Star Equity Holdings, Inc.

Greetings, ladies and gentlemen, and welcome to the STAR Equity Holdings Incorporated second quarter 2021 results conference call. Some discussions made today include forward-looking statements. Actual results could differ materially from the statements made today. Please refer to STAR's most recent 10-K and 10-Q filings for a more complete description of risk factors that could affect these projections and assumptions. The company assumes no obligations to update forward-looking statements as a result of new information, future events, or otherwise. Please also note that on this call, management may reference two non-GAAP financial measures, including EBITDA, adjusted EBITDA, adjusted net income, or adjusted earnings per share, which are all financial measures not recognized under U.S. GAAP. As required by SEC rules and regulations, these non-GAAP financial measures are reconciled to their most comparable GAAP financial measures in our earnings release issued this morning. If you didn't receive a copy of the press release and would like one, please contact STAR at 203-489-9500 after the call or its investor relations representative, Lena Caddy of the Equity Group at 212- 836-9611. Also, this call is being broadcast live on the internet and may be accessed at STAR's website via www.starequity.com. Shortly after the call, a replay will also be available on the company's website. It is now my pleasure to introduce Jeff Everwein, Executive Chairman of STAR Equity.

Thank you, Operator. Good morning and thank you all for joining us today for our second quarter 2021 results conference call. On the call with me today are Matt Mulchin, CEO of DigiRad Health, our Chief Financial and Chief Operating Officer, David Noble, and various executives in our construction business. In the second quarter 2021, business activity returned to more normal levels. Our healthcare rebounded, our healthcare division rebounded versus the second quarter of last year, with revenue increasing 57% versus the prior year quarter. Our construction division grew revenue 117%, with much of this growth attributable to significantly increased output at our KBS business in New England, coupled with increased activity levels at Edgefilter in the Midwest. The gross margin percentage at our construction division declined significantly in Q2 2021 versus the prior year's quarter. as a consequence of an unprecedented rise in raw material input costs, but is expected to begin to return to normal levels in the second half of this year due to steps we have taken to increase our product pricing and improve operations, as well as the expectation that raw material input costs will continue to normalize later this year. With the asset sales completed at the end of the first quarter 2021, we substantially improved our balance sheet and liquidity position, resulting in net debt declining from $14.3 million a year ago to $6.8 million at the end of the second quarter 2021. We are now much better positioned to fund high-return internal growth investments and pursue acquisitions, which, as we have previously discussed, could be bolt-ons in our healthcare or construction businesses or entry into an entirely new business sector. With that, I'll turn it over to our healthcare CEO, Matt Mulchen. Matt, please go ahead.

Thanks, Jeff. Revenue from our healthcare division in Q2 2021 increased by 57% to $14.9 million over the same period in the prior year. This division has largely recovered from the COVID-19 pandemic-related downturn and is now performing at pre-pandemic levels. Doctors' offices have reopened and we are operating at full capacity. Gross profit for the Q2 2021 reporting period increased by 56% and gross margin remained fairly consistent, decreasing slightly by 0.2% over the same period last year. In diagnostic services, revenue and gross margin percentage for the second quarter of 2021 were 11.7 million and 20.4% compared to 7.1 million and 13.3% in last year's second quarter. The increase in diagnostic services revenue and gross margin percentage compared to the prior year was primarily due to increasing scan volumes. In our diagnostic imaging business, we also saw improvement in the top line results. Revenue and gross margin percentage for the second quarter of 2021 was 3.1 million and 32.5% respectively, compared to 2.3 million and 52.8% respectively in the prior year's second quarter. The increase in diagnostic imaging revenue is related to increased camera sales, which is a good indication that hospitals and physician practices are recovering from the impact due to COVID-19. Now I'm going to turn the call over to Dave Noble, our CFO and COO, who will provide additional financial highlights for the second quarter. Dave, please go ahead.

Thank you, Matt, and good morning. I'll start by summarizing the construction division results. Second quarter 2021 construction division revenue was $10.9 million compared to $5.0 million in the prior year's second quarter. Gross margin on the construction side was a negative 16.9%. compared to a positive 20.9% in the prior year second quarter. The significant increase in revenue for the construction division was due to higher production levels driven by strong demand at KBS and some large commercial jobs at Edge Builder. The negative gross margin percentage was due to the adverse effects of a rapid rise in raw material prices, which hit historic levels during the second quarter. Moving on to consolidated results for the second quarter of 2021, company-wide SG&A increased by $1.9 million compared to second quarter 2020. This was due in part to a $0.4 million increase at the construction business as a result of increased commissions and headcount. Also, we experienced a $0.2 million increase at the healthcare business as a result of increased commissions and a $0.4 million increase in audit fees. as well as a 0.4 million increase in IT and outside service costs. Moving on to consolidated bottom line results for the second quarter of 2021, we had a net loss from continuing operations of 1.8 million compared to a net loss from continuing operations of 0.8 million in the same period in 2020. Non-GAAP adjusted net loss from continuing operations in the second quarter of 2021 was 3.7 million, or 74 cents per share, compared to an adjusted net income of 0.2 million or six cents a share in the second quarter of last year. Non-GAAP adjusted EBITDA was negative 2.9 million for the second quarter of 2021, compared to a positive 0.8 million in the second quarter of last year. The change this quarter is largely driven by the rapid rise in lumber prices, which significantly impacted our COGS on the construction side of the business. For the second quarter of 2021, we registered an operating cash outflow of 5.4 million compared to an operating cash outflow of 0.6 million in the second quarter of last year. As of June 30th, 2021, the outstanding balance on our credit facilities was 13.1 million. Our overall net debt position taking into account 6.3 million we hold in cash and cash equivalents was just 6.8 million. This compares to $16.5 million at June 30, 2020. Now I'd like to turn the call over to the operator for questions. Operator.

Thank you.

Ladies and gentlemen, we will now be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up the handset before pressing the star keys. One moment, please, while we poll for questions. Our first question comes from the line of Theodore O'Neill with Litchfield Research. Please proceed with your question.

Good morning. Thank you very much. So in the construction business, you know, we've all seen the prices rising on lumber and all of the companies that supply it are adding significantly to CapEx for this year and and planning for next year as well, which a lot of people are thinking it could result in a decline in prices, lumber prices. And I'm trying to get an idea of how that would impact STAR. If lumber prices started falling today, how long would it take before you were able to benefit from that? I'm assuming you have to place orders well in advance.

yeah thanks for the the question and we had a lot of things that plagued our second quarter results but that was by far the biggest one you know if you think about um our business on average having roughly a six month backlog it does take a while for things to run through the system um so we've increased prices about 20 year to date particularly on the kbs side of the business and um If we have a six-month backlog, it takes a couple quarters before that starts to show up in our revenue. You get some of it sooner than that on the residential side, but the commercial projects, you know, we might book those six months in advance. And lumber, historically, lumber and all the other input costs, we've had a little bit of a just-in-time inventory approach where we order them in so that they get there in time to start being constructed. But as you point out, lumber has already declined quite a bit. I think it peaked in May. So our average input cost will decline significantly in the second half of the year versus the first half of the year. And our average price will be much better in the second half of the year versus the first half of the year. Longer term, for this business, there's always moving parts in any given quarter, but our goal is to have a gross margin above 20%, even higher than that, but let's say 20% to 25% range, and to not suffer from these wild swings in commodity prices. And so we've done a lot of things to change our contract terms, even begun to hedge a little bit here and there on a project specific basis. I mean, the volatility we've had is unprecedented and we want to be better prepared for it in the future. But this is the strongest thing I would say is that despite all of the volatility and ups and downs of the construction business, we do like this business and do see it achieving a 20% gross margin or better over the long term. Okay, thanks very much.

Thank you. Our next question comes from the line of Tate Sullivan with Maxim Group. Please proceed with your question.

Okay, thank you for those comments on lumber and maybe shifting to health care for a bit in the margin, and you commented earlier on some of the operating at full capacity and the margin, good rebound in the margin there from the prior quarter to about 23%. Is that a sustainable level, or what is a normal capacity operating level for that business?

Are you talking about on the health care side? Health care.

Yeah, I'll let Matt.

Correct. Yeah, I'll let Matt Mulchin will answer that.

Yes, thank you. Yeah, Tate, I think that you're correct. I mean, there's two portions of the business, right? One is the diagnostic services business and the other is diagnostic imaging. We're selling the cameras. So, you know, obviously the gross margin for our diagnostic imaging business can swing based on the mix of our cameras. So the different cameras that we sell can be more profitable, and that could have an impact on gross margin. But on diagnostic services, that comment was more based on the diagnostic services business where we are operating at full capacity or back to pre-pandemic levels of capacity. And so we would foresee that that type of gross margin in that business is pretty steady to continue that type of margin for diagnostic services. Based on the mix, you could see improvements with diagnostic imaging based on the cameras that we would sell in any given quarter.

Can you refresh me, Jeff or David? You mentioned gross profit margin targeted greater than 20% in construction. Do you have a similar goal for the healthcare business?

Yeah, I think that type of goal between 20% and 25% within healthcare is where we would see that business. you know, 25% being, you know, the overall goal for the business. But as we work towards that, depending on the mix of the cameras, as I said, and then, you know, the steady state, you know, nature of our diagnostic services business where we're, you know, going out to physician offices and providing, you know, the service on a lease basis.

Great. Thank you. And then with the, you commented on the nature of, possibly changing some of the contract terms and previous backlog shifting to construction, excuse me. Can you comment on the demand side for your construction, the modular construction business, the raw material cost swings, delay some orders, or how have your customers reacted to this unprecedented situation? Is your backlog still increasing in that business?

Yeah, no, that's a good question, Tate. The answer is kind of D, all the above. So, Demand is really, really strong. Our sales pipeline, I think, is the strongest I've ever seen. Our backlog is the strongest I've ever seen. And that's despite us increasing our prices on average 20% year to date. And we also have better contracts that spell out more what risks we're going to take on and what risks we're not going to take on. So we feel much better about our contracts and our pricing today than we did at the beginning of the year. All that said, there have certainly been projects that have been pushed to the right or delayed, especially kind of bigger commercial projects, because there's typically a series of price points. So look at that. And it's common to get an initial estimate for a construction project. And then as you get closer and if raw materials are changing, you might get a refreshed update. And those refreshed updates have been shocking to some clients. And so there have been projects put on hold. So, you know, this business can be a cyclical business, but we see a lot of demand out there, a lot of projects to do. We see modular projects. increasing its market share over time. And we are doing many things to diversify our business. We're continually adding more clients, adding more in markets. The things one can do with modular is growing over time. So despite the second quarter results, we're very excited about this business. And now that raw materials have declined, Our hope is orders just continue and anything that was on hold goes off hold.

Great, and thank you for the comments on the longer-term targets to going past these wild swings in the short term. And then just for the setup for the next quarter, I noticed the inventory build, and maybe it's normal between 1Q and 2Q. Is that from about 10 to 12? Is that related more on the medical side or construction, or is it both? Can you just comment on that? Is that mostly raw materials in there for construction?

Yeah, largely construction. Dave, do you want to talk about that?

Yeah, sure. I mean, probably more of that is really related to the edge builder business where we do the wall panels. We've been accumulating some inventory for some large commercial projects that kick off in the next month. So That would be what a lot of that is. We also are building some inventory on the KBS side. That's a little more just in time, as Jeff said. And the only other thing I'd want to point out about how we feel about margins going forward is there's not a lot of spare capacity in the industry right now. So even though commodity prices are coming down, which is great, our pricing power seems pretty strong right now. We've got a little bit of capacity for the end of the year. And we're not finding a lot of pressure there, and the demand remains very, very strong and has throughout the volatility that we've seen this year.

Just a last one for me. Can you refresh me, Dave, on the expansion plans for modular construction? Did you open up the second facility in New England or could you just expand? not be on the current footprint, the module in New England, please.

We have not. We have a second idle facility that we would like to open at the appropriate time, and we, you know, fully intend to do that. We just haven't found that time just yet.

Okay. Okay. Thank you for all the updates.

Thank you. Our next question comes from the line of Adam Waldo with Lismore Partners. Please proceed with your question.

Good day. Thanks very much for taking my questions. A few areas I'd like to explore, if you can hear me okay.

We can hear you.

Okay, great. So first, you resumed paying the preferred stock dividend, you know, there in June with the declaration in late May. And as you sort of look out into the second half of this year and maybe into the early part of 2022, should we expect that you'll start or that you'll continue paying it on a but not seek to pay down the arrears, or kind of what's the current thinking on the preferred stock dividend?

Yeah, no, that's a good question. This is Jeff. I'll take that one. So I would just say a few things that might be helpful. First off, it's a board-level decision, not a management decision. We We do have a much cleaner balance sheet than we had before. We did do a series of asset sales in the first quarter that allowed us to pay down a lot of debt and did allow us to start making dividends on that preferred stock. I think the board will make a determination about the third quarter dividend and we'll make an announcement about that. the record dates for the preferred stock per its charter are September 1st, then I believe it's December 1st, March 1st, and June 1st. So I would expect the board to make a determination before that September 1st record date. And all of those issues you raised are top of mind. We do talk about them. The board does debate them. We didn't start paying dividends lightly and I would just say stay tuned on that front and the board will make an announcement when it's, you know, very soon after it's made its determination.

Fair enough. Thank you. As we think about the construction gross margin progression, as you sit there today and see kind of what your lumber cost structure looks like and what your pricing structure looks like. Can you give any sort of guidance range on third quarter gross margin that you would expect in a business and any outlook as to the progression into the fourth quarter?

Dave, do you want to take a stab at that? I mean, we're not giving specific guidance, but, you know, I think directionally, We see second half being much, much better. But Dave, go ahead on that specifics.

Yeah, I mean, we're still shipping a couple of projects, you know, invoicing and shipping a couple of projects from the first half. And so those would reflect, you know, some of the higher priced input costs. But our current backlog, as Jeff mentioned, is significantly higher in price than what we had in the first half year over year around that 20% increase mark. So, I mean, we definitely should be approaching, if not achieving, that 20% plus in the second half. I mean, we've got three businesses, right, in the construction arena, two in the Midwest. We've got wall panels, which, you know, slightly below that 20. Then they have the retail business, which is well above that 20% margin. Then you have the KBS business, which is our modular, which, as Jeff said, we're trying to price things in the 20 to 25% range. So, You know, we should be there by the end of the year and hopefully a lot sooner than that, but there's a couple of projects that we're finishing up that were at, you know, margins that were reflective of much higher commodity input prices. But we're buying materials, you know, at quite a bit lower now. I mean, I think since June, wood-based commodities are down about 20 percent. And again, we're achieving price levels that are much higher, and we think that is sustainable on the KBS side particularly. given that capacity utilization is pretty high throughout the industry. We feel like we have good pricing power as we go through the second half of the year.

So that's encouraging.

Oh, I'm sorry.

Yeah, this is Jeff. I was just going to add a little bit to that. We would have had a difficult quarter in the second quarter, regardless of the unusual items, just because of the unprecedented rise in raw material costs and the delay in um increasing our pricing i just you know you increase price on january 1st and you don't really see the impact for many months and really not the full impact until maybe the third quarter but um this is going to point out in the second quarter we probably had about a million dollars of costs that were a collection of different things we're putting in a new um i.t system and uh we wrote down a variety of things really cleaned up a lot of accounting areas like one example is we were renting out our smallest plant in the KBS business and the subtenant was hadn't paid rent in a long time partly due to kovat and ended up going under so we just we wrote off all of the rent that we were supposed to receive and now we have a new tenant there who is paying rent and have an agreement with them to sell that plant, which will probably happen before the end of the year. So I think we'll have about 2 million of proceeds in the second half of this year coming in from that asset sale and various other asset sales. And then in addition to the million or so of costs that we recognized in Q2 but didn't really pertain to Q2, we had a very large project where just technical accounting issue these days. Even though we finished it and the client took title to it, based on the shipping date, that's revenue that got pushed from Q2 to Q3 and that was over a million dollars. And of course, the variable costs get recognized when the revenue gets recognized, but it's not great for profitability to have our factory work on a project for a whole month and not recognize any of the revenue. We have all the fixed costs and things like that of running the construction business and it was really revenue 1.1 million that was for work done in Q2, but it won't show up in our numbers until Q3.

That's very helpful. Thank you. And I guess I'm going to do some quick back-down load math. I'm sure I'm off a little bit, and I hope you can help me on this. As I sort of think about the, you know, intermediate-term to longer-term guidance, if we sort of think of each of the two segments, most of the divestitures, we kind of have, you know, gross margin guidance in the 20%, 25% range for each. And we have sort of our run rate revenue looking pretty good again for each. And when you sort of, you know, pencil that out, we're at maybe – five to six million of gross profit in SG&A of about the same, right, based on what you showed in the second quarter. So am I right to say that sort of to get above break even here on a book accounting basis and maybe in the same vicinity on a cash flow basis, we need to pursue some opportunities on the SG&A side? Or what are some steps that we can pursue to – you know, to get to a sustainably higher level of, um, of EBITDA and cashflow.

Yeah, we're, we're working on all those things. I mean, we're increasing our pricing, we're working to lower our cost structure. We're working to lower our overhead structure. Um, but, uh, in general, just, uh, raising our prices and having good volumes will be, um, extremely helpful and you've seen the revenue growth and healthcare, I think it's rebounding to pre-COVID levels and long-term, we think that business does have some growth and normal level of revenue is something in the 15 million a quarter range, 60 million a year with some growth to it. And the construction business really has a lot of revenue upside and the more units we produce in general, the higher our gross margin is and the lower our unit costs are. So we do think about break evens. We do work on that. But kind of getting the revenue right and getting the cost of goods sold right are really important. first step and the goal for, we've already talked about the goals for both businesses having gross margin on the 20, 25% range. And for construction, I know there's a tremendous amount of volatility. We're not giving specific guidance, but our, our goal is that, um, uh, you know, towards the end of this year where everything has been, um, I want to say plus through the system, but our price increases are showing up in revenue, input costs are more normalized, and our hope would be that the gross margin would therefore be back to more normal levels while we continue to have really strong revenue growth.

And can you be more specific in terms of bracketing a range for quarterly SG&A at kind of a $25 to $30 million in quarterly revenue, more normalized environments?

Dave, do you mind taking us out of that?

Yeah, man, it's hard to cuff. I mean, we can come back to on that. There are a couple of one-offs in there. Jeff mentioned the rent write-off. So it's hard to do that off the cuff, but I'm happy to try and run that math. But I guess the only thing I would add to what Jeff said is I do think it's a scale issue in trying to grow revenues and spread out our overhead. But we're always looking for ways to cut SG&A, and we've done that in the past. We've We've eliminated credit card fees on the healthcare side. We've reduced our contract, for example, with Microsoft where we had some extra seats that weren't utilized. We've done a number of things when we find that we can really reduce costs in one area or another, we do attack that. So we're always looking, as Jeff said, to kind of take out costs when it makes sense. I think on the construction side, KVS is built for a larger unit volume, and we're focused on getting to that larger unit volume, which will obviously improve our net margin.

Okay. Thanks very much. Very helpful insights, and good luck in continuing the recovery. Thank you.

Thank you. As a reminder, ladies and gentlemen, please press star 1 if you'd like to ask a question. It appears there are no further questions at this time. I would like to turn it back to management for closing comments.

Well, I'd like to thank Dave, Matt, and the management team for being on the call with me and answering questions. And just want to say that we're always available to take your call, take your questions. Our contact information is at the end of every press release and at the end of our investor deck. so please don't hesitate to contact us. And we appreciate all of our shareholders and people who follow us. Thank you for your feedback and support, and we look forward to next quarter's call. Thanks for your time and attention today.

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.