Quarterhill Inc.

Good morning and welcome to Quarter Hill's Q2 Fiscal 2021 Financial Results Conference Call. On this morning's call, we have Paul Hill, President and CEO, and John Rimm, Chief Financial Officer. At this time, all participants are in a listen-only mode. Following management's presentation, we will conduct a question and answer session, during which analysts are invited to ask questions. To ask a question, please press star 1 on your touchtone phone to register. Should you require any assistance during the call, please press star 0. Earlier this morning, Quarter Hill issued a news release announcing its financial results for the three- and six-month periods ended June 30, 2021. This news release, along with the company's MD&A and financial statements, will be available on Quarter Hill's website and will be filed on CDAR. Certain matters discussed during today's conference call or answers that may be given to questions could constitute forward-looking statements. Actual results could differ materially from those anticipated. Risk factors that could affect results are detailed in the company's annual information form and other public filings that are available on CDAR. During this conference call, Quarterhill will refer to adjusted EBITDA. Adjusted EBITDA does not have any standardized meaning prescribed by IFRS. Please refer to page 3 of the company's Q2 2021 Management's Discussion and Analysis for full cautionary notes regarding the use of forward-looking statements and non-IFRS measures. Finally, please note that all financial information provided is in Canadian dollars unless otherwise specified. I will now turn the meeting over to Mr. Hill. Please go ahead, sir.

Good morning, everyone, and thanks for joining us on today's call. In terms of agenda, I'll start with a look at the business highlights, followed by John, who will take a look at financial results. Then we'll open it up for questions. Q2 consolidated revenue was $18.9 million. Consolidated adjusted EBITDA was negative $3 million. and we generated 1.7 million of positive cash from operations. We ended the quarter with a strong balance sheet with 122.7 million of cash and working capital of 138.5 million. In Q2, we continued to make progress on our M&A strategy, completing our second acquisition of the year, VDS. We've made considerable progress integrating both acquisitions, generating new revenue opportunities, realizing cost synergies and laying the groundwork for IRD's further expansion into Europe. I'll touch on these developments in more detail shortly. YLAN completed license agreements in Q2, but COVID-19 continues to be a headwind for some licensing discussions and litigations where in-person meetings or court schedules are being delayed. As a result, Q2, some agreements that we had planned on closing in the quarter got pushed out to future periods. Earlier this week, Wyland announced patent portfolio acquisitions and a license agreement on patents that relate to wireless technologies used in the automotive industry. So they're off to a good start in Q3. The automotive industry is a promising new market segment for our wireless patents, and we have a number of new opportunities in the pipeline. Those who have followed us for a long time know the episodic nature of Wyland's revenue. Despite the quarter variability, on a relatively consistent basis while it delivers significant annual cash flow. We expect that to be the case again in 2021. This means that we're looking for a strong second half from the business and we remain encouraged by the pipeline of agreements the team is working on. Regarding our litigation in the US with Apple, all preliminary briefings have been completed and we're waiting for the oral hearing date from the Federal Court of Appeals, which could be released any day. We believe the hearing will likely take place this fall or early in the spring of 2022. In addition, YLAN has upcoming trials with Amazon this November and with Micron in August 2022. The business is also evaluating several interesting patent portfolios for acquisition in the coming quarters. IRD had a good quarter with solid financial performance, integration of two acquisition and growth in its pipeline. So far in Q1 and Q2, SensorLine has performed to our expectations and the integration is going well. In North America, IRD is leading all sales efforts for SensorLine products and has already closed deals in New York and Indiana. IRD is currently conducting trials in other states which could result in much larger multi-million dollar opportunities that wouldn't have been accessible to SensorLine on its own. With VDS, Q2 reflected a contribution only for May and June. So far, the business is on track and the integration is going very well. BDS develops and manufactures and sells traffic monitoring devices that record driver speed and red light infractions. Theirs are currently the only radar-based product certified under new regulations in Germany that enable direct enforcement of traffic violations. This is an area of enforcement that we really like and think has significant growth potential. For example, here in Toronto, The city has installed more than 150 red light cameras along with 50 speed cameras and is the process of rolling out 50 more. I can tell you from personal experience these cameras are working. In terms of revenue synergies, IRD and BDS are working together on several opportunities in Germany. BDS is leveraging IRD's European footprint to bid on new business in countries where they have no previous sales coverage. Together, these two acquisitions demonstrate the global platform of the IRD business and its ability to identify, acquire, and grow acquired companies. IRD has initiated a further integration of its three EU subsidiaries, SensorLine, VDS, and ICOMS, to establish a more substantial beachhead in Europe. The company is open to search for a European general manager who will oversee the acquired companies and lead the expansion of IRD in Europe. We are pleased so far with the progress of the two acquisitions and we intend to complete more transactions this year. We think we can get a couple more done in 2021. We have a solid pipeline and we'd like to get some larger deals on the board this year. These could be businesses that are similar in size and scope to IRD with well-established brands and with their own M&A strategy. With attractive market tailwinds in place, we believe the outlook for IRD and the ITS industry in general is very positive. With that, I'll turn it over to John for a look at the financial highlights.

Thank you, Paul, and good morning, everyone. I'll take a look at key consolidated numbers as well as the numbers from our ITS and licensing segments separately. Starting with revenue, consolidated revenue in Q2 was $18.9 million and $38.2 million year to date. Revenue was up year over year in Q2 as both the ITS and licensing segments grew revenue, but slightly lower year to date due to a more moderate value of agreements completed in the licensing business in Q1 this year. ITS revenue is higher for both Q2 and the year-to-date period, primarily due to the inclusion of revenue from the acquired companies, as well as resilience in its core business, despite the COVID-19 pandemic still remaining a challenge in most parts of the world. Paul mentioned we are already seeing revenue synergies from the acquisitions and expect this to continue as the businesses become more integrated. Licensing revenue was up in Q2 compared to the same period last year, but down slightly year to date. Despite the headwinds related to COVID-19, YLAN continues to show it can complete agreements in a challenging environment. And as Paul mentioned, YLAN is off to a great start in Q3 with a license agreement completed on patents that relate to the LTE wireless tech in the automotive sector, which is a new business. We expect a stronger second half of the year for YLAN going forward. From a gross margin perspective, consolidated gross margin Q2 was 18% and 26% for the year-to-date period. Gross margin in the two periods was lower than last year, primarily due to lower litigation expenses at YLAN in the respective 2020 periods. Litigation payments do fluctuate based on the level of activity in the particular period. For example, in Q2 last year, litigation activity was low as the courts reacted to the initial onset of the COVID-19 pandemic. ITS gross margin was 37% in Q2 and 42% near today. The decrease in Q2 compared to last year was primarily due to the activity and nature of projects underway in the quarter and their specific margin profiles. The increase in year to date gross margin was primarily due to there being a higher proportion of product sales, which tend to carry a higher margin than in the same period last year. In terms of operating expenses, total consolidated operating expenses were slightly lower in both Q2 2021 and the year to date period. ITS operating expenses were up modestly in Q2 with the addition of the central line and BDS acquisitions. Overall, as always, we continue to keep a close eye on expenses at our corporate level and our portfolio companies. In terms of adjusted EBITDA, the ITS segment had positive adjusted EBITDA in Q2 of $2.7 million, which was down from Q2 last year. and 4.1 million for the year-to-date period, which was up from the same period last year. For both Q2 and the year-to-date period, the ITS adjusted EBITDA margin was around 15%. Adjusted EBITDA margin for ITS can, as I mentioned before, fluctuate depending on the nature of projects underway in the quarter, the revenue mix, and the seasonality that is inherent in the ITS industry. And as we've mentioned before, Q1 is typically a slower period just due to the weather. Adjusted EBITDA for the licensing business was lower in Q2 and the USA period, primarily due to the higher contingent legal and partner costs in 2021. On a consolidated basis, adjusted EBITDA was negative $3 million after corporate expenses, which generally include all our public company costs. In terms of cash flow in the balance sheet, so cash generated from operations was $1.7 million in the second quarter, and cash used in operations for the year-to-date period is $4.1 million. The balance sheet remains very, very strong with $122.7 million in cash and $138.5 million in working capital, again with no debt. We continued our quarterly dividend payments in Q2 along with our share buyback, spending a combined $3.2 million on both activities. And this morning in our earnings release, we announced details of our next dividend. The board has declared an eligible dividend of 1.25 cents per share on October 8, 2021 for shareholders of record on September 10, 2021. So in closing, we remain very well positioned financially to continue to execute on our M&A strategy. We still have a very strong balance sheet with significant cash and working capital, as well as the ability to support leverage. And we have two operating segments that we continue to believe in and that continue to generate cash annually on a consolidated basis to help support our acquisition strategy. As we've talked about before, our plan is to deploy $400 million on our strategy over the next five years. We've already made two smaller acquisitions. And as discussed on our last call, we believe that doing so could add an incremental $300 million plus of revenue to our ITS business along with $50 million of adjusted EBITDA over the next five years on top of what we're doing already. ITS revenue, in line with our strategy, comes with a more steady and predictable profile, and we believe that should result in Quarter Hill receiving a valuation that's consistent with other public ITS and IoT telematics companies that have achieved similar scale. So the net result of our strategy is to unlock that shareholder value over the next five years and remain very optimistic that we're going to execute on that. So that concludes my review of the financial results, and I'll now turn the call over to the operator for Q&A.

Thank you. Ladies and gentlemen, we will now begin the question and answer session. Should you have a question, please press star followed by one on your touchtone phone. You will hear a three-tone prompt acknowledging your request. and your questions will be polled in the order they are received. Should you wish to decline from the polling process, please press star followed by 2. If you are using a speakerphone, please lift the handset before pressing any keys. One moment please for your first question. Your first question comes from Doug Taylor, Canaccord. Doug, please go ahead.

Yeah, thank you. Good morning. One area I just want to flesh out a little bit is, I mean, you're looking for a little help with what gives you the confidence in the inflection in the YLAN business. You're telegraphing here for the second half of this year. Is this some of these signings we've seen post-quarter? Is it the pipeline? And I just want to understand how you're handicapping the risk that Court openings would slip further because I think many of the jurisdictions you typically are litigating in are in areas that seem to be in the midst of a third wave right now.

Hey, Doug, it's Paul. Yeah, the courts isn't really the issue it was a year ago. They were closed for, in some cases, over a month. We're not seeing that at the moment. What gives me confidence is just the pipeline, the level of activity, the fact that we're off to a better start in Q3 than we were in Q2. We've announced a couple of deals already. So, yeah, there's just a lot to work with, and it's starting to look like the year is going to shape up in a similar fashion to last year. Not exactly, probably, but it's back-end loaded, it's fair to say. but there's just enough to work on. We spend a lot of time on the pipeline and working with the YLAN team to understand that.

Okay, and the other thing that I want to drill down on that you mentioned in your prepared remarks is I think talking about the potential for more sizable deals, at least a little more constructively than we've We've heard recently, and I think in particular, you said deals of the same size and scale as the IRD transaction. And so I just want to understand with deals like that, are we going to be looking at things that are potentially accretive on a multiples basis, which has kind of been challenging given the multiple that has been afforded to the YLAN business? Is it going to be about cost synergies, combining these with IRD? Are these going to represent kind of new platforms that you're going to be layering on additional tuck-ins to get cost synergies down the road? Just help us think about what we should expect from those first couple transactions of size that you're talking about.

I would say the most likely scenario is more of a platform acquisition that would take us into adjacencies to IRD, companies with their own brand, their own M&A strategy that would have sort of similar scale and scope as IRD, but in an adjacent ITS market would be something that's quite possible. But in the meantime, I mean, we have a pipeline that has varying sizes of acquisition targets. And it has, you know, I've been here one year. John's been here since last fall. And that M&A pipeline has matured a lot over that period of time. And it's not surprising that the first couple of acquisitions were smaller in nature, right? As you would imagine, those are easier to get done, take less time, easier to integrate. And so as the pipeline matures, as our time in the seat increases, is longer than we can contemplate larger acquisitions.

Yeah, I think, Doug, to add to that, I mean, you mentioned sort of IRB, that type of size. We certainly have the financial means to do it. As I mentioned before, we're carrying no debt, so we have opportunities for leverage in this very low-cost interest environment. And then secondly, as Paul mentioned, it's a pipeline, so those kinds of companies are out there. Obviously, we have to come together and make sure it's good for us, it's good for the seller, but what we can say is that we're definitely exploring those kinds of opportunities.

Last question for me. Are you comfortable with more sizable acquisitions doing these fully, I guess virtually, or are you waiting for travel restrictions to ease, particularly for transactions that might be in Europe of size or elsewhere in the world? or are you going to be waiting to meet and visit, site visit and all that before pulling the trigger on something of size?

I'm traveling. So it's an acquisition of that sort of scope. Obviously, you want to spend some time with the teams, getting to know the teams, seeing the facilities, et cetera. So I am traveling.

And on the financial diligence side, I mean, Even before COVID, you're getting information from a data room and scheduling calls. The in-person stuff is very important, obviously.

We got the first two done without going in person, although we had people on the ground in Europe because we do own a Belgian company called ICOMS and that was helpful and we have some staff on the ground in Europe. So we were able to to do the smaller acquisitions remotely, that wouldn't be possible with a large acquisition. And I am personally traveling, and some of my team is now traveling.

Just wanting to confirm that COVID restrictions or travel restrictions don't seem to be a gating factor here in the rollout of your M&A program, and it sounds like it isn't. Thank you. I'll pass the line.

Yeah, okay.

Thanks. Thank you. Your next question comes from Maxim Baron, Cormark. Maxim, please go ahead.

Hey, good morning. I just had a couple of questions regarding the strength and why land in the second half of the year. So my first question is, does the strength come from several large deals or is it more broad based across the type of deals that you're getting? And just my second question would be the strength. Is it split evenly between license agreements and litigation or how's that split look? Thanks.

Yeah, I would say it's a number of deals. So the pipeline, the way we get to our numbers in the second half, there are many paths and many combinations that will get us there. So I think you can assume that it's a number of transactions of different sizes, as opposed to a couple of very large deals that kind of swing one way or the other more dramatically. So that would be my comment on that.

Did you want to comment, John? No, yeah, I'd echo that.

There's many pathways, and they're all... No, the litigation... I mean, I did mention Amazon. You know, we are... There is a trial date in November. It's a hard question to answer because sometimes cases are settled before it gets to trial, right? So... I don't know how you would categorize that. Is that a licensing deal or is that a litigation, right? So I would say that is also a mix.

Yeah, like the very... If you look at the history, the very few have actually gone full, you know, all the way through the court process. It's really negotiated beforehand. That's right. So, you know, what I was going to say is they're all of varying sizes. It's just timing and, you know... We've got to come together to get something that's comfortable for both parties.

Yeah, and I would just point out, we are off to a good start in Q3. We've announced a couple of deals already. So, you know, already we're headed in the right direction in Q3. Yep.

Thank you. Your next question comes from Todd Copeland, CIBC. Todd, please go ahead.

Yeah, good morning, everyone.

Morning. Morning.

I wanted to first ask about... I guess it's IRD plus the acquisitions, so ITS in total. Is that the $17 million in the quarter, is that a pretty good run rate for all the businesses now that have been acquired?

Well, VDS wasn't fully integrated in the financial results, right? It was only a half a quarter, roughly?

Yeah, we acquired VDS in April, but that's relatively small. I would say, obviously, Q3 has been the largest quarter always for IRD. In terms of the other two acquisitions, what I can tell you is that they're tracking towards our business case, which basically forms our budget for the year. The other thing to take note, too, is we report in Canadian dollars. And as you're familiar with, IRD's business, half of it is in the U.S. And so last year with the onset of COVID, the exchange rate was quite high. I think it was in and around the 1.39. That's quite a big FX headwind right now with the U.S.

dollars.

Now it is changing, and I think that's one reason for optimism as well, too, as that flips and sort of normalizes back to sort of at least the last five-year average. But this year, we're looking at 1.25 in the quarter. So that's a big difference. I would say on a constant currency basis, the businesses are tracking. But because we reported Canadian dollars and the difference in exchange rate, that's hit us a little bit. But we're optimistic that that's going to normalize. And you'll start to see the run rate numbers pretty soon.

Okay. And then... there any way to think about sort of organic constant currency growth in ITS with the acquired businesses and IRD I mean is it mid single digits is it low double digits how are you thinking about the market or those combined businesses we track

The IRD business organically tracks more or less to the market. Historically, the market CAGR is somewhere in the 5%, 6% range. There's some recent market studies that are predicting more like a doubling of that number over the next number of years as all this new infrastructure spending comes into the market. When I talk about the tailwinds, that's what I'm referring to. It's the For example, in the U.S., the infrastructure spending bill, right? That money will eventually flow down to the state level and show up as new opportunities for ITS vendors like ourselves. So that's more in the kind of 13% to 15% CAGR. But it's going to take a bit of time for that cash to flow down to that level, probably a few quarters. So we think we'll start seeing that CAGR improve somewhere in 2022. So you won't see necessarily a lot of organic growth beyond kind of that 5%, 6% range probably until that money starts flowing.

The other aspect is, and we have talked about sales synergies. Now, you know, SensorLine and VDS are smaller acquisitions, but again, you know, they were very much limited to sort of the European market and they didn't have the sales channels and the same infrastructure related to sales as we did. And so we're already seeing opportunities now those take time to flush out the nature of rfp cycles in the its industry are longer let's say relatively to maybe some other industries but we're already starting to see those and paul you want to talk about a few yeah i mean we landed a couple of deals already i mentioned in my remarks indiana new york those are deals that probably centerline wouldn't have seen on their own we have coverage in those markets we have existing relationships so we can bring those products if you look at dds they're a german

They're a product that sells primarily in the German and Austrian market. I mean, that also very, very... It's great technology that's being adopted all over the world now. As I mentioned, you know, if you look at photo radar, red light cameras, there's a lot of investment in those areas to drive new sources of revenue to government. So we think we can take those products into IRD, which operates in over 50 countries right now.

Yeah, and, you know, Paul also mentioned our integration efforts. I mean, they're pretty much... From an operational perspective, you know, we're going to start unlocking those synergies, but they're already integrated. Obviously, they're integrated on the sort of back office financial reporting. And we also expect to achieve cost synergies as well, too, whether it's global insurance policies or redundancies in management and staff. You know, we're starting to unlock those after a transitionary period as well, too. So we'll hit synergies on both sides. It just takes a few quarters to kind of you know, see them roll through the results. And, you know, hopefully we get some cooperation on the FX as well too.

Okay. That's super helpful. And then I thought you said EBITDA margin was 15% in ITS. Is that the right number to think about in this business on a run rate basis? Or what's the range with synergies? I guess this may be a more direct question.

You know, you... So a couple things. One is in our ITS business, and ITS is such a big tent. We're in commercial vehicle operations. We do dabble in other areas, obviously, as well, too. And we do projects, services, and we sell some products as well, too, right? Products tend to be higher margin. So that's going to flow all the way down to your EBITDA margin. But other areas in ITS business, could have a different margin profile. I would say for our current ITS business right now, I mean, we can go back to previous financial reporting and you can do the math, but they were around 11% to 13%. So getting to 15% already, I think that's a reflection of some of the acquisitions we've made as well as some of the centers.

Yeah, the gross margin has improved with some of the more product-centric acquisitions.

Exactly. Yeah, the products are anywhere from 50% to 65% gross margin. So 15% is actually kind of the bar that we try to get to.

That's a pretty good working number.

Yeah, for IRD. But other businesses that we acquire going forward in the industry could be higher or it could be slightly less, but still very cash generative depending on the type of business that it is.

Okay. That's helpful. And then on Amazon, can you just remind us what is actually the infringement that they've been taking advantage of? Yeah, just to help us understand which patents you put forward. Thanks.

Just at a very high level without attempting to get into lots of detail around it, it's essentially the voice-activated assistant technology. So, you know, you think of Siri as an example of that. So it's some of the underlying technologies related to voice-activated assistants.

Okay. I mean, you're taking it to trial, so your opportunity is not sort of single digits of millions. This is like a a material infringement, and you'll just see where you get to, I guess, is the read on going all the way to trial, right?

I can't comment on that, the size or scope. But, yeah, I mean, that is the area that we're focused on with them.

Okay. Okay. And then just what you got asked about YLAN a little bit, but if I could just – you said you'll do the catch-up and sort of get back to – sort of averages in terms of YLAN. I mean, that's how I've always thought about that business, so it's not a big surprise to hear that. Is the catch-up, though, I guess if you're going to catch up in the second half of the year for the full year, get you back to averages, it probably is actually going to be potentially quite a bit higher in the second half. And is there scenarios where you sort of have an outsized year with everything that's in the pipeline, or is it just getting you back into the averages, the things that you think is going to end up closing? Thanks a lot.

Yeah, no, I think the year is shaping up in many ways like last year, except I think that last year we had the one really large YLAN quarter. It may not be that kind of scenario, but is definitely the similarity is that it's a back-end loaded year but terms of order of magnitude that that would be kind of the range but I would say you know if the wild card is there are some large projects that could settle at any point right so that's the part that you just can't predict at all we have an Apple case we have hearings happening in the fall, right? So it's hard to predict that kind of scenario, and I wouldn't factor that into my comments, really. Yeah.

Okay.

That's helpful.

Thanks a lot, guys. Appreciate it.

Thank you. There are no further questions at this time. I will now turn the call back to Mr. Hill for closing remarks.

Okay. Well, thanks, Operator, and thanks, everyone, for participating in today's call, and we look forward to speaking to you again in the coming months. Thank you.

Thank you. Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.