Consensus Cloud Solutions, Inc. Q4 FY2022 Earnings Call

Good day, ladies and gentlemen, and welcome to the Consensus Q4 2022 Earnings Call. My name is Paul, and I will be the operator assisting you today. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. On this call from Consensus will be Scott Turicchi, CEO; John Nebergall, COO; and Jim Malone, CFO. I will now turn the call over to John Nebergall, COO at Consensus. Thank you. You may begin.

Good afternoon, and welcome to the Consensus investor call to discuss our Q4 and full year 2022 financial results and our 2023 initial guidance. Joining me today are Scott Turicchi, CEO; and Jim Malone, CFO. The earnings call will begin with Scott providing opening remarks. I will give an update on a major realignment of our operating structure as well as sales and technology results, and then Jim will follow up and discuss our full year and Q4 financial results. After we finish with our prepared remarks, we will conduct a Q&A session. At that time, the operator will instruct you on procedures for asking a question. A copy of this presentation and the associated press release will be available on our website. Also, if you have any questions, you can always send an e-mail to investor@consensus.com. Before we begin our prepared remarks, allow me to direct you to the safe harbor language on Slide 2. As you know, this call and webcast will include forward-looking statements. Such statements may involve risks and uncertainties that would cause actual results to differ materially from the anticipated results. Some of those risks and uncertainties include, but are not limited to, the risk factors outlined on Slide 3 that we have disclosed in our SEC 10-K filing as well as a summary of those risk factors that we have included as part of the slideshow for the webcast. We refer you to discussions in these documents regarding safe harbor language as well as forward-looking statements. Now let me turn the call over to Scott.

Thank you, John. I would like to touch on several areas before handing the call over to John and Jim for more details on our operations Q4 financial results, fiscal year '22 results as well as the publication of our 2023 guidance. As noted in our press release, we intend to file an amended Q3 2022 10-Q to primarily address 2 unintentional errors we have identified in the preparation of our Form 10-K. The first area is related to an accounting practice we inherited from the spin. Notably, our SOHO revenue stream was inadvertently grossed up by $5.3 million over the first 3 quarters of 2022 with a corresponding offset to bad debt expense. This correction has no impact on the company's operating income, net income, EBITDA or cash for the relevant periods. The second area relates to the timing of revenue recognition. We initially recognized $2.2 million of revenue in Q3 2022 for the sale of certain perpetual software licenses to one of our customers, which upon further review, we have decided to reclassify as deferred revenue. This correction impacts timing only, not the amount of revenue that we recognized over the contract term. Neither error has any impact on the company's cash or cash equivalents. Jim will provide further details in his financial presentation later in the call. Our operational miss in revenue for the year to achieve the low end of our revenue range was approximately $3 million and was largely due to the timing of both customer decisions and implementation. As we noted in our Q3 call and again earlier this year at an investor conference, we continued to see a more deliberate approach to decision-making and implementation by our largest prospects and customers. We believe that this trend will continue in 2023 and have accounted for it in our financial guidance. As John will later detail, we continue to have a number of prospects in our pipeline and remain optimistic that over time, they will translate into revenue. I would also observe the changes in our incremental revenue are more dependent on revenue coming from medium to large enterprise customers, the timing of which is harder to predict. As we believe that this will continue to be the case and is independent of economic conditions, we are widening the revenue range for our guidance that Jim will detail for you later. In conjunction with our performance in Q4, we evaluated the sales and marketing structure that we inherited at the time of the spin. We concluded the approach of the 3 revenue streams, SOHO, mid-market and enterprise, and organizations to manage them does not allow an optimal go-to-market strategy. The siloed approach inhibits efficient marketing spend and creates gaps where one channel of revenue ends and the other begins. I am enthusiastic about the realignment of our people and resources and believe it will produce a greater pipeline of opportunities, giving us more paths to meet or preferably beat our guidance. John will give you the details in his presentation. We continue to operate at healthy EBITDA margins of 54.3%, consistent with our guidance of between 50% and 55%. These results were driven by continued strong performance in the corporate business, which grew 10.1% versus Q4 2021 and 6.5% of which was organic. Our SoHo channel had good results, notwithstanding continuing FX headwinds, which primarily affect this channel of revenue. Also, as we discussed last quarter, there were additional customers affected by the price change, which had a modest impact on our cancel rate. While slower than previously planned, the VA is on the verge of rolling out our EC fax to its first medical facility. We expect revenue to start sometime in late Q2 or Q3. The interest in EC Fax from other government agencies has more than doubled since the end of Q3. There are now more than 15 agencies interested in the service. It is still early, and we do not expect any of these new agency opportunities to produce revenue in 2023 but are encouraged by the widespread interest in the solution. Before handing the call over to John, I'd like to comment on the economy and how it is affecting our business outlook. As noted previously, the uncertain economic conditions and fear of recession have slowed down decision-making of our largest potential customers. We believe that there will be a recession at some point this year and expect the slower decision-making trend to continue as well as to modestly impact the cancel rate of our SoHo or e-commerce business. In addition, the tight labor market and sticky inflation has an impact on the cost of our labor force, which is our largest single expenditure. We anticipate there will be an increase of approximately $12 million in cash compensation expense this year over 2022, which is a combination of having more employees in 2023 than 2022 as well as higher wages across the board. We anticipate that this will have a 2.3 percentage point impact on our EBITDA margin in 2023. As our employees are our most valuable asset, and we need them to ramp up from the spin to meet the obligations of a stand-alone public company as well as dedicate more resources to our development, sales and marketing efforts, we do not see an opportunity for cost savings in this area. However, we are looking carefully at our nonemployee areas to make our operations more efficient. Moreover, we believe these investments in both technology and human capital will strengthen our leadership position in the market. Finally, we remain liquid with more than $94 million of cash on our balance sheet and the undrawn line of credit that we put in place in March of 2022.

Thank you, Scott. Let's move to Slide 5. In early Q4 of last year, Johnny Hecker joined consensus. Johnny came to us from Google, where he led sales efforts in Europe and previously to that has a long history in the Cloud Fax industry. We gave him the objective of evaluating our current go-to-market structure and to develop recommendations to improve our offensive capabilities, finding ways to break down any silos that stifle performance, ensuring a strong focus on healthcare, bringing more discipline in data analytics to drive the business and to find ways to make our overall execution, more effective and efficient. Based on those recommendations, the executive team has implemented a sweeping realignment of our go-to-market operation. I have asked Johnny to lead this new go-to-market team and have implemented the following changes. A strategic sales team has been established to focus on our largest current customers and biggest prospects, including government. This will be a hand-selected team working with only large multimillion dollar opportunities. A single direct sales organization that eliminates the former enterprise and mid-market sales approach for a more integrated sales operation. As part of this change, the old SoHo sales segment has been eliminated and responsibility for e-commerce sales is now a sales function rather than a marketing function. We have created a new discipline called the sales enablement and optimization function. This team will be dedicated to using data analytics and statistical analysis to continuously improve our sales process to manage our RFP and RFI responses and control pricing across the organization. This will unlock the power of our internal data collection program and optimize sales execution. Marketing will be consolidated into a single organization. We have recognized that our marketing program on the web also has an enormous impact on driving upmarket customer behavior, and so we have integrated the marketing function. The marketing team will maximize our demand generation efforts driving leads to sales and our e-commerce portals managing spend more efficiently and improving overall impact of our efforts. Our channel program and services team will also join the new revenue organization and report to Johnny Hecker as well. A new strategy team will be formed under Bevey Miner, a recognized expert in healthcare IT. This team will concentrate efforts on emerging opportunities in the healthcare industry, becoming involved in giving consensus voice and legislation in CMS, HHS rule making and standards boards. The strategy team will also provide competitive analysis, manage the events that we attend, and develop a series of seminars and webinars aimed at the North American healthcare market. The international operations are unchanged in this realignment. It is important to emphasize that this action is focused on improving our efficiency and our effectiveness in the North American market with a strong emphasis on healthcare interoperability. This is not, I repeat, not a cost-cutting exercise, a reduction in force or downsizing. We believe that taking these actions will help us become even more competitive, raise our profile in the industry and give us better command over our overall go-to-market execution. Now let's go on to Slide 6. I will comment on the year, the quarter, and the number of in-progress operating items. First, for the year 2022, we saw record corporate sales performance with $23.2 million in bookings, a 59% improvement over 2021 and a 35% improvement if you exclude sales associated with the assets acquired in our purchase of Summit Healthcare. Sales included $9.7 million in our advanced product set, more than double last year, and in total, these non-fax products represented slightly more than 36% of our overall bookings. As we have stated on a number of occasions over the last several months, we were beginning to see a more deliberate pace of decision-making by our prospects, largely as a result of the economic uncertainty that dominated the financial news. While our pipeline remains promising, deferrals by several key prospects as well as the natural historical seasonality of our business impacted the fourth quarter results. Overall bookings for the quarter were $4.6 million, a 44% increase over Q4 2021. And when you exclude the perpetual license products sale of $2.5 million in Q3, it was a 22% decline. That sequential decline is somewhat better than the 2021 seasonal decline of 32% between Q3 and Q4. In the quarter, we also saw sales of our advanced products at 46% of total bookings. The broad price increase we executed in the SOHO base is nearing completion. All in-year increases for 2022 have been implemented, and all that remains are the outstanding annual plans that will receive the increase when the renewal comes due. For the quarter, overall SOHO churn was 3.82%, a 22 basis point increase from Q3, which was better than the 28-point basis point increase we experienced last year. The churn rate remains favorable to our post-price increase modeling, which we continue to monitor closely. On the ECFax front, we are well into the planning stage of the first system deployment and anticipate that we will be live with the first user in either late Q1 or Q2. We have spoken on previous calls, and there has been interest from other government agencies for use of the ECFax system, and we've actually scheduled the first demos of the system in the coming weeks. Aside from those scheduled demos, we also have a number of formal RFI and RFPs that we have received. Over the past 2 quarters, we've been involved in a proof-of-concept trial with our Clarity product. I'm pleased to say that we're now in the final stages of negotiating the production SOW for Clarity, which is expected to put us into production in Q2. The product team continues its initiatives in Q4, rolling out the compliance 365 initiative. The purpose of this program is to weave compliance and security into our daily execution, not only on the development team but throughout the entire organization. While we continue to support the SOC2, FedRAMP, and HIGHTRUST audits as they come due, the team is also working to maintain a very aggressive schedule of employee training, self-review, and earned internal testing that ensures our security environment is second to none in the industry. We move our customers' most critical information and remain committed to strengthen our already formidable security programs. Our technology team is also expanding the ability for us to support our customer base with the formation of a level 3 support team. Moving further past what is considered ordinary technical support, the Level 3 group will have development skills to work with clients on a deeper technical level, solving their most important and challenging issues. Alike expansion in our product team is the addition of product marketing to our capability set. This newly formed group will be dedicated to product commercialization, education and launch activities. Working closely with the newly announced strategy team, product marketing will serve as the key link between the drawing board and revenue generation. Finally, our engineers continue to be hard at work, pushing forward a project that builds on what's already the most flexible platform in the industry and applying emerging practices and technologies to ensure we offer our customers an exceptional experience while supporting emerging needs and revenue opportunities. The team is also building for the future with Harmony, and we are still expecting an MVP version of the product by the close of Q4. To sum up, the operations finished the year with record bookings, a clear establishment of our advanced products in the marketplace and execution of a wide range in price increase. While we have seen prospect decisions slow in Q4, we are confident that this is a timing issue and anticipate that the pipeline will produce many deals this year that we had expected in 2022. Now I'll turn it over to our Chief Financial Officer, Jim Malone, for a closer look at the financial metrics.

Thank you, John, and good afternoon, everyone. I would like to review our fourth quarter financial results, discuss our performance for the full year 2022 as well as provide our initial guidance for 2023. Before I discuss our Q4 results, and as Scott alluded to earlier in the call, I want to call out that overall revenue in 2022 was impacted by 2 extraordinary items totaling approximately $10 million. A legacy spin accounting practice that was inadvertently increased revenue with an offset reducing bad debt. A second separate accounting error in Q3, where a $2.5 million revenue transaction was incorrectly recorded as revenue instead of deferred revenue. Jumping to this first item, the SOHO legacy adjustment. As a consequence of the spin, Consensus inherited a legacy Soho practice affecting revenue and bad debt. This practice inadvertently grossed up revenue with a corresponding offset to bad debt expense. Our 2022 financials reflect a correcting adjustment, reducing revenue for the 9 months ending September 30, 2022, by $5.3 million and the full year by $7.3 million, with an offsetting reduction in our bad debt expense of the same amount with no impact on net income, EBITDA or cash. The adjustment is not cumulative but represents a discrete reclassification between revenue and bad debt. This issue will not reoccur. The second item in the third quarter of 2022, the company recorded $2.5 million of revenue related to a sale of perpetual software products. Upon further consideration, the company reclassed the revenue to deferred revenue. Consensus invoiced the customer who was paid in full in Q3. Revenue and EBITDA was reduced by $2.5 million and net income was negatively impacted by approximately $2 million. Now turning to the fourth quarter. Consolidated revenue was $90.2 million, an increase of $1.2 million compared to Q4 of 2021 or 1.4% growth. On a constant dollar basis, revenue grew 2.8% as foreign exchange fluctuations had an unfavorable impact of $1.2 million. Q4 reported adjusted EBITDA was $49 million, down $2.6 million or 5.1%, delivering a 54.3% EBITDA margin in line with expectations. Non-GAAP EPS of $1.13 reflects a decrease of $0.21 versus $1.34 in Q4 of '21. The decrease reflects higher revenue, fully offset by the EBITDA shortfall and the negative impact of foreign exchange from a strong dollar. Jumping to corporate fourth quarter, revenue was $47.8 million, an increase of $4.4 million over the prior year period. Corporate revenue increased $4.7 million on a constant dollar basis or 11%. As John discussed in his prepared remarks, we continue to add meaningful new logos in the fourth quarter, a testament to the value that we are delivering as we help solve the health care interoperability and connectivity challenges that our customers face. SOHO in the fourth quarter, revenue was $42.4 million, a decrease of $2.9 million over the prior quarter. On a constant dollar basis, SOHO revenue decreased by $2 million or 4.6%. As I mentioned previously, of the $7.3 million revenue reversal impacting 2022, $2 million was moved out of the fourth quarter. The Soho market is price sensitive and churn was better than our expectations, even considering the implementation of a $1 to $2 price increase. It is important to note that as our customers churn, we are left with a more stable and higher quality sticky base of revenue. Now turning to full year results. Consolidated revenue of $362.4 million was up $9.7 million over full year 2021, a 2.8% increase and increased $14.1 million on a constant dollar basis or 4%. Note that full year has grown at the approximate $10 million of revenue adjustments discussed earlier in this call. Reported adjusted EBITDA for the full year 2022 was $196.7 million, a decline of $6.3 million or negative 3.1%, delivering a 54.3% margin, in line with our expectations and achieving the upper band of our historical rate of 50% to 55% guidance on EBITDA margin. Adjusted EBITDA was negatively impacted by the deferred reclass of the $2.5 million. Finally, non-GAAP EPS for the year 2022 was $5.33, a decrease of $0.13 or 2.4%. The impact of the deferred revenue adjustment of $2.5 million was $0.10. We ended Q4 just over $94 million in cash. Our liquidity remains strong to support our operations with the added benefit of a $50 million line in credit that remains undrawn. I would like now to provide a preliminary view of guidance for 2023. We expect 2023 revenue to be in the range of $370 million to $390 million. We expect EBITDA in the range of $192 million to $206 million, translating to a margin of approximately 52.3% at the midpoint. We expect Non-GAAP to be in a range of $4.93 to $5.20. Net income would be negatively impacted by increased depreciation and amortization of $6 million to $7 million relating to software products placed in service.

This is Mark on for Fatima. Digging a little bit into 2023 guidance, can you maybe parse out the assumptions on macro conditions and maybe how much noise or headwinds from the go-to-market realignment efforts you guys are expecting? And then just maybe as a quick follow-on there. Is there anything that we should keep in mind in terms of just first half, second half balance for the year, just given all the headwinds and changes that you guys are going through? And how we should think about the quarters for 2023?

Sure. This is Scott, Mark. It’s great to have you on the call. As you know, everyone has their own perspective on the economy and the possibility of a recession, including when it might happen. I’ll share our assumptions, although we might be mistaken like many other companies, but it does affect our guidance. Currently, we do not view the economy as being in a recession. However, the uncertainty we've discussed for the last two quarters has led to delays in decision-making among our larger customers, which has impacted revenue in Q3 and is expected to continue affecting Q4. We believe this trend will influence all four quarters. The e-commerce space, formerly known as SoHo, shows the most sensitivity in our customer streams. From our analysis, the cancellation rate appears stable throughout the year, remaining elevated at around 3.8%. In the near term, particularly in Q1 and Q2, we still have a lag effect from annual customers who won't reach their one-year mark until June 30. We anticipate a return to normal cancellation rates in the second half of the year, maintaining around that 3.8% level, understanding how potential recession dynamics may affect the SOHO base’s cancellation rates later in the year. We do not expect any upcoming recession to mirror the '08/'09 downturn, which could lead to additional cancellations. We’ve also noticed a decrease in new paid ads in the latter half of the year, as businesses often reduce marketing during recessions, affecting effectiveness for customers who may be more vulnerable. This overall economic sentiment influences our perspective on the SOHO business's performance, and to some degree, the timing of decisions among our larger and strategic accounts. In terms of revenue distribution throughout the year, we expect approximately 24% in Q1, 25% in Q2, just above 25% in Q3, and around 26% in Q4. This indicates a gradual ramp-up as we benefit from our Q4 customers throughout the year. Regarding the margin profile, while Jim highlighted a 52.3% EBITDA margin at the midpoint of the range, many costs throughout the year are more fixed than variable. Therefore, we anticipate a slightly lower EBITDA margin in Q1 due to lower revenue and a somewhat higher margin in Q4. While we don’t expect drastic variations across the four quarters, the margins should not remain constant throughout the year.

This is Isaac Sellhausen speaking on behalf of Ian. My question pertains to the $3 million in missing revenue attributed to customer decisions and implementation choices. As we look ahead to the first quarter and throughout this year, do you anticipate that revenue will rebound, and how do you envision the pacing of implementations and customers' decisions regarding adopting the solution?

Yes. This is John. Thanks for the question. I think what we're going to see is that this deliberate decision-making is going to be something that occurs as the continued coverage of what may or may not happen with the economy is sort of the topic of the day, and that went into our thinking. As we looked at the coming year and we thought about where we would wind up, we certainly factored in what we saw in Q4 and made the assumption that until whatever it is, is going to happen in the economy actually manifests itself that we would continue to see this deliberate kind of pace of people being able to make decisions that they felt comfortable making or be able to have enough assets in place to be able to actually implement and roll out. And our expectation is that while this sort of hangs over the heads of everybody that has to work in this economy that, that was what we were going to see. But that also, as I mentioned before, was factored into our thinking as we came into the guidance that we provided.

And let me just add to that. So things we were talking about in Q3 and Q4, yes, we are seeing them coming to fruition in Q1, but things we thought would come to fruition in Q1 may not now play out until Q2 or Q3. That's the thinking of what we've imposed, if you will, on the budgetary model as we roll out over the 4 quarters. Now as I say, in my earlier remarks, how the economy will actually play out and how people will behave against it is very much, I think, to be determined. But we felt it was prudent to take our near-term experience and assume that at least for the current 4 quarters, meaning 2023, that this situation will persist. And so, things that we thought would occur will occur, but on a delayed basis, and then we just keep rolling that from a pipeline perspective throughout the year, meaning things that we thought would occur in '23 may probably occur till '24 as you get later in the year.

Just a quick one on the deferred revenue. Over what time frame do you expect to recognize than the ones that are identified in '22 that are going there?

This is Jim. That deferred revenue will be recognized, and I want to emphasize that it represents solid revenue. The product was accepted by the client, and we have received the cash. It's a timing issue rather than a question about the revenue itself. We are currently looking into this matter, John. According to accounting principles, the revenue will be recognized over the term of the contract or a shorter period. Therefore, it is indeed good future revenue. We anticipate seeing some of that revenue in 2023, and we will continue to assess the situation.

The new structure has been implemented, which is positive news. Although it wasn't initially designed for cost savings, I believe there will be efficiencies in our marketing spend due to the reorganization of sales and marketing. The main objective was to create a better framework and enable our current team to explore greater opportunities. As we transition to this new structure, there may be some additional hires to fill certain gaps. The new roles have been assigned, and we recently rolled it out, so it has been in operation for a few months, though only fully functional for about a week. It is still early days, and while everyone is positioned correctly, they will need time to adjust to their new roles and collaborate effectively. This shift requires changing a longstanding mindset; the siloed approach has been around for 20 years, and many employees have been with us for a long time. We need to move towards a unified marketing strategy without strictly categorizing ourselves by sales channels such as e-commerce or mid-market. We've identified customer segments that previously fell between the gaps of our old structures, particularly those generating tens of thousands to possibly $100,000 monthly in revenue. It will take some time for the team to become confident in this new framework. Ultimately, our goal is to significantly broaden our sales pipeline to create more opportunities for revenue, rather than relying heavily on a small number of larger customers, which can cause delays in revenue recognition.

Well, for those of you who don't know, TEFCA is a framework for interoperability that relies on entities called QHINs to be able to communicate via fire or fast health care Internet resources in order to move information. Now we believe the TEFCA framework is going to play favorably for us. I think that we have a place to play in front of the QHINs to be able to assimilate communications through a number of different protocols, delivering those to QHIN, who will then speak fire to other QHIN. So, from our point of view, we've got an opportunity with the QHIN, and, as you pointed out, there are a couple who are already customers to potentially expand our footprint there as a multichannel multiprotocol intake to be able to deliver information to a QHIN so that they can communicate over the TEFCA network. So, we're looking at it as an opportunity for us.

We have one additional question that came in via email, so I'll address it before we wrap up the call as we are nearing the hour mark. I believe it’s a valuable question regarding free cash flow generation. While we don’t provide specific guidance on free cash flow due to the complexities involved in estimating it, I do want to discuss the free cash flow from 2022 and the various adjustments that affected our reported results. Some of these will happen again in 2023, but most will not. Notably, around $22.5 million to $23 million in payments impacted our free cash flow in 2022, with two of these not expected to reoccur. One payment was related to taxes we paid in 2022 that connected to $21 million of payments, and we also had payments to Zip, which totaled about $11 million. Additionally, as Jim has mentioned and you can see in our quarterly reports, we’ve been working with the states to resolve historical sales tax issues. We paid about $5 million for this, primarily in the fourth quarter but also towards the end of 2022. This totals nearly $23 million in free cash flow. The VDA aspect will continue into 2023, although it is difficult to estimate the amount we will pay out in that year since it depends on how quickly the states respond to us. We anticipate it could be between $5 million and $7 million, but it may vary slightly. Given the $197 million of EBITDA, we paid $30 million in cash taxes for the year, $52 million in interest expenses, and $30 million in capital expenditures, which suggests we would typically expect around $85 million in free cash flow. After accounting for the aforementioned adjustments, we are looking at the mid- to high-70s range. There will always be minor fluctuations related to working capital timing as well. The follow-up question was about our expectations for free cash flow at the midpoint of the guidance range, which is based on $199 million of EBITDA. Our capital expenditures, particularly for capitalized labor, may increase, likely offsetting the difference between $197 million and $199 million. Therefore, I would project free cash flow to be in the high 70s to mid-80s range. However, this will depend on how quickly we can settle with the states, which we are eager to do. Our settlements have generally been below our accruals, which is favorable. The process has been quite smooth, and we are keen to move past it. However, we cannot rush this, as it involves discussions with different states. That concludes all the questions we have, both live and via email. Thank you for your time and attention in listening to the Q4 and fiscal year 2022 call. I hope we have provided sufficient information regarding our historical results, the two accounting adjustments, and our guidance for 2023. We will be participating in several conferences over the next two to three months, including the JMP conference in early March, which will be a live presentation. There is also a virtual conference coming up. We will announce these details via press release so you can join us live or request one-on-one discussions. In most cases, there will be either a fireside chat or a formal presentation available on the web.

Thank you. This does conclude today's conference. You may disconnect at this time and have a wonderful day. Thank you for your participation.