Earnings Call Transcript - TH Q2 2022

Operator, Operator

Good morning and welcome to the Target Hospitality Second Quarter 2022 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Mark Schuck, Senior Vice President of Investor Relations. Please go ahead.

Mark Schuck, Senior Vice President of Investor Relations

Thank you. Good morning, everyone and welcome to Target Hospitality's second quarter 2022 earnings call. The press release we issued this morning, outlining our second quarter results can be found in the Investors section of our website. In addition, a replay of this call will be archived on our website for a limited time. Please note the cautionary language regarding forward-looking statements contained in 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, August 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. I will 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. Target's record-setting second quarter results illustrate the benefit of Target's strategically located network and superior operating capabilities which have supported Target's ability to efficiently meet our customers' varying needs. Target has intentionally aligned itself with premier customers, including the United States government, who find increased value in the flexibility and premium service offering Target provides. We continue to experience consistent increases in customer demand across our HFS segments, supported by strong demand fundamentals. Target HFS customers continue to benefit from the size and scale of our network which provides premium hospitality solutions and logistical flexibility for their dynamic labor allocation requirements. The intrinsic value of Target's network has supported an over 90% customer renewal rate for more than six years and an 18% increase in customer labor allocation from the second quarter of 2021. We anticipate consistent increases in customer activity throughout 2022 and are well positioned to benefit from this positive momentum across our network and HFS segment. Target's operating capabilities and network flexibility provided the foundation to expand our critical service offering to the United States Government through the expanded humanitarian contract which we announced last month. As a reminder, this contract represents a 60% increase from the initial contract we announced in 2021 and includes significantly enhanced amenities and support services for a population of approximately 6,400 individuals. These critical humanitarian services are centered around minimum revenue contracts backed by the United States government which provide enhanced long-term revenue and cash flow visibility. Our intentional focus to expand the critical hospitality service offerings we provide the United States government has materially strengthened Target's financial profile. Target's Government segment represented over 68% of second quarter 2022 revenue and is expected to represent approximately 73% of full year 2022 revenue. This is a clear illustration of our commitment to diversify and expand Target's end markets, while simultaneously high-grading counterparty exposure and contract structure. These accomplishments have materially strengthened Target's financial position and establish the foundation to continue pursuing strategic growth initiatives. These elements, along with Target's unmatched operating capabilities and distinct core competencies create the optimal scenario to pursue a balanced portfolio of value-enhancing growth initiatives. These opportunities span Target's existing end market portfolio as well as naturally adjacent business and industry applications which we believe creates the greatest opportunity to accelerate value creation. We are encouraged by the sustained momentum experienced in the first half of 2022 and believe we are well positioned to continue benefiting from our strategic position as North America's leading provider of comprehensive hospitality solutions and value-added services. I'll now turn the call over to Eric to discuss our second quarter financial results and ongoing growth initiatives in more detail.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Thank you, Brad. In the second quarter, we experienced continued strong demand fundamentals and positive momentum in customer activity, predominantly driven by the materially expanded government services contract we announced last month. Second quarter total revenue was $110 million and adjusted EBITDA was approximately $56 million. Our Government segment produced quarterly revenue of approximately $75 million compared to $45 million in the same period last year. The significant increase was attributed to the expanded humanitarian contract that we announced on July 6 which had an effective date of May 16, 2022. As a result, the new humanitarian contract contributed approximately six weeks of earnings during the quarter. As a reminder, Target's Government segment including the expanded humanitarian contract center around annual minimum revenue commitments. Additionally, the expanded humanitarian contract includes variable services revenue that will align with monthly changes to community population. Our HFS segments delivered strong second quarter revenue of $34 million compared to $29 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 and demand fundamentals. While Target has significantly grown its revenue and adjusted EBITDA over the past year, we have remained diligent in appropriately managing cost components across the organization. We take an active approach managing our input cost and benefit from our service offering flexibility which allows us to adjust primary cost components to mitigate pricing pressure. Recurring corporate expenses for the quarter were approximately $8 million and illustrate our ability to significantly grow the business, while incurring minimal incremental corporate costs. As a result of this scalable business model, we anticipate recurring corporate expenses to remain around $8 million to $9 million per quarter through 2022. Total capital expenditures for the quarter were approximately $37 million, with $35 million related to the substantial infrastructure enhancements associated with the expanded humanitarian contract. As a reminder, this expanded contract will result in a transitory increase in 2022 capital spending. However, this increase will be balance sheet neutral with continuing leverage improvement occurring by year-end 2022. Further, Target anticipates additional balance sheet strengthening continuing into next year, with the expectation of having zero net debt by year-end 2023. We ended the quarter with $10 million of cash and total available liquidity of $114 million, including $104 million available under the company's $125 million revolving credit facility and a net leverage ratio of 2.3x. We expect leverage to come down materially by year-end 2022. These strong business fundamentals and intentional focus on increasing our critical service offering in support of the United States government's domestic humanitarian missions has materially strengthened Target's management profile and contract structure. These elements have resulted in a significant increase in long-term revenue visibility with approximately 99% of Target's 2022 revenue under contract and approximately 75% of contracted revenue having minimum revenue commitments. 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. Additionally, this strong financial position creates the optimal platform to continue pursuing our strategic growth aspirations focused on further expanding the company's long-term opportunities. Our established and growing presence within the government services end market creates a natural opportunity to expand our reach across agencies and geographies. These broad-reaching opportunities utilize key elements of Target's existing capabilities including construction and facilities management, offering long-term growth opportunity pipelines. These strategic growth initiatives will focus on utilizing Target's existing operating capabilities to pursue a balanced portfolio of value-enhancing opportunities across Target's existing end market portfolio and adjacent end market applications which we believe provides the greatest opportunity to continue accelerating long-term value creation. With that, I will turn the call back over to Brad for closing comments.

Brad Archer, President and Chief Executive Officer

Thanks, Eric. Our record-setting second quarter results are a direct reflection of our superior operating capabilities and unmatched network flexibility which supports Target's unique position as North America's largest provider of premium vertically integrated hospitality services and solutions. These attributes have supported strong demand from our world-class customers, including the United States government which has significantly strengthened Target's financial profile. This operating platform creates the ideal scenario to continue pursuing value-enhancing growth initiatives, focused on expanding Target's long-term growth pipeline. We believe this intentional focus creates the greatest opportunity to continue 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

First question will come from Scott Schneeberger with Oppenheimer.

Scott Schneeberger, Analyst

I'd like to start off by asking just about how the ramp-up is going with the expansion of the West Texas government facility. Do you see that progressing as on pace with the original schedule that you had anticipated? Just any additional color on that.

Brad Archer, President and Chief Executive Officer

Scott, this is Brad. Thanks. Look, no change from the last time we all talked, it's actually progressing very well. We've hit all the milestones, some of the turnover already on some of the buildings as well for the customer. But fully on schedule and we anticipate that to continue on that way with a full turnover sometime in early October.

Scott Schneeberger, Analyst

That's great. How should we think about the ramp in utilization levels in that facility? Additionally, how should we anticipate margin progression in the second half of this year?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Scott, it's Eric. Yes. So as we think about this, the thing about utilization there, we're not going to be specifically disclosing what that trend looks like. Bear in mind that the entirety of the facility is not up and running. There are a couple of phases here. So we'll see that progressing as we move here over the next month or two. And then specifically, it will depend partially on how the government decides to nominate its variable component which is a question mark for us. So look, we expect it to continue to improve over the next few months and then we get to more of a steady state. And then from there, the government will make its elections as it sees fit. As we think about the margin movement, what I would say is this. So look, there is a ramp, as you can imagine, right, in a big project like this. And so as we think about moving this forward, you obviously have the numbers that we put out for Q2. Look, those will continue to move in the right direction as we move through time here. Is there something specific on the margin that you're thinking about as opposed to just speaking of generalities?

Scott Schneeberger, Analyst

No. Thanks, Eric. Yes, I guess we’ll watch as that progresses. I would imagine as occupancy increases, we would see a bit of margin improvement assuming that the margin rate, the gross margin of the West Texas facility will be attractive relative to overall corporate rate. That’s actually what I’m getting at. Just kind of circling back by year-end, Brad mentioned probably the expansion should be largely complete or certainly the bed parts by October if everything goes as planned, it sounds like it is. Could we see a potential maximum occupancy from the government by year-end? I know you don’t want to speak because you don’t know that yet but that’s kind of to this as well. So you have kind of a 2-part to response there.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Yes. I'll let Brad address the trend regarding the government's disposition. As we improve our occupancy levels, our margin will also strengthen. It's important to note that there are two components affecting the margin: the minimum revenue and the variable piece, which don't impact the margins equally. As we see an increase in occupancy and per head numbers, the incremental margin may slightly decrease from the minimum. You should consider it in terms of different stages. In the short term, the margin will improve. However, as we progress and achieve higher occupancy, we may experience a plateau in the margin. Eventually, when we reach peak occupancy, the incremental margin may slightly decline, even as nominal dollars increase significantly. I hope that clarifies things. We can discuss this further in more detail if needed.

Brad Archer, President and Chief Executive Officer

Regarding your question about the ramp-up, we don't have control over that aspect. What we can manage is ensuring timely delivery, the number of beds, and fulfilling contracts to facilitate the ramp-up. It's well known how much investment is being made and the type of facility we are providing. There is a significant demand for beds in the market, and the expectation is that they will utilize this capacity swiftly and start the ramp-up process. While this isn't reflected in our projections and we aren't stating it will definitely happen, it seems reasonable to anticipate that this will occur as the year progresses.

Scott Schneeberger, Analyst

Yes, totally understood. Got that, Brad. And Eric, I think you made a good point. Even if on the side, even if yes, you do have diminishing on the improving incremental margin, your absolute dollars are still going up is, I think, the takeaway point there. So thanks. I've asked a bunch of I'll turn it over but one last kind of high level. I'm guessing there's no update but just any thoughts on long-term extension of this government contract, it's a frequent question. Just want to see if you have any incremental comments.

Brad Archer, President and Chief Executive Officer

Yes. Really no update there, Scott, other than what we’ve all talked about, you look at what’s being spent upfront on this project, just the overall design of a purpose-built really look at this very similar to what happened at our Dilley project and it’s being built for the long term and we expect that to continue on. Even though it’s a one year with a six month option on this first contract, we look at this as does our partners as a long-term solution.

Operator, Operator

Our next question will come from Greg Gibas with Northland Securities.

Greg Gibas, Analyst

Congratulations on the results. I am just curious about what might have contributed to the positive outlook for Q2, as it seems to have exceeded your expectations. Additionally, I would like to know if there have been any changes regarding your full year projections.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Greg, regarding the full year, there is no change. This project has been transformative for the company and highly beneficial, so there are no updates there. Concerning the outperformance, this is a significant project, not only in terms of operational scope but also financial impact. The outperformance you're observing is partly due to the margins in the early months being somewhat inflated when undertaking projects like this. That was evident in this quarter. It's important to note that this will normalize over time. We expect to see continued improvement in progressive occupancy on an incremental margin basis, although it will eventually stabilize. Overall, the strong operational execution has contributed to the outperformance.

Greg Gibas, Analyst

Great. Good to hear. And I guess, any commentary you can provide on how the new contract might impact cadence in the back half, maybe if we think about kind of traditional seasonality, if there’d be any change there this year?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

I don't anticipate any changes in seasonality. Occasionally, we observe a slight degradation of a couple of percent in the fourth quarter for the HFS side, mainly due to holiday turnover, especially in December. However, I wouldn't expect that to be the case this time.

Greg Gibas, Analyst

Okay, great. I have one last question about how we should consider the potential upside to guidance for the full year, particularly regarding your expectations on the variable side of the contract. Can you share any insights on what your assumptions might be for that?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

We have not specifically provided a variable occupancy component or any occupancy component at all, which makes it challenging to address that question. Primarily, it depends on our partners and the government making their nominations on the variable side. Until that number is known, it’s difficult to determine much more in terms of potential upside. I can say that we are very enthusiastic about the project and excited about the opportunity here, but I wouldn’t suggest any changes to what we have already communicated.

Operator, Operator

Our next question will come from Stephen Gengaro with Stifel.

Stephen Gengaro, Analyst

Just a couple of things. The first is regarding the HFS South part of the business. It seems that revenue growth has been lagging behind rig activity and completion activity during the quarter. It appears that you are experiencing more steady demand, so perhaps your performance doesn’t fluctuate as much as activity levels do. Can you provide some insight into what is happening in that area of the business?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Certainly, I can address a few points. There’s nothing surprising happening that doesn't align with our long-held expectations. We've indicated for some time that the market is gradually improving, and that has indeed occurred. However, I did mention last quarter that the speed of this progression has started to slow and stabilize at a more consistent level. This is what you're noticing. On the revenue side, we saw a slight improvement, although our margins did decline. This is not due to activity levels, but rather a result of the lower costs we experienced last year compared to the higher costs we are facing this year, along with some mismatched costs related to enhancing our business, which affected the margins. However, we did see an increase in margins in HFS South, specifically up 100 basis points from the previous quarter. This indicates we are moving in the right direction. Lastly, it's important to note that labor typically lags behind by a few months; as market conditions improve, we should expect to see an increase from the labor side, although it does not immediately correlate with activity levels.

Stephen Gengaro, Analyst

Okay, it's not a huge piece. I just kind of wanted to triangulate the model a bit. So two things on the government side of the business. And just one question that I get pretty often is when you're bidding on this work and you're looking at additional opportunities maybe along the same lines, maybe in different areas, who are you competing against? Because it doesn't feel like a lot of people have your track record and infrastructure to meet the demand, right? So I'm sort of just trying to get a sense of what's the competitive landscape when you're bidding on the government contracts?

Brad Archer, President and Chief Executive Officer

Look, this is Brad. I'm not going to call out the names but there's definitely competition out there, right? I would tell you, I mean, your point is right, not a lot of folks that are setting with the assets that we have, the ability to get those installed, construction done in just really a few short months. Also just the track record we've had for years with Dilley and we have some great partners. So there's definitely competition. They get competed but we're set up very well to continue to go after even new business. We have a great track record of performing.

Stephen Gengaro, Analyst

Okay. And then just one final question. The variable component of the new contract is approximately $185 million a year. Is that amount proportional to the utilization of the 6,400 beds? Additionally, I think that the government would not allocate this funding if they did not anticipate the occupancy rates for that part to be quite high. Can you provide some insight on that?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Sure. Regarding the first part of your question about linearity, it's not exactly linear due to margin movement and promotions, which creates some variances. However, it remains proportional. As occupancy increases, you will see nominal dollar increases, though at a slightly lower rate compared to previous quarters. I hope that clarifies things. We can certainly delve deeper if necessary. On your point about spending and volume, we expect this facility to be utilized according to government standards, which will be based on their satisfaction with the spending in relation to their humanitarian efforts. We'll have to see how this unfolds over time, but it's clear that the government intends to use the facility at a significant capacity; otherwise, they would have made a different choice.

Operator, Operator

Our next question will be a follow-up from Stephen Gengaro from Stifel.

Stephen Gengaro, Analyst

Well, thanks. I should have just asked the question, I guess.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

You never know, Stephen, you never know.

Stephen Gengaro, Analyst

I didn’t want to be rude, so I thought I’d get back in line. When you look at other opportunities, and you mentioned this a bit in the press release, in general terms, outside of what you’re already doing, what types of end markets do you think your capabilities are best suited for?

Brad Archer, President and Chief Executive Officer

Yes. I believe there are several areas, including building maintenance and facilities management, and catering fits well within our service offerings. There is a large untapped market for us in these areas. On the organic side, we are focused on continuing our current operations, expanding in the HFS sector, and delving into comprehensive government services beyond our current scope. We plan to extend our reach to different government agencies, providing similar products and services as we do now under our government contracts. There are many avenues within government services that we haven't pursued yet, but we have a strong reputation that we can leverage to explore these opportunities.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

I think Stephen, another important point to consider is that the solutions we offer today are generally comprehensive turnkey solutions. There's a significant opportunity to perhaps streamline some aspects of this approach. This means that instead of providing all available solutions, we might choose to offer a select few from our suite to various applications. Ultimately, our goal is to elevate Target from a business that has discussed $500 million in revenue with considerable margins to nearly $1 billion in revenue over time, whether through government contracts or engagements with other industries. This is our strategic aim, and it’s something we are very focused on. We want to pursue this goal wisely, ensuring that we don't spread ourselves too thin and compromise the significance of our efforts. We are pursuing opportunities that complement our goals and have turned down some potential transactions because they did not meet our return expectations or align operationally and commercially with our strategy. To clarify, we are actively searching for and assessing opportunities, and we will keep doing that. There are many prospects for us, whether we pursue complete turnkey solutions or adopt a more streamlined approach.

Stephen Gengaro, Analyst

I wanted to mention that you have approximately $330 million in long-term debt. If our model holds true, you should have significant visibility and are likely to generate more than $200 million of free cash in 2023 and 2024. What are your plans? Will you pay down debt, refinance to lower rates with the new contract visibility, or initiate a program to return capital to shareholders through dividends or share repurchases? How should we consider the benchmarks and ratios you would be comfortable with when planning to return more cash to shareholders?

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Sure. There are a few points to consider. You're correct about the amounts of cash generation. When it comes to capital structure, returning capital, and general cash use, there are multiple options. You can pay down debt, repurchase stock, issue dividends, or pursue transactions, among others. As we think about our priorities, the immediate focus isn't necessarily on returning capital to shareholders but rather on strengthening the balance sheet. Our goal is to reduce leverage to a level where we have maximum flexibility to continue diversifying the business. This means generating cash in the short term and optimizing our balance sheet. I've previously mentioned my discomfort with our debt cost. We have ways to address that, but the current high-end markets have been somewhat unpredictable. Therefore, our top priority is to reduce indebtedness. Our second priority is to maintain excess capital for potentially beneficial transactions, allowing for maximum returns from those opportunities. If we aren't able to achieve these first two priorities, we can then consider dividends or share repurchases. However, we need to progress through these steps and accumulate sufficient cash before starting those actions. I hope this clarifies our approach.

Brad Archer, President and Chief Executive Officer

The only thing I would add there, all the things Eric mentioned is none of them are mutually exclusive, right? With the cash we're going to generate over time. There's multiple things at once that we could go after to maximize shareholder value.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

I wouldn't say that there is a priority over either two of those at this point.

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, President and Chief Executive Officer

Thank you. Before we close, I would just like to give a big thank you to all of our dedicated Target Hospitality team members. Without you leading the way every day and taking care of our customers, we would not be able to deliver the record-breaking results we did today. Thank you again for your business or your relentless dedication to each other and for what you do every day. It’s very appreciated. With that said, I would like to thank all of you who joined the call today and we look forward to speaking again in November. Operator, that concludes the call.

Operator, Operator

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