Earnings Call Transcript - TH Q4 2022

Operator, Operator

Good morning, and welcome to the Target Hospitality Fourth Quarter and Full Year 2022 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. 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 of Investor Relations

Thank you. Good morning everyone and welcome to Target Hospitality's fourth quarter and full year 2022 earnings call. The press release we issued this morning outlining our fourth quarter and full year 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 this 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, March 10, 2023. 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 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, CEO

Thanks, Mark. Good morning everyone and thank you for joining us on the call today. Target's record-setting 2022 results are a direct reflection of our commitment to further solidify our strong financial standing while positioning the business to quickly respond to strategic growth opportunities. Throughout 2022, Target meaningfully increased its minimum revenue commitments, diversified its in-market customers, and increased discretionary cash flow by 215%. We achieved these accomplishments while serving a diverse customer base across 29 communities. We have remained focused on providing premium full-service hospitality solutions to our world-class HFS clients, many of whom have been customers for over a decade. As a result, Target had consecutive quarterly HFS demand increases, resulting in a 17% year-over-year increase in utilization with consistent customer renewal rates of over 90%, which we have enjoyed for over seven years. Target’s reputation and our commitment to these customers supported numerous HFS contract renewals and extensions over the past year. We anticipate these contracts will add over $200 million of cumulative revenue through 2028. We are pleased with our current HFS utilization and its ability to meet our strong customer demand. However, we will thoughtfully evaluate select opportunities to add capacity in response to customer demand where appropriate, while also adequately expanding our significant market share. During 2022, we demonstrated Target’s superior operational flexibility that allowed us to match increasing HFS demand while simultaneously utilizing existing assets to expand our government segment by 60%. The end result was a more fully optimized network and more valuable contracts. Regarding the Government segment, we have completed the enhancements to our expanded humanitarian community announced in July of 2022. With its completion, we have solidified this community as the only purpose-built campus with the sole mission of providing critical hospitality solutions in support of the government's humanitarian aid efforts. We can say this one-of-a-kind all-inclusive community has exceeded the expectations of our partner and the U.S. government. Since its inception in 2021, it has been our belief this world-class facility would be the premier community providing critical hospitality solutions to the government's humanitarian aid missions. This belief has recently been affirmed with the U.S. government publicly announcing their intention to consolidate the remaining active influx care facilities. Additionally, we're pleased to announce that our non-profit partner has recently been awarded an indefinite delivery, indefinite quantity contract related to the extension of our humanitarian community in Vegas. This award, consisting of a base five-year term with an additional five-year option, established as the contracting vehicle required by the U.S. government to appropriately fund multiyear contract awards. The IDIQ award to our non-profit partner is one of the final steps in the government's contract award process, prior to working through definitive agreements. We are highly pleased with the progress as the contracting vehicles come sooner than expected, and we anticipate working through additional contract specifications over the coming months. We look forward to solidifying the longevity of this community and the critical humanitarian mission it was purpose-built to provide. As a reminder, last year we entered into an exclusive 11-year partnership with our national non-profit partner. The long-term agreement solidified our joint commitment to continue providing critical humanitarian services to the United States government at this highly customized campus. In summary, we have achieved our strategic objectives to materially strengthen Target’s financial position, while simultaneously diversifying our customer base and continuing to accelerate value creation for our shareholders. I'll now turn the call over to Eric to discuss our fourth quarter financial results, 2023 financial outlook and capital allocation initiatives in more detail.

Eric Kalamaras, CFO

Thank you, Brad. In the fourth quarter, we experienced continued strong demand fundamentals and positive momentum in customer activity, predominantly driven by growth in our government segment and the materially expanded humanitarian community. Fourth quarter of 2022 total revenue was $152 million and adjusted EBITDA was approximately $91 million. Our Government segment produced quarterly revenue of approximately $150 million compared to $47 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, centers around annual minimum revenue commitments. Additionally, the expanded humanitarian community includes variable service revenue that aligns with monthly changes to community population. This contract structure provides ideal flexibility for our customers, as their occupancy requirements fluctuate over time, while also providing meaningful minimum revenue commitments that create significant revenue and cash flow visibility for Target. We have found this structure to be the optimal outcome for all parties, and it creates a sustainable structure, which we believe is the basis for contract longevity for years to come. Our HFS segments delivered fourth quarter revenue of $36 million compared to $34 million in the same period last year. This increase was driven by sustained momentum in customer demand for Target’s premium service offerings. Recurring corporate expenses for the quarter were approximately $9 million, and we anticipate recurring corporate expenses will remain around $9 million to $10 million per quarter for the remainder of the year. Total capital expenditures for the quarter were approximately $27 million, of which $23 million related to the substantial infrastructure enhancements required at the expanded humanitarian community. With the completion of community enhancements in 2022, we expect a more moderate pace of capital expenditures. We ended the quarter with $182 million of cash and over $305 million of liquidity with zero borrowings under the company's $125 million revolving credit facility, and a net leverage ratio of 0.6x. From 2020 through 2022, Target has remained focused on reducing total indebtedness and maximizing financial flexibility. Over this time, we have reduced total cumulative debt by more than $225 million. Additionally, we recently announced a $125 million partial redemption of the 9.5% senior secured notes, further illustrating our commitment to a disciplined capital allocation strategy focused on high return initiatives. Inclusive of the $125 million note redemption, we will have reduced total indebtedness by over $350 million since 2020, with over $200 million in the last 12 months alone. Over the past 12 months, we have increased the intrinsic value of the equity by over $2 per share just for these balance sheet initiatives. This highlights our commitment to allocating capital to high return initiatives, while continuing to maximize value creation for our shareholders. Turning to our financial outlook and capital allocation objectives, Target’s enhanced end market portfolio and contract structure has supported increased minimum revenue commitments and provided greater visibility on long-term revenue and cash flow. Additionally, we are pleased with the progress of discussions relating to the multi-year term extensions for the expanded humanitarian community. We believe the government's decision this week to issue an IDIQ contract award to our non-profit partner solidifies the sustainability of this purpose-built community by establishing the necessary mechanism to fund specific multi-year contract awards. We continue to work closely with our non-profit partner and anticipate additional contract specifics related to Target’s critical hospitality solutions to be finalized in the coming months. Coupled with our ongoing business development efforts that have created the strongest project pipeline the company has seen in several years, the company is reiterating its preliminary 2023 financial outlook, which includes revenue of $525 million, maximum revenue of $710 million, with adjusted EBITDA of $365 million. Excluding acquisitions, 2023 capital spending should approach more normal levels between $20 million and $30 million per year, predominantly focused on organic growth capital. The range of preliminary 2023 revenue reflects the possible contribution of variable service revenue associated with the expanded humanitarian community, along with other potential second-half weighted revenue catalysts. As it relates to the expanded humanitarian community, Target expects the government to continue managing its community allotments based on a variety of factors, including seasonality, the regular use of smaller dispersed shelter capacity across the United States, and other variable demand dynamics. For the quarter, the government's nominations to our community have remained in line with expectations, which contemplate the range of variable demand dynamics, including typically lower seasonal census during the winter months. However, there are a variety of other potential catalysts that have shifted from our original expectations. For instance, the government delayed its previously anticipated lifting of Title 42 from December 2022 to May 2023. As a result, the consolidation of remaining influx care facilities has taken longer than expected, resulting in the delayed timing of additional variable service revenue. We expect an increase in variable service revenue weighted more towards the second half of 2023 as a result of this shift. Target’s enhanced balance sheet will allow the company to continue evaluating a range of high return capital allocation initiatives focused on maximizing long-term shareholder value, while simultaneously expanding long-term growth opportunities. Target has identified and continues to pursue an active and expanding pipeline of strategic growth opportunities. These opportunities include expanding our reach across government agencies in support of select National Defense projects as well as unique commercial diversification opportunities spanning a variety of domestic energy transition initiatives. Target is prepared to allocate over $500 million of net growth capital to these high return opportunities through 2027. As a result of the size and scale of these strategic projects, there's inherently a longer program cycle prior to award announcement. While final outcomes are not 100% certain, we can say we are quite pleased with the progress of discussions and believe there are tangible milestones being achieved on these important large-scale projects. We look forward to providing additional updates in the coming quarters as the opportunities progress. With that, I will turn the call back over to Brad for his closing comments.

Brad Archer, CEO

Thanks, Eric. Our record-setting 2022 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 with an optimal balance sheet and over $300 million of liquidity. We will utilize this foundation and the tremendous momentum we have created 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.

Operator, Operator

We will now begin the question-and-answer session. The first question comes from Scott Schneeberger with Oppenheimer. Please go ahead.

Scott Schneeberger, Analyst

Thank you very much. Good morning, everyone. For my first question, I would like to kind of hone in on the development with your partner with regard to the IDIQ award. Could you just talk a little bit more about another level of detail about what has occurred there? And if helpful, maybe compare and contrast this year's negotiation period and process as opposed to last year? Thank you.

Eric Kalamaras, CFO

Hi, Scott. Good morning. It’s Eric. So it's a great question. So let's discuss last year first, and I think it's a good segue to this current discussion. So recall last year when the awards were done, they were done on an emergency basis, right? And so they were done that way specifically in 2021. We redid that in 2022. And those emergency mechanisms by nature are effectively one year of funding structure, which determines the contract term. So with this IDIQ, I think the big change on this is the permanent shift in how the government is thinking through the infrastructure around their UC capacity. And this allows for the mechanism to be much longer, right, a multi-year process. Now there are effectively two-step functions here. The first step function, which is this, which is to create the IDIQ funding mechanism, which in this case is a really super important point, because it establishes the five-year initial term, and then the one five-year option, which is what we've been talking about for many months. From that point forward, then there's a discussion around what exactly the scope of services look like and any sort of economics out of that. Now last year, if you recall, and we don't expect any changes, we have not made any changes in terms of the economics. So I think that's important. We've had that experience for nine years with our partner. We had that experience last year as well. Now last year also though the scope increased, right? So the only modifications we made were structurally to increase the scope, but no other economic terms effectively changed. Now we would expect the same here going forward as it stands today, which is why we have not made any changes to our outlook. And we'll continue the discussion around with our government partner as well as our non-profit partner around that scope as the government releases that information over the next few months.

Brad Archer, CEO

Scott, maybe if I'll just add. This is Brad. Good morning. But add a few things there, because I think it's very important. Eric mentioned going from emergency to the ICS. And when you look at that, today there's only two active ICS. And one of them we know was that Fort Bliss has been out publicly that at some point here in midyear of 2023 that they're going to mothball that and not use it anymore. That's there. They put that out publicly. So this has always been out there, and the government moving into the more permanent type facilities long term, but I think that bodes well for where we're at. But that was a big distinction in this contract, moving into the more permanent facility, the government rebalancing their portfolio as well. And this is allowing them to do that.

Scott Schneeberger, Analyst

Okay. Thanks, guys. Very informative, some good points there. Let's transition to kind of more near term that sounds like an excellent long-term development, but more near term. Eric, you highlighted it sounded like second half stronger than first half on seasonal utilization in West Texas. Could you just speak to, and as Brad just mentioned kind of the Fort Bliss wind down dynamic, how should we be thinking about your inflows at West Texas based on seasonality one and wind down at Fort Bliss? Thanks.

Eric Kalamaras, CFO

Thank you for your question. Overall, the capacity we're experiencing aligns with our expectations, closely mirroring last year's situation. The contractual arrangements and occupancy levels are functioning as anticipated. One notable change was the delay in lifting Title 42 by the administration on December 21, 2022, which impacted our timelines. Around the same period, we were finalizing our expansion, causing the government to extend the Fort Bliss contract longer than we initially expected. Consequently, the capacity has been utilized between our expanded community and Fort Bliss. Looking ahead, with Title 42 being lifted and the usual seasonal influx, combined with the transition from Fort Bliss this summer and its eventual conclusion, we anticipate a significant shift in the second half of the year. While I would like to provide specific numbers, I'm unable to do so at this time. That said, many factors seem to be aligning for a stronger second half, though estimating the exact inflows is challenging due to the unpredictability of migration patterns. It’s worth noting that in 2022, over half of the immigration encounters were rejected due to Title 42, while the remainder were processed under Title 8, the standard asylum procedure. Once Title 42 is lifted, we could see immigration flows potentially double compared to 2022 figures. This context should be considered as we move forward, and I expect significant inflows in the latter part of the year.

Scott Schneeberger, Analyst

Thanks. And just one more for me, and I'll turn it over. And it goes back to the first topic I raised and one of your comments during prepared remarks or in response to that first question was with your partner and the IDIQ award, should we anticipate now that it looks like it would be a five-year base and a five-year extension, it sounds like that is being established in this new development? I inferred from something that one of you mentioned that it would probably be the same structure as a base lease payment and then a variable utilization component. Is that how we should think about the future contracts, or may it be structured in another fashion? Thanks.

Brad Archer, CEO

Scott, when we submitted with our partner on the IDIQ, that's exactly how we submitted, the way it's set up today. We haven't heard any change as the way the IDIQ at this point was given to them. So we had to put in a base concept pricing and all of that to be awarded this.

Scott Schneeberger, Analyst

Understood. All right, I'll turn it over. Thank you.

Eric Kalamaras, CFO

Thank you.

Brad Archer, CEO

Thanks, Scott.

Operator, Operator

The next question comes from Greg Gibas with Northland. Please go ahead.

Gregory Gibas, Analyst

Hi. Good morning, Brad and Eric. Thanks for taking the questions. Congrats on the quarter as well. If I really could just follow up on that IDIQ from the non-profit partner, what are the next steps there? And when would we expect to see an update on that contract?

Eric Kalamaras, CFO

Yes, that’s a great question. As we've mentioned, these processes take some time. We need to ensure any scope modifications resulting from the changes are addressed. The first step is to establish the funding mechanism with the allocated dollars. The next step is for the government to finalize its scope. Last year, we increased the scope significantly from 4,000 beds to an additional 2,400. This reflects the progressive nature of the facility, which is truly world-class and the best facility available. Additionally, it's important to consider that the government is rethinking its capacity. They have 22 small shelter locations across the U.S. that face logistical challenges, and we understand they are exploring other alternatives. Therefore, there may be other locations involved, and we will need to assess any scope changes or location increases as they arise. However, this process will take a few months.

Brad Archer, CEO

Yes, this is much shorter than our previous efforts. We began this process in September with the IDIQ when we submitted, and we've been discussing it even before that. We see this as a significant hurdle that we've overcome. To reiterate, it will likely take a couple of months, as Eric mentioned. Discussions are already underway, and I expect we should wrap this up in the next few months. To be clear, it's not going to take 6 to 10 months.

Gregory Gibas, Analyst

Yes, great point. And it's very helpful, guys. And just to follow up there again, as we think about them thinking about perhaps changing the scope on that contract. If we think about Fort Bliss being mothballed, like you said, is that a safe assumption to assume that they would require more scope?

Brad Archer, CEO

Look, I think when you look at Title 42 supposedly coming off in May, I would just tell you high level, I think the need for our types of services are going to be greater. We think there'll be more deals out there. We would have to win those. I'm not sure there'll be more scope, if you will, at our West Texas facility. But I think overall on the border across the U.S., some of the things that we're dealing on now, I think there will be a greater need. It doesn't mean we're going to end up with them. But I think our pipeline, and we touch on this, is more active and more real than it's been ever in our company.

Eric Kalamaras, CFO

I think that's a great point. I think to add on to that, as Brad mentioned a great point, which is our pipeline is exceptionally active in and around these types of things. But in addition to that, Greg, just for clarification, the government as part of this process has clearly indicated that they are net short capacity, right, and they know it. And so to Brad's point, what the ultimate outcome of that is still yet to be determined, but I would submit to say it's not a far stretch that looks much better for Target. So we'll just leave it at that, but it's certainly very positive.

Gregory Gibas, Analyst

Got it, very helpful. And then I guess lastly just, what is maybe reasonable to assume regarding variable revenue this year? I know you provided the range, but what would maybe be kind of a rough baseline that would be a fair assumption?

Eric Kalamaras, CFO

We initially projected around $50 million in variable revenue for 2023. As I mentioned, this is now expected more in the second half of the year, influenced partly by Title 42, but largely due to the usual seasonal trends we are currently experiencing, which are quite typical. Overall, this is progressing well. While I'd like to suggest it could be better, we will need to wait and see. It's still a bit early to determine if it truly will be better, and if so, to what extent. It's challenging to make a clear assessment right now, especially during this transitional period when there has been a decline in the number of children arriving over the past few months. This affects our capacity and demand slightly, but we will have a clearer picture as we approach spring, a traditionally strong season. The recent changes in administration policy could result in an exceptionally robust spring.

Gregory Gibas, Analyst

Got it. Thanks for the color. I'll pass it on.

Brad Archer, CEO

Thanks.

Operator, Operator

The next question comes from Stephen Gengaro with Stifel. Please go ahead.

Stephen Gengaro, Analyst

Thank you. Good morning, everybody.

Brad Archer, CEO

Good morning.

Eric Kalamaras, CFO

Hi, Steve.

Stephen Gengaro, Analyst

A couple of things for me, the first was just on the variable piece and I don't want to read into this too much, but when we think about the $50 million expectation for the year at least I guess is the sort of baseline. How much those utilization of the asset this year impact the negotiation? Like, is it pretty clear this long-term need is sufficient where like if your utilization was low this year that the government could rethink the capacity needs longer term, or is that reading into too short term of a data point?

Eric Kalamaras, CFO

I understand why you'd ask that question. It seems to be based on a short-term data point, especially since what we're experiencing now is quite similar to last year at the same time. Additionally, our previous contract serves as a good example; it was renewed for five more years during the COVID pandemic, even when occupancy was low due to health concerns. Therefore, I don't see any real correlation with that situation. As we discussed, the government is currently limited in its capacity, which doesn't significantly affect their long-term thinking on this matter.

Stephen Gengaro, Analyst

Okay, thanks. That was what I thought, but I've gotten questions so I figured I'd ask you. So the other sort of bigger picture question, if we work under the assumption and our model is kind of built this way that you guys do secure this long-term contract. And then we look out and you don't have to bless the number, but then you're looking at, I don't know, $175 million to $200 million of annual free cash flow and visibility on that free cash flow. What does we do over a multi-year period as far as utilizing that cash? And maybe I know we've touched on this a little bit, but what are the other sort of end markets you might access or could this just be a massive return of capital to investors?

Eric Kalamaras, CFO

That's a great question. I've probably repeated myself a lot over the past year on this. The responses vary when you're talking about an emergency funding mechanism versus a long-term IDIQ structure. So, I want to point out that my answer might shift a bit. I believe there may come a time when we start considering other capital return initiatives, and we could be nearing that time. However, we are also very much in growth mode. We have several avenues to explore in this regard. We can look at cash transactions, which we have done, but we've been careful and patient about it. We haven’t found the right opportunity at the right value just yet, but there are some prospects available. Other ways to significantly grow the business include equity exchange transactions, although that wouldn’t necessarily require cash. We have opportunities to enhance and diversify the business this way. Additionally, we have positioned the balance sheet as we intended. Looking ahead over the next few years, as we potentially accumulate $600 million to $800 million in free cash flow, we will begin to consider shareholder return activities.

Brad Archer, CEO

And none of these are mutually exclusive.

Eric Kalamaras, CFO

And to Brad's point, none of these are mutually exclusive. And we have a tremendous amount of flexibility. And so what we can do with this is we can do cash transactions, we can do equity exchange deals, we can do dividends, et cetera. We can do these things, all contemporaneously at this point. And so look, I think we’ll enter a node where we'll start looking at that in a more deliberate fashion. Because I think that's probably close to that time coming.

Stephen Gengaro, Analyst

Great. Thank you. And then just one follow up for me. When you think about the oil patch and what's going on in HFS, it feels like there was a sustained level of activity there, probably not a lot of growth given the way the EMPs have remained pretty disciplined. Is it reasonable to think about that business as being kind of pretty steady state at current levels? I know you had the contract extensions, which gives visibility, but is that a reasonable way to be thinking about that piece of the business in 2023?

Eric Kalamaras, CFO

I think you're right. We view that business as excellent. Recently, we secured $200 million in contract renewals there. As we have mentioned before, we typically experience some lag, so we anticipate margin growth in the coming quarters, potentially considerable margin expansion, which is encouraging. This business generates significant cash, greatly aiding the diversification of our balance sheet and future potential. Even though it currently operates like a GDP-type business, unless we pursue smaller acquisitions, it's still a strong business for us. We will continue to drive operations, capturing as much market share and margin as we can while supporting our customers. Despite the growth challenges, it's a truly outstanding business.

Brad Archer, CEO

Yes, utilization is increasing, right?

Eric Kalamaras, CFO

Absolutely, it is. I think, look, we have put that business in a fantastic optimizational spot. And we're really, really pleased with where that's positioned at this point.

Brad Archer, CEO

We’re starting to see some movement on price, and that's not huge but, as Eric said, there's always that lag. It's not going to be a huge mover for us, because we have a lot of long-term contracts that are already baked in. But as we come up on renewals and high grading customers, we're having a much better outcome on those negotiations. So not sure you'll see a huge move, but it's nice to see that we are getting some of those now and higher utilization. I think overall, we really over the past couple of years looking at the consolidated portfolio, right? When we look at margins, when we look at growth, what can we do to maximize every room in our portfolio? So when we look at that, we look at it holistically whether that's with government, whether that's with commercial-type companies, or if that's the oil and gas side. And I think the team has done a tremendous job in really capturing that for us.

Stephen Gengaro, Analyst

Yes. Thank you. That's helpful color. I mean the feedback we get is very positive. So it dovetails with what you just said. So thanks.

Operator, Operator

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

Brad Archer, CEO

Thanks again for joining us on the call today, and we look forward to speaking to you again in May when we deliver our first quarter numbers. Thanks.

Operator, Operator

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