Quarterhill Inc. (QTRH) Earnings Call Transcript & Summary

Good morning, and welcome to Quarterhill Incorporated Update's conference call announcing its acquisition of Electronic Transaction Consultants, ETC. On this morning's call, we have Quarterhill's President and CEO, Paul Hill; and its Chief Financial Officer, John Rim. [Operator Instructions] Earlier this morning, Quarterhill issued a news release announcing the acquisition of ETC. This news release is available on Quarterhill's website and on SEDAR. 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 SEDAR. 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 to announce our $150 million acquisition of ETC, a tolling leader in the ITS industry. In terms of agenda, I'll start with highlights of the transaction, the strategic rationale and an overview of the ETC business. John will take a look at the key financial elements of the transaction, and then we'll open it up for questions. This is a very exciting transaction for Quarterhill and its shareholders. It transforms Quarterhill into a key player in the ITS industry, establishes a new beachhead in the tolling vertical, which has very strong macro tailwinds. There are strong revenue synergy opportunities between ETC and IRD, and the deal meets our valuation criteria. Post synergies, we believe ETC should deliver $95 million to $120 million in revenue and $12.5 million to $15 million of adjusted EBITDA. ETC has been in business for more than 20 years and provides end-to-end tolling systems to some of the largest tolling authorities in the U.S., including Texas, California and Illinois. The company's platform processes more than 2 billion transactions annually, representing more than $3 billion in toll billings across more than 1,500 toll lanes, all of which are in the U.S. The transaction fits perfectly with our M&A strategy for several reasons. Tolling is one of the most important ITS verticals in the coming years, and the U.S. market is the most attractive. As discussed on prior calls, the tolling market has significant tailwinds as governments need revenue from these types of systems to build and sustain their road networks. The Biden infrastructure bill that just got approved makes the U.S. one of the most attractive markets for ITS spending in the future. ETC has a very experienced management team with deep ITS domain knowledge and long-standing customer relationships. Recent hires include a CTO and COO to support the next phase of their growth. ETC has a leadership position in the U.S. market. The key reason for this is their modern software platform, which is a key differentiator in securing new business. They have a large sales pipeline, and we also see potential for international expansion with the help of IRD, which operates in 80 countries. It also provides a second platform in ITS for tuck-in acquisitions. On the financial side, their long-term customer contracts and their ability to land and expand gives a lot of confidence to us in their future performance. ETC's core product is the riteSuite platform. It's a highly scalable cloud-based solution. The platform has applications for the roadside and the back office, with strengths in vehicle identification, tracking, usage charging and interoperability. ETC also supports all the integration, maintenance and operations functions related to building out their tolling systems. Regarding revenue synergies, ETC's strength in tolling is complementary to IRD, which is a leader in commercial vehicle operations and enforcement technology. ETC's back office reporting and interoperability technology complements IRD's lane embedded sensors and audit systems. Also, IRD's global footprint can pave the way for the 2 companies to collaborate and pursue tolling opportunities internationally. ETC has customers across the U.S., having recently won new contracts that will significantly expand the level of services being provided in those states. ETC's focus on quality products and great customer service has enabled them to expand agreements in some states from low 7- or 8-figure mandates to long-term 9-figure-plus mandates. Their average contract length is 12 years and average total lifetime revenue from contracts is 8.8x the original contract value. These metrics reflect a business with a strong, solid core offering and a stable and growing business opportunity. Equally compelling is ETC's significant contracted backlog and growing sales pipeline. Similar to other ITS businesses, including IRD, these metrics provide strong visibility into future revenue and earnings. You've heard me speak about the Biden infrastructure plan, which has significant allocation for roads. Just last week, the Senate approved a $1 trillion plan with more than $100 billion of incremental spend allocated to roads and bridges. We believe this will be a tailwind for ITS and, in particular, for tolling and mobility solutions for many years to come. As you can see from the chart, the growth in the number of toll lanes has been rising, and it's expected to continue to do so with an expected CAGR of 17.5%. The number of toll-enabled vehicles is also expected to grow at more than 7%, so there's a compounding effect where -- with more toll lanes and more toll-enabled vehicles using them. At the same time, there's been a steady decline in revenue from the gas tax since 1993. This has been the major source of funding for new roads. With the advent of electric vehicles and the general adversion (sic) [ aversion ] to tax increases, this source of revenue is likely to continue to be under pressure. This is a prime reason why we think so highly of the tolling space. We believe tolling revenues are a key solution to the challenge of funding and sustaining our highways, much like red light cameras and photo radar are doing at the municipal level. Infrastructure is badly needed but traditional sources to finance them are being replaced with these newer ones. In summary, this is a transformational acquisition and establishes Quarterhill as a leader in ITS. It delivers a scale in the tolling market, an area where we see strong growth trends, and it significantly diversifies our future financial results. The transaction is also a significant commitment to our M&A strategy in ITS. So far in 2021, we have completed 3 deals in 3 quarters at an aggregate value of almost $160 million, and we are making great progress on our 5-year $400 million deployment target. From an organizational perspective, ETC will operate as a stand-alone entity within Quarterhill, very much a sister organization to IRD. ETC and IRD will work closely together to collaborate on revenue opportunities, with product and geographic expansion being 2 areas they will be able to support each other. Led by CEO Bret Kidd, ETC has a deep and experienced management team that will continue to guide the company through integration and align their future growth trajectory. The company has an award-winning reputation, long-standing customer relationships, significant contracted backlog and a growing pipeline, and we couldn't be more thrilled to welcome ETC to the Quarterhill family. With that, I'll turn it over to John to discuss the financial terms of the agreement.

Thanks, Paul, and good morning, everyone. This acquisition marks a significant milestone in the evolution of Quarterhill. With one fell swoop, it squarely places Quarterhill as primarily an ITS company and firmly establishes it as a leader in this industry. The ETC acquisition, as Paul mentioned, is also a major step towards our 5-year $400 million capital deployment target, and we're hopeful that investors will begin to price Quarterhill comparably with other public ITS companies at scale to unlock value for our shareholders. Regarding the financial highlights, ETC is being acquired for total cash consideration of $150 million plus transaction-related expenses and will be funded by a combination of syndicated debt and cash on hand. Of the purchase price, the debt component is $75 million, while the cash from our balance sheet makes up the other $75 million. As mentioned earlier, on a post-synergy basis, within the next 12 to 18 months we estimate ETC will generate annualized revenue between $95 million to $120 million and adjusted EBITDA between $12.5 million to $15 million. Based on the acquisition price, the post-synergy valuation multiple is expected to be approximately 1.25x revenue and between approximately 10 to 12x adjusted EBITDA. In terms of time line, the acquisition is subject to customary closing conditions and approvals and is expected to close here within the third quarter of 2021. Details on the debt financing will be announced in due course as a standard closing condition. ETC's business model has several attractive financial highlights. First, in line with our strategy of increasing predictable revenues and cash flows quarter-on-quarter, ETC's core business of existing customers provides strong visibility into consistent base-level performance. Second, their significant backlog and recent win rate for new contracts provides confidence in the company's ability to continue to deliver growth. Third, change orders are a common feature of their agreements and provide high gross margin upside and also result in lifetime contract values that are significant multiples of the original base contracts. Finally, this acquisition provides significant scale to our overall ITS business and also adds a new platform for acquisitions in the tolling vertical, with the potential to drive further cost and revenue synergies. On the next slide, I'd like to revisit our value creation model that we first introduced on our Q1 call this year. We've updated this slide to show the progress we've made in 2021 towards our 5-year $400 million capital deployment goal. As we've stated previously, executing our target capital deployment plan by acquiring high-quality assets such as ETC will add significant revenue and adjusted EBITDA over the next 5 years on top of our current business over that time. As discussed, ITS revenue comes with a more steady and predictable profile, which will smooth out quarterly financial performance. And we believe this should result in Quarterhill receiving a valuation consistent with other public ITS and IoT telematics companies that have achieved similar scale. These comparable companies at scale are trading at an adjusted EBITDA multiple of 15x, while the multiple for our ITS business currently today is lower. So we believe we stand to gain from both growth in absolute level of adjusted EBITDA, as well as the valuation multiple they receive. The net result of our strategy is to unlock and grow shareholder value over the next 5 years. And with today's announcement, we believe we have taken a major step in achieving those objectives. This concludes my review of the financial terms. And I'll now turn the call back to the operator for Q&A.

[Operator Instructions] Your first question comes from Doug Taylor with Canaccord.

Congratulations on hitting this milestone in this announcement.

Thank you.

I'd like to go through a couple of the financial details you provided or get a little deeper into them. First of all, I mean, in terms of the revenue recognized from ETC, can you speak a little bit more about the degree to which this is hardware-related versus software or some recurring elements and services? Could you perhaps better describe the revenue profile?

Yes. Thanks, Doug. Yes, I'll start and I'll pass it to John. You're familiar with the IRD business, which is basically a systems business which is comprised of hardware, software and maintenance and services. So it's essentially 1/3, 1/3, 1/3 is the way I kind of think of the IRD business. This business is similar, although one of their major product lines is essentially a vertical ERP system. It's their back office business, and that's a software business, okay? So this is -- the way to think of this business is there's a roadside business, which is implementation of the tolls themselves, the tolling systems themselves, which is much more like the IRD business; and then there's a back office business, which is essentially a software platform that's purpose-built for tolling and departments of transportation. And that's one of their differentiators, actually. So this has a bit more of a software component because of that second part of the business, and we see a lot of opportunity in that area. I don't know, John, if you wanted to comment more on that.

No. I think you've captured it, Paul. Does that help, Doug?

Yes. No, that's very helpful. And so you've provided a range and it's a post-synergy range for revenue and EBITDA, and this is over a period of 12 to 18 months. And I guess I'd just like to understand: would the low end of that range represent the current run rate of this business and then the high end, including synergies? What are the components of either growth or synergies that kind of get you there? I think any color there would be helpful in our initial modeling of this transaction.

Sure. I can start, and I'm sure Paul will have some other comments as well, too. So with respect to sort of the ranges there, that's built into sort of our forecasts as we review and diligence the business. The business has undergone some changes, I guess, within the last couple of years with a little bit of customer churn. So there's a couple of customers that are transitioning off, but then several new customers have been added on. And so that forecast that we have articulated on the presentation and on our call, so it represents our view of where the business is going, again, with already contracts in place. Contracts typically start with an implementation phase over between 12, 12 months plus. And then within -- soon after the implementation phase, we start to receive change orders from the customers as well, too. And again, there's some variability in the change orders like in terms of timing. So that's why we provide a range there. But given the new customers that have been signed up and contracted and onboarded and work is already underway, that's how we are driving our revenue and EBITDA forecast.

And so you said that there's a bunch of -- most of that revenue forecast is with existing customers. So there's not a significant amount of new customer wins or cross-sell into the IRD built into that forecast at this point?

That's right. Yes. There's already a lot of visibility on it. This is a bit of a different business than IRD in one way. IRD, this company only does less than 5 deals a year and more like 2 to 3 deals a year. They're very large in nature, very long duration. And so it's a bit of a different business. So when you look at their pipeline, what you'll see is a lot of the effort they put in is identifying the -- sort of the best fit customers, and they pursue those RFPs -- because these are all RFP-driven processes, they pursue those ones. So it's a long way of saying we already kind of -- we already know what next year looks like, by and large, because the pipeline -- those are deals that were closed this year essentially, lots of visibility.

Yes. And as their customers, which are obviously like state-level Departments of Transportation, as they -- as the states themselves expand their infrastructure, right, then the related services that ETC provides as well also get expanded and, hence, the change orders that I mentioned earlier. In addition to that, there's, as Paul mentioned, a massive pipeline of opportunities which ETC is at various stages at. Some are very, very close to resolution and some are at the beginning of the process. And so we also take into consideration sort of near-term forecasts on pipeline growth opportunities as well in the forecast.

Two more real quick ones, and then I'll pass the line. First of all, I think you mentioned that this would be functionally separate from IRD. Are we also to take that as meaning you'll be reporting this separately in your disclosure as a separate unit?

No. This is squarely in ITS. So we will be reporting all of it in ITS. I think Paul could speak more to this. But what we mean by that is it has separate management teams and they report up to Quarterhill separately. They are...

Yes, just from an operational standpoint. And they will be -- as I said on the call, they will be pursuing their own tuck-in acquisition strategy the same way IRD has with the 2 ones that they did this year. So we're going to have essentially -- think of it this way, IRD is a company that specializes in commercial vehicle operations and enforcement. So the acquisition of VDS, which was Photo Radar, is an enforcement technology, right? So that's kind of going to be their lane, for lack of a better term. And then ETC is going to be much more on mobility as a service, tolling, those types of capabilities, and then they'll have their own tuck-in acquisition strategy. Where IRD can help is they own the sensor line business. Those sensors are quite useful in tolling applications. So there will be some cross-selling of components and capabilities. And then the other thing is IRD has a very strong international presence. ETC is entirely U.S. right now. So there is an opportunity longer term to bring ETC into other markets.

Okay. And all reported together. I mean I know...

An ITS segment essentially, yes, that's right. Yes.

Last one, you mentioned the debt financing and that there will be more details to follow on that. But in general, is the idea to secure that debt with the combined ITS asset base and EBITDA base so we can think about the leverage profile there? Or are you intending to secure it based just on the ETC business?

It's the former, Doug. It's on the entire ITS business, including IRD.

Your question comes from Gavin Fairweather with Cormark Securities.

Congrats on the deal.

Thank you. Good morning.

I wanted to start out just on the competitive positioning. It sounds like ETC is a very solid market positioning. Can you just maybe provide us with a bit of a look into how they compare versus some of their U.S. peers from a size or a client base or a tech perspective? Just some more detail there would be helpful.

Yes. In our due diligence, what we basically found is ETC has a competitive advantage primarily around their product and services offering, product in particular. So some of the competitors only do roadside, meaning they only do the physical tolling systems that you would see as a driver on the highway kind of thing, but they don't do the back office capability. ETC has very strong back office capability. Meaning they have this -- as I mentioned earlier, think of it like a vertical ERP system that handles all of the processing, which ultimately translates to billings and things like that, right? So they have all the customer data. So that's the thing, is they have both components where many of the competition is quite weak in back office and is really much more focused on the hardware essentially. So I would say that's the primary differences.

And just on the back office, is that attached then to most deals? And just as a follow-on, is payments being monetized at all? Or is that using third parties to do the actual billing and payments to the customer -- to the end users?

Yes. On the first point, it's a mix. So there are customers that have both back office and roadside. They have lots of customers that just have roadside or just have back office. And of course, those ones, there's an opportunity to bring those together. They have -- there was a slide in here. Kind of the way I think of it is kind of like a, for lack of a better description, a sandwich where the -- there's the roadside. There's an interoperability layer and then there's the back office. That middle layer is what connects their back office to third-party roadside systems. So there's lots of scenarios where ETC is the back-office provider but not the roadside provider. So they can coexist with their competition, and that's actually a big advantage for them, is they can go into an account and not have to displace the roadside. They can integrate with the roadside through the interoperability platform. And so that was one of the slides. I think it was Slide 5, we presented that 3 layers of capability: the roadside, the interoperability platform, and then finally, the back office capability. So we see a lot of cross-selling of these 2 capabilities into their own installed base but also into competition's installed base as well.

That's helpful. And then just lastly for me. You referenced taking ETC international via IRD's channel. Are there specific markets that you're interested in? And how, from an operational perspective, would you plan to execute on projects and deploy projects and service clients internationally? Would that be something which you would do with your own personnel or leverage the channel?

It's too early to say. I mean in terms of what markets are attractive to us, they would be the markets that IRD has particular strength in. So IRD is quite strong in Europe and in South America. In fact, we have an operation in Chile, for example, so where IRD already has the customer relationships. The buyer of the ETC system is the same buyer as the IRD system. So it's the Department of Transportation level of government. So it's like, in the case of Canada, that would be the province. In the case of the U.S., it would be at the state level. So it's quite handy because IRD has long-standing relationships with those customers. So step 1 is to potentially introduce ETC into those relationships. And IRD actually is in tolling in a small way. They do a lot of the sensors around toll plazas. So that's not the free-flowing toll systems. That's the ones where you go up to the toll and stop. And so the sensor line sensors are often used to do vehicle counting and classification, for example. So that's sort of another jumping off point where we're already working with toll authorities in a small way but then we can introduce a much more sophisticated platform with ETC.

[Operator Instructions] Your next question comes from Todd Coupland with CIBC.

I had a few questions. I'll just sort of run through them here, if that's okay. Just on the purchase price and timing and all that, it looks like Align would be a private equity firm. Can you just talk about the background to the sale, how long they owned it and what happened to the business while they had it and what -- how is ETC's management tied up as they come over to Quarterhill?

Yes, there is a bit of a story there. So ETC, if you go back a bit more than a year ago, it was actually owned by an Italian multinational. And I guess maybe a way to describe it was ETC was a little bit orphaned by that organization. It wasn't really a core asset and misunderstood, I think, to a certain extent. And the owner of that company, I think, was looking to monetize it and in a relatively short period of time. And I think what happened basically is they shopped the company a year ago. There was a competitive process and ACP bought the company about 1 year ago at quite a low valuation just because of the nature of the seller and the dynamic that was at play. So this came to our attention. It's a company we've been aware of for a long time. They were not -- ACP was not, I don't believe, proactively interested in selling the business, and we approached them and were able to come to an agreement with them that made sense for them financially because they're primarily a financial investor. It made sense from a strategic standpoint for us. So we were able to buy the company at what we believe is a very attractive multiple for such a strategic asset, yet ACP was still able to meet their financial hurdles as well. So that's how it came together. We approached them and it kind of went from there.

Okay. And I get the business is $100 million and $12 million to $15 million in EBITDA more or less. You provided some market stats at the beginning with 17% growth in the total market, et cetera. I mean is that the right way to think about growth on the $100 million? Is it growing at that rate? So what did it look like pre-pandemic, if you could just talk a little bit about that.

The CAGRs in this market were lower. They were -- in fact, in my last call, I talked about this a little bit -- they were more like 5% to 7% CAGR but they are increasing to that kind of 17-plus range. In fact, the modeling we've done is a little better than that. But that -- we think it's -- we're quite comfortable with that kind of CAGR for this business based on what we know about the backlog, the pipeline and the recent execution of the business. So yes, it's a long way of saying I think you can use that sort of 17.5% CAGR, the market CAGR for tolling as a good proxy for the ETC business.

Okay. But then you said there was a twist. What was your point on the incremental 7% above and beyond the market growth?

There's more vehicles and there's more toll roads. There's both. Toll-enabled vehicles, there's not more vehicles. There's more toll-enabled vehicles. And so that's where you can get potentially a little bit more lift, but I wouldn't multiply the numbers or anything. But again, I think I would focus much more on the 17 versus the 7. The other big thing, Todd, is like, like if you look at that Slide 8, the gas tax is dropping, right? Like all the time, it's dropping. There's more electric vehicles. There's less sources of revenue from gas tax. And it's just putting a lot of pressure on how do you fund these roads in the future. And tolling is the most obvious answer to that question. And then you combine that with the fact that Biden just have got that approval on the infrastructure bill, which means more roads and more tolls. When you have more tolls, you have more ITS. So it's all tied together basically.