Hackett Group, Inc. Q2 FY2020 Earnings Call

Welcome to The Hackett Group's Second Quarter Earnings Conference Call. Hosting this call are Mr. Ted Fernandez, Chairman and CEO, and Mr. Rob Ramirez, Chief Financial Officer. Mr. Ramirez, please proceed.

Thank you, Operator. Good afternoon, everyone, and thank you for joining us to discuss The Hackett Group's second quarter results. Speaking on the call today and here to answer your questions, Ted Fernandez, Chairman and CEO of the Hackett Group; and myself, Rob Ramirez, Chief Financial Officer. A press announcement was released over the wire at 4:05 P.M. Eastern Time. For a copy of the release, please visit our website at www.thehackettgroup.com. We will also place any additional financial or statistical data discussed on this call that is not contained in the release on the Investor Relations page of our website. Before we begin, I would like to remind you that in the following comments and in the question-and-answer session, we will be making statements about expected future results, which may be forward-looking statements for the purposes of the federal securities laws. These statements relate to our current expectations, estimates, and projections and are not a guarantee of future performance. They involve risks, uncertainties, and assumptions that are difficult to predict and may not be accurate, especially in light of COVID-19. Actual results may vary. These forward-looking statements should be considered only in conjunction with the detailed information, particularly the risk factors that are contained in our SEC filings. At this point, I would like to turn it over to Ted.

Thank you, Rob, and welcome, everyone, to our second quarter earnings call. As we normally do, I will open the call with some overview comments on the quarter. I will then turn it back over to Rob to comment on the detailed operating results, cash flow, as well as comment on outlook. We will then review our market and strategy-related comments, and then we will proceed to Q&A. Please allow me to start the call by acknowledging the incredible work and commitment of our healthcare providers, first responders, and those dedicated individuals who have continued to work non-stop and under, in some circumstances, very dangerous conditions to support all of us during this pandemic. I would also like to acknowledge our associates and clients who quickly and successfully adapted to the remote delivery requirements around the globe. In spite of the limited notice and varying circumstances, I commend their focus on their respective client initiatives and in allowing substantially all of our engagements to continue. As I said last time, we eagerly wait for the conditions to exist where all of us around the globe are able to return to our normal lives, however that is ultimately defined. Just to provide a little background on the quarter, let me go back to March. As I said last quarter, we started the year by aggressively adding associates and strategic hires, consistent with our 2020 growth prospects. As we started to feel the effects of the pandemic in early March and knew we were entering a challenging period but with a strong cash position, we quickly decided to make the safety and well-being of our associates our top priority. That meant not only making sure that we were taking all necessary precautions to ensure associate safety, but to avoid any layoffs directly resulting from the pandemic through the end of our second quarter. We believe this would provide our associates with very important peace of mind to weather the storm while we gained critical market information from which to make any further decisions. On our first weekly coronavirus global update call on March 20th, we shared our commitments with our associates and communicated that we were prepared to forgo profitability in this second quarter as long as we did not weaken our strong cash position. We also informed our associates that we would update our employee-related decisions as we better understood the impact of the economic disruption on our client decision-making and address any required changes prior to the beginning of the third quarter. Consistent with this approach, as we saw the pandemic volatility continuing into Q3, we communicated our associate reductions prior to, but effective, at the end of our second quarter. This resulted in a $5 million severance restructuring charge. This charge will allow us to significantly improve our sequential quarterly results, fully fund our operating actions, as well as our dividend without any need to use our credit facility and also continue to maintain the high cash balances we're used to operating with. Now on to our operating results. This afternoon, we reported net revenues of $52.6 million and pro forma earnings per share of $0.06. It was clear from the onset of the quarter that the economic disruption would be significant in both the way we engaged clients and delivered our services. As we expected, the technology-related implementation services, which already had significant remote delivery in place, were least affected, and in our business transformation services, which require more client executive interaction, were most affected. Most importantly, as the virus impact lengthened, we have seen clients start to adapt to current circumstances and increase their engagement. This is allowing us to see an increase in initiatives and projects in our strategy and business transformation group. We are also seeing increasing client activity in our EEA practices, which is allowing us to build our pipeline and extend existing engagements. As an example, our meeting counts from April to June increased by over 75%. Overall, U.S. results were down 16% sequentially and year-on-year with EEA slightly up sequentially, offset by the decline in our Strategy and Business Transformation Group. On the international front, Europe continued to be challenging with our overall results down strongly sequentially and year-on-year. Correspondingly, we decided we needed to be more aggressive with associates' reductions in this region, which accounted for approximately 50% of our total restructuring charge. The investments we have made to fully digitize all of our IP and the development of our IP-as-a-service platform, which include Quantum Leap, our state-of-the-art global leading benchmark platform and our proprietary Hackett digital transformation platform, or DTP, are allowing us to highly differentiate our offerings and will continue to be important drivers of our growth for many years to come. Specifically, it's important to note that we have had a significant increase in interest from potential partners' desire to license these platforms to bolster their business case development and value-selling efforts over the last six months. Additionally, our investments with our rapidly growing eProcurement, EPM, and workflow automation groups continue to be key to our digital transformation strategy, also, and are important future drivers of our overall growth strategy. On the balance sheet side, our ability to generate strong cash flow from operations has allowed us to continue our dividend, buy back stock if we wanted to, and fund acquisitions while continuing to invest in our business. I cannot tell you how important it was to start the year and to finish both the first and second quarters with our strong cash balances and without any outstanding debt. This has provided us with the ability to properly manage our future during this volatile economic period. With that said, let me ask Rob to provide details on our operating results, cash flow, and also comment on outlook. I will make additional comments on strategy and market conditions following Rob's comments.

Thank you, Ted. As I typically do, I'll cover the following topics during this portion of the call: an overview of our 2020 second quarter results along with an overview of related key operating statistics, an overview of our cash flow activities during the quarter, and I'll then conclude with a discussion on our financial outlook for the third quarter of 2020. For purposes of this call, I will comment separately regarding the financial results of our Strategy and Business Transformation Group, or S&BT our ERP, EPM, and Analytics Solutions Group, or EEA; and our International Group; as well as the total Company. Our S&BT group includes the results of our North America IP-as-a-service offerings, which include our executive advisory programs and benchmarking services and our business transformation practices. Our EEA Solutions Group includes the results of our North America Oracle, SAP solutions and OneStream practices. Our International Group includes the results of our S&BT and our EEA groups that are based primarily in Europe. In addition, please note that all references to net revenues represent revenues excluding reimbursable expenses. Reimbursable expenses are primarily project travel-related expenses passed through to our clients and have no associated impact on our margin or profitability. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information to investors. We have included reconciliations of non-GAAP to GAAP financial measures in our press release filed earlier today. Additionally, my comments today are based on results from continuing operations. For the second quarter of 2020, our net revenues decreased by 19% sequentially to $52.6 million when compared to the prior period, which is in line with our revenue expectations discussed last quarter. The Q2 2020 reimbursable expense ratio on net revenues was 0.2% as compared to 8.2% for the second quarter of the prior year. Net revenues and reimbursable expenses were both affected as the economic disruption from the COVID-19 pandemic interrupted travel and as we transitioned to a remote service delivery model throughout the U.S. and Europe. Net revenues for our EEA Solutions group were $31.4 million in the second quarter of 2020, an increase of 1% on a year-over-year basis. This was driven by growth from our SAP S/4HANA implementation and reseller practices and growth from our Oracle Cloud ERP and OneStream practices. Specific to our Oracle practice within EEA, we continue to see an improved mix of cloud to on-premise implementation revenue, which is now in excess of 80%. Net revenues for our S&BT Group were $16.8 million in the second quarter of 2020, a decrease of 36% when compared to the same period in the prior year. This Group's business transformation practice is where much of our Q2 COVID-19 pandemic disruption was felt. Our U.S. operations, which currently represent 92% of our total Company net revenues for the second quarter of 2020 were down 16% on both a year-over-year and sequential basis. Net revenues for our International Group were $4.4 million in the second quarter of 2020, a decrease of 59% on a year-over-year basis, as expected and discussed in the previous quarter. Total Company international net revenues accounted for 8% of total Company net revenues in the second quarter of 2020 as compared to 16% in the second quarter of the prior year. Our recurring revenues, which include our executive and best practice advisory and AMS groups, accounted for approximately 24% of our total Company net revenues and approximately 62% of our total Company pre-tax practice profitability in the second quarter of 2020. Total Company pro forma cost of sales, excluding reimbursable expenses, totaled $38.7 million or 73.4% of net revenues in the second quarter of 2020 as compared to $40.8 million or 60.1% of net revenues for the same period in the prior year. As we discussed last quarter, the Company elected to maintain staffing levels through the balance of the second quarter and, as a result, expected to forgo a significant level of profitability as we were evaluating the impact of the COVID-19 pandemic-related disruption. However, as a response to the ongoing disruption, the Company implemented plans to reduce its global workforce by approximately 10% in order to continue to protect as many of our associates while targeting improved levels of profitability throughout the balance of the year. Total Company consultant headcount was 908 at the end of the second quarter of 2020 as compared to 1,026 in the previous quarter and 999 at the end of the second quarter of 2019. Total Company pro forma gross margin was 26.6% of net revenues in the second quarter as compared to 39.9% in the second quarter of 2019, primarily due to our decision to protect associate staffing levels during the second quarter. S&BT gross margins on net revenues were 26.4% in the second quarter as compared to 48.7% in the second quarter of the prior year. The margin decrease was primarily driven by the revenue declines that were impacted by the COVID-19 pandemic disruption. EEA gross margins on net revenues were 29.7% in the second quarter of 2020 as compared to 35.1% in the second quarter of the prior year as modest revenue growth was offset by increased utilization of subcontractors and increased hiring in our rapidly growing OneStream practice. International gross margins on net revenues were 5.1% in the second quarter as compared to 32.5% in the second quarter of the prior year, primarily driven by revenue volatility, as previously discussed. Pro forma SG&A was $11.4 million in the second quarter of 2020 as compared to $15.2 million in the previous year, and represented approximately 22% of net revenues in both periods. The absolute dollar decrease of $3.7 million was primarily due to decreased travel related to selling and marketing activities throughout the quarter. Pro forma EBITDA in the second quarter of 2020 was $3.4 million as compared to $12.8 million in the same period of the prior year and represented 6.6% and 18.9% of net revenues, respectively. Total Company pro forma net income for the second quarter of 2020 totaled $1.9 million or $0.06 per diluted share. This compares to pro forma net income of $8.9 million or $0.28 per diluted share in the second quarter of 2019. Our pro forma return on equity was 20% for the second quarter of 2020. GAAP diluted loss per share was $0.13 for the second quarter of 2020 as compared to earnings per share of $0.22 in the second quarter of the previous year. GAAP results for the second quarter of 2020 include a $5 million or $0.13 restructuring expense for severance costs related to the reduction of staff in the U.S. and Europe. The Company's cash balances were $37.4 million at the end of the second quarter of 2020 as compared to $23.3 million at the end of the previous quarter. Net cash provided by operating activities in the second quarter of 2020 was $14.5 million, which was primarily driven by absolute decreases in accounts receivable and unbilled revenues of $16.4 million. Our DSO, or days sales outstanding, at the end of the second quarter of 2020 was 64 days as compared to 70 days at the end of the previous quarter. Given our high cash balances, the Company did not need to draw down on its credit facility during the second quarter, which has approximately $45 million of available funds. In June 2020, the Board declared a dividend of $0.095 per share, which was paid in July 2020. At its most recent meeting, the Board declared the next quarterly dividend of $0.095 per share, which will be paid in early October 2020. I'll now move to our outlook for the third quarter. As Ted mentioned in his comments, although economic uncertainty from the COVID-19 pandemic continues to be high, the Company's current estimates suggest that net revenue for the third quarter of 2020 will be in the range of $52 million to $54 million. We expect sequential revenues for S&BT to be up, EEA revenues to be down, and Europe to be flat. However, as a result of the restructuring actions that the Company has taken, we estimate pro forma diluted earnings per share in the third quarter of 2020 to be up strongly and sequentially and in the range of $0.13 to $0.15. We expect pro forma gross margin on net revenues to be approximately 33% to 34%. We expect pro forma SG&A and interest expense for the third quarter to be approximately $12 million. We expect third quarter pro forma EBITDA on net revenues to be in the range of approximately 13% to 14%. We expect cash to be neutral when excluding restructuring and dividend payments in the quarter. At this point, I would like to turn it back over to Ted to review our market outlook and strategic priorities in the coming months.

Thank you, Rob. As we look forward, let me share our thoughts on the short and long-term demand environment and on the growth opportunity it offers our organization. It goes without saying that we have entered an unprecedented period where the demand disruption necessitated to ensure our safety has required extreme measures. But it is now also clearly evident that the digital transformation era is just beginning, and it is now being rapidly accelerated by the pandemic. This means that digital innovation on emerging enterprise cloud applications, workflow automation, process mining, and artificial intelligence is dramatically influencing the way businesses compete and deliver their services. Digital transformation is redefining all activities at an accelerated pace, forcing organizations to fundamentally change and adopt these new capabilities in order to remain competitive. Both our Strategy and Business Transformation Group, as well as our EEA Group's offerings and technology capabilities are directly and totally focused on this transformation. On the demand side, the short-term environment is improving as our clients now understand that they must continue to transform and that the virus will continue to disrupt our lives until a vaccine is successfully available. This means they must adapt to a highly volatile environment while we sort through the changes that have resulted from the pandemic. We are encouraged that we are seeing the reverse of Q2 play out in Q3 where we are seeing increasing momentum from the first to the second month of the quarter versus the decreasing momentum we saw in Q2. Strategically, our focus will remain the same, which is to continue to build our brand with our new offerings and capabilities focused on the digital transformation around our fully digitized and unmatched benchmarking and best practices intellectual capital. This should allow us to serve our clients strategically, increasingly remotely, and whenever possible, continuously. Specifically, we will continue to redefine our global benchmarking leadership through enhancements in Quantum Leap, our digital benchmark software-as-a-service solution. This platform allows us to deliver more information with significantly less client effort. It also allows our clients to leverage our IP to track their transformation initiatives over the life of their respective efforts. We believe that there is no comparable platform in the market. We also believe these platforms enhance all of the services that we currently take to market. We will also continue to refine and improve our digital transformation platform to further differentiate our unique IP and related capabilities. DTP has allowed us to fully digitize our IP and align proven software configuration and organizational solutions to help our clients drive transformational change. DTP is a core asset to both our business transformation and cloud implementation offerings. Given the success of our existing IP-as-a-Service initiative and the improved functionality we continue to add to our Quantum Leap and DTP platforms, we believe we will attract other global brand strategic partners to similar programs. We have launched paid pilot initiatives and have received inbound interest from new potential partners that should allow us to further demonstrate the unique capabilities and unmatched credibility that our brand brings to digital transformation, business case assessment as well as implementations. Lastly, even though we believe that the client base and the offerings that we have to grow our business, we continue to look for acquisitions and alliances that strategically leverage our IP and add scope, scale, and capability, which we can accelerate our growth. The trick during this transition will be to understand the short-term impact as well as the long-term opportunity of those candidates that we focus on and also determine a fair price during this period. In summary, we continue to believe that we are well positioned to resume our growth as demand disruptions subside. We're also encouraged to see that the power of our brand and the focus of our offerings, along with our strong financial position, allows us to positively address the most challenging health and economic events. This validates our focus and investments we're making in our platforms, in our cloud applications capability, on emerging software partners, as well as our IP-as-a-Service offerings, which provide us with highly differentiated offerings and strategic access to most of the leading global companies. As always, let me close by thanking our associates and asking them to remain safe for their tireless efforts and always urge them to stay focused on our clients and our people regardless of the short-term challenges we encounter. This concludes my comments. Let me turn it over to our operator, and let us move on to the Q&A section of our call.

Thank you. We will now begin our question-and-answer session. Our first question comes from Jeff Martin from ROTH Capital Partners. Your line is now open.

Thanks. Good afternoon, Ted and Rob, how're you doing?

Good afternoon, Jeff.

Hi, Jeff.

I wanted to explore business transformation, specifically how the sales process is changing, and whether you believe it still needs significant face-to-face interaction for the deals in the pipeline to progress.

There is no doubt that client interaction and access is key to the service. In Q2, clients made deliberate decisions regarding necessary headcount reductions without considering long-term consequences, largely due to the rapid impact of the pandemic felt in March. It's clear now that our clients recognize two important points. First, any reductions made without a comprehensive organizational and technology plan are not sustainable. Second, clients acknowledge that they must continue to take action despite the restricted access and interaction resulting from the prolonged pandemic effects into Q3. They are aware that their quick decisions were made without the usual planning, and they understand these actions are not sustainable. Consequently, they are considering the transformation initiatives they initially planned but now deem necessary due to the changes they implemented. This activity, combined with an expected increase in meeting counts from Q2 to Q3, leads us to believe that clients are making necessary adjustments and that we are aligning those adjustments together with them.

Okay. Are there any areas of the business where remote delivery is a particular challenge? Or have you successfully migrated all of that to remote delivery?

No, the delivery side is not. However, in some significant business transformation initiatives, the organizational changes that usually involve senior executives working closely with our team are now taking place remotely. This has been the main aspect that has been most disrupted when we evaluate the impact of Q2 and the activity as we move into Q3 during this pandemic.

Okay. And then wanted to ask other projects that were nearing launch were perhaps recently launched in the February, March time frame that may have gotten pushed out 60 days, I think, you referred to in the past. What's been your experience with those? Have those started back up? Are they still timeline dependent on a future date? Curious to kind of get your input there.

Well, it's a mix of both. We are experiencing some activity and momentum as we move from Q2 to Q3, particularly in strategy and business transformation. However, some projects started with a different scope, possibly impacted by client access and the prioritization changes that occurred in Q2. Other projects have begun, but they started late in Q2 or are just now launching in Q3. The transition I am referring to involves everyone adapting to the current situation, determining the assistance they need, reengaging with us, and starting those initiatives, even if their delivery, scope, or contracts are affected. Each client's situation is unique, and I could share numerous stories highlighting this. Ultimately, this transition is influenced by the ongoing circumstances, particularly regarding vaccine timelines, as everyone remains hopeful. However, it's crucial for clients to continue making necessary changes to avoid business risks and be ready for any recovery. This dynamic is shaping our engagement with clients.

Okay. And then last question on the IP-as-a-Service initiative, you mentioned some pilots have started. Curious, the duration of those pilots, when you'll know if those will actually convert to longer-term partnerships? And if you could give us an indication of what kind of fields or industry sectors those are in.

We have several initiatives underway, some of which have recently launched. A key observation is the heightened interest we've experienced over the past six months from potential partners that we always believed could form this type of relationship with us. Moving forward, we will need to make two key decisions: first, how extensively we will implement our capabilities across various sectors, and second, how open we want to be in allowing consultancies, systems integrators, and outsourcers to engage with our sector. Importantly, the level of interest, activity, and discussions has increased rather than diminished. Significant opportunities in software and other services are still available, even though we've been advised to work through the next couple of quarters to adjust our priorities. These opportunities have not disappeared.

Great. Thanks for the detail. Appreciate it.

Our next question comes from George Sutton from Craig-Hallum. Your line is open.

Hey, Ted and Rob. This is someone filling in for George. Can you discuss the demand trends you're observing at the product level, particularly within the Oracle solution portfolio as well as with Coupa and OneStream? I’m curious about where you might be identifying strengths and weaknesses in those evolving demand trends.

I believe the key point related to both Oracle and SAP is that their core ERP products are generating the most activity. Opportunities for us arise from that ERP base, expanding into additional support areas like HCM or EPM, which some organizations may not consider core. The eProcurement sector remains very active, continuing through Q2 and into Q3. If you ask about other relationships, OneStream has been growing for us. As we observe these trends, it raises the question of whether we will broaden our enterprise application alliance with other successful providers. You can expect us to develop these relationships further before the year ends.

Great. And then I mean, obviously, your clients' priorities have certainly changed since the pandemic hit. I guess how are you staying engaged with clients who may be putting some of the larger projects on the back burner?

Well, I mean everyone's agility is being tested. So the real question for the client is whether they can really do that through brute force or they can do that through some deployment of technology. And which would then require organizational change. So I would say that we have clients in all of those camps. But what can't be ignored by anyone, it includes all of our client base, is that there's been tremendous acceleration of the whole digital transformation initiatives within their organizations. They can see it. Those that were better prepared or benefited from them, those that have not are clearly having to prioritize and understand that those investments will not be ignored. So we expect, again, digital transformation, organizational change, and implementation of technology to only accelerate as the immediate pressure and the change in the way we're engaging and where people go to work and how becomes more commonplace or it subsides and we return to some newly defined normal.

Okay. Thank you guys. That's it from me.

Our next question comes from Vincent Colicchio from Barrington Research. Your line is open.

Yes. Rob, did I hear it correctly that the EEA revenue will be lower in the quarter, Q3? If so, was that year-over-year or sequential?

No. EEA is going to be down sequentially.

And what will drive that lower revenue? Is there anything specific?

Some of the decline is related to value-added reseller activity in the SAP group, which we do not anticipate will maintain the same level in Q2. Additionally, we have one or two engagements that are currently in transition. In EEA, we are observing increased activity and the expansion of existing engagements. We believe that if we defer any opportunities from Q3, it will fully benefit Q4. There is no lack of activity; it is simply about the timing.

So I assume the overall EEA pipeline improves sequentially. Is that accurate?

Yes. The difference is that you started using some of the backlog from Q1 into Q2. So you are doing both extending and rebuilding the pipeline with that increased activity. This means there are some engagement transitions happening. EEA is expected to experience some of this during Q3. However, if we are correct and it does not occur or begin in Q3, then you will see it in Q4.

And with the outlook in Europe flat, if I heard that correctly, for Q3, are we near a bottom there? Or is it too early to tell?

We sincerely hope so. As you know, Europe has been through a pretty tough time now here for about the last 12 months to 18 months. So we sincerely hope that this is a plateau, a flattening for them. And as you mentioned on the relative cost of our severance charges that were part of the reductions that we made, 50%. Even though it was not 50% of the headcount, 50% of the dollars resulted from the European reduction in force.

And your top client ticked up pretty nicely here, should we expect that to continue in the mix? Or what's going on there?

It's just a mix, just a stable mix that happens from time to time, Vince. There's nothing crazy about that one.

Okay, thank you.

Okay. There being no other questions from analysts, let me then say I thank you for participating on the second quarter earnings call and look forward to updating you again when we report the third quarter. Thank you.