DIRTT Environmental Solutions Ltd. (NASDAQ:DRTT) Q4 2022 Earnings Call Transcript

DIRTT Environmental Solutions Ltd. (NASDAQ:DRTT) Q4 2022 Earnings Call Transcript February 25, 2023

Operator: Thank you for standing by. This is the conference operator. Welcome to DIRTT Environmental Solutions’ Fourth Quarter 2022 Financial Results Conference Call. I would now like to turn the call over to , Director. Please go ahead.

Unidentified Company Representative: Thank you, operator, and good morning, everyone. Welcome to today’s call to discuss DIRTT’s fourth quarter 2022 results. Joining me on the call today are Benjamin Urban, DIRTT’s CEO; and Brad Little, CFO. Today’s prepared remarks are accompanied by presentation slides. To access the slides, please view them from the web page of this webcast or on our website at dirtt.com. Today’s call will include forward-looking statements within the meaning of applicable Canadian and United States securities laws. These statements are based on the company’s current intent, expectations and projections. They are not guarantees of future performance. In addition, this call will reference non-GAAP results, excluding special items.

Please reference our Form 10-K as filed on February 22, 2023, with the Securities and Exchange Commission, or SEC, and other reports and filings with the SEC for information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results. I will also remind you that this webcast is being recorded, and a replay will be available tomorrow. I now turn the call over to Benjamin.

Benjamin Urban : Thank you, , and good morning, everyone. It is my pleasure to be joining you today and to share the highlights of a very productive fourth quarter, closing out a challenging 2022, a year of turnover, market volatility and disruption. It has been a particularly challenging year for our people, our partners and our key stakeholders. On behalf of my entire leadership team, I want to personally thank all of you for continuing to support us through this year of great change and transition. Before I talk about the fourth quarter, I want to reflect on some of the critical observations I’ve made over my first 2 full quarters with the company. First, over the years, it is clear that we had gotten away from the emphasis we have historically placed on innovation and the importance it has played in the success of DIRTT.

Innovation is very much a participation sport, and we are getting back to a place where our customers and construction partners play an active role in our innovation of the solutions our ecosystem relies on. Second, if I look back at the key decisions that have been made over the past several years, the ones that have been most successful are the decisions that were made in the spirit with which DIRTT was created. DIRTT was created in the spirit of adaptability, flexibility, customization and removing risk from construction. We continue to provide solutions that support a rapidly changing workplace, a changing health care and education landscape. No one knows what the future holds, but we pride ourselves in supporting our end users through whatever comes their way.

In retrospect, some of the decisions made were not in service to this core principle, and we learned a tough lesson from that. And we will apply those lessons learned to future decisions and strategy. Lastly, maybe my greatest observation is the resiliency of our people. They have remained patient and loyal to DIRTT and our founding vision through so many changes and challenges. Our people are our most valuable resource and are the single biggest reason we will be successful as we continue to improve for years to come. Turning to our fourth quarter performance. The improvements we made in the business earlier during 2022 paid off and improved financial results during the quarter. On our last call, we indicated that we had line of sight to cash flow and adjusted EBITDA breakeven during the fourth quarter, and that is exactly what happened.

As Brad will outline, we achieved positive adjusted EBITDA and an increase in cash flow from operations during a quarter for the first time since 2020. We continued our world-class safety record with 0 recordable incidents during the fourth quarter, finishing the year with a total reportable incident frequency rate of 0.1. This equates to about 1 recordable incident every 2 million working hours. I have been amazed at the commitment from everyone in the organization around keeping our team members safe. On the commercial side of the business, we have added new construction partners and are further expanding and refining both our sales channels and go-to-market strategy. We continue to see adoption of our solutions within some of the most prestigious and recognizable companies like Visa, Google and Frost Bank of Texas, among many others.

We are gaining strategic advantages through collaboration with our construction partners in both innovation and efficiency, and this is resulting in a healthier sales pipeline. We see great opportunity for growth in 2023 and beyond, and we are channeling resources directly at our commercial organization in order to do that. We are operating with a high sense of urgency and recognize that time is of the essence. It is that vein that we have announced certain staffing changes and realigned responsibilities in order to maximize efficiency and direct communication to our people, construction partners and end customers. I am personally leveraging my experience and will be taking on an even more active role in our commercial organization to help drive top line growth.

I have also been actively involved with our partner success team as we continue to bolster that group with successful DIRTT veterans that also know our business intimately. From an operations standpoint, our team members in both Calgary and Savannah are hard at work improving production efficiencies and quality while mitigating against rising supply chain costs and overtime rates during the fourth quarter. Our improved gross margin is as much about their performance as it is from the pricing actions taken over the past year. While we have not restarted operations at Rock Hill, we continue to maintain that facility and are actively monitoring demand levels in 2023 and 2024. We believe that this facility supports a critical aspect of future expansion and growth.

We remain committed to our sustainability journey and our ESG commitments. We strive to build a better world, both through our products and by leveraging our solutions to help our customers achieve their sustainability commitments. We know that our proactive and transparent approach to establishing, measuring and reporting on ESG factors impacts our bottom line. This year, as we publish our third annual ESG report, we celebrate our second IR Magazine nomination for the best ESG reporting by a small cap award. I would like to emphasize that we are never satisfied with our performance, be it safety, optimization or profitability. With a full quarter to measure and observe the effects of our changes made in Q3, it has aided in further illuminating areas for additional refinement or alternatively required investment.

Some of these changes have already been implemented at the beginning of Q1 2023 as we continue to move with precision and haste in tight alignment with our Board of Directors. The continued increase in the understanding of underlying factors that drive our cost, efficiency and pipeline further direct our investment in resources. Even with reaching positive adjusted EBITDA and operating cash flow in the quarter, we continue to be relentless with strategic initiatives to further improve our balance sheet as well as provide additional investment for growth. More so than financial results, our performance is continuing to build increased trust and credibility with our construction partners, customers and employees. This renewed stability provides us with a solid operating platform for 2023 to both drive organic growth and implement our planned strategic initiatives.

I am excited about the future of DIRTT and the opportunities in front of us. I’ll now turn it over to Brad to discuss our financial results in greater detail.

Bradley Little : Thank you, Benjamin, and good morning all. As is customary, we have issued a press release discussing our fourth quarter results and have provided additional analysis in a supplemental presentation, which is now posted on our website. My comments this morning are designed to add additional color on our financial results for the quarter and update you on the progress of the various liquidity initiatives we discussed last quarter. Revenues for the fourth quarter were $42.4 million, in line with prior year. As expected, revenue during the fourth quarter reflects virtually all of the price increases we have implemented over the previous 15 months. Revenue declined 9% compared to the third quarter of 2022, driven by a reduction in volume, offset by favorable impact from pricing.

The volume decrease is primarily the result of a normal seasonal pattern of shipments and order pace slowing around the major holidays in the U.S. and Canada in the last 2 weeks of the fiscal year. This impact was muted during 2021 due to price increases announced early in the fourth quarter of 2021, which motivated our customers to accelerate delivery of materials to avoid the increases. Turning to gross profit. We continue to see meaningful expansion in gross profit margin. Compared to the fourth quarter of 2021, gross profit margin increased 770 basis points from 19.6% to 27.3% in the fourth quarter of 2022. Similarly, adjusted gross profit margin, which excludes the impact of depreciation, increased 670 basis points from 25.3% in the fourth quarter of 2021 to 32% in the fourth quarter of 2022.

Compared to the third quarter of 2022, gross profit margin increased 1,232 basis points from 15% to 27.3% in the fourth quarter of 2022. Adjusted gross profit margin increased from 21.7% in the third quarter to 32% in the fourth quarter of 2022. The improved margin is due to the realization of the price increases just discussed and cost reduction initiatives executed during the second and third quarters. Additionally, we are continuing to see sequential quarter improvement in manufacturing efficiencies despite lower volumes during the fourth quarter of 2022. Regarding operating expenses, we saw, again, decreases across all of our normal back-office operating expense line items, mostly from the cost reduction initiatives implemented throughout 2022, but also due to more disciplined discretionary spending.

From January 2022 through January 2023, the company has reduced production overhead and G&A headcount by 111 or 20%. As Benjamin mentioned previously, we achieved adjusted EBITDA for the first time since the third quarter of 2022. Adjusted EBITDA for the fourth quarter improved to $600,000 from a $9.7 million loss in the period of 2021 and a loss of $5.4 million during the third quarter of 2022 despite approximately 15% lower volumes in both comparable periods. The improved profitability has been driven by the reduction in operating expenses and improvements in gross profit margin just described, all while still delivering at our historical short lead times. You can find further detail on these as well as other financial information in our supplemental presentation, which again is published on our website.

Turning to liquidity. When I came on board, I indicated there was no larger priority than strengthening our balance sheet through improved financial results and implementing a number of strategic initiatives to drive improved cash flow. We finished the year with $10.8 million in unrestricted cash, up $4 million from $6.8 million at September 30, 2022. Cash provided from operations for the fourth quarter was $3.2 million compared to cash consumed by operations of $10.7 million during the third quarter of 2022 and $7.3 million in cash consumed by operations during the fourth quarter of 2021. This marks the first time we have delivered sequential quarter improvement in cash flow from operations since the third quarter of 2020. The improvement from September 2022 was driven by a combination of improved profitability, the cash proceeds from the private placement offering announced in November and increased rigor around our working capital management program.

Liquidity, which includes our availability under our ABL credit facility, was $16.1 million at December 2022, up $300,000 or 2% from September 30, 2022. The improved cash and liquidity at December 31, 2022, is particularly important as we shift into a seasonal period with increased cash and working capital requirements. Net working capital at the end of the quarter was $26.1 million or even with September 2022. Availability under our ABL facility was $5.3 million at the end of the quarter. We did not need to draw on that facility in the fourth quarter and have not had to thus far in the first quarter of 2023. Also of note, earlier in the month, we completed an extension of this facility through February 2024 with similar terms, giving us flexibility as we expect to invest in working capital as volumes and revenues improve.

Availability under this facility is expected to range between $5 million and $15 million during 2023. I also wanted to update you on the cash initiatives I discussed with you during our third quarter call. First, during the fourth quarter, we implemented certain customer-friendly incentives for those customers in good standing, including the ability to take advantage of modest discounts for early payment of receivables. This program contributed an incremental $2 million in cash to our fourth quarter while only impacting revenue by approximately $50,000. Second, during the third quarter of 2022, we recognized a tax receivable of $7.1 million associated with the Employee Retention Tax Credit program in the United States. This remains accrued at December 31, and we expect to receive this in 2023.

We are continuing to evaluate certain company-owned properties from a sale leaseback or sublease standpoint. We made meaningful progress on 2 such properties to date and expect to have resolution on one or both of them as early as March. As a reminder, we do not intend to vacate these premises as they still serve a critical aspect of our value proposition. Lastly, we are continuing to evaluate multiple strategic initiatives to advance DIRTT’s long-term vision around the ICE platform. We have also made progress on this initiative during the fourth quarter and expect our evaluation to be completed within the next 90 days. Collectively, we expect these initiatives to generate meaningful cash flow during 2023 as early as the second quarter. Turning to 2023.

Our 12-month forward sales pipeline at January 1, 2023, was $391 million compared to $311 million at January 1, 2022, or about 26% higher, driven by a combination of price and expected volume. In particular, we have seen year-over-year growth in projects at higher stages in the sales cycle, increasing the likelihood of ordering during the year. While we are encouraged by the pipeline growth, our order pace and quarterly revenue and supply chain forecasting continues to be challenged by high pushout rates and longer-than-normal engineering and design time associated with large and complex projects. We are closely monitoring our cost structure, including the underlying materials that comprise our products. Although we are somewhat insulated from the near-term effects from a potential recession in the United States or Canada as our pipeline is largely comprised of projects that have already started, we are susceptible to the inflationary impact of labor and commodity pricing, particularly aluminum and wood.

In response to the risks associated with these items, we have taken additional actions over the past two months that will reduce our annualized overhead cost by $3 million to $5 million. These cost reductions were related to efficiencies and streamlining our back office and operational support functions, not pursuant to a planned restructuring program. We are also evaluating certain instruments that will hedge against inflation and volatility associated with our primary materials. We believe that the combination of growth in our sales pipeline, the improved margins from pricing actions already taken and the reduced cost structure will set us up well to deliver year-over-year growth in revenue, gross margin and adjusted EBITDA during 2023. And now we’ll open the call for your questions.

Operator?

Q&A Session

Operator: And our first question is from Greg Palm with Craig-Hallum.

Gregory Palm : Congrats on the results. It’s been quite a long time since we’ve been talking about a profitable quarter. So kudos to you guys.

Benjamin Urban : Thanks, Greg.

Bradley Scott : Thank you, Greg.

Gregory Palm : My first question is just around that. I mean you achieved EBITDA profitability on a much lower revenue run rate than what I was expecting. So I guess, do you think that this level of revenue is now a better approximation of a breakeven point? I’m just trying to get a sense on how you’re thinking about sustaining profitability this year and going forward.

Bradley Little : Well, I’ll start and then let Benjamin kick in. No, the level of revenue here is not what we are — certainly not what we’re looking for. I think this was an inflection point where we’ve been able to implement the price increases, and we’re starting to see the efficiencies in our operations, our supply chain and our pricing and discounting structure. Our pipeline year-over-year has gone up 26%. And it’s the mix within the pipeline has a higher mix of products and projects that are further along in the cycle. So we do think we see growth in 2023. But for the — we don’t see costs going up commensurate with the revenue generation. Benjamin, do you want…

Benjamin Urban : Yes, sure. Greg, yes, just to add further to Brad’s comments, I think it’s very representative of what the opportunity is there for us that if we can break even at these revenue numbers, that means that as we continue to increase conversion rates and organically add growth in the pipeline, the ability to handle that additional capacity isn’t around retooling, it’s more around adding additional ships and whatnot to satisfy that. So to Brad’s point, the increased pipeline over last year and then anything organic on top of that is what we’re expecting.

Gregory Palm : Got it. So I mean just to be clear, if you’re expecting a little bit of a revenue bump in this year relative to what you just reported in Q4, there’s no reason why you shouldn’t see sort of a similar bump in EBITDA relative to what the levels you just reported. Just want to make sure that that’s clear.

Bradley Little : Yes, that’s right. And I think the larger issue is the leverage from our cost structure that we’ve taken out. I think as volumes improve and clearly, from a pricing and revenue standpoint, we feel very confident in our pricing, you will start to see better leverage of our fixed cost structure without meaningful investment in that structure as revenues increase.

Gregory Palm : Yes. Okay, makes sense. I mean just big picture, you alluded to the pipeline, pretty solid growth year-over-year. I don’t know, maybe just touch on the value proposition of your solution in today’s world. I mean it feels like to me there’s some, I don’t know, new tailwinds that are emerging or at least getting stronger on the sort of post-COVID, post supply chain mess of a world. I mean do you have any thoughts, maybe just a little bit more on kind of the makeup of the pipeline and some of the drivers behind that?

Benjamin Urban : Yes, sure, Greg. You’re absolutely right, I think if you unpack that 2 ways, one is the diversification of the pipeline where we’re seeing year-over-year growth from different verticals, be it — not just commercial, but in health care as well as government and education. Those help bolster the pipeline over the next 12 to 18 months. But additionally to that, in your comments around some kind of higher-level discussion on post-COVID, if you will, every value proposition that DIRTT provides is in direct support of derisking everything that we do, be it price certainty, be it lead times, be it ability to change. And I think that’s probably the biggest thing that has been embraced out of all of the values that there are circling DIRTT is the unknown, right?

So being able to basically plan for not knowing what’s coming and using DIRTT to do that, before the pandemic, it wasn’t painful enough with general construction. We’ve come full circle, and now the value that’s there is much more amplified.

Gregory Palm : Do you have evidence that some of the pipeline activity is directly attributable to stuff like that? I don’t know if you’ve got any description of what’s in the pipeline. Is it mostly customers you worked with before? Or is it new customers that are looking at really how they sort of change how they procure this stuff in a post-COVID world?

Benjamin Urban : Yes, Greg, I think it’s twofold. One is return and repeat customers, clearly, that understand the value of DIRTT, and so they continue to utilize us as a construction solution. And that tends to be many times some of the larger customers that we have national accounts with that we can depend on. But further to that, I’d say what’s interesting within the pipeline is the conversion from companies that may have maybe only looked at us for acoustic reasons or aesthetic and maybe not the full solution that DIRTT provides. Now entertaining or investing in, okay, we understand now that we’ve lived through having to reconfigure or uncertainty, we’re going to invest more with DIRTT. And essentially those projects that may have been, just speaking rhetorically, $100,000 in product are now $200,000 because they have a full solution associated with them with our solid partitions, modular power, raised flooring, et cetera.

Gregory Palm : Interesting. Okay. Maybe I’ll ask a couple more. I know it’s maybe too early to talk about long-term targets, but I’m going to try anyways. Do you just have any thoughts around long-term aspirational goals, whether that’s revenue growth, earnings power? Just give us some idea on how you’re thinking about the trajectory of this business over the next 3, 4, 5 years.

Bradley Little : Yes. Benjamin, do you want to start kind of on the aspirational, and I can layer in a financial overture as to what that would mean from a profitability standpoint.

Benjamin Urban : Yes, great. Yes, Greg, from a longer-term perspective, we touched on it a little bit at the beginning of the call, but some of the redirection of resources that we’re applying towards growth really around the commercial organization. We’ve got a good handle on the operational side. We’re back to regular lead times. Clearly, we’ve got sufficient capacity, and we can satisfy the demand that’s coming in strategically from long-term growth and how do we increase conversion rates within the pipeline, how do we add top line growth. I touched on how do we increase scope on those projects that we have. A lot of that is things that we can affect internally, but also I’d say that we’ve proven that we’ve been at $300 million before, right?

And so year-over-year growth, not saying we’re going to be there that fast, but we do have, by adding and diversifying our construction partners in markets which were under-serviced previously, that applied with strategic channels for additional top line revenue growth that had previously not been entertained is also opening up some windows to revenue that we, in the past, weren’t able to actually even participate in. So if you layer those two on top of each other where you have some standard growth just through the base distribution construction partner model and then layer on some additional revenue channels to us, those two things alone will help us with that long-term growth that’s sustainable to also assist on the manufacturing capacity side.

Bradley Little : Yes. And what I would say is in the first 6 months of being at the company alongside Benjamin, being blessed with a really strong finance team has really helped me get out onto the road. So we’ve been engaging with customers and end users and partners at a very deep level. And it’s really clear that it’s very important that we rebuild the trust with our partners, our people and our key stakeholders. And as we return to levels of revenue generation that we’ve demonstrated previously, it’s really imperative that we’re doing what we say we’re going to do. We’re reconnecting, better understanding the partner community and the opportunities there. If you were — the structure now that we have in place, both from a pricing, a supply chain and a cost structure standpoint, we can return to levels of revenue previously generated while delivering gross margins in the higher than 40% range, simply from the leverage, from the cost structure and the indirect overhead, production overhead.

EBITDA margins of 15% to 20% are certainly — we are capable of delivering those once we get our volume levels to the optimal level.

Benjamin Urban : Greg, one thing — yes, I wanted to add one more thing to that question. The other thing that we’ve seen is increased adoption of our technology platform so that the ICE software is continuing to prove to be a valuable part of our actual portfolio as well as our value proposition with other manufacturers interested in it.

Gregory Palm : Yes. Okay. I appreciate all that color. I guess last one, more of a housekeeping question. But can you just give us any update on the litigation with Falk?

Benjamin Urban : Yes, sure, I’ll take that one. So as you know, we filed a summary judgment application last year. In November, Falkbuilt filed a duplicative lawsuit. The court struck it, finding it to be a general abuse of the process. Earlier this month, the court dismissed an application by Falkbuilt to strike our summary judgment application in order for them to submit the cross-examination, which we are in the process of performing, making good progress there. The court has directed that a hearing for the summary judgment application will be scheduled in the justice chambers at the first available hearing date after June 15 of this summer this year. And we believe we’ve tendered strong evidence supporting our claims. And we’ll be — we’re optimistic that the summary judgment application will succeed.

Gregory Palm : Got it. Well, I think I’m probably over my allotment. So I will leave it there. Best of luck going forward.

Bradley Little : Thanks a lot, Greg.

Benjamin Urban : Thanks, Greg.

Operator: I would now like to turn the conference back to Benjamin Urban for closing remarks.

Benjamin Urban : Thank you. I’d like to thank all of you for joining us today. On behalf of our more than 900-person team, we are committed to continuing to move this organization forward and believe strongly that our best days are ahead of us. We look forward to talking with you again either on the road or our next — or at our next quarterly earnings call. Thank you.

Operator: And this concludes today’s conference call. Thank you for participating. You may now disconnect.