DIRTT Environmental Solutions Ltd., an interior construction company that uses technology for client-driven design and manufacturing, today announced its financial results for the three months ended June 30, 2019. All financial information in this news release is in Canadian dollars, unless otherwise stated.

SECOND QUARTER 2019 VS. SECOND QUARTER 2018

Revenue of $85.6 million vs. $80.7 million (up 6%)
Gross profit percentage of 41.4% vs. 40.6%
Adjusted Gross Profit percentage1 of 43.1% vs. 43.0%
Operating expenses of $29.1 million2 vs. $31.0 million
Adjusted Operating Expenses1,3 of $27.1 million vs. $26.6 million
Adjusted EBITDA1,3 of $9.1 million vs. $8.2 million
Adjusted EBITDA percentage1,3 of 10.7% vs. 10.1%
Net income of $3.0 million3 or $0.03 per share vs. net income of $0.8 million or $0.01 per share

Note: (1) See "Non-IFRS Measures". (2) Includes $2.2 million recovery of stock-based compensation expenses. (3) In the current quarter, Adjusted EBITDA and Adjusted Operating Expenses were impacted by the prospective adoption of a new accounting standard for operating leases, which had the impact of increasing depreciation by $1.4 million and finance costs by $0.3 million with a corresponding reduction in rent expense. The change in accounting policy increased 2019 Adjusted EBITDA by $1.7 million, or 2.0% of revenue, and decreased Adjusted operating expenses by $1.7 million over the comparable 2018 period.

COMMENTARY FROM KEVIN O’MEARA, CHIEF EXECUTIVE OFFICER

We are pleased to announce the successful conclusion of DIRTT’s comprehensive search for a chief commercial officer, a role that was created for the purpose of leading our sales and marketing transformation to drive aggressive growth. We will announce our successful candidate’s name in the coming weeks, in order to allow her former company time to manage the transition of her responsibilities. Her expected start date is in the late third quarter. Our new CCO has most recently served as an executive vice president at a multi-billion dollar, publicly traded enterprise software company with a global footprint, leading product marketing, product management, marketing and sales. She is an accomplished executive with proven expertise in driving business-to-business sales and marketing programs at a company that goes to market via a value-added distribution partner network with an offering that has long sales cycles, similar to DIRTT. We look forward to sharing further details on our CCO in the coming weeks.

In another significant step forward, we are planning to establish a new manufacturing facility in the southeastern US, with commitments to purchase equipment beginning in the third quarter of this year. This new factory fulfills three critical needs: first, it ensures sufficient capacity is available to allow our sales force and distribution partners to sell with confidence to drive growth; second, it eliminates single plant risk; third, it provides better currency-matching of the costs of production with the associated sales. We have conducted a comprehensive analysis of potential locations, including the proximity of commercial real estate markets and customers, labor availability, logistics costs, and sources of raw materials and narrowed the location to two potential sites. We expect to announce our final decision later this year. We expect this factory to be operational in the first quarter of 2021. We anticipate total capital costs of the facility to be US$18.5 million, which we expect to fund with cash on hand.

We are also pleased to announce a permanent solution to the incidence of post-delivery tile warping that was caused by regulatory-driven composition changes to the MDF substrate we use and as discussed in last quarter reporting. The solution involves applying a primer coating on both sides of the MDF, which will result in significantly less moisture absorption than unprimed MDF. This method is being implemented in two phases. The first is that we will initially source the primed MDF from a third party, while we acquire and install the necessary equipment to self-prime the MDF (phase two). We expect total equipment and installation costs to be $2.6 million, with anticipated commissioning in the first quarter of 2020. For the remainder of 2019 and until commissioning of this equipment, we expect that costs for MDF will be commensurate with those incurred in the first two quarters of 2019.

Second quarter revenue growth of 6% was consistent with our expectations. Gross profit increased 8%, compared to the same period in 2018, on higher revenue and the realization of modest improvements in operating efficiencies in our manufacturing facilities. These improvements were partially offset by residual tile deficiency costs of $0.7 million and $0.9 million of incremental costs attributable to certain installations that were sold on fixed price contracts by prior management.

Adjusted EBITDA was $9.1 million compared to $8.2 million in 2018, and included the $1.7 million positive effect of the new leasing standard that was adopted prospectively in 2019. This change reflects higher gross profit for the reasons mentioned above and is offset by slight increases in adjusted operating expenses that were partly attributable to the management consulting engagement and US listing costs discussed in the prior quarter.

In July, we replaced our US$18 million undrawn revolving credit facility that expired on June 30, 2019, with a $50 million three-year committed revolving credit facility with Royal Bank of Canada, of which $40 million is available until certain post-closing conditions are cleared. Management believes that the combination of cash on hand, expected cashflow from operations and this new facility will provide sufficient financial capacity to fund future foreseeable capital requirements.

We also continue to progress toward the anticipated listing of DIRTT’s common shares on the Nasdaq Stock Market. In preparation, management has completed the conversion of the Company’s financial statements to US GAAP with a US dollar presentation currency and has also performed an in-depth assessment of its governance policies and related documentation to comply with US securities standards. We anticipate the listing to occur this fall.

Looking to the balance of the year and based on current visibility, DIRTT’s management team reaffirms an annual revenue guidance range of 5% to 10%, with an expectation that we will be at the lower end of that range for the full year. This is due to the timing of some projects now anticipated to deliver in early 2020.

DIRTT’s chairman of the board, Steve Parry, also announced that effective at the Company’s next board meeting in November 2019, board member Richard Haray would retire from the board. Mr. Haray has served as a board member since 2016. “We’ve been fortunate to have Richard serve on DIRTT’s board for the past three years and we’re particularly appreciative of his active role in assisting DIRTT through last year’s management changes,” said Parry. “We extend our gratitude and best wishes to Richard and his family.”

SECOND QUARTER FINANCIAL REVIEW

Revenue
Revenue growth of 6% in the second quarter over the prior year period was driven primarily by a weaker Canadian dollar and increased education sales. Combined with modest growth in the commercial segment and increased installation activity, this increase was partially offset by lower healthcare sales, which reflect the timing of projects and modest reductions in government sales.

Gross Profit / Gross Profit % / Adjusted Gross Profit / Adjusted Gross Profit %
Gross profit increased to $35.5 million or 41.4% of revenue for the three months ended June 30, 2019, from $32.8 million or 40.6% of revenue for the same period of 2018. During the quarter, DIRTT began to realize the benefits of operational improvement activities in its manufacturing facilities. Reductions in direct material and transportation costs—due to improved efficiency and product mix—offset the incremental costs of $0.7 million (0.8% of gross profit) to mitigate further warping of DIRTT’s tiles, $1.3 million of costs associated with headcount additions throughout 2018 in anticipation of higher volumes, and a $0.9 million reduction in gross profit on certain uneconomic installation projects.

Adjusted Gross Profit and Adjusted Gross Profit % increased to $36.8 million or 43.1% of revenue in the second quarter of 2019, from $34.7 million or 43.0% of revenue in the same period of 2018, for the reasons described above.

Operating Expenses / Adjusted Operating Expenses
Adjusted Operating Expenses exclude the impact of depreciation, stock-based compensation and reorganization costs. Adjusted Operating Expenses increased $0.5 million to $27.1 million in the second quarter of 2019, compared to $26.6 million in the second quarter of 2018. Adjusted Operating Expenses were impacted by the prospective adoption of a new accounting standard for operating leases. The change in accounting policy decreased Adjusted Operating Expenses by $1.7 million, as $1.4 million of increased depreciation was subtracted in the calculation of Adjusted Operating Expenses and $0.3 million was classified as finance costs.

Sales and marketing expenses
Sales and marketing expenses decreased $0.3 million to $12.8 million for the three months ended June 30, 2019, from $13.0 million for the three months ended June 30, 2018. Included in sales and marketing expenses in the second quarter was $1.7 million of consulting costs related to the sales and marketing consulting engagement, as described last quarter. These costs were absorbed by continued reductions in travel, meals and entertainment costs, along with reductions related to specific trade shows. None of these expense reductions are expected to impact sales revenue.

General and administrative expenses
General and administrative expenses decreased $1.1 million to $8.9 million for the three-months ended June 30, 2019, from $10.1 million for the same period in 2018. In the second quarter of 2018, the Company incurred $1.2 million related to proxy defense costs, which did not recur in 2019. This reduction was partially offset by $0.5 million of costs related to the US listing that were incurred in the second quarter of 2019.

Operations support expenditures
Operations support expenditures increased $1.3 million to $5.9 million for the three-month period ended June 30, 3019, from $4.6 million for the same period in 2018. Included in operations support expenditures in the second quarter was $0.9 million of consultant costs, which were incurred to assist with the evaluation of current operations and the rectification of the tile warping issue. Additionally, personnel costs increased due to team additions and an increased provision for variable compensation.

Technology and development expenses
Technology and development expenses increased $1.7 million to $3.6 million for the three months ended June 30, 2019 from $1.9 million for the three months ended June 30, 2018. This is due to a $0.7 million decrease in capitalized salaries for the quarter, as the current mix of projects undertaken by the team included a higher portion of efforts related to business process improvements that weren’t eligible for capitalization. Additionally, the Company has provided $0.4 million higher provision for variable compensation in the current year, and in 2018, $0.4 million additional salary and benefit costs were classified as cost of sales of technical services.

Stock-based compensation
Stock-based compensation reflected a $2.2 million recovery in the second quarter of 2019 (2018 - $0.3 million expense). The Company recorded fair value adjustments on cash settled stock options during the three-month period ended June 30, 2019, with no fair value adjustment in the respective prior year periods.

The fair value adjustment was a result of the cash surrender feature put in place for employee stock options, subsequent to the Company ceasing to qualify as a foreign private issuer. Once a US registration statement is filed and accepted by the Securities Exchange Commission, the Company will cease accounting for the fair value of the outstanding stock options.

The Company incurred no reorganization costs in the second quarter of 2019.

Adjusted EBITDA / Adjusted EBITDA %
For three months ended June 30, 2019, Adjusted EBITDA increased to $9.1 million or 10.7% of revenue, from $8.2 million or 10.1% of revenue in the same period of 2018. This increase reflects the $2.1 million increase in Adjusted Gross Profit, increases in Adjusted Operating Expenses of $0.5 million that included the impacts of the sales and marketing consulting engagement, US listing costs, and other one-time costs noted previously, the $1.7 million benefit of the new accounting standard for leases discussed above, and a $0.5 million impact of foreign exchange losses.

Net income / Adjusted Net Income
Net income was $3.0 million or $0.03 per share in the second quarter of 2019, compared to net income of $0.8 million or $0.01 per share for the second quarter of 2018. This variance is the result of changes in gross margin and operating expenses as described above. Net income for the three months ended June 30, 2019 includes the impact of a $2.2 million recovery (2018 - $0.3 million expense) in stock-based compensation and $nil (2018 - $1.0 million) of reorganization costs. Excluding these items, Adjusted Net Income was a $0.4 million loss or $nil per share for the second quarter of 2019, an increase from $1.5 million Adjusted Net Income or $0.02 per share in the second quarter of 2018.

Liquidity and Capital Resources
As at June 30, 2019, the Company held cash and cash equivalents of $76.9 million, an increase of $4.0 million from December 31, 2018. In July 2019, the Company entered into a $50 million revolving operating facility with the Royal Bank of Canada (of which $40 million is available until certain post-closing conditions are cleared), replacing the US$18 million revolving operating facility that expired June 30, 2019. Management believes that existing cash and cash equivalents, cash flows from operations and available borrowings under its credit facility will be sufficient to support working capital and capital expenditure requirements for the foreseeable future.

Capital expenditures decreased by $2.7 million for the three months ended June 30, 2019, of which $0.7 million relates to a reduction in capital expenditures on internally generated intangible assets. The level of capitalizable activity decreased comparatively, as 2018 included significant internal efforts on the DIRTT Timber and DIRTT for Life development activities which were curtailed in the second half of 2018. Additionally, a portion of the ICE software development team’s current development activities includes projects related to business process improvements that are not eligible for capitalization.