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Good morning, and thank you for standing by. I'm the operator on today's call. Welcome to the DIRTT Environmental Solutions 2018 Fourth Quarter and Year-End Financial Results Conference Call. [Operator Instructions] I will now turn the call over to Ms. Kim MacEachern, Director of Investor Relations for DIRTT. Ms. MacEachern, please go ahead.
Thank you. Good morning, everyone, and welcome to today's call to discuss DIRTT's 2018 fourth quarter and year-end results. Joining me on the call are DIRTT's Chief Executive Officer, Kevin O'Meara; and Chief Financial Officer, Geoff Krause. Management's prepared remarks today are accompanied by presentation slides. To access the slides, if you've not already done so, please view them from the web page of this webcast or go to the Investors Section of DIRTT's website. The earnings press release that was issued yesterday afternoon can also be found on our website. We will begin with opening remarks from Kevin on Slide 4, followed by Geoff providing review of our results and our current outlook. We will then move to the Q&A portion of the call. Today's call will include forward-looking statements and because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially. In addition, as this call will include references to non-IFRS results, including special items, please reference the company's management discussion and analysis available in the Investors section of dirtt.net. or on sedar.com for further information regarding forward-looking statements and reconciliations of non-IFRS results to IFRS results.I will also remind you that this webcast is being recorded and a replay will be available today at approximately 1:00 p.m. Eastern Time. And now I'd like to turn the call over to Kevin.
Thank you, Kim. Good morning, and welcome to our call, my second earnings call for DIRTT since joining the company last September. After examining the business over these last 6 months, 2 significant observations have shaped my view of the years to come and the strategy that will drive our success. First, it's a testament to the strength of DIRTT's innovative solutions that the company has achieved the historical growth it has, despite an immature approach to sales and marketing, which I believe has contributed to the variability in growth rates over the last 5 years. Second, our approach to manufacturing resulted in a reactive rather than proactive management within several areas, including quality, capacity and delivery. As a consequence, we haven't been able to effectively scale with any significant revenue growth. What really excites me though is that these are very addressable issues. I believe that once they are addressed, we will have a platform for scalable and replicable growth. The maturation process we're guiding DIRTT to right now is fundamental to the long-range strategic plan we will be discussing with you in the third quarter of this year. Our evolution is a deliberate, multi-step process that continued with our executive announcements back in mid-January. Putting the right people in place is crucial to building a solid foundation. It is these people who will lead the transformational change within their areas of expertise and within their teams. While our search for Chief Commercial Officer is underway, we are driving forward with improvements to our sales and marketing approach. For example, we're introducing structure into our sales organization to increase accountability and enhance performance management, and we are implementing a focused, national account strategy with the goal of establishing a systematic framework for capturing and delivering on these opportunities.Turning to operations. As you might recall, we named Jeff Calkins as our interim Chief Operating Officer in January. I'm delighted to say that in February we removed the interim from his title, and now Jeff is our permanent COO. Jeff was clearly identified from the onset as the superior candidate [Audio Gap]and it's a testament to DIRTT and the opportunity ahead of us that he was eager to step away from a consulting firm that he spent 18 years building for this full-time position. Leveraging his expertise, we are implementing lean manufacturing techniques, including key performance indicators for safety, quality, delivery, inventory and productivity. We are also creating comprehensive methods to more accurately measure our manufacturing capacity. This includes the reduction of bottlenecks, the establishment of a continuous improvement team within each facility to drive real-time process improvements on the shop floor. To support our operational initiatives, we recently welcomed 2 senior operations leaders. For the U.S., we have Tom Bates in Savannah, and for Canada, we have Surya Sagi in Calgary. Tom and Surya each have extensive experience in lead manufacturing and operations leadership and will be working closely with Jeff Calkins in overseeing DIRTT's operations moving forward.In addition to the overarching observations discussed, we made some important logistical decisions intended to streamline the business. Most notably, we elected to close our small legacy manufacturing facility in Kelowna, British Columbia, and to consolidate the distribution center in Calgary into an existing facility. The Kelowna factory focused solely on the electrical component manufacturing for which we had ample capacity in our other facilities. From a sales perspective, we are currently designing and building our Green Learning Centers under existing leases in 2 prominent commercial real estate markets, Seattle and New York City.I'll turn the call over to Geoff to discuss our financial results. Geoff?
Thank you, Kevin. Looking at Slide 5. Full year 2018 revenue was $356.7 million, an increase of 22% compared to 2017. We're pleased to see growth in both Canada and the U.S. and specifically an increase in market penetration in health care, where year-over-year sales increased 59%. Health care, as a percentage of product and transportation revenue, grew to 23% in 2018 versus 18% in 2017.In the fourth quarter, revenue was $98.7 million, an increase of 33% compared to Q4 of 2017. While we are pleased with these results, it is important to note that our fourth quarter 2018 results benefited from a 4% increase in the U.S. dollar exchange rate, which increased revenue by $3 million. In addition and for comparative purposes, fourth quarter 2017 revenue was negatively impacted by hurricanes, which delayed certain project schedules. We estimate fourth quarter 2017 was approximately $5 million to $10 million lower from sales that shifted into 2018.Turning to Slide 6. 2018 full year adjusted gross profit percentage increased to 44.1% from 43.5% in 2017. While we experienced savings from the increased leverage on fixed manufacturing overhead costs, we saw higher-than-normal volume of tile defects. This resulted in approximately $4.5 million of repair costs and provisions, negatively impacting adjusted gross profit percentage by 125 basis points for the year.In the fourth quarter, adjusted gross profit percentage decreased to 41.9% from 42.4% in the fourth quarter 2017. We anticipate some pressure on adjusted gross profit in the first half of 2019, while we work to fully resolve the tile defect issues experienced in 2018. Once resolved, we expect adjusted gross profit to revert to historical averages. We also expect benefits from the operational improvements Kevin discussed earlier. To provide clarity on the production issues, in mid-2018, we began experiencing a higher-than-normal incidence of defects with a small portion of our tiles warping after delivery. We concluded that a regulatory change in late 2017 impacted the composition of the MDF substrate that we use for our tiles. This caused increased moisture absorption rates in some environments. For a short time, the overall deficiency rate of tiles rose to 5% from less than 1% historically. We are currently working with our substrate supplier to identify modification or alternatives, and we are committed to replacing any tiles for clients experiencing issues. I can confirm that the occurrence is intermittent and isolated to a small number of projects. The $4.5 million of deficiency costs noted previously includes an increase of $2 million for warranty and other provisions.Looking at operating expenses on Slide 7 to date. We've increased our disclosure around the components of the expense line. We've broken out total SG&A into 4 categories to increase transparency and to better understand where we are spending in the business.Adjusted general and administrative expenses decreased modestly from $34.1 million in 2017 to $33.4 million in 2018. For the fourth quarter, they also decreased from $9.9 million in 2017 to $8.5 million in 2018. The onetime costs associated with the activist defense and special committee of the Board of Directors, totaling $1.9 million, were offset by reductions in nonessential travel and entertainment and other savings realized through process improvements and increased cost control discipline. We expect modest increases in 2019 due to inflation as well as onetime and ongoing costs related with the U.S. listing.Adjusted sales and marketing expenses decreased significantly from $58.3 million in 2017 to $51.5 million in 2018. Reductions in nonrevenue-generating marketing and trade show expenses and associated travel, meals and entertainment costs were offset by increases in commission expense related to higher sales levels.Fourth quarter sales and marketing expenses decreased from $17.5 million to $13.6 million in 2018 due to the same factors. Our focus in 2019 is concentrating on enhancing the sales organization. We expect sales and marketing expenses to increase in conjunction with higher sales, albeit at a lower rate, due to efficiency improvements.Adjusted operations support is comprised of the fixed costs associated with DIRTT Solutions delivery, project management and operating cost of the company's manufacturing facilities. These costs increased to $16.2 million in 2018 versus $14.2 million in 2017. For the quarter, adjusted operating expenses increased to $4.3 million in 2018 from $3.8 million in 2017. These increases are attributable to higher rents and operating costs as well as salaries and wages. We anticipate operating costs in 2019 to remain consistent with 2018. Increases in salaries and incentive programs for key staff members are offset by cost reductions from the consolidation of the Kelowna plant and the Calgary distribution center.Adjusted technology and development expense is related to the noncapitalizable costs associated with the company's product and software development team. These costs remain relatively constant for both the fourth quarter and full year periods. We expect similar levels of expenditures continued for the foreseeable future as the development of our technology and solutions is an ongoing activity and vital to DIRTT's competitive edge.Turning to Slide 9. Adjusted EBITDA in 2018 increased to $56.2 million or 15.7% of revenue compared to $15.8 million or 5.4% of revenue in 2017. This slightly exceeds the stated guidance for the year and represents a 254% increase over 2017.For the fourth quarter of 28 (sic) [ 2018 ], adjusted EBITDA increased to $17.5 million or 17.7% of revenue from a $1 million loss for the same period of 2017. This increase -- these increases were due to higher revenue and the resulting adjusted gross profit as well as a reduction in adjusted operating expenses.For clarity, on Slide 10, we summarized the impairment expenses and the reorganization costs that are included in net income but excluded from adjusted EBITDA. As disclosed in the third quarter, we recognized a total of $13.3 million and $1.7 million of impairment expenses for DIRTT Timber and DIRTT for Life, respectively. We recognized the $2.6 million provision for onerous contract losses in the fourth quarter of 2018. This amount largely pertains to the outstanding leases for the Kelowna facility and the Calgary distribution center, both of which were determined to be unnecessary for current operations. Lastly, we incurred a charge of $2.4 million related to leasehold impairments at the aforementioned properties. At this time, we do not expect any further material impairment expenses in 2019.Regarding reorganization costs, a total of $9.6 million was recognized in 2018 compared to $1.5 million in 2017. We anticipate an additional $3 million of reorganization cost in the first quarter of 2019 with no material reorganization charges expected thereafter. Despite the aforementioned expenses, net income increased to $3.5 million or $0.04 a share and $3 million or $0.04 a share in the fourth quarter and year-to-date periods, respectively, for 2018. This compares to a net loss of $7.4 million and $7.3 million for the respective quarter and year-to-date periods in 2017.In 2018, we invested a total of $11.1 million on property, plant and equipment versus $18.6 million in 2017. This includes manufacturing equipment to increase capacity and improved quality as well as additions to offices and GLCs. We spent a total of $7.9 million on intangible assets in 2018, primarily for enhancements to our ICE software versus $10.6 million in 2017.As part of the current strategic planning process, we are determining the appropriate level of investment in the business, including how and when to invest. As a growth company, with significant opportunities in front of us, we are committed to investing in the development of our products and technologies as well as our sales and marketing efforts. Should growth continue at the current pace, we expect the need to expand our manufacturing capacity in the next 2 to 3 years.Our strong cash position allows the flexibility to invest in such expansion without the need to raise capital or seek external financing. We will speak more to our capital allocation policy when we introduce our 3- and 5-year strategic plan in the third quarter of this year. Working capital increased from $79.5 million to $96 million in 2018. We are making good progress in working capital management with a strong focus on timely collection of receivables and appropriate accounts payable management. Subsequent to year-end, we paid off the balance of our long-term debt and currently have cash and cash equivalents in excess of $75 million.Lastly, as outlined on Slide 11, we are moving forward with preparations for an intended U.S. listing in 2019. I would like to quickly review the thought process behind the listing and the benefits going forward. As we discussed in our last call, DIRTT no longer qualifies as a Foreign Private Issuer under SEC rules, partly due to the fact that the majority of our shareholders are U.S. based. As a result, equity issuance, including our employee stock option plan, are subject to a 1 year hold. Given that this is restrictive to our capital structure and despite the absent of any current plans to raise capital, it is prudent to alleviate this restriction through U.S. listing. In addition, we can avail ourselves of the opportunity to list under the emerging growth company rules. This is cost effective from the perspective of regulatory requirements, including the timing of SOX compliance.Roughly, 80% to 85% of our revenue is generated from The United States, suggesting the U.S. listing here is logical. Further, our relationships with the U.S. investment community and listing in the U.S. will support not only visibility amongst the financial community but will help develop our company recognition broadly as we continue our growth plans going forward. I will now turn it back to Kevin for his closing remarks.
Thank you, Geoff. Looking at Slide 12, we see 2019 as a transitional year where we make the necessary changes to drive our future success. We are confident many of our efficiency and cost-reduction efforts will allow us to continue to demonstrate strong adjusted EBITDA margins. We're being intentionally cautious as we provide our early views of 2019. In our review of larger projects, defined as those greater than $2.5 million, we've seen annual step-function increases over the several years. As we look at 2019, we've hit a plateau.Our current visibility shows a similar level of larger projects in 2019 as compared to 2018. Changes to our sales and marketing function, combined with our national account strategy, will enable a return to this step-function growth in the future. Accordingly, we anticipate 2019 revenue growth to be in the 5% to 10% range, more moderate than 2018. It is important to note, however, that we are encouraged by the activity levels and types of projects being pursued by our sales reps and distribution partners. We will update you on our expectations as the year progresses. Before we open the line for questions, I want to recognize our outstanding employees and DIRTT partners whose efforts, hard work and dedication were integral to these record results. I am more convinced than ever in the power of DIRTT, our people and our business model.In summary, we're closing out a record year, and our focus now is clearly on what lies ahead. There is immense opportunity for significant growth and market penetration in the future.I will turn the call over to the operator for questions.
[Operator Instructions] Your first question comes from David Quezada with Raymond James.
My first question here, just on your outlook for 2019, can certainly appreciate that there is a lot of changes happening in the company and I understand your comments about the level of large projects that you are seeing. I'm wondering if -- as you make adjustments to your manufacturing process, do you see any constraints on that end as you try to make those changes throughout the year?
No, I think we'll be able to manage our capacity to stay ahead of any sales growth. In the short- and intermediate-term, we have the flexibility to add a second shift, and longer term as we're putting together our strategic plan, we will be looking at potentially adding new clients.
Okay. Great. And then just in the health care market specifically, obviously, really strong performance there. Wondering if there is any color you can provide on -- is it more projects or deeper scope with existing customers, just any color on the nature of that growth?
At the moment, it's more projects, and we continue to make penetrations across the industry. I suspect that over time, more the intermediate term than the long term, we will see where we will have significant number of repeat customers that are building similar type facilities, and we just continue to work with them on a standardized footprint and model.
Okay. Great. And then maybe just one more for me. On your search for a Chief Commercial Officer, any color you can provide? Are you down to a shortlist at this point? And any thoughts on timing for that?
We are down to a shortlist of a handful of candidates that are coming for next round of interviews. I'd like to tell you that it's -- call it 6 weeks off, but you never know with these things. This is a critical search, and it's harder than the average search because there's a lot of different people and a lot of different backgrounds that could come from heavier in sales, heavier in marketing, what have you. And this is so critical to our future growth, and it's a new role. So it's not like there's work that historically has been done that's not being done. We are super paranoid on making sure that we get the absolute right person. And so that's why we're going on err on taking a little bit longer and making sure we have the exact right person as opposed to rushing to fill the slot.
Your next question comes from Rupert Merer with National Bank.
So I understand you're still reviewing your strategic plan. But looking at that organic growth, if you're not going to see much in the way an increase in large jobs, how are you seeing the pace of organic growth? You mentioned in the disclosures, there is an increased interest in prefab construction, and of course, there is a worsening job site labor shortage. Are you able to capitalize on this? Do you have much of a sales push right now with DIRTT or with your distribution partners?
We do admit that activity level is very, very high. We've got many interesting projects that we're pursuing at the moment. We're still small enough that it can be a little bit chunky, and it is a long sales cycle, and I think that's part of what we're seeing as well. But I see no reason other than the law of small versus big numbers as we get bigger to dampen our enthusiasm for the -- for going forward and what's possible going forward. Obviously, if you take a given piece of business and when you're much smaller company, that's a larger percentage than if you're larger and you get that piece of business.
So how are you able to drive new sales and to, as I get the message out there to those who haven't heard about DIRTT in the past?
I think there is 2 ways that it has been done historically. One is through the sales reps, DIRTT sales reps, and then the other's through the distribution partners. What we're starting to embark on now is a third leg of the stool which is national accounts and focusing on the corporate headquarters of very large companies that might be in a position to where they've got operations throughout North America, where it would make sense to come up with a standard template either for new operations or for remodeling and then partner with them. So that's really our primary focus. And then within our own organization what we find is we have people that are more business development people where they are building relationships in a given geography and then other people that are more driven towards specific projects and booking a specific sale.
Okay. Great. And then just finally, looking at the cash balance, of course, it hasn't changed much in the last year. But do you have any fresh thoughts on how to put that cash to work for investors? Any thoughts on dividend or share buyback or investments, M&A, for example?
Rupert, it is Geoff here. Certainly, that is top of mind for us, as we are working our way through our strategic plan. And critical for us is making sure that we achieve the best value for our shareholders. I think the things that we see is that this is a high-cash generating business. Our capital needs are not -- it's not capital-intensive. And as we said in the script, we have sufficient cash on hand to fund plant expansions. What we do with the balance we're looking at. And be it whether we look at dividends or share buybacks or something of that sort is something that we will go through as the [ strat ] plan. But with shareholder value being top of mind, I think on the M&A front, we see such an opportunity in front of us as it relates to organic growth, that is really not top of mind for us right now. We think we can continue to accelerate this business and grow it organically.
Next question comes from Colin Healey with Haywood.
You mentioned provision to cover warpage on certain product. I wonder if you could just tell me what percentage of sales of that product does that provision represent. And I guess can we expect -- until that's rectified, can we expect to see that provision creep up?
It's Geoff here. So it's a very small portion of our overall sales. And we think that we have sufficient amount within that provision now to cover us as we work our way through resolving the tile deficiency. So it's not a very large number, but it is a portion of the $4.5 million, as I mentioned in the remarks. And we don't really expect to see that go up in the future.
Okay. And with the closure of Kelowna and the consolidation in Calgary, what kind of savings or margin improvement are you guys attributing or expecting that to deliver?
The overall savings are in the range of about $1 million per annum, and we've been -- used those savings as part of the savings that we used to offset the executive changes that we talked about previously.
Okay. And just on the streamlining that you mentioned within the manufacturing process that Geoff is going to be focusing on, what do you expect for -- in terms of margin improvement that you can drive from that? And also, do you expect any significant capital investment as you kind of look at the process and invest to streamline?
It's early days for us to put margin numbers around how much value we think that we can derive from these activities. I do think it will be meaningful. And in terms of capital, I do not expect there to be meaningful increases in capital in order to implement what he has in mind. That's more in the short term. Now in the longer term, as we put together our strategic plan to look at capacity, that's where you may see larger expenditures in capital, but that's more going to be related to capacity expansion that is going to be to spending capital to drive efficiency savings.
Next question comes from Neil Linsdell with Industrial Alliance.
Just wanted to touch -- so this guidance for 2019, so revenue growth, which is more modest than what we would've seen before, is that related in any way to the reduction in the sales and marketing efforts that you guys have been kind of rightsizing throughout the year? And is there any impact from being more selective or changing who you want your customers to be?
Neil, it's Geoff here. So the short answer is no, it is not a function of that. The reduction in our travel and marketing costs in 2018 were really adding a lot more discipline into that and looking at a return on sales perspective versus what we were spending. So that was not the impact. I think as we look forward and we refine our marketing strategy and we refine our national account piece, we expect that we can drive that level -- or drive those sales growth in the future, but it wasn't a result of that.
I'll comment on the second part of your question, which is that, we do, from time to time, if you look at DIRTT's history, take on business that has a high cost to serve, that is below the gross margin line. And I do think that going forward, on a selective basis, we will probably avoid business that's just for the sake of revenue, if the high cost to serve means it's really not profitable.
Right. So more focus on the profitability out of each of one of the businesses. So the follow-up is, I was trying to understand from your guidance, are you also implying that the adjusted EBITDA is going to go in the 5% to 10% range? Or with all these cost savings that you're talking about, should we expect a larger improvement in that?
No. I think as you work the math, we're able to keep many of our corporate SG&A and sales costs reasonably flat year-over-year, and so you would see the leverage up accordingly.
Okay. And I know you're going to save obviously the strategic plan to reveal in Q3. It seems most of it, again, has been rightsizing the business, making sure you've got profitable growth and you're established core additional growth. Is there anything, I mean, you can hint at, as far as what we should expect or should be thinking about seeing in that strategic plan reveal?
I don't think it's going to be anything particularly earth-shattering. I think the core drivers of the business are pretty clear. It's our product development solutions set, it's software development, it's efficient operations that are able to consistently perform at a high level with a 2-week lead time, so that people in a relatively short period of time can go from viewing their space virtually to moving in. And that's the real essence and drivers of value of the business. And so part will be refining that and time how those will be moving forward. I think the next piece will be us giving thoughts around what we think the long-term potential for the business is from a growth standpoint as well as a profitability standpoint; and then given that, what we think capacity additions look like, what sort of facilities where they might be located, that kind of thing. I don't think -- there is not going to be the show stoppers, like, "Oh my goodness, I've never thought about that before." It's going to be building on the basic pillars that have always driven the value of the business.
Okay. And just based on that comment you made as well when you talk about adding manufacturing capacity perhaps in 2 or 3 years to deal with what it -- sounds like it's going to be a more aggressive growth guidance into 2020. Would you be looking at continuing to focus, can you say, on the U.S.? Or would we perhaps see manufacturing operations outside the U.S. and international markets?
We'll be looking within North America. And we'll look at the footprint of where the customers are, where labor is available as well as raw materials. Shipping lanes have come up with the best possible location, top rate the most efficiently wherever that might be. Our current expectation is that given the size of the North American market, it would be limited to North America and not be more international than that.
At least in the next 2 to 5 years?
Correct.
[Operator Instructions] We have a question from Chris Martino with Laurentian Bank Securities.
Just on the defect of tilery work, could you talk about where you are in terms of progress with your substrate suppliers and finding an alternative? And I guess, prior to finding an alternative, is the moisture issue possible to recur? Or is it more of a one-off situation?
We are working closely with them. We've got a couple of potential substrates that are in testing right now. It's too early to indicate what the success of those will be. We tend to be optimistic people by nature, but at this point, it's a little bit too early to tell. I think that it will be a seasonal occurrence until we ultimately modify the substrate and solve the problem. It's derived from the substrate, the MDF, taking on moisture and periods -- now in the winter when it's a little drier in places like the Southeast United States, and so forth, it's not an issue. Where we run into issues is more in the summertime when we're shipping from relatively dry Calgary to relatively humid places, primarily in United States, although there is some in Canada as well. And then you combine that with people, from time to time, storing them in unconditioned spaces while they are awaiting installation, and that adds to the potential issue. It's not a consistent issue. It's a little bit spotty, which candidly makes a little bit harder to completely nail down. And we just handle it by remakes and so forth, and obviously, diligently working on the ultimate solution.
Okay. That's great. And I guess tying into the full year revenue guidance, this was a pretty strong Q4 and what would typically be seasonally weaker. Apart from the U.S. de-benefit, was there anything else to note here? Was there maybe an outlier in terms of maybe some demand being pulled forward from the first half? Or should we expect a strong first half going forward?
I think it's more of a function of the chunky nature of the business. We had a lot of activity move forward as we moved into the first part of this year. Certainly, we continue to be busy. I will remind you that if you looked at 2017, 2017 was significantly impacted by the hurricane. So if you turn that out, it would be down more in the 20% to 21% range. Very good growth, but as we're moving forward, we see -- our similar weighting of about 45% of our revenue in the first half and 55% in the second half, and that's been the same historically.
[Operator Instructions] As we do not have any questions at this time, this does conclude today's call. On behalf of DIRTT, thank you for joining us today.