August and then in July, that variability amount is really largely dependent upon the government allocations in terms of how they're seeing the flows and how they want to nominate to just across the portfolio. So it's always hard to say. And so I think at this point in time, it's, I think, give us a little more time to figure out how that manifests itself. As Brad mentioned, the facility is not even fully opened yet. It's a new program for everyone. And so we're all learning around about exactly what that's going to look like going forward. I think a couple of things to bear in mind though, while we wait and try to get more clarity through time is that there is a little bit of seasonality in terms of the flows and migration. And so we do bear all that in mind. And so the government will allocate with all that. And hopefully, when we have something specific, we will provide you updated information accordingly as well.

Brad Archer, President and Chief Executive Officer

Scott, I can offer more details on that. To Eric's point, we have to complete everything first. There will be a ramp-up period before they fully utilize this. Reflecting back to when we began this contract over a year ago, we started with 19 temporary facilities housing kids across the United States. Now, there are only 2 ICF facilities nationwide. This indicates a shift from temporary facilities to purpose-built ones. We are the only purpose-built facility in the United States constructed with permanent materials, and there is just one such facility. There is indeed a ramp-up period, but all the changes being made are very encouraging for us and consistent with what we've discussed.

Scott Schneeberger, Analyst

Excellent. Sounds good. I want to take this further. I thought I heard in the prepared remarks, though I don't believe it was in the press release, and this is more for Brad, but Eric, we'll discuss the one-time mobilization expense. It seems like you're now tying facilities in HFS Midwest into your extended partnership with your not-for-profit partner and the government contract. Could you elaborate on how the Midwest HFS is being included? And then to finish up, Eric, could you discuss the one-time charge, how it affected the quarter compared to expectations, and how it might affect the fourth quarter compared to prior expectations? Clearly, it's not expected to carry over into next year, but more elaboration would be appreciated.

Brad Archer, President and Chief Executive Officer

Yes. So Scott, on the rebalancing, we have been chipping away at this for 5 years. We'd get a project, we would cost it in, and we had moved some units that were either not utilized or underutilized in North Dakota. So we've moved them around. This project itself and the decision we made a few months ago to use our own assets really allowed us to rebalance our portfolio in one fell swoop. And not only in North Dakota, we actually moved some product around in Texas as well. They were utilized, but not 100%. So this project as large as it is, it allowed us to really look holistically at all of our assets, anywhere in the country and say, how are we going to rebalance this to get more revenue out of it. We think it's a great move for the company. It's going to pay off long term for us, the investors, etc. So today, again, we're pretty much done now with the rebalancing of it. That's what it allowed us to do.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Scott, in response to your question from a financial perspective, the situation involves a one-time mobilization expense impact of around $10 million in Q3. When we compare that to a reduction in capital spending of approximately $60 million, it represents a 6:1 payoff, making that trade worthwhile. As we consider this, the impact on Q4 is minimal, and there will be no effects in 2023. This outlines our thought process regarding the return impact, and I hope it clarifies your question about what happened in Q3.

Scott Schneeberger, Analyst

Okay. I will pass it over, but I'm curious, Brad, regarding this rebalancing. Is the government going to be involved with the assets in North Dakota, or are you relocating those assets to Texas? I'm not sure if you can share, but what is happening with this rebalancing?

Brad Archer, President and Chief Executive Officer

Yes, we moved the units from various locations in North Dakota and some in Texas to the government project. All the rooms we relocated are consistently receiving the warm status. At the same time, we considered the variability aspect of the deal. We evaluated where we could secure payment every day for the rooms, which guided our decision. This project allowed us to have the expenses covered for moving and setting up the units again, and ultimately saved us from purchasing new products.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

And Scott, this is an important modification because, as Brad mentioned, this has been something that has been worked on for a significant period of time. When you make that shift, nothing is ever permanent, but that's a substantial shift in the asset mix in a way where the market up there was not really allowing. To Brad's point, that was a pretty important structural change where you're taking assets that were underutilized and now not only are you upgrading customers, you're also upgrading contracts and significantly improving margins on them.

Brad Archer, President and Chief Executive Officer

Yes. And it helps in efficiencies as well, right, when your utilization goes up. If you just look at Midwest, last year what it is today, you're starting to see that flow through on utilization. So efficiencies in operations, you're taking rooms out of the market. It should help us as we get into the future on pricing, those types of things as well. We think this was a great move that the government project allowed us to do.

Scott Schneeberger, Analyst

I will turn it over. But just to clarify, can you share whether these assets changed from Held for Sale to government categorization? I believe they moved from North Dakota to Texas. Can you confirm if that happened, or did they remain in their original location?

Brad Archer, President and Chief Executive Officer

They were moved from North Dakota to Texas and are currently being used on the government project. They were relocated.

Stephen Gengaro, Analyst

I have a couple of questions. First, could you clarify the 2023 guidance? Does EBITDA include any contribution from the variable revenue portion?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Yes, it does. It does include a small amount there. We've allocated approximately $50 million of revenue there. So again, we can look at that through time. But realizing we have a fair bit of runway as we move through 2023, we just felt given the material change in the business, that it was appropriate to try to at least guide the market to something in 2023. But $50 million was a spot to start with.

Stephen Gengaro, Analyst

Okay. When I consider your business and the level of interest and feedback I receive from investors regularly, I've noticed a significant shift away from the oil sector, which is positive. However, this has introduced a concentration risk due to a major government contract. I'm trying to understand what insights you can share about your confidence in reallocating resources from the energy sector. What milestones and data points can we expect to ensure that there will be substantial growth in this area moving forward?

Brad Archer, President and Chief Executive Officer

Yes. I'll address this, and then Eric can add as well. Regarding the 11-year partnership, this collaboration with our nonprofit partner reaffirms our shared commitment to deliver necessary care and services for the U.S. government. Additionally, it's worth noting that we have recently been asked to submit a proposal for a 10-year lease on the facility, which aligns with the partnership. I see the 11-year partnership as a stepping stone to something larger. We're approaching our second year, and construction is nearly complete. After establishing the partnership with our nonprofit partner, the government has already inquired about making this a more permanent fixture in their network. It’s important to mention that initially, there were 19 of these facilities, and now we are down to 2. We are optimistic about securing a long-term agreement in the future. Although we are only 6 months into this contract and the government moves somewhat slowly, we appreciate the current pace and feel positive about our long-term prospects.

Stephen Gengaro, Analyst

Great. That's helpful. The other question I had is about next year's capital expenditures. It seems like they are decreasing, and you're consistently reducing your net debt levels. How should we view the relationship between EBITDA and free cash flow for next year? The working capital might change a bit, but can you share any guidance as we transition from the 2023 baseline EBITDA to free cash flow?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

No, you're right, Stephen, there are not actually a lot of moving pieces and you would expect that cash conversion to be pretty substantial. I think the 1 thing to remember, and I think you know this is there is the $117 million amortization, which we talked about before. It's in the release. Certainly happy to talk about it offline to the extent that we need to. So obviously, that will be an adjustment to the operating cash flow. I think once you have adjusted for that and then taking normal working capital into consideration, everything else is pretty much status quo. And so to your point, you end up with a significant amount of cash generation into 2023 and certainly into 2024 and beyond. And so that obviously begs a host of other questions in terms of capital allocation. But as you look at the model, once you've adjusted for that, what you're probably seeing is what you're going to get.

Stephen Gengaro, Analyst

I also have one last question before I pass it over. Considering the oil sector, I noticed that the utilization of your available rooms in the Permian HFS South was around 89% for the quarter. With the reallocation of rooms to the government, does this impact capacity in the Permian and provide you with any pricing power?

Brad Archer, President and Chief Executive Officer

It does. And I mentioned this a little bit earlier, right? It builds in some efficiencies. As your utilization goes up, you get more efficient and it should bring up some pricing power as well. It also gives us an opportunity to look in some areas, is there some equipment out there. Look, we're definitely continuing to grow the HFS. We're not running away from it. It's a great business that produces a great margin, and we have great contracts. It's a great business. So we'll continue to look at some things there to continue to grow that business as well. But yes, on the pricing problem.

Greg Gibas, Analyst

I wanted to follow up on the significance of the 11-year partnership. Congratulations on that. Should we view it as a way to reduce competition risks, or might it encourage the government to collaborate more with your partner? Please share your thoughts on its high-level significance.

Brad Archer, President and Chief Executive Officer

Yes, from a high-level perspective, this partnership demonstrates our solidarity in delivering an exceptional service and product. The government recognizes our proven performance and alignment with their needs. We believe this initiative is a long-term solution that will be integrated into their plans. We were validated when they requested the proposal we submitted. While we understand they take their time, we are just beginning this process. The significance of this 11-year partnership lies in its potential to achieve critical milestones. This was an anticipated move for us and it exemplifies our collaborative relationship. Keep in mind, our nonprofit partner engages in efforts beyond just Pecos, indicating their openness to collaborate further. We believe this outcome is significant for us and there is still much more ahead.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Yes, I think this is Eric. As Brad mentioned, while it may not be explicitly stated, there is now a framework that allows for additional opportunities over time for us to partner with our nonprofit and other applications. Although this isn't specifically included in the exclusivity agreement, I can confidently say there is a commercial commitment from both parties to explore these opportunities together. This is important not only from a contractual standpoint but also from a commercial arrangement perspective.

Greg Gibas, Analyst

Great. Yes, that makes a lot of sense. If I could follow up, I know you've already touched on the variable revenue component in relation to next year's expectations. However, there seems to be a wide range. You mentioned that the EBITDA outlook includes an expectation of around $50 million in revenue from that. From an investor perspective, should we assume the low end of that range, or do you have more clarity on the midpoint, or anything else you can share regarding that wide range?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Sure, that’s a great question, and I appreciate it. There are a couple of points to consider. The revenue range we've provided serves as a guideline for what our goals could be and offers some direction, but it's important to note that we still have 15 to 14 months to reach that timeframe. Therefore, we felt it was necessary to share some benchmarks. Regarding EBITDA, we believed it was appropriate to set a minimum expectation, understanding that it could be significantly higher than that, but we aren't sure what that will be at this moment. If I were in your position, I would align my expectations with what we've provided. As time progresses, we can adjust our outlook as necessary. We want to be cautious and not make assumptions about government actions. It's too early to predict. Our management team is conservative, and we aim to deliver on our commitments. That's how I would frame the situation right now.

Greg Gibas, Analyst

Great. Very helpful. I just wanted to follow up on the updated guidance. Is the reduction in EBITDA this year solely due to the mobilization expense, or are there other factors involved as well?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

It's the majority of it. That was really the significant part.

Scott Schneeberger, Analyst

Okay. Have you quantified the, I guess, expense there?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Sure. We haven't given a specific figure, but I will. The net impact is around $10 million to $12 million from an EBITDA perspective.

Brad Archer, President and Chief Executive Officer

Thank you. Before we close, I want to express how proud I am of our team, our people and the many accomplishments we've achieved this past year. In 2022 alone, we have set records for revenues, cash generation, and EBITDA and today, sit with more dry powder than ever before with more than $300 million of liquidity. We are proud of the record-setting results, which have more than doubled the size of the business, including increasing adjusted EBITDA by $135 million from our original 2022 outlook. Lastly, we said we would diversify our business and we have, and we will continue to deliver on that promise. I can't be more excited about the future of Target Hospitality as we head into 2023. While we are extremely proud of what we have accomplished to date, there's more to do. But make no mistake, with the strong momentum we've created, I have no doubt the future Target Hospitality is even brighter. Thanks for joining us on the call today, and I look forward to speaking again in the first quarter of 2023. Operator, that concludes our call for today.

Operator, Operator

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