Earnings Call Transcript - TH Q1 2023

Operator, Operator

Good morning, and welcome to the Target Hospitality First Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. 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 first quarter 2023 earnings call. The press release we issued this morning outlining our first 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 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, May 9, 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’ll 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. Our strong first quarter performance reflects the positive business momentum we have sustained over the past year, which has supported many strategic achievements. We have meaningfully diversified the business and revenue mix with over 70% of revenue now derived from committed contracts backed by the United States government. These high-graded contracts have provided enhanced revenue and cash flow visibility, supporting over $339 million of discretionary cash flow over the last 12 months, representing an impressive discretionary cash flow yield to revenue of approximately 60% over that time. These accomplishments have solidified Target’s balance sheet with over $350 million of cumulative debt reduction since 2020, and an 80% improvement in Target’s net leverage ratio over the past year. We have significantly transformed Target’s operating platform while continuing to serve our existing world-class customers while simultaneously positioning the business to quickly respond to strategic growth opportunities. In our HFS-South segment, we have remained focused on providing premium full-service hospitality solutions to our world-class customers, many of whom have been customers for over a decade. As a result, Target continues to benefit from consecutive quarterly increases in customer demand, resulting in a 15% year-over-year increase in utilization with consistent customer renewal rates over 90%, which we have enjoyed for over seven years. This continued strong demand and positive customer outlooks supported the acquisition of select community assets in the first quarter to appropriately align our network capacity with existing customers’ growing labor allocation requirements. In addition, the strategic location of these assets enhances Target’s regional presence and provides opportunities to further expand our premier customer base. We are pleased with our current HFS utilization and its ability to meet our strong customer demand while benefiting from the more fully optimized network we have created over the past year. Regarding our Government segment, our purpose-built portfolio of assets continues to serve the critical humanitarian aid mission that they were designed to support while exceeding the expectations of our partners in the U.S. government since our first community was established in 2014. Further, the U.S. government has continued to state its urgent need for additional humanitarian housing capacity, particularly with the impending removal of Title 42, which is anticipated to result in a substantial increase of individuals crossing the U.S. Southwest border. In preparation for this meaningful increase in demand and to ensure uninterrupted access to existing humanitarian housing solutions, including Target’s expanded humanitarian community, the U.S. government has indicated it intends to exercise the existing contract's six-month option. This decision will allow for seamless continuity of the service offering at the expanded humanitarian community and serve as a bridge before long-term contract specifications are finalized. As previously discussed, our non-profit partner was awarded an indefinite delivery, indefinite quantity contract related to the extension of our humanitarian community in Pecos. As a reminder, this award consists of a base five-year term with an additional five-year option establishing the contracting vehicle required by the U.S. government to appropriately fund multi-year contract awards. The IDIQ award to our non-profit partner is one of the final steps in the government’s contract award process, before working through definitive agreements. We remain highly pleased with the ongoing discussions with the U.S. government and our non-profit partner, and we anticipate working through additional contract specifications over the coming months with likely culmination in the fall of this year. We look forward to solidifying the longevity of this community and the critical humanitarian mission it was purpose-built to support. 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 first quarter financial results, 2023 outlook, and capital allocation initiatives in more detail.

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

Thank you, Brad. In the first quarter, we experienced continued strong demand fundamentals and positive momentum in customer activity, which further solidified our strong financial position. For the first quarter of 2023, total revenue was $148 million, and adjusted EBITDA was approximately $91 million. Our Government segment produced quarterly revenue of approximately $110 million compared to $47 million in the same period last year. A significant increase was attributable to the expanded humanitarian community. 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 services 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 providing meaningful minimum revenue commitments that create significant revenue and cash flow visibility for Target. We have found the structure to be the optimal outcome for all parties, creating a sustainable basis for contract longevity while maximizing operational flexibility. Our HFS segment delivered first quarter revenue of $36 million compared to $32 million in the same period last year. This increase was driven by sustained momentum and 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 spending for the quarter was approximately $32 million, with the majority related to select HFS-South asset acquisitions focused on increasing capacity to appropriately match growing customer demand. We expect a more moderate pace of capital spending through the remainder of the year, excluding potential acquisitions. We ended the quarter with $42 million of cash and over $167 million of liquidity, with zero borrowings under the company’s $125 million revolving credit facility and a leverage ratio of 0.5 times. As we previously announced on March 15, we partially redeemed $125 million of the 9.5% senior secured notes, which we view as a high-risk free cash return. As it relates to the outstanding senior notes, we continue to evaluate a range of possible liability management initiatives focused on further strengthening our financial position while balancing the expanding pipeline of strategic growth opportunities. This approach is centered on maximizing financial flexibility, enabling us to quickly react to value-enhancing growth opportunities as they arise. Turning to our financial outlook and capital allocation initiatives. Target’s enhanced end market portfolio and contract structure has supported an increase in minimum revenue commitments and provided greater visibility on long-term revenue and cash flow. We believe the government’s decision to issue an IDIQ contract award to our non-profit partner solidifies the sustainability of this purpose-built facility by establishing the necessary mechanism to fund specific multi-year contract awards. Further, the government’s desire to exercise the existing contract’s six-month option supports the importance of this community as the government prepares for a significant increase in demand for humanitarian housing following the lifting of Title 42. 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 later this year. Further, in response to the government’s stated urgent and compelling need for additional humanitarian housing solutions, we recently acquired a strategic humanitarian asset, which we believe will allow Target to react quickly in support of the government’s demand for these humanitarian solutions. 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 minimum revenue of $525 million, maximum revenue of $710 million, and minimum adjusted EBITDA of $365 million. Excluding acquisitions for 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 Target’s strategic initiatives, Target is pursuing an expanding pipeline of growth opportunities and partnerships. These opportunities are designed to jointly leverage Target’s operating expertise with contracting vehicles that will create a number of solutions across various U.S. government agencies for projects that support national defense, energy transition, and other humanitarian projects for the U.S. government. As previously stated, Target is prepared to allocate over $500 million in net growth capital to these high return opportunities over the next several years. We are pleased with the progress of discussions for many of these projects and partnerships, and we have achieved tangible milestones regarding some of these large-scale projects. We look forward to providing additional updates in the coming quarters as the opportunities fully progress. With that, I will turn the call back over to Brad for his closing comments.

Brad Archer, President and Chief Executive Officer

Thanks, Eric. Our strong first quarter results reflect our ability to sustain momentum and continue achieving our strategic objectives. Over the past several years, we have exponentially grown the business, prudently managed our balance sheet, and significantly enhanced our financial flexibility. These accomplishments have exceeded our expectations. We are excited about the operating platform we have created and are focused on pursuing an expanding pipeline of growth opportunities while continuing 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

The first question comes from Scott Schneeberger from Oppenheimer. Please go ahead.

Unidentified Analyst, Analyst

Hey, good morning. It’s Daniel on for Scott. Thanks for taking our questions here. Could you please elaborate on the May 5 update related to the work statement, please?

Brad Archer, President and Chief Executive Officer

Sure. Good morning, Daniel, it’s Brad. What we talk about there is a performance work statement. What that is, it comes out before the task order, but it describes what’s going to be in this task order. It sets out the requirements of what we will submit to the government and to our partner. Reading this performance work statement, it’s very materially aligned to what we’re already providing, so we’re happy to see that. At some point here over the next few months, this task order will come out. We will submit to that and then an award will be made. So this is just really the next step that we’ve been waiting on to get that out there and get a long-term agreement.

Unidentified Analyst, Analyst

Got it. Thank you. Sounds good. And regarding Title 42 removal, have there been any conversations about removing the warm status of the Pecos facility?

Brad Archer, President and Chief Executive Officer

Yes, we’ve been in talks with them. There have been some calls about moving back into hot status. Nothing yet has been officially given to us on that, other than the calls and conversations coming in asking us how quickly we could ramp that up in anticipation of Title 42 going away and the need for those beds to be filled. Furthermore, just across the board, I know there’s probably going to be this question on Title 42, the number of conversations we’re having with different agencies is staggering. There have been lots of them over the past few weeks asking what we can do for them. So, active conversations are going on across the board through different agencies as well as for the Pecos facility.

Unidentified Analyst, Analyst

Got it, thank you. And regarding the strategic asset purchase you made in the quarter related to the Government segment, can you please elaborate on that a little bit and help us think about the financial implications and when we may get an update on that? The second part of the question is the CapEx spend of $31 million in the quarter in the HFS-South segment. If you could please help us think about how we should view that going forward as well.

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

Sure. Good morning. It’s Eric. Regarding the Government asset, there has been a consistent need and desire for additional influx capacity and space that’s been well stated by the government. We keep hearing that same theme. What we chose to do was acquire a strategic asset; that asset was previously used for similar capacity and aims to provide the government with a more immediate solution for other influx opportunities. We know that additional influx sites are something that they’re trying to evaluate as part of being an extension of the permanent portfolio. So, I want to give them lots of different options, and lots of different geographic opportunities, et cetera. So that was the purpose of that. But at this point in time, nothing to report on cash flow contribution yet, although we’re hopeful that at some point here in the near future, we will have something specifically we can say. Specifically to your question regarding the Permian transaction, we had talked for some time that we felt like we were becoming a little bit net short in our capacity. So we wanted to take the opportunity to go ahead and increase and expand the market share we have in the Permian Basin and did so with an asset that we’ve been looking at for a while. We feel like that was a solid addition to the portfolio. In terms of current cash flow, it’s not a super large transaction, as you can see, but it’s an important one, and one that continues to give us additional breadth, additional customers, and defend that market share. So, from a modeling perspective, it’s such a size that I wouldn’t ascribe too much to it in terms of modifications in EBITDA, because we are still integrating that asset and we have some expenses from that. But I think it’s a nice growth opportunity for us and we’ll continue to create those tuck-ins as we see fit in the future.

Brad Archer, President and Chief Executive Officer

Let me just add one thing on the strategic facility acquisition. As Eric talked about, when we first did this, it was more to continue to expand the ICFs; what has evolved from this is a lot of other conversations with multiple agencies from CPP to others in the government. Once you acquire this, we do a design, we go out and we lay this out in front of different agencies with Title 42 coming up. There’s been a lot of increased awareness about this facility and multiple discussions being had throughout different agencies. So, while we talk about ICFs, I wouldn’t be surprised if this ultimately results in something even more significant given the active conversations we are currently having. To Eric’s point, having it ready for us to be able to respond quickly is crucial, especially in times like this. So we believe this will help us do that.

Unidentified Analyst, Analyst

Got it. Thank you so much.

Operator, Operator

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

Greg Gibas, Analyst

Great. Good morning, Brad and Eric. Thanks for taking the questions. Congrats on the strong results in Q1. Wanted to just ask your thoughts on the breakout between variable and fixed revenue on the humanitarian side in the quarter, and I guess just wondering if anything’s changed with respect to your variable revenue expectations for the full year? I think it was previously $50 million as a kind of a baseline assumption. Just trying to get a sense of whether anything’s changed.

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

Yes, sure. There is not a large variable component for the quarter. Certainly, we would always like to see that at higher levels. It was what we would consider to be at the minimum levels on that. But I want to refrain from giving specific numbers on that, Greg. I think the important point is that we expected this to be a seasonal slowdown; that was actually very much in line. The thing we have to wait for now is, with Title 42, many people are being held at the border, and the question is how quickly we move into hot status and to what extent. Because of that, and because we allocated approximately $50 million of variable revenue through the year, and given the surge we expect during the warm summer months into the early fall time period, we just don’t know the extent of that. And for that reason, we’ve chosen not to change anything regarding our revenue outlook. Despite that, we expected approximately 10% of the variable revenue contribution to be realized in the first quarter and a half. My point is we’ve consumed very little of that, and there’s still a lot of upside opportunities left throughout the year.

Brad Archer, President and Chief Executive Officer

The thought on the business hasn’t changed.

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

Hasn’t changed one bit. The concept between when we set up the contract, joining with our nonprofit partner, at the request of the government, was for this minimum revenue component. That was to keep the facility ready and waiting for when the surge happens. That is the definition of the influx capacity. We are ready and waiting for that. And when that revenue hits, it can be meaningful. So for that reason, the timing may have shifted a little towards the back half, but we’re not alarmed by that.

Greg Gibas, Analyst

Great. Really appreciate the color; helps a lot in understanding how you’re thinking about it. I do realize that variable is a small component compared to the fixed. I was going to ask about getting back to that hot status from warm, but I think you kind of already addressed that in discussions there. Regarding another step forward towards finalizing that multi-year contract, you mentioned being one of the final steps before completion. Could you maybe discuss what the remaining steps we need to see are before we get that multi-contract extension finalized?

Brad Archer, President and Chief Executive Officer

Yes, it goes from the performance work statement to actually putting in our numbers on an initial task order. The government will issue this task order. We will put our RFQ in for that, if you will our bid, and then an award would be expected towards the latter part of the third quarter.

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

Yes. I think the one thing I would add in addition to Brad’s comments is when you take a step back and think about the performance work statement, it’s further defining any scope modifications, and importantly, there weren’t any. And so that’s an important point, right? Because that allows that to fit nicely with the facility today. There’s nothing that requires incremental changes today, which helps speed this process along fairly well.

Brad Archer, President and Chief Executive Officer

Yes, it’s designed the same way, warm to hot status; the discussions go beyond just our assets.

Greg Gibas, Analyst

Got it. That’s helpful. If I could follow up too on your comments relating to that recent strategic asset acquisition, it seems to make a lot of sense given what you’re hearing from the government still being that short capacity and there being a lot of demand there. But you mentioned you don’t expect anything in terms of contributions to financials this year. Are you currently in discussions with the government about how to utilize that? If we’re not expecting to see something near term, when would you think about the timing of that facility beginning to be used?

Brad Archer, President and Chief Executive Officer

Yes, we are currently having multiple discussions with different agencies regarding this facility. There has been a lot of high-level interest, particularly with May 11th right around the corner and Title 42 coming to an end. While we don’t have anything reflected in the numbers yet, the hope is at some point, this will transition from just a real estate acquisition to actually becoming accretive for us. That is the goal.

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

Yes, and Greg, if I misspoke and said don’t expect anything this year, that wasn’t necessarily my intention. What I’m saying is, we have the asset ready and available, but it doesn’t mean we can’t have opportunities with that asset as we work through this performance work process.

Greg Gibas, Analyst

Okay, perfect. Thanks for clarifying and I appreciate the color guys.

Operator, Operator

The next question comes from Alec Scheibelhoffer from Stifel. Please go ahead.

Alec Scheibelhoffer, Analyst

Hi, good morning everyone. Thanks for taking my question. So just to get a start here, just based on earnings, it appears activity in the Permian is likely to remain flat at current levels for the balance of 2023. Would you say that’s in line with your view, and can you talk about demand in the Permian and expectations for activity over the next few quarters?

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

Sure. As we have stated for the past few quarters, we came off some pretty good growth, and then we’ve seen that start to level. I would say that from a gross profit perspective, it’s probably steady as she goes. I think we will continue to see slight improvements even gradually. This past quarter, as I mentioned, we did have some integration expenses from the asset purchase, which did have an impact to bring down margins a little and increased costs. But beyond that, I think that business is strong and continues to generate significant cash for us. In the marketplace, other producers and integrated companies continue to maintain their capital spending, and they too are expecting fairly low to mid-single-digit growth as well. I think it will follow along that line, but that should be fine for us.

Brad Archer, President and Chief Executive Officer

We’re excited about that business as always. It’s something that we’ve operated for a long time. It’s a great customer base. It’s a fantastic area to be in. It’s not going to be hot and stick growth out there, but I think it will be consistent. Rates will hopefully improve over time as inflation subsides, but it takes a while since we have long-term contracts. Eric mentioned some costs that won’t be ongoing; that was a one-time hit. Overall, I believe the performance will continue to tick up at a reasonable rate.

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

One thing we haven’t touched on during the call is that we look to continue expanding the HFS business in other areas. We’ve discussed our commercial diversification efforts, and they’re really starting to take hold. While we’ve seen HFS-South remain steady, there are some promising growth drivers we’re exploring. More updates should follow as we move forward.

Brad Archer, President and Chief Executive Officer

Yes. Additionally, as we increased our government contracts, it allows for some of the HFS rooms to be used differently. This mix creates a far more profitable position for the company than it has seen in the past few years. We are pleased with the direction and mix at this point.

Alec Scheibelhoffer, Analyst

That’s excellent color. Thank you for that, and I’ll turn it back.

Operator, Operator

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

Brad Archer, President and Chief Executive Officer

Thanks again for joining us on our call today, and we look forward to speaking again in August. Thank you.