Dexterra Group, Inc. (OTCPK:HZNOF) Q3 2022 Earnings Conference Call November 9, 2022 8:30 AM ET
Company Participants
Drew Knight – CFO
William McFarland – Independent Chair
John MacCuish – CEO
Conference Call Participants
Aaron MacNeil – TD Securities
Chris Murray – ATB Capital Markets
Zachary Evershed – National Bank Financial
Frederic Bastien – Raymond James
Jonathan Goldman – Scotiabank
Trevor Reynolds – Acumen Capital
Operator
Good morning, and welcome to the Dexterra Group Third Quarter Results Conference Call. All participants will be in listen-only mode. [Operator Instruction] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Drew Knight, CFO. Please go ahead.
Drew Knight
Thank you, Kate, and good morning. My name is Drew Knight, and I am the Chief Financial Officer of Dexterra Group Inc. With me today on the call are John MacCuish, CEO; and our Board Chair, Bill McFarland, who will provide some brief introductory comments. The format of this conference call will be the same as our past calls. After a brief presentation, we will take questions, with the call ending by 9:15 Eastern Time.
We will be commenting on our Q3 2022 results with the assumption that you have read the Q3 earnings, press release and MD&A and financial statements. The slide presentation which supports today’s comments is posted on our website, and we encourage participants to access the slides and follow along with our presentation.
Before we begin, I would like to make some comments about forward-looking information. In yesterday’s news release and on Slide 2 of the presentation that we have posted to our website, you will find cautionary notes in that regard. I won’t read the content of the cautionary notes in their entirety. We do claim in there protection for any forward-looking information that we might disclose on this conference call today.
I will now turn it over to Bill McFarland for his introductory comments.
William McFarland
Thank you, Drew, and welcome. Q3 was a solid quarter with good revenue growth and improved earnings. As our regulatory filings noted, we also took steps in Q3 to strengthen our foundation in each of our business units. These actions position us to adapt to the challenging business environment uncertainty that all businesses face today, with high inflation, rising interest rates and challenges in attracting and retaining people.
Our actions also included completing the transition and integration of the IFM acquisitions completed earlier in the year, executing on the 4 point improvement plan in the Modular business unit, proactively managing inflation and strengthening our senior management team. Our financial position is also strong and this will allow us to take advantage of opportunities in the market in the future.
To be clear, Dexterra’s goals have not changed. Our focus is on building a profitable, long term sustainable business. And in the short term, we are and will continue to take actions to proactively manage inflationary pressures, improve margins and drive profitable revenue growth.
I will now pass it over to John MacCuish to provide some more details on our results and actions.
John MacCuish
Thank you, Bill. Good morning. Our Q3 revenue was $260 million and adjusted EBITDA was $20.1 million. Revenue increased $57 million, or 28% compared to the same quarter in 2021. All three business units had good revenue growth year-over-year. Additional revenue of $25 million was generated through the IFM acquisitions in Q1 of this year, continued high activity levels in natural resources benefited the loss business and we had greater throughput in the Modular business.
Inflation, recent disruptions to supply chain and hiring and retaining talent continue to be our most important challenges. Inflation over the quarter on food was 6%, janitorial supplies 10%, building materials 5% to 20%, subcontractors up to 30% increase. So what steps have we taken?
Our supply chain team have increased the number of approved vendors and consolidated spend to drive improved volume discounts. Our culinary team are active in menu management, ensuring high quality meals with the best cost inputs. Our operations teams are engaging clients to ensure inflation clauses in contracts are enacted as well as collaborating on service and delivery levels that meet client affordability.
In the Services business, IFM and WAFES’ inflation cost us roughly 2 points of margin. On the people front, we continue to have strong employee engagement, driving retention. Our employee referral program is active and successful, and we have significantly reduced the number of vacant positions.
We are also executing the business improvement plan for our Modular Solutions business unit, resulting in a return to profitability for the business during Q3, with further margin improvements expected in upcoming quarters. Margins are expected to normalize by mid-2023 as we work out the backlog of existing fixed price contracts.
I’ll now dive into some more details by business unit. Starting with IFM, this business unit increased revenue from $39 million to $71 million in Q3 2022 compared to prior year. This increase is largely related to the Q1 acquisitions, but also includes new business wins that contributed $5 million of revenue in Q3. That’s $20 million annually.
Our airport business also saw an uplift from prior quarters and the IFM team renewed several contracts, including the Greater Toronto Airport Authority, which is a significant contract and a strategic partner for Dexterra.
Last quarter, we announced the appointment of Sanjay Gomes as the President of our IFM business. Sanjay has conducted reviews of the two IFM acquisitions completed in Q1 2022, completed transition plans, which include bringing them on our systems, reducing overhead costs, reviewing and acting on non-profitable contracts. With that review completed, those businesses will have strong margins.
Dana Hospitality also had lower margins due to the seasonality of education business in the summer months. This business has fully rebounded this fall to post-pandemic levels. The IFM business also has a good pipeline of opportunities, and the ongoing focus is winning new work that is profitable and with contractual terms to deal with inflationary pressures.
Moving over to WAFES. Q3 2022 revenue grew to $132.6 million, which is up 12% compared to the same quarter in 2021. WAFES revenue performance is strong due to the $7 million increase in catering infrastructure installs and rental activities in Western Canada, which resulted in increased occupancy utilization across all services and a $7 million increase in energy services revenue mostly from higher access matting activity.
The overall increase was achieved despite a $4 million reduction in fire support activity in 2022. This growth reflects our strong brand and high service levels of WAFES and included $10 million of revenue from forestry seasonal activity in Q3.
The Modular Solutions business grew Q3 2022 revenue to $54.5 million compared to a revenue of $45.1 million in the same quarter in 2021 and exceeded Q2 levels. During the quarter, we also announced the appointment of Robert Johnston as our new President of Modular Solutions.
We’re very excited to have Rob join our executive team. Rob’s wealth of project and construction industry expertise and business acumen are valuable additions to the team. He is focused on expanding the modular client base through product and end market diversification.
The 4-point plan had an initial goal of returning the business to profitability in Q3 2022, and that was achieved. U.S. destination supply projects now represent 15% of the total revenue for the business unit, also help utilize our plant capacity and generate growing revenues in Q3. This product diversification reduces our revenue concentration risk.
However, social affordable housing will continue to be an important part of the business, especially as governments continue to support funding of these projects. Our modular backlog is over $200 million. The backlog increase of $30 million from Q2 2022 is associated with the growth of our U.S. supply only business, which will also benefit from the strengthened U.S. dollar.
I’ll now turn it to Drew for comments on our financial position.
Drew Knight
Thank you, John. I’ll discuss the EBITDA by business unit, our financial position and some other general comments, as John has already taken you through revenue.
Starting on Slide 10, our IFM EBITDA margin was 4% for Q3 2022. The decrease in margin is primarily a result, as John explained of completing the transition and integration plan related to the IFM acquisitions and includes the impact of the seasonality in Dana’s education sector. These activities had a $1.5 million impact or about 2 points of margin.
IFM also encountered continued inflationary pressures for which there is a lag in passing on cost to the customer. A number of significant contracts reach their anniversary dates to pass costs on later in the quarter. Margins are expected to improve significantly in Q4 of 2022.
The WAFES business had adjusted EBITDA in Q3 2022 was $20.9 million, which is up by $4.6 million compared to Q2 2022 and was consistent with Q3 2021. The revenue increase in Q3 2022 when compared to Q3 2021 is primarily due to contract wins during 2021 and 2022, which were profitable, but were offset by lower forestry and fire support business in 2022 and the impacts of inflation.
Management continues to manage the inflation impacts on this business unit, but there are timing delays in our ability to pass costs on to customers. There was also strong profitability in Energy Services from higher mat volumes and install work in Q3. The 2021 results also included some sales of excess camp equipment, which contributed to its profitability.
The Modular Solutions business had an adjusted EBITDA of $0.9 million compared to a loss of $3 million in Q2 2021 and a profit of $2.8 million in Q3 2021. The Q3 improvement was the result of the execution of the business unit turnaround plan with contract pricing adjusted for inflation where possible, better project management and higher plant efficiencies.
New contracts have terms to manage inflation risk. We had planned for a return to profitability in Q3 and expect gradual margin improvements in upcoming quarters with normal margins expected to return by mid-2023 as older fixed price contracts are completed.
Looking at Slide 11. The corporation’s financial position and liquidity remains strong, with debt reduced to $111 million and Dexterra has $77 million of unused capacity on its credit lines at September 30, 2022. The debt reduction was assisted by a significant reduction in working capital. This reduction is expected to be sustainable as we work towards — as we worked actively with clients to reduce days sales and receivables.
Leverage is down significantly over the past two years and we continue to manage our debt levels in this uncertain business environment. The conversion of EBITDA to free cash flow for 2022 is expected to exceed 50%. Dexterra Group also declared a dividend for Q4 2022 of $0.0875 per share for shareholders of record at December 31, 2022, to be paid on January 16, 2023.
I will now return it back to John for closing comments.
John MacCuish
Thank you, Drew. As we look to the future, the focus of the IFM business is on our organic profitable growth and margin improvement. Margins will increase with contract pricing adjustments and cost management initiatives for labor and material, which will be realized in upcoming quarters.
We are also looking opportunistically at tuck-in acquisitions. WAFES is expected to remain strong and will be buoyed by solid natural resource activity levels in upcoming quarters with high demand for goods and services in our Energy Services division. The Crossroads Lodge in Kitimat, BC had limited occupancy in Q3.
We do not expect a significant increase in its occupancy levels in Q4 2022. We continue to proactively monitor the situation with LNG Canada, and we’re looking to increase occupancy via other regional clients. In Modular, it’s all about executing the business improvement plan and bringing our margins back to normal levels.
Overall, Dexterra’s management team is focused on the hiring and retention of people, as people are our most important assets. Proactively managing inflation and maintaining our strong financial position will provide us with flexibility to take advantage of opportunities as we manage in these uncertain business environment.
In conclusion, we have lots of positive momentum and we’re well positioned for the future. This concludes our prepared remarks for today. At this time, I’ll turn the call back to our Operator for the Q&A portion of the call. We ask that you begin by limiting yourself to two questions. If we have time at the end, we will circle back for additional questions. Thank you for joining us today. Please go ahead, Operator.
Question-and-Answer Session
Operator
We will now begin the question-and-answer session. [Operator Instruction] Our first question is from Aaron MacNeil of TD Securities. Please go ahead.
Aaron MacNeil
Good morning, all. Thanks for taking my questions. What are your updated views on sort of the cyclicality of your energy-weighted businesses, Energy Services and matting in particular? And what sort of expectations do you have looking into 2023? I mean, do you see the continued strength in the energy sector as an opportunity to divest of these businesses, to fund your acquisition strategy in IFM?
Drew Knight
Well, I think, Aaron, the Energy business is strong as you note and we see volumes continuing to be strong through 2023 and for the foreseeable future. Certainly, we’re well aware of the cyclicality of the business. And we are focused on acquisitions for IFM, as you know. But at the moment, we’re not actively looking to market any of these businesses.
Aaron MacNeil
Okay. Can you walk us through what — switching gears to IFM, I guess. Can you walk us through what a recession might mean for IFM on the revenue side? How resilient do you think the revenues are too broadly reduce economic activity. And then on the flip side, do you see a potential for a recession to act as an opportunity for some relief from inflationary and wage pressures?
John MacCuish
I’ll try that on, Aaron. Look, we’re very strong on the IFM business. I think revenue-wise the inflationary environment we’re in does cause clients to rethink how they deliver certain services in their buildings, in their infrastructure. So we’re not anticipating any dullness around the revenue at all. In fact, there may be opportunities to deliver a better solution for clients. Obviously, on inflation, I mean, there’s a body and knowledge out there that indicates this could go on for a while. No one really knows. And we’re just going to continue to do the things that I talked about.
We’re going to focus on our contracts and make sure that the terms in any new contracts are contemplating inflation at a brisk rate. We’re going to continue with our client engagement to ensure that we’re meeting a scope that works for them and their affordability. And then, of course, obviously strategic supply chain will continue to be a strong initiative for us. So I think we’re well positioned to work through these inflationary times. Still lots of uncertainty, but we feel we’re equipped to carry on in that environment successfully.
Drew Knight
Yeah. Aaron, I think I’d add to that. Our IFM business is a very resilient business and a recession certainly would be concerning, but it’s not a huge impact for — on our IFM business. We don’t expect — it’s nothing like COVID was a couple of years ago, right?
Operator
The next question is from Chris Murray of ATB Capital Markets. Please go ahead.
Chris Murray
Yeah. Thanks. Good morning, folks. Drew, you made the comment that you thought that margins in IFM would be materially higher, I guess, in Q4 and in the ’23. Can you talk a little bit about — and maybe go back just so I understand, what’s the bridge between where you were for Q3 to what you think will be materially higher? And I guess maybe to frame this in maybe a different way. Does materially higher get you back in that 7% to 8% range that you’ve historically talked about for IFM?
Drew Knight
Yeah, Chris. I think you’ll see in the material and in the script, we mentioned there was a $1.5 million charge in the quarter, and that really bridges us back to pretty close to those historical rates. The education sector on one of the acquired businesses was a big impact in July and August. We did a lot of work to remediate that business and we’re expecting a big bounce back. And it seems like the education sector in 2021 wasn’t terribly — it wasn’t back to pre-COVID levels, but in 2022, it’s back to pre-COVID levels. Like all the residences are back, all the private schools are back. And that’s a big piece of the acquired business.
Chris Murray
All right. So there’s nothing getting us back to where you guys had talked about in that range. And then John, just in terms of contract structure, is there a chance to put CPI inflation or anything like that kind of midyear into these contracts or is this something that’s only revisited annually? Can you just kind of maybe walk us through the structure of how you’re going to get some of this cost recovery?
John MacCuish
Right. So historically, the CPI or inflationary clauses were annually — annual. We’ve been living for the last 12 years with in a different environment. And I think when I say the client engagement, that’s exactly what I’m talking about. Annual isn’t enough right now and it’s that client engagement. Whether it’s in the contract or not, we’re making overtures to clients, sharing the facts, co-opting them into the discussion. Take an example. In IFM, labor is a big component, is a big input to cost.
And clients know in their facility that employees are feeling the pinch of inflation and affordability for their own families. So clients are willing to talk about how we might deliver our fund pressures on wages. And clients have the same issues we have. So it’s not like we’re trying to introduce a new dimension here. They’re living with it in their own business and they’re quite aware of what we’re all dealing with. And to be honest, we have great client relationships. And thank goodness we do, because this is the time when you need to rely on those relationships. I hope that answers the question.
Operator
The next question is from Zachary Evershed of National Bank Financial. Please go ahead.
Zachary Evershed
Good morning, everyone. Thanks for taking my questions. The backlog increase in Modular of almost $31 million from Q2 is associated with continued federal funding for rapid affordable housing. And you say that may be impacted by large projects. Can we get a clarification on that phrasing? Like, what’s the implication of maybe impacted by large projects?
Drew Knight
Yeah. I guess it’s just — it’s a lumpy thing. And to be honest, we weren’t expecting growth in the backlog in the current time frame. But a couple of contracts came through that were over $20 million for the coming periods, and that impacts that backlog pretty significantly. So if there’s not those big lumps coming through in the future, the backlog will oscillate up and down. And also, the U.S. business has been strong for us, I think, we mentioned. So most of our contracts are in Canadian dollars. We do benefit from the exchange rate even if it is in Canadian dollars when we’re selling. So that’s been helpful for the last nine months or so.
Zachary Evershed
Got you. Thank you. And then do you still believe EBITDA margins for the Modular segment can reach 3% to 4% in the back half of the year and is normal EBITDA by mid-2023 still around 6% in your mind?
Drew Knight
Yeah. I think we’re looking at gradual improvements. And the EBITDA for Q3 was about 2 points for Modular. And we’re thinking it’s going to add a point every quarter as we go forward. And then, by mid-2023, we’ll be back to that 6% or 7% range.
Operator
[Operator Instruction] The next question is from Frederic Bastien of Raymond James. Please go ahead.
Frederic Bastien
Drew, you partly answered some of those questions. But there’s obviously confidence in your ability to bring margins back to — or to have the margins normalized by the middle of next year. But can you remind us exactly what normal margins look like by segment? I think it was 7%, 8% — 7% to 8% in facilities management. But what are the other two?
Drew Knight
Yeah. Sure. So IFM, yes, we’re targeting to be a little over 7%. Modular is really north of 6% and could be over 7%. And then the WAFES business usually sits around 15%. So that’s generally where we’re at. But we are watching inflation in all those businesses. So it does — with those timing delays that we articulate, it does fluctuate by a point or two till we get that stuff digested. Yes, that’s it.
Frederic Bastien
Understood. Can you discuss the occupancy delays at the Crossroads Lodge? Obviously, you were pointing to, I think, a faster ramp up. What’s behind the delay? Is it client driven? Just curious about that, if you could provide more color?
Drew Knight
Yes, it’s something outside of management’s control. But maybe I’ll let John take it.
John MacCuish
Yeah. Just to give you color around this. Obviously, it is associated with — our big client for this camp would be LNG Canada. It’s impacted by ramp-up on the project, labor shortages, et cetera. So we’re staying very close to that client. And we don’t know — we’re not in total control of this. We are active around other regional opportunities. And the key here is Crossroad continues to be an opportunity and an upside for us.
Drew Knight
Yeah. Like Crossroads was essentially breakeven in Q3 this past quarter. So we’re looking at other regional players, and there are a few other regional players that will give us upside from our Q3 results. And then anything that comes from the construction of the LNG facility is upside as well.
Operator
The next question is from Jonathan Goldman of Scotiabank. Please go ahead.
Jonathan Goldman
Hey. Good morning, guys. Just a clarification question. The $1.5 million impact in IFM on profitability, were there three causes to that or two? I think — I’m just trying to clarify between the script and the press release.
Drew Knight
Yeah. It was mostly fixated on the two acquisitions. So as we integrated and transitioned those businesses, there were some costs getting them onto our systems and getting the accounting straight for all the transactions and activities and then also taking a look at their contracts. They were sort of getting new information as they adapt to the way we run our businesses and data is powerful. And so we see that we saw some contracts that were underwater.
And in a post-COVID world, some of those contracts just never really came back to where they were before. So it caused us to get them to talk to their clients and either adjust the contract or potentially walk away from some business. So in the summer months, especially in that education sector, there were some big losses in July and August that now we’ve reconciled and fixed. So I think the $1.5 million is a non-recurring thing that should come back.
Jonathan Goldman
Okay. That makes sense. So just — I guess, along those lines, I guess, if you were to normalize for that 1.5% IFM margins, I guess, by my math would be 6%. I guess some more pass throughs are going to kick in, in Q4. Would the 6% be a good baseline to then model some improvement on top of that going through the back half — or rather last quarter of the year?
Drew Knight
Yes. That’s — you hit the nail on the head. That’s the way we’re viewing it in the short term, in the next couple of quarters. But we are targeting to get back north of 7% in a few quarters from now.
Operator
The next question is from Trevor Reynolds of Acumen Capital. Please go ahead.
Trevor Reynolds
Good morning, guys. You guys walked through some of the inflation numbers that you guys have seen. And just wondering, have those levels moderated in Q3 or they can — sorry, into Q4. Have — what are you seeing on that front across the board?
John MacCuish
Yeah. Look Trevor, this whole inflation situation is very fluid. It’s driven by all kinds of influences. We’ve seen up, we’ve seen down. We’ve seen building supplies skyrocket up six months ago and then come back down a bit, only to go back up again. So we are monitoring everything as closely as we can. The actions we’re taking are the things that we have control over.
So we have control over our client contracts and our engagement with clients around recovery. We have control over our strategic supply chain so that we can consolidate spend with fewer approved vendors and drive better volume discounts. We can control our inputs. So that’s why I spoke about our culinary team doing menu management so that we make the best of the situation. So hard for me to answer that. I think we don’t expect it to be larger, let me say that.
Trevor Reynolds
Okay. That’s fair. And then, obviously, subcontractors is a big portion of that. Are you getting enough labor that you’re seeing that the amount of subcontractors that you have to use come down or where does that sit?
John MacCuish
Yes. I wouldn’t say that we’re at that point. Because look, to be honest with you, these are trades positions. Our subcontractors are around license, HVAC technicians and other trades people. And just read the literature out there. There’s a lot of demand and a lot of shortage. So we’re being very attentive to this.
So around recruiting, we’ve got a higher referral bonus inside the company for trades people to kind of entice in our employee network to attract people. So we’re constantly looking at the value of self-delivery versus subcontractor. And we’re hoping that as we get our staffing to higher levels, we’ll be able to be less dependent on subcontractors.
Operator
The next question is a follow-up from those Zachary Evershed of National Bank Financial. Please go ahead.
Zachary Evershed
Just a quick follow up on the integration cost in the quarter, the $1.5 million. Would those in line with your expectations? And what were they attributable to? What integration activities were they for?
Drew Knight
Yeah. Hi, Zach. It — we knew we had issues coming up. It was probably similar with what our plans were. But it was mostly getting both of those businesses on to our systems, getting them used to certain business administration practices like issuing POs, et cetera, and also getting their contracts buttoned down. So there’s a lot of contracts that have been changed in a post-COVID world. The way hospitals operate is tremendously different.
It hasn’t really come back from COVID the way the rest of the world has. So some of those contracts are in a very challenged position. So we’ve — with more data from our systems — maybe the businesses were flying blind a little bit, they’ve realized there’s a few contracts that were underwater. And now we’ve had to reconcile those contracts, go back to the client and either restructure or jettison (ph). So we do think it’s a one-timer.
Zachary Evershed
And that answers my next question. Thanks very much.
Operator
This concludes our question-and-answer session and today’s conference. Thank you for attending today’s presentation. You may now disconnect.
Drew Knight
Thank you.
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