Custom Truck One Source, Inc. (CTOS) Q2 2023 Earnings Call Transcript

Custom Truck One Source, Inc. (NYSE:CTOS) Q2 2023 Results Conference Call August 8, 2023 5:00 PM ET

Company Participants

Brian Perman - VP of IR

Ryan McMonagle - CEO

Chris Eperjesy - CFO

Conference Call Participants

Michael Shlisky - D.A. Davidson

Tami Zakaria - JPMorgan

Justin Hauke - Robert W Baird

Scott Schneeberger - Oppenheimer

Nicole DeBlase - Deutsche Bank

Tim Thein - Citigroup

Operator

Ladies and gentlemen, thank you for standing by and welcome to Custom Truck One Source Second Quarter 2023 Earnings Conference Call. Please note that this conference call is being recorded.

I would like to hand the conference over to your host today, Brian Perman, Vice President of Investor Relations for Custom Truck. Please go ahead.

Brian Perman

Thank you and good afternoon. Before we begin, we would like to remind you that management's commentary and responses to questions on today's call may include forward-looking statements, which by their nature are uncertain and outside of the Company's control. Although these forward-looking statements are based on management's current expectations and beliefs, actual results may differ materially.

For a discussion of some of the factors that could cause actual results to differ, please refer to the Risk Factors section of the Company's filings with the SEC. Additionally, please note that you can find reconciliations of the historical non-GAAP financial measures discussed during the call in the press release we issued today. The press release we issued this afternoon and our quarterly investor presentation are posted on the Investor Relations section of our website.

We filed our second quarter 2023 10-Q with the SEC this afternoon. Today's discussion of our results of operations for Custom Truck One Source Inc. or Custom Truck is presented on a historical basis as of or for the three months ended June 30, 2023 and prior periods. Joining me today are Ryan McMonagle, CEO; and Chris Eperjesy, CFO.

I will now turn the call over to Ryan.

Ryan McMonagle

Thanks, Brian. And welcome, everyone, to today's call. I'd like to begin by thanking all of our employees, customers and suppliers who continue to support our business and helped us deliver another strong quarter. The entire Custom Truck team continues to deliver record levels of production, which enables us to continue to grow our rental fleet to meet continued strong demand for new equipment and to fulfill our goal of providing unrivaled service to our customers. For the second quarter of the year, we delivered strong year-over-year revenue, adjusted gross profit and adjusted EBITDA growth. We generated $457 million of revenue, $154 million of adjusted gross profit and $103 million of adjusted EBITDA in Q2, up 26%, 22% and 21%, respectively, versus Q2 2022.

Our second quarter results align with our expectations that our business this year would reflect the benefits of moderating inflation, improved supply chain performance and continued operational excellence. Demand remains strong in each of our strategically selected end markets: utility or T&D, telecom, rail and infrastructure. These markets continue to offer compelling long-term growth opportunities well in excess of GDP, which we believe should continue for the foreseeable future. The reported backlogs of the utility and telecom contractors, our largest customer base, continue to be good proxies for this sustained growth and remain at or near record levels. We see continued strong demand in our own new sales backlog and in the performance of the rental fleet. Additionally, in the second quarter, we continued to experience strong demand from our customers to purchase assets in the rental fleet.

We see all of these as positive leading indicators for sustained future demand. The rental segment experienced 16% revenue growth year-over-year. We continue to see strong demand for rental equipment and we remain focused on rental pricing and the amount of time it takes to turn a piece of equipment and make it available to go back on rent, both of which positively impact adjusted gross margin. In the quarter utilization finished at just under 82%, which is historically very strong. We experienced a decline in utility, distribution, equipment utilization; which we believe is temporary and primarily related to our customers' supply chain delays. We continue to invest in our rental fleet and sell certain aged assets. This resulted in the reduction of our fleet age down to 3.6 years, which we believe remains the youngest in the industry. We expect to continue to invest in the fleet for the remainder of the year as demand remains robust.

In the TES segment, we sold $251 million of equipment in the quarter, a 39% increase compared to Q2 2022 and the highest level of quarterly sales in the Company's history. Additionally, gross margin improved significantly versus Q2 of last year and our backlog continued to grow ending the quarter at $864 million, up 30% versus a year ago and up modestly versus the end of Q1. As we continue to achieve record TES sales and production levels, we should experience slower growth in our backlog, which we expect will eventually return to a more normalized level. This past quarter's TES results point to continued strong demand for new equipment. We are proud of the relationships we have with our chassis, body and attachment vendors and we continue to work closely with them to address supply chain issues as they arise.

We continue to see an increase in equipment availability from our chassis and attachment suppliers, which positions us well to meet our production, fleet growth and sales goals for the remainder of the year and beyond. Strategically we remain focused on investing in and optimizing our production capacity and service footprint to ensure that we deliver the product and service levels our customers expect from us. On last quarter's call, we discussed the expansion projects at our Kansas City, Missouri and Union Grove, Wisconsin locations. The work at the Union Grove location is complete and the new capacity is largely online while the expansion in Kansas City is expected to be complete later this year. These investments will ensure that we have sufficient capacity to meet our growth targets for both our rental fleet and new equipment sales as well as be a catalyst for growth in our APS segment.

As we look ahead to the rest of the year; we believe that our first half results, favorable end market tailwinds, robust customer demand, improving supply chain dynamics and continued outstanding execution by our team; all provide Custom Truck with the momentum to deliver strong revenue, adjusted gross profit and adjusted EBITDA growth. While Chris will discuss our 2023 outlook in greater detail, based on year-to-date performance and the outlook for the remainder of the year, we are increasing our projected total revenue guidance range to $1.725 billion to $1.83 billion and our adjusted EBITDA range to $425 million to $445 million. In closing, we know our employees are the key to delivering the unequaled customer service and outstanding financial results we saw in the second quarter and I'd like to extend a sincere thank you to them.

I will now turn it over to Chris.

Chris Eperjesy

Thanks, Ryan. Q2 was another very strong quarter. End market demand remained strong resulting in total revenue of $457 million, up 26% compared to Q2 2022. Adjusted gross profit was $154 million, up 22% compared to Q2 2022 resulting in an adjusted gross margin for the quarter of 34%. Adjusted EBITDA was $103 million, a 21% improvement compared to Q2 2022. Adjusted gross profit and adjusted EBITDA growth lagged revenue growth largely as a result of segment revenue mix. While all of our segments experienced year-over-year growth, rental asset sales and TES revenue, which have a lower average gross margin associated with them than our equipment rental business, comprised 66% of total revenue in Q2 2023 versus 60% in Q2 2022. SG&A was $58 million for Q2 or 12.7% of revenues, an improvement versus 13.5% in Q2 2022.

Net income for the quarter was $11.6 million, the third consecutive quarter of positive net income. Ryan referenced our continued strong performance within our ERS segment for the quarter, utilization was just under 82% and average OEC on rent increased by more than $53 million compared to Q2 2022. On rent yield was over 40% for the quarter compared to just over 39% for Q2 2022. We continue to see the benefits from previously announced pricing actions implemented since the beginning of last year. Our OEC in the rental fleet ended the quarter at $1.47 billion, up by $68 million versus Q2 2022. Consistent with our expectation, we had continued strong investment in our rental fleet this quarter with net CapEx of $50 million. We expect to continue to invest in the fleet during the second half of the year.

For Q2, ERS rental revenue was $118 million, a 9% increase versus Q2 2022. ERS used equipment sales for Q2 remained strong at $51 million, up more than 36% versus Q2 2022. ERS adjusted gross profit was $97 million for Q2, up 12% from Q2 2022. Adjusted gross margin was 57.8% in the quarter, a more than 640 basis points sequential improvement from Q1 as rental revenue comprised a larger percentage of total ERS revenue in Q2 than in Q1. TES saw another record quarter with revenues of $251 million, which were up almost 39% from Q2 2022. This segment continues to benefit from record backlog, continued strong inventory flows and record levels of production. Gross profit increased by more than 69% in the quarter compared to Q2 2022. Gross margin for the quarter was over 18%, an improvement of over 330 basis points from Q2 2022.

The improvement in TES gross margin reflects the implementation of ongoing production efficiency initiatives as well as maintaining pricing discipline. Our sales and order activity continues to be strong with backlog growing in the quarter to $864 million, which is 30% higher than at the end of Q2 2022. We believe the continued growth in the TES sales backlog reflects sustained long-term demand for equipment indicative of our favorable end market dynamics, our strong market share gains and our pricing discipline. As this quarter's TES results show, we are confident we will be able to hold margins at or above the average we experienced for all of 2022 over the coming quarters even with elevated levels of inflation. Our APS business posted revenue of $37 million, up 4% versus Q2 2022. Adjusted gross profit margin in the segment improved to 29.5% in Q2.

Maintaining a strong liquidity position and improving leverage remain priorities for us as do investing in the rental fleet, expanding our geographic footprint and pursuing selective strategic growth through M&A. Since initiating our stock repurchase program in the third quarter of last year, we have repurchased approximately $15 million of our stock. During the second quarter, we increased borrowings under our ABL by more than $30 million mainly to fund working capital as we replenish inventory and ramp up production to meet demand with the outstanding balance at the end of Q2 at $492 million. As of June 30, we had $255 million available and nearly $300 million of suppressed availability under the ABL with the ability to upsize the facility. With LTM adjusted EBITDA of $425 million, we finished Q2 with net leverage of 3.3x, an improvement of 1.3 turns since the close of the transaction with Nesco in April of 2021 and down from just over 3.4x last quarter.

Achieving net leverage below 3x remains our target and the one that we believe we can achieve by the end of fiscal 2023 even while continuing to grow our rental fleet, to expand our production capacity and to invest in working capital for future growth. We will continue to seek to make incremental investments and prudent acquisitions when we believe they create long-term shareholder value. With respect to our 2023 outlook, we believe ERS will continue to benefit from strong demand from our rental customers as well as for purchases of rental fleet units, particularly older equipment, for the rest of the year. We continue to expect to further grow our net OEC by mid to high single digits this year. Regarding TES, continuing supply chain improvements, improved inventory levels and record backlog levels should improve our ability to produce and deliver more units than previously expected in the coming quarters.

As a result of our improved outlook, we are updating guidance for our segments as follows: we expect ERS revenue of between $700 million and $735 million, TES revenue in the range of $880 million to $940 million and APS revenue of between $145 million and $155 million. As Ryan mentioned previously, this results in total revenue in the range of $1.725 billion to $1.83 billion and we are projecting adjusted EBITDA from $425 million to $445 million. In closing, I want to echo Ryan's comments regarding our continued strong performance. As we've moved into the third year of our successful combination with Nesco, we continue to deliver strong revenue and adjusted EBITDA growth to hold or expand margins in an inflationary environment and to reduce leverage, all while providing the highest levels of service to our customers.

With that, I will turn it over to the operator to open the line for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Michael Shlisky with D.A. Davidson.

Michael Shlisky

Can you go back and explain again the utilization being down quarter-over-quarter? I wasn't sure I caught the flotation, could you just give more detail? Did you imply that the customers that didn't have the supply chain for the things that they put on to their equipment? Or I guess I would normally expect it to be a little bit warmer outside so just higher utilization. Just give a little more of a narrative as to why it went down quarter-over-quarter?

Ryan McMonagle

Sure. Mike, it's Ryan. You're right, utilization did decline a touch from Q1 to Q2. It's still kind of at very strong levels of 81.7% for the second quarter. Normally there is just a touch of seasonality in the second quarter too so that's a pretty normal decline that we see. And then what we did see this year is that some of the distribution equipment, we saw utilization fall a bit in distribution equipment. We're seeing it return now later into August so we're seeing it pick back up. And the explanation we're hearing from customers is really around availability of their supply chain so things like transformers in particular. So I think it's a onetime issue and it will continue to come back and again it's at 81.7%, which is if we hadn't been running in the mid 80%s, we would say it's as good as it gets really from a utilization standpoint. So still feel really good about it. And then we expect transmission equipment will pick up kind of to your hot comment. Transmission will pick up here as the heat breaks and as some of the new transmission work begins, which typically happens right after the end of the summer.

Michael Shlisky

Got it. I wanted to turn to truck chassis supply. The broader Class 8 outlook for 2024 truck production is still down and that includes both vocational and cargo. I can understand cargo being down, but it sounds like you've got such great tailwinds in your end markets that we'll see vocational trucks to be up, at least that's what you'd like it to be. I guess could you give us some thoughts as to how you feel about chassis supply for next year if the trajectory of the way things are going now continue also in the next couple of quarters?

Ryan McMonagle

It's a great question. We're still seeing constrained supply chain, right? So it's not wide open that we're able to receive as many chassis as we'd like, but we are seeing our chassis flow increase. So that's why you see TES revenue in particular is up as much as it is in the first half of the year. You're also seeing that we've deployed more capital into the rental fleet in the first half of the year too because truck supply chain is up.

I guess where we look forward a little bit is when we're able to deliver the growth that we have in TES and see backlog continue to grow from the beginning of the year and even quarter-on-quarter. We think demand will obviously remain very strong into next year. And right now in our conversations with our chassis partners, we're anticipating that we should see more chassis next year. How many more chassis is somewhat to be determined and we do think it will still be a constrained supply chain, but we do think that we'll see a larger allocation heading into next year as well.

Operator

The next question comes from Tami Zakaria with JPMorgan.

Tami Zakaria

So my first question is your ending OEC came in somewhat below what we were modeling and you're expecting mid to high single-digit growth for the year. So can you help us understand are you expecting to scale back equipment sales versus the first half or accelerate asset purchases to get to that mid to high single-digit percent number?

Chris Eperjesy

Tami, this is Chris. As we said, it would be mid to high single digits. That still is our plan. We still expect to get there. We're somewhat flexible in terms of gross CapEx versus some of the sales and so there could be some movement. I think previously we've given guidance that we expect to spend over $400 million on gross rental CapEx. That's still our plan and it's still our plan to grow in the mid high single digits.

Tami Zakaria

Got it. That's helpful. And then the other question I have on rent yield, you saw a sequential tick up. Is that mostly pricing benefits flowing through? Should we expect this to continue to tick up until you lap some of these price increases?

Chris Eperjesy

I think that's fair. Yes, that would be fair to say, Tami.

Tami Zakaria

Okay. So we should be modeling like sequential growth in 3Q and 4Q as well?

Ryan McMonagle

Tami, it's Ryan. It takes about a year, right, for the whole fleet to turn in terms of new pricing and obviously depends on utilization and some specifics. But yes, I think right now we're still seeing kind of the benefits of price flow through in terms of that on rent yield metric. So we think it will continue to pick up a bit in the second half of the year.

Operator

The next question comes from Justin Hauke with Robert W Baird.

Justin Hauke

I wanted to ask about the ERS segment guidance for the second half, which is implying even at the high end kind of flat revenue growth for the second half and that segment is always hard to kind of model because it's got the rental component and then the sales component and I know you had some kind of unusual sales activity last year that makes some difficult comps in there. But maybe just thinking about the seasonality between 3Q and 4Q and I guess how we should think about maybe the sales component of that business in particular.

Chris Eperjesy

I think you summarized it pretty well. It is going to be a tough comp versus last year. We talked a little bit about the utilization, the decrease in utilization we saw at the end of the quarter leading into Q3. And so there are some components there that clearly are a little more difficult to predict, in particular the rental asset sales. But I think you summarized it pretty well in terms of our thinking.

Justin Hauke

Okay. Any comment on just the sequencing of 3Q versus 4Q in terms of the difficulty in the comps?

Chris Eperjesy

I don't think we expect. We talked earlier in the year in terms of how the year typically plays out. So our expectation coming into the year, both revenue and EBITDA was 45/55 split. We think that's narrowed somewhat first half versus second half. Q4 tends to be the strongest, we continue to expect that to be the case. So I don't think any updated guidance there in terms of what our expectations are.

Justin Hauke

Okay. And then I guess my second question is just on the free cash flow. One of the biggest drags that you've had year-to-date has been the inventory investment on the working capital side, which makes sense, that's steadily increased really every quarter sequentially and it makes sense because you're growing. But is that a release of free cash flow in the back half as maybe some of the really high sales activity kind of moderates? I'm just trying to understand what the moving pieces are for free cash flow in the second half.

Chris Eperjesy

Yes, we certainly would expect in Q4 that you would see that. We're in a position where with all the growth, we're happy to have the chassis, we're happy to have the attachments. So it's a situation where just 18 months ago we were in a much different position. So we feel very good about the level of inventory we have certainly as we look out to 2024. But to your comment, we should definitely see improved cash flow in the second half of the year and certainly in Q4.

Operator

The next question comes from Scott Schneeberger with Oppenheimer.

Scott Schneeberger

If we could, could we talk about the guidance increase, Chris? What was the outperformance in second quarter that you factored and then what were your considerations in the back half? I think a lot of the prior questions have gotten at this point, but can you tie it all together about how you factored in the second half guidance particularly with regard to EBITDA?

Chris Eperjesy

Yes. I'll maybe just start on revenue. We've seen a significant improvement in terms of our inventory flow which has allowed us, as Ryan talked about, certainly to have record quarters on new equipment sales and deliveries and so we expect that to continue in the second half of the year. So that's part of it. You saw a pretty significant increase on the revenue there. We've continued to see strong utilization, strong demand for rental asset sales so we took that into account. The reason you're not seeing it all flow through on the EBITDA is because we're also seeing with the increased inventory with higher rates, increased costs with respect to floor plan. So there's a little bit of not the flow through you might have expected and that's why you're seeing the $5 million on the lower and top end on EBITDA and a little bit higher on the revenue -- on the higher revenue and higher EBITDA range with the higher commissions and higher bonuses paid. And so we took all that into account as we updated the guidance.

Scott Schneeberger

Okay. And could you talk a little bit about rental versus sales decisions as you are seeing the supply chain open up a good bit? Just how you're feeling? It sounds like you're feeling good about getting what you want -- most of what you want maybe not all of what you want, in the back half of this year. Maybe a comment on that. And then on how you're allocating sales versus rental, the decision process there.

Ryan McMonagle

Scott, it's Ryan. You're right. We are seeing improvement, right, and so we're able to able to increase rental OEC what we're putting into the fleet, which is what you see relative to last year. I think it's about a $50 million increase versus last year on a year-to-date basis and that's why we aren't able to sell because we're selling into so much backlog too. So look, we obviously allocated $1 to a rental asset kind of on the margin where we can, but right now it's just about taking care of the customer. And even with kind of the pace of new sales that we've realized really in the last two months -- sorry, the last two quarters, we're still seeing backlog grow, right? So there is still more demand out there that we're trying the best we can to take care of both and obviously do that prudently and we'll continue to do that in the back half of the year as well.

Scott Schneeberger

All right. One more from me if I could. Could you just address your primary end markets, what you're seeing good and bad? And as a kind of a 1b part of the question. Are you seeing anything associated with the infrastructure bill yet? It doesn't seem like the funds are flowing or there's a lot of project allocation. What are you seeing on that front?

Ryan McMonagle

Great question. We're still seeing really good demand on transmission and distribution. We're hearing more about transmission jobs that are being awarded. We are -- so still a really good kind of macro landscape that we're playing into and we're seeing a lot of distribution work that needs to be done. The only constraint that we're hearing about now is their supply chain. So as they're waiting for transformers or conductor that it's just taking time, right, to get that equipment to be able to work. So that's the only constraint that we're hearing. We think that's temporary, but that's the constraint that we're hearing. When we look at positive indicators and we mentioned that we're still seeing strong RPO buyouts, real asset buyouts in both of those categories. So we take that as a really positive indicator and we're continuing to see that into the beginning of Q3.

And so we're seeing a good dynamic there, which we certainly feel like there's a bullish run that will continue on both sides on transmission and distribution, which is the largest end market. And then related to the IRA question, I would agree with what you said that we are hearing about dollars being allocated. We are having some discussions now and seeing in our backlog maybe a little bit on the vocational side of things so some of the specialty dump trucks and that type of equipment. We're starting to see some of that that we think is IRA related. But I would say that it's very little revenue still at this point, but we're starting to see a little bit of it show up in backlog. So we think that's again just more tailwind for why backlog will continue to perform well and why we'll be able to deploy capital into the rental fleet as well.

Operator

The next question comes from Nicole DeBlase with Deutsche Bank.

Nicole DeBlase

Maybe just starting with a follow-up on the utilization discussion. So with the I guess delays that you're seeing with distribution, do you think that that's a quick factor where you kind of see utilization kind of snap back in the second half or do you think it will take time for that to kind of work its way through?

Ryan McMonagle

Yes, I think it will gradually improve. We think you have two dynamics playing there. You'll have distribution kind of gradually improve, which is what we're already seeing so far in the third quarter and then on the transmission side, you'll see the pickup that normally happens that we are still anticipating for later this summer, early fall. So you'll see both of those continue to pick up like we normally see in the third quarter.

Nicole DeBlase

Okay. Got it. And then with respect to the TES backlog, can you just speak to where lead times stand now and if those have come down at all?

Ryan McMonagle

So total backlog where it is almost four quarters even looking at kind of where the Q2 sales number was. So it is still higher than we would have expected more than it would be historically, maybe I'll say that, and we are seeing lead times continue to push. So we are largely on order for a good portion of next year when it comes to our key attachment suppliers and the same is true on chassis as we're talking about full year allocations and just waiting on final numbers to begin to put those units on order too. So again it depends by product category and in the aggregate we saw backlog build and the majority of product categories build in the second quarter. There were a few that we saw some modest declines, but those were already in product categories where backlog is elevated. So we are still seeing really good overall demand across all the product categories.

Operator

[Operator Instructions] The next question comes from Tim Thein with Citigroup.

Tim Thein

Maybe just one quick one on your telecom customers. I'm just curious if they -- certainly there's been a lot in the press around these potential [lead] cable issue and I'm just curious if that -- and who knows what the potential costs could be to remove or remediate these cables. I mean do you think that impacts at all their capital decisions as they kind of ponder what could be a bigger outlay? Does that impact Nesco in any way do you think or just TBD?

Ryan McMonagle

Tim, I'd say TBD. Telecom is less than 5% of revenue and backlog is still there and we've still been delivering. So it's not anything that's come up in any significant way in any of our conversations with our customers, but obviously it's in the news so we're watching it closely. But it's nothing that's come up to this point.

Tim Thein

Okay. I appreciate that the significance or lack of you guys, I'm just curious if that bleeds into other areas of the business, but I don't care as much. And just on the TES backlog and given the growth there and given how long it extends, is it too early in terms of your discussions with suppliers as you look into '24, presumably the uncertainty around inflationary cost pressures I would imagine have abated. But how are you approaching that in terms of how you price these new orders relative to a backlog that continues to extend and just making sure you're keeping the -- the question relates to basically the gross profit and the backlog and how you're approaching those pricing decisions in what I would imagine is still kind of an uncertain cost backdrop?

Ryan McMonagle

Yes, you're right. We're still working closely with suppliers in terms of understanding costs so that we can price appropriately. But I think we mentioned it a few calls ago that we have the ability to reprice the backlog as we need to and so when we see significant -- so we're using our best estimates and we're communicating that to the customers. But when we see a significant price increase come through, we're obviously going back to our customers and talking through that with them. So it's something we're very aware of and we'll continue to manage closely.

Operator

This concludes the question-and-answer session. I would like to turn the conference back over to Ryan McMonagle for any closing remarks. Please go ahead.

Ryan McMonagle

Thank you. Thanks, everyone, for your time today and your interest in Custom Truck. We look forward to speaking with you on our next quarterly earnings call. And in the meantime, please don't hesitate to reach out with any questions. Thank you again.

Operator

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.