Information Services Group Inc (III) 2018 Q3 法說會逐字稿

Good day, and welcome to the Information Services Group 2018 Third Quarter Investor Conference Call. Today's conference is being recorded, and a replay will be available on ISG's website within 24 hours. At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. Barry Holt. Please go ahead, sir.

Thank you, operator. Hello, and good morning. My name is Barry Holt. I'm a Senior Communications Executive at ISG. I'd like to welcome everyone to ISG third quarter conference call. I'm joined today by Michael Connors, Chairman and Chief Executive Officer; and David Berger, Executive Vice President and Chief Financial Officer. Before we begin, I'd like to read a forward-looking statement. It is important to note that this communication may contain forward-looking statements, which represent the current expectations and beliefs of the management of ISG concerning future events and their potential effects. These statements are not guarantees of future results and are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated. For a more detailed listing of the risks and other factors that could affect future results, please refer to the forward-looking statement contained in our Form 8-K that was furnished yesterday to the SEC and the Risk Factors section in ISG's Form 10-K covering full year results. You should also read ISG's annual report on Form 10-K for the fiscal year ending December 31, 2017, and any other relevant documents including any amendments or supplements to these documents filed with the SEC. You'll be able to obtain free copies of any of the ISG's SEC filings on either ISG's website at www.isg-one.com or the SEC's website at www.sec.gov. ISG undertakes no obligation to update or revise any forward-looking statements to reflect subsequent events or circumstances. During this call, we will discuss certain non-GAAP financial measures, which ISG believes improves the comparability of the company's financial results between periods and provides for greater transparency of key measures used to evaluate the company's performance. The non-GAAP measures, which we will touch on today, include adjusted EBITDA, adjusted net earnings and the presentation of selected financial data on a constant currency basis. Non-GAAP measures are provided as additional information and should not be considered in isolation or as a substitute for financial results prepared in accordance with GAAP. For the reconciliation of all non-GAAP measures presented to the most closely applicable GAAP measure, please refer to our current report on Form 8-K, which was filed yesterday with the SEC.

And now, I'd like to turn the call over to Michael Connors, who'll be followed by David Berger. Mike?

Thank you, Barry, and good morning, everyone. Today, we will review our third quarter results, brief you on our key operating and client highlights and update you on our full year forecast. Let me review our progress in some key metrics. Our Go Digital strategy is working. Digital solutions continue to be a growth engine for the firm representing more than 40% of total revenues. We're responding to client demand with continued investments in this area, including building our ISG automation business and recently launching our ISG Blockchain Now solution.

Moving workloads to the cloud and automating business processes are 2 of the most important digital transformation areas for our clients. That's reflected in the strong growth of our automation services. ISG automation is on track to produce run rate revenues of $25 million in 2018, up significantly from our startup phase in late 2016.

We recently formed a partnership with UiPath, the third-largest RPA software provider. This is in addition to the partnerships we already enjoy with the #1 and #2 providers, Automation Anywhere and Blue Prism. Strong demand for automation services and software is reflected in the market valuations of these companies, which I will discuss in a moment.

Our recurring revenues are on a run rate to reach nearly $80 million this year on the way to our goal of $100 million within 3 years. This progress comes despite a significant decline in our U.S. public sector multiyear contract this year.

With a robust European demand environment, our revenues grew by more than 20%, with particularly strong growth in Germany, the Nordics and France. Europe's growth in As-a-Service is accelerating, indicating stronger demand for our digital transformation services. In terms of industries, 2 of our biggest growth sectors are insurance, up 30%, and manufacturing, up 15%. We used our cash to reduce our debt by $9 million in the quarter, $16 million in the first 9 months, and we expect by $18 million for the full year.

Our strengthening financial position can put us in line to resume more substantial share repurchases, following the announcement of our year-end results in March. Our GAAP earnings per share of $0.08 was up $0.05 over the prior year, and adjusted earnings per share of $0.14 was up 40%.

We are pleased with our recent margin acceleration. Our EBITDA margin for the quarter was 13%, the fourth time in the last 5 quarters we have reached this level or higher. Our third quarter revenues at $68 million were even with the prior year. Revenue growth in the Americas was impacted by a continued softness in our public sector market and a number of timing delays and network engagements being completed. We expect to see much of this network revenue in the fourth quarter.

Our network business generates above-average firm margins. To remind you, this business normally includes a gain-sharing component that flows through after carrier contracts are signed. So as we have discussed in the past, due to the nature of the work, revenues can be at times a bit uneven. The trade-off, however, is much stronger margins.

ISG served 430 clients during the quarter, the seventh time in the past 8 quarters in which the number of clients has exceeded 400. Through the first 9 months, we served almost 600 clients. Our business, overall, continued to have good growth potential near-term based both on our building pipeline and industry expansion. The growth of the sourcing industry, overall, with an emphasis on digital business and customer experience, rather than only cost savings is good news for ISG as we enter 2019. We expect $80 billion of infrastructure contracts to come due by the end of 2020. And we expect nearly half of that work to move to the cloud and be in the center of digital transformation services. Clearly, our decision to move quickly into automation in 2017 is beginning to pay dividends. Automation is our fastest growing digital business, and clients are joining the journey in increasing numbers. Valuations continue to rise in this sector.

In September, UiPath, we just signed with, announced the completion of a Series C funding, which raised $225 million at a valuation of $3 billion, up from $1.1 billion valuation in March. Automation Anywhere, another RPA software partner firm, raised $250 million in July, putting their value at $1.8 billion. And Blue Prism, publicly traded in the U.K. as a market cap in excess of $1.5 billion, on trailing 12-month revenue of around $50 million.

We have partnerships with all 3 of these software providers. The automation business -- the ISG automation business, with a combination of services and recurring software subscriptions, is becoming increasingly more valuable for our firm and our shareholders. ISG's automation is on pace to deliver run rate revenues of $25 million in 2018, driven in part by software subscriptions. These recurring software revenues for ISG have now increased to nearly 30% of our automation revenue since our startup phase in late 2016.

A recent study from ISG shows that many companies have been able to automate a few processes successfully, but are struggling with enterprise-wide adoption, what we call at ISG, Bot 3.0. Many organizations hit the RPA wall after automating 10 to 20 processes. They have trouble scaling automation across the enterprise. Our value lies in supporting clients by creating an automation roadmap and a dedicated RPA center of excellence to govern their automation journey. As our clients adopt a range of digital technologies, they must also consider upgrading their networks to support the increasing digitization of their organizations.

In September, we held our first ever ISG Future Networks Summit in Chicago. Our experts addressed the key issues for moving to the network of the future, including using software-defined networks to bring the network into the cloud. One of the most talked about and, perhaps, least understood digital technologies is blockchain. Last month, we announced the launch of ISG Blockchain Now. This new advisory and sourcing solution enables enterprise clients to improve the efficiency, the accuracy and security of their business processes through distributed ledger technology.

Beyond cryptocurrency, blockchain is being used in such areas of supply chain management, logistics, smart contracts and more. We are currently working with a global building systems manufacturer on a proof of concept for using blockchain to streamline and coordinate the supply chain interactions between the company, service technicians and building owners to keep the installed base of equipment running smoothly. We expect our blockchain business to evolve over time, but as with automation, ISG is entering the arena now that create use cases with clients in preparation for when this technology becomes even more mainstream over the next few years.

Now turning to our regions. In Europe, we reported revenues of $24 million, up 22% versus the prior year and in line with our record quarterly revenues in Q2. Our performance this quarter also was a reversal of historical trends. As you may recall, Europe's third quarter is typically slower in Q2 due to client vacations during the summer months. However, especially strong demand for our services reversed this trend with over 20% growth in Germany, France and the Nordics.

Overall, we saw good growth during the third quarter in our technology, manufacturing, energy and life sciences verticals. Key client engagements in Europe in the third quarter included Volkswagen, BASF, Bayer, Fresenius, Ikano Bank and BMW. Among our significant wins in Europe during the quarter, ISG won $1 million plus piece of business with a U.K.-based aircraft engine and power systems manufacturer for a major dev ops transformation program aimed at creating a complete end-to-end product-oriented operating model.

In the Nordics, we won another $1 million digital transformation engagement with (inaudible) manufacturer, supporting our client to strategize, design and manage the building of a digital landing platform for all future software products under their digital product family. ISG has also been selected to support the development of a central IT shared services unit for a very large European insurance company. ISG will program manage the data center transition and transformation, finalize the IT information library and project manage the IT cost-saving initiative.

In the Americas, revenues were $39 million, down 7%, principally due to the continued softness in the U.S. public sector and the timing of revenues in our networks service business I mentioned earlier. Key client engagements in the quarter included Exelon, Caterpillar, Humana, Entergy, Bell Canada and AIG.

Turning to a few of our notable client wins in the Americas. We recently signed $1 million managed services agreement with a major entertainment company, extending a successful relationship that began with an organizational change management, or OCM engagement, more than a year ago. ISG also has been selected for $1 million strategic sourcing engagement by a major multistate U.S. utility. Our engagement, covering applications, workplace services and infrastructure, supports a new demand management program created as part of a reengineering of the clients' technology ecosystem. ISG also won $1 million engagement with a large global insurance company based in the United States. This engagement includes workplace services transformation, including our ISG future source transaction services, transition and organizational change management.

Shifting to Asia Pacific. Our third quarter revenues of $5.4 million were down $1.7 million due to slowness in the Australian public sector vertical, which accounted for a majority of the shortfall. Treasurer Scott Morrison has become Australia's sixth Prime Minister in 11 years after Malcolm Turnbull lost control of the ruling Liberal Party. Such political turmoil impacts spending in the federal sector with ISG.

Key clients in the region included Qantas, the Department of Home Affairs, Toll Holdings, Insurance Australia Group and Westpac. During the quarter, ISG was selected by one of the world's largest metals and mining corporations in the region to develop a combined global human resources and payroll strategy for that company.

Now turning to our guidance. We expect the best quarter in our history in Q4, both in terms of revenue and adjusted EBITDA based on continuing demand for our digital services and the addition of revenues from our delayed network engagements, all of which are creating a more profitable revenue mix for ISG.

As a result, we remain confident we will achieve our full year adjusted EBITDA guidance, and we are updating our full year revenue guidance to $280 million to $285 million to reflect the softness we are experiencing in the public sector markets.

Finally, your ISG management team recently returned from its annual strategy off-site meeting held over a weekend in late October. We reaffirmed our strategy direction around all things digital, including the continued expansion of our automation business as well as our continued focus on recurring revenue growth. We are targeting digital revenues for our firm to exceed 50% within 18 months and recurring revenues to reach $100 million by the end of 2020.

With that, let me turn the call over to David Berger, who will summarize our financial results.

Thanks, Mike, and good morning, everyone. Third quarter revenues were $68 million compared with $68.3 million in the prior year, flat in constant currency and a decrease of 1% on a reported basis. Currency negatively impacted reported revenues by 1% or $800,000.

Revenues were $24 million in Europe, up 22% from the same period in 2017; $38.5 million in the Americas, which was down 7%; and $5.4 million in Asia Pacific, down $1.7 million from the prior year.

Third quarter 2018 adjusted EBITDA was $8.8 million versus $9.6 million in the prior year. Our net income for the quarter of $4 million was up 180% over the $1.4 million of net income reported in the prior year. Our reported fully diluted earnings per share were $0.08 compared with a fully diluted income per share of $0.03 for the same period in 2015 (sic) [2017]. Included in the net income for the third quarter of 2018 was the reversal of $3.6 million in tax accruals, of which $900,000 was offset by a charge to SG&A for prior acquisitions.

Adjusted net income for the third quarter was $6.6 million or $0.14 per share on a diluted basis, up more than 40% compared with the adjusted net income of $4.7 million or $0.10 per share on a diluted basis in the prior year's third quarter.

Utilization for the quarter was 66%. Quarter ended headcount was 1,344 versus 1,371 in June. Our balance sheet continues to have the strength and flexibility to support our business over the long term. Net cash provided by operations for the first 9 months was $11.2 million versus $3.3 million last year.

Through the first 9 months, we invested $3.6 million in capital expenditures, repaid $15.6 million in debt, repurchased $2.9 million in shares and paid $1.2 million in contingent consideration associated with prior acquisitions.

On the balance sheet, we ended the quarter with $13.5 million in cash and $101.2 million of debt.

As Mike indicated earlier, our improved financial position puts us in line to resume more substantial share repurchases following the announcement of our year-end results in March. Our average borrowing rate for the quarter was 5.3%, and we had 45.2 million shares outstanding as of October 26.

Mike will now share concluding remarks before we go to Q&A.

Thank you, David. Overall, we are pleased with our operating momentum through the first 9 months and remain optimistic about the full year and our longer-term future.

To summarize, in Q3, we delivered $68 million in revenues and EBITDA of almost $9 million. That translated into an EBITDA margin of 13%, continuing our acceleration of EBITDA margins over the past 2 years. Digital services continues to be a strong growth engine, representing over 40% of our revenues for the quarter. And our ISG automation business revenues are expanding with recurring software revenues and are at a full year run rate of $25 million.

Our year-to-date recurring revenues reached nearly $60 million, on the way to our 3-year target of $100 million. Our GAAP earnings per share was up $0.05 versus the prior year and our adjusted EPS up 40%. We generated $11 million in cash versus $3 million at this time last year. We've repaid $16 million of debt during the first 9 months and anticipate $18 million for the full year. And with the shift of network revenues into the fourth quarter and the continued growth of our digital services, we expect Q4 to be the best quarter in our history, both in terms of revenue and adjusted EBITDA.

As always, we are focused on creating shareholder value for the long term, and we are steadfast in our mission to deliver operational excellence to our clients. Overall, our foundation remains solid. Recurring revenues, digital, including automation services, a who's who list of blue-chip clients and a talented global team of 1,300 professionals on the ground in the middle of the digital revolution. Thanks very much for calling in this morning. And let me turn the session over to the operator for any questions.

(Operator Instructions) We will take our first question from Sarkis Sherbetchyan with B. Riley FBR.

So just to ask a quick one on the top line guidance. If I take the midpoint of the top line range you just communicated, it represents about, call it, 5% annual growth. And then I suppose if you kind of think about the growth algorithm of the business, clearly, many different layers here. Can you just remind us what you expect the consolidated growth plan to be for the business? Is it still in the mid-single-digit range? Do you expect some acceleration, perhaps, with the growing recurring revenues bucket? Just some color there, please.

Yes. We are targeting high single-digit growth on an organic basis, and we would be there this year, but not for the public sector. So our commercial business is quite strong. So yes, we would expect to see that in 2019.

Understood. And as you ramp the recurring revenue component of the business, seems like automation run rates growing nicely. Would you expect the margin profile to accelerate? Kind of as we look at 2019 and beyond, just kind of any thoughts around the margin and profile from where we are today to where it could go?

Yes. We would like to be within 3 years through our planning process. We think we can get 15% EBITDA margins. We've got good trajectory. A couple of years ago, we were at 9% to 10%. Now we're kind of 12%, going to 13%, and I would hope that that trajectory continues. But we think we have at least 200 basis points of improvement over the 3-year period. That's including our investments that we make along the way.

Got it. And would there be anything that kind of comes about where you'd either accelerate the investments or kind of stay on the current trajectory that you are on? Just kind of help us understand the opportunities you see to accelerate some and/or kind of pullback.

So I think we are on a pretty good steady state here with our recurring revenue investments, with our digital investments, our automation. Clearly, if artificial intelligence moves at a faster pace than we might expect, then we would probably accelerate in that area. We like the blockchain investments that we're making now, kind of like what we did in 2016 and -- on digital, where we've got now 40%, going to 50% of our revenue. Blockchain can help drive that, maybe a little bit quicker if it takes hold faster. So there are some accelerators around, I would say, digital transformation and technologies that are disrupting many industry segments, which, when there is disruption, whether in technology or in business models, those are all good news for ISG.

We will take our next question from Vincent Colicchio with Barrington Research.

Yes, Mike, I'd like to ask about the network management business. You had several delays here. Do you see that as a growth business going forward? And what's causing this last round of delays?

Yes. So our network business is growing. I think when we acquired Alsbridge 2 years ago, I mentioned at the time that we have this new jewel called network, and from an ISG standpoint, it was a whitespace and it's normally about the third largest spend inside large corporations. We now have, we believe, the world's largest database as it relates to network. The business is good. It's strong, but it's uneven. And by that, I mean that we have a component of that because that's what the market dictates. It's not only our fee base, but we also put fees at risk on a success basis or a gain-share basis. Those gain shares do not get recorded until the carrier physically signs the contract for us. So when those get signed, do not fit necessarily into a nice quarterly package. But overall, the network business is a growth engine for us, and it is above-average firm margin. So it's a very good business, and we are looking to accelerate that business, frankly, in 2019 because of the success that we've had, but it does bring a little unevenness in quarters. You may recall, we had stuff in Q1 that moved to Q2 and these things just happen with this business. But overall, on a full year basis, it's a great little growth business with higher-than-average firm margins.

I can see that the European business had a healthy quarter. I'm curious, is there any signs, or whatsoever, from your clients in the U.K. that Brexit may have an impact on their decision making?

So good question. So overall, Europe, very strong for the quarter and really year to date, very strong double-digit growing there. What we're seeing in the U.K. is that our digital, our automation business, in particular, is being consumed by the retail, by the financial institutions. And their perspective is look, because of some Brexit disruption that may occur, automation is going to go with them, no matter what happens from that standpoint. So I think, we believe, that it's going to continue to disrupt, I think, both the U.K. and Europe, what we call, the applications and services marking -- market. But I think it would be mostly felt, of course, in the financial institutions and probably in healthcare and life sciences. But for us, we think it may be helping us because they're looking for shorter-term solutions while this disruption occurs. So yes, there is going to be some disruption, but unlike 2016, when the shock of Brexit first hit and they stopped spending altogether. You may recall we made the decision to keep all of our people and resource and expense there in anticipation that it would benefit us as the Brexit thing unfolded, and we are seeing that with the results that we have through Europe and in the U.K. So yes, there is going to be some disruption on ADM services with clients, but to our view, that could service to our advantage, and it has this year, and we expect it to again next year.

And then my last question. Any thoughts on when we may see an improvement in the U.S. public sector?

So I think the issue with the public sector is we have been seeing the uncertainty and slowness in decisions across the market for this year and including the quarter, especially during the election cycle, where there was over -- I think there was over 20 states electing governors. So our portfolio includes Michigan and Illinois and Arizona and Texas and Florida, Kansas, all of which had governors coming up for election. So our hope is that 2019, we will see a rebound in the public sector. We haven't done our complete planning for next year, but now that the midterm cycle is behind us, our hope is that eliminates a lot of uncertainty. The governors, whoever they may be, will be in, and decisioning will go back to a more normal state. So '19 may be the year.

We'll take our next question from Marco Rodriguez with Stonegate Capital Market.

Wondering -- I was wondering, if -- can you quantify the revenues that were delayed in the networks -- for network services?

Yes. It's around $2 million that got -- that will shift from the third quarter into the fourth quarter.

Got it. And then kind of following up on the prior question here on the U.S. public sector. I just kind of want to better understand in fiscal '19. So is that business for you more aligned with the states rather than Federal Government type spending?

Yes. In fact, all of our -- Marco, all of our business is either state or local, no federal. So our business is aligned directly with the states or large local municipalities like Jacksonville or Fort Worth, Texas. But we do not operate in the federal sector. So it is all state-driven.

Got you. Understood. Then shifting here in terms of the growth profile that you had answered to a prior question, one of the first questions asked, on a upper single-digit kind of growth rate. When looking into fiscal '19, it kind of sounds like you're expecting maybe a more normalized Americas growth rate. I was wondering if maybe you could talk a little bit about your expectations for Europe and then also Asia-Pac?

So I'll go around the horn then. So yes, I think the U.S. growth rate will have somewhat dependency on if the public sector can rebound a bit. If that does, that will keep us up in that high single digit in the U.S. business. Europe, it's a little early to call, but we would expect Europe to probably continue on to a double-digit level next year based on the digital work that's going on over there, despite the Brexit noise. And then on Asia Pacific, it's going to depend on the federal spending in Canberra in Australia. It is a chunk of our business. It's been quite disruptive with all of the changes with governments down there. And the growth rate there, I'd be hard pressed to give you one at the moment until we understand how that's going to play out for next year, Marco. The only other thing I would add maybe is on automation, which is also helping us in Europe. We did launch into Germany with our ISG automation business earlier this year. And we should begin to see that as part of our growth in 2019 as well. That helps our European business.

Got you. And I'm not sure if I caught all of this, I apologize. You had mentioned something about clients, with the automation, moving to Bot 3.0 and some of them having, I guess, troubles with scaling that business. Can you maybe provide a little more color there? And is this an issue of the technologies not available for them to scale past certain points? Or kind of what's going around that sort of a statement, if you will?

Yes. So the way we view the automation business is, we think, approximately -- our research would show that approximately 40% of clients in our kind of portfolio have begun the process of robotics. And the begun might be a proof of concept, it might be a few processes that have been automated, might be 5, might be 10. For the most part -- and there are few exceptions, for the most part, most of all those organizations have not scaled to any degree, scaling meaning taking what may be a handful or a dozen processes and making them into a 50, 100, 200, 300 process changes. And the rationale for that is just it's still early stage. It's still kind of first inning, second inning for most clients. Financial services, just like outsourcing years ago, they are faster to adopt and adapt here. So we are seeing some of our major bank clients beginning to scale part of the robotics. But if you chase down almost every other industry vertical, it is still very early stages. So the -- it's more about the pace, the pace of change. You're talking about saying, "Hey, look, I'm going to take my claims processing or my credit card processing that I've always done X way, and I'm now going to automate it and have a digital labor handle that." That's a major transformation for companies. So they tend to start small and then they will scale. And we have not seen the scaling happen, but when we do, then this automation business will continue, we think, to accelerate. So it's a very good business for us. As you well know, we've started it and we're now up to kind of the $25 million -- we're going to be in the $25 million range. So that's what we see going. And that -- that's why we think that the whole RPA future is so bright that we're still in such early stages that scaling has not occurred yet.

We'll take our next question from Joe Gomes with NOBLE Capital.

Just on the debt level, you guys have done a great job of paying down debt this year. If you could just remind us what debt level are you guys trying to get down to be comfortable with?

Well, we're comfortable at the current level. We leveraged up slightly to do the Alsbridge deal. As you commented, we've been successful, as we noted, paying $16 million of debt down through 3 quarters. That included a $7 million payment of the Alsbridge seller note. We would be targeting around 2, 2.5x gross debt to EBITDA level. Again, we're comfortable at the current level, but we would see driving down to that level.

Okay. And then on -- just on the buyback. If you could just remind us what amount do you have left on that if you were to start? And what are kind of the metrics you're looking at to decide whether you should be buying back more?

Yes. We're -- we have a authorization of $12 million outstanding at the current time. We evaluate our uses of cash. Our main uses of cash are to pay down debt. We continue to look for acquisitions that -- bolt-on acquisitions that would enhance our service offering, and then share buybacks is the third component of our use of cash. So we evaluate within those 3 items.

And it appears there are no further questions at this time.

Okay. Well, then let me close by saying thank you to our 1,300 professionals around the world. It is their ability to help our clients achieve operational excellence and faster growth, especially through digital transformation, and that continues to be the reason for our strong performance. Thanks to all of you on the call for your continued support and confidence in our firm, and have a great day.

That concludes today's call. Thank you for your participation. You may now disconnect.