Hackett Group, Inc. Q3 FY2022 Earnings Call

Good afternoon, everyone, and thank you for joining us to discuss The Hackett Group's Third Quarter Results. Speaking on the call today, and here to answer your questions are Ted Fernandez, Chairman and CEO of The Hackett Group; and myself Rob Ramirez, Chief Financial Officer. A press announcement was released over the wires at 4:05 PM 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 which 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 third-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 review our detailed operating results, cash flow and provide our quarterly guidance. We will then review our market strategy-related comments, after which we will open it up for Q&A. This afternoon, we reported total revenues of $72 million and revenues before reimbursements of $71 million, and adjusted earnings per share of $0.37, which was above our quarterly guidance, and up 19% on a year-over-year basis. Our results were driven by 11% growth in revenues before reimbursements from our Global S&BT Group, which also reported the year-over-year segment profit growth of 18%. This growth was driven by our strong S&BT consulting performance and by the growth and increasing revenue mix of our higher-margin Research Advisory and IP-as-a-service offering. This highlights the reasons why we have accelerated our investments in this area. The quarter benefitted from the growth of our IPaaS revenues as our contract we discussed last quarter continued to ramp. We also continue to be actively engaged in contract and pilot discussions with several large software and service companies to help them bolster their value-selling and value-realization efforts. Our results also benefited from the growth of our research advisory business. During the quarter, we launched our first of three new market intelligence programs that we plan to launch by year-end. These programs allow us to compare the differentiating capabilities of software and services providers, which should help them strategically support their sales and marketing efforts. The Global S&BT or Strategy and Business Transformation segment revenue growth was partially offset by the results of our Oracle and SAP segments, which were down as expected in the quarter. Both groups have been rebuilding their pipelines after strong 2021 performance. We now expect year-on-year revenues for both segments to level off in Q1 and return to growth in Q2 of 2023. Our investments that we made to fully digitize our IP and the development of our digital platforms, which include Quantum Leap, our state-of-the-art global benchmarking platform and our proprietary Hackett Digital Transformation Platform or DTP are starting to pay off. These platforms are allowing us to highly differentiate all of our offerings and also develop new licensing and research relationships with software and services providers across the enterprise. On the balance sheet side, our ability to generate strong cash flow from operations has allowed us to increase our dividend, and today we announced the expansion of our credit facility and a $120 million Dutch tender offer to acquire over five million shares of our company's common stock. This tender offer should be strongly accretive, especially when you consider that the reduction of the dividend payment due to this buyback is expected to offset more than half of our net tax interest expense that we expect to incur. As we have discussed on our last few calls, we wanted to be more aggressive with our balance sheet by expanding our credit facility to fund acquisitions into buyback stock while continuing to invest in our business. With that said, let me ask Rob to provide details on our operating results, cash flow and also comment on the outlook. Rob?

Thank you, Ted. As I typically do, I'll cover the following topics during this portion of the call. I'll go through an overview of our third quarter results, along with an overview of related key operating statistics. I'll go over an overview of our cash flow activities in the quarter, and I'll conclude with a discussion on our financial outlook for the fourth quarter of 2022, as well as make some comments in relation to the Dutch. Before moving to our results, I'd like to comment on the Form 10-KA that was filed this evening. Based on common letters and discussions with the staff of the SEC, the company concluded that we had a material weakness in our internal control on financial reporting, as it relates to segment disclosures. It is important to note that, the omission of additional segment disclosures did not result in material misstatement of the company's financial statements. Effective in the third quarter of 2022, the company has reorganized its operating and internal reporting structure to better align with its primary market solutions. Due to this reorganization, the company is expanding its reporting to three segments; one, Global Strategy and Business Transformation or Global S&BT; two, Oracle Solutions; and three, SAP Solutions. As a result, I will comment separately regarding the revenues of our Global S&BT, our Oracle Solutions Group, our SAP Solutions Group and the total company. Our Global S&BT Group includes the results of our North America and international IP-as-a-service offerings, our research advisory programs and benchmarking services our OneStream offerings, and our business transformation groups. Our Oracle Solutions and our SAP Solutions segments include the results of our North America Oracle and SAP offerings respectively. Please note that, we will be referencing both total revenues and revenues before reimbursements in our discussion. Reimbursable expenses are primarily project travel-related expenses passed on to our clients, and have no associated impact on our profitability. During our call today, we will also reference certain non-GAAP financial measures, which we believe provide useful information to investors. We included reconciliations of GAAP to non-GAAP financial measures in our press release filed earlier today, and we'll post any additional information based on the discussions from this call to the Investor Relations page of the company's website. For the third quarter of 2022, our total revenue was $72 million. Our revenues before reimbursements were $71 million, which was in line with our quarterly guidance. The third-quarter reimbursable expense ratio on revenues before reimbursements was 1.5%, as compared to 1.6% in the prior quarter and 0.7% when compared to the same period in the prior year. Post-COVID, as we said, we have experienced increased client-related travel. However, given our transition to a remote delivery model, we do not expect these project-related travel expenses to return to pre-COVID levels. Revenues before reimbursements for our Global S&BT segment were $41.1 million, an increase of 11% when compared to the same period in the prior year, reflecting the continued year-over-year growth since the second quarter of 2020 and the continuing demand for digital transformation investments. The US S&BT revenue before reimbursements growth was 13.2% and international S&BT was 1.6%, but was 60% utilizing the same foreign currency rates in the third quarter of the prior year. Revenues before reimbursements for the Oracle Solutions segment were $17.4 million, a decrease of 16% when compared to the same period in the prior year. We experienced extended client decision-making during the quarter, as clients reconsidered their spending priorities. As we exited the quarter, however, several large opportunities closed, which is further evidence that the digital transformation demand remains healthy. Revenues before reimbursements for SAP Solutions segment was $12.5 million, a decrease of 10% when compared to the same period in the prior year. As we have stated previously, SAP Solutions is coming off of strong 2021 results and it continues to rebuild this pipeline after the completion of some large SAP engagements late in 2021. SAP results benefited from strong VAR activity at the end of the quarter. Approximately 21% of our total company revenues before reimbursements consisted of recurring and subscription-based revenues, which include our research advisory, IP as-a-Service, multi-year benchmarks, and application-managed service contracts. Total company adjusted cost of sales, which exclude reimbursable expenses and non-cash stock-based compensation expense totaled $41.2 million or 58.1% of revenues before reimbursements in the third quarter of 2022, as compared to $43.6 million or 61% of revenues before reimbursements in the prior year. Total company consultant headcount was 1,121 at the end of the third quarter, as compared to the total company consultant headcount of 1,122 in the previous quarter and 1,075 at the end of the third quarter of 2021. The year-over-year increase was primarily the result of higher activities and increased utilization of subcontractors. Total company adjusted gross margin and revenues before reimbursements, which excludes reimbursable expenses and non-cash stock-based compensation expense was 41.9% in the third quarter of 2022, as compared to 39% in the prior year period. The 290 basis point gross margin improvement was primarily driven by the relative mix of higher-margin Global S&BT revenues as well as higher-margin VAR sales during the quarter. Our adjusted SG&A which excludes non-cash stock-based compensation expense, intangible asset amortization, and restructuring activity was $13.8 million or 19.4% of revenues before reimbursements in the third quarter. This is compared to $13.6 million or 19.1% of revenues before reimbursements in the prior year period. Adjusted EBITDA was $16.9 million or 23.7% of revenues before reimbursements in the third quarter of 2022, as compared to $15.1 million or 21.1% of revenues before reimbursements in the prior year. GAAP net income for the third quarter of 2022 totaled $10.4 million or diluted earnings per share of $0.32 for the third quarter of 2022, as compared to GAAP net income of $8.1 million or diluted earnings per share of $0.25 in the third quarter of the previous year. Adjusted net income, which excludes non-cash stock-based compensation expense and restructuring activity in the third quarter of 2022, total $11.8 million or adjusted diluted net income per common share of $0.37, which is above the high-end of our earnings guidance range. Our adjusted net income for the third quarter of 2022 was favorably impacted by approximately $0.01 due to the utilization of a GAAP effective tax rate on adjusted earnings, which was 26% as compared to the 28% that was utilized for our third quarter 2022 guidance. In Q2 of this year, we moved to an actual GAAP effective tax rate for adjusted net income reporting purposes. This compares to adjusted net income of $10.3 million or adjusted diluted net income per common share of $0.31 in the third quarter of the prior year. Adjusted net income for the prior year included an effective tax rate of 27.8% on a GAAP basis. The company's cash balances were $67 million at the end of the third quarter of 2022, as compared to $61.7 million at the end of our previous quarter. Net cash provided by operating activities in the quarter was $9.8 million, primarily driven by net income adjusted for non-cash activity and increases in income tax liabilities, partially offset by increases in accounts receivable and decreases in accrued expenses and contract liabilities. Our DSO or days sales outstanding at the end of the quarter was 66 days, as compared to 59 days at the end of the previous quarter, primarily due to quarter-end SAP license-related sales. Our remaining stock repurchase authorization at the end of the quarter was $10.6 million. Subsequent to the quarter, the company's Board of Directors authorized a $120 million increase in the company's share repurchase authorization. Additionally, the Board declared the fourth quarterly dividend of $0.11 per share for its shareholders of record on December 23, 2022, to be paid on January 6, 2023. Before I move to guidance for the fourth quarter of 2022, I would like to remind everyone of the seasonality of our business, specifically the increased holiday and vacation time that is historically taken in the fourth quarter will decrease our available billing days by approximately 8% to 10% when compared to the third quarter. The company estimates total revenue before reimbursements for the fourth quarter of 2022 to be in the range of $66 million to $68 million. We expect Global S&BT revenue before reimbursements to be up on a year-over-year basis and we expect Oracle Solutions and SAP Solutions to be down on a year-over-year basis. We estimate adjusted diluted net income per common share in the third quarter of 2022 to be in the range of $0.33 to $0.35, which assumes an effective tax rate on adjusted earnings of 28%. It's important to note that GAAP results for the fourth quarter of the prior year included a $7.7 million or $0.23 per diluted share tax benefit related to the exercise of our outstanding share appreciation rights, which will impact year-over-year comparisons. We expect adjusted gross margin on revenues before reimbursements to be approximately 44% to 45%. We expect adjusted SG&A and interest expense in the fourth quarter to be approximately $50 million. We expect fourth-quarter adjusted EBITDA and revenues before reimbursements to be in the range of approximately 23% to 24%. Now, let me provide some details regarding our tender offer that Ted mentioned. The company announced today its plan to launch a tender offer to purchase up to $120 million in value of its common stock at a price not greater than $20.50, nor less than $23.50. We expect to launch the tender offer tomorrow, which would mean it would expire on December 8th of 2022. We plan to conduct a tender offer through a procedure commonly known as a Modified Dutch Auction. This procedure allows stockholders to select their price within the specified price range set by the company, at which stockholders are willing to sell their shares. The company will select the single lowest purchase price within the range that will allow the company to purchase $120 million in value of shares at such price based on the number of shares tendered. All shares purchased in the tender offer will be purchased at the same price. The tender offer will only be made pursuant to the offer to purchase, the related letter of transmittal, and other tender offer materials which the company will file tomorrow with the Securities and Exchange Commission. Any specific questions should be addressed directly with the dealer manager or the information agent for the tender offer. Their contact information will be included in the press release we will issue tomorrow announcing this tender offer and in the tender offer materials being filed with the SEC tomorrow. Additionally, subsequent to the end of the third quarter, the company entered into a new five-year $100 million credit facility with Bank of America and US Bank. Under the credit agreement, these banks have agreed to lend the company up to $100 million from time to time pursuant to a revolving line of credit. The loans under the credit facility will bear interest based on a Bloomberg Short-Term Bank Yield Index or BSBY plus an applicable margin which ranges between $1.5 and $2.25 per annum. The proceeds of the credit facility will be used along with cash on hand for the purchase of the shares in the tender offer along with the related fees associated with the offer and the credit facility. Lastly, we expect our cash balances to be down from the third quarter, as we plan to use approximately $50 million in cash to fund the tender offer, as well as costs associated with the tender offer and credit facility.

Thank you, Rob. As we look forward, let me share our thoughts on the near and long-term demand environment and on the growth opportunities it offers to our organization. Digital innovation in enterprise cloud applications, analytics and infrastructure, workflow automation and process mining are 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. Clients understand that the payback from digital transformation projects are critical to their long-term competitiveness and as they evaluate the Fed's aggressive attempts to slow down the economy and the impact on their respective businesses as well. With that said, although digital transformation demand remains strong, it is being impacted by extended decision-making, as organizations assess competing priorities created by the increasing interest rates. During the quarter, we experienced a disruption of a meaningful project and noticed clients reassessing their spending priorities. However, we also saw other large projects going forward as we exited the quarter. During the quarter, we also saw some of our clients rebalance their spending with productivity and strategic cost-reduction efforts, which are also core to our offerings. On the talent side, competition for experienced talent continues, but we saw turnover moderate during the quarter and expect that trend to continue. Long term, we have transitioned to a hybrid sales and delivery model, which provides us with effective access to our clients and their respective teams. This hybrid model provides our associates with greater personal flexibility to perform their defined responsibilities, which is very valuable to them. This should also allow us to attract and retain talent that we have struggled to retain because of the demanding historical travel requirements of our industry. Strategically, we are accelerating our focus on our recurring high margin IP-related services by increasing the content development and the sales and marketing resources dedicated to this area. Additionally, we have increased our investment in our research advisory member platform and expect to have a new version launched in early 2023. As I previously mentioned, we have also started to launch a series of new market intelligence programs that will help assess and highlight the unique capabilities of software and services providers across selected categories. Our goal is to launch three programs by year-end and then further accelerate the number of new programs launched in 2023. We are absorbing these increased costs in our current results, but believe that they can add high-margin recurring revenue. It is also important to note that we continue to see increasing downstream revenues from our benchmarking and research advisory clients to our business transformation and technology consulting services. Over the last two years, over 40% of our consulting services have come from our research advisory and benchmarking client base. Simply put, organizations that rely on our IP, research, and benchmarking services are also more likely to utilize our consulting services. We are also exploring strategic relationships that will allow us to syndicate our IP through new channels that will allow us to reach significantly beyond the current Global 1,000 focus in a very efficient manner. We expect to launch the first of these relationships, which should result in new high-return margin revenue, prior to the end of the year. We will also continue to redefine our global benchmarking leadership through enhancements in Quantum Leap, our digital benchmarking software-as-a-service solution, along with our Digital Transformation Platform. These platforms allow us to deliver more information with significantly less effort. They are also the underpinning technology for our IP-as-a-Service offering. It also allows our clients to leverage our IP to create compelling benefit case assessments, accelerate process flow and software configuration decisions, and track the value realization of transformation initiatives over the life of their respective efforts. We believe there are no comparable IP-led platforms in the market. As I've been mentioning on our calls, we have added a 20-minute demo of our Investor Relations page on our website, so that investors can become more familiar with the capabilities of our platforms. We plan to refresh those as well as we enter 2023 for those of you who have been exposed to it before and just want to continue to see our innovation. Lastly, even though we believe that we have the client base and the offerings to grow our business, we continue to look for acquisitions and alliances that strategically leverage our IP and add scope, scale and capability, which can accelerate our growth. As always, let me close by congratulating our associates on their performance and by thanking them for their tireless efforts, and always urge them to stay highly focused on our clients and our people no matter what challenges we may encounter. Those conclude my comments. Let me turn it over to our operator, and let's move into the Q&A section of our call.

Thank you. Our first question is from Jeff Martin with ROTH Capital Partners. You may go ahead.

Thanks. Good afternoon, Ted and Rob. Hope you are doing well?

Thanks, Jeff.

Thanks, Jeff.

Ted wanted to know about the disruption of a significant contract with S&BT in the quarter. He was curious whether this disruption is temporary or if it will continue to affect Q4, and if this was taken into account in your guidance for the quarter.

It was certainly part of our consideration. There is a difference between an actual project stopping, which by the way impacted two, three, by probably a penny or two and impacts Q4 by a penny or two. But overall, what we're seeing is the demand and activity for the digital transformation initiatives remain unchanged, but we're seeing clients being challenged in new ways, which forces them to re-prioritize and rethink their spending. We know we're not unaffected by it. We are benefiting by some of our benchmarking and strategic cost reduction activity, which comes with some of those clients reassessing their spending priorities. But look, we're expecting this extended decision-making to continue until we see it change. So that's what's reflected in our guidance.

Okay. Great. And then with respect to process mining, could you give us maybe a progress report on what's been done this year to position the business for that market? And if that's contributing to revenue and profitability, I don't know if that is more of a 2023 and beyond sort of an impact driver?

No, it continues to be an area that we believe has high potential for our business model. However, mid-year, when we assessed the opportunities related to IPaaS growth, content development, and the launch of new market intelligence programs, as well as syndicating our IP, all of which we control, we decided to halt the strategic joint venture efforts we had initiated earlier in the year. Instead, we focused our time and attention on these other areas, which we fully control and are optimistic about the prospects we are observing.

Okay. And then with respect to your target model, which is 5% to 10% revenue growth. I think 15% to 25% earnings growth. I would imagine you'd be at the low end of that range initially in terms of setting an expectation for 2023. Just curious if you could comment around that?

If we look ahead, we expect the slowing economy to affect the fourth quarter and possibly the first half of next year. However, if demand stays stable and concerns about economic slowdowns lessen, we anticipate a strong second half of 2023. The investments we're making in our new programs and increased sales efforts in research advisory are expected to contribute to what we consider our normal long-term growth rate. Additionally, if this growth continues, it would come with higher margins. Our operating and EBITDA margins are improving, and we expect this trend to continue regularly, which highlights the great potential of our business. Regarding our Oracle and SAP Solutions, despite the challenges faced in 2022 following a solid 2021, we're observing positive activity in these areas. We believe they will contribute to growth at least at the lower end of our long-term growth rate, regardless of the economic climate. We're also optimistic about improving margins as we increase our offshore resources. Wage increases are being effectively managed through this strategy across all segments. All these factors are enhancing our margin profile, and if we perform close to the high end of our revenue growth rate with an improved margin structure, our profitability will clearly be on the rise, a trend evident throughout 2022. While it's easy to overlook due to the impact of rising rates and challenges across various industries, our strong performance in the first half of the year allows us to still expect results for 2022 to exceed our record-setting results from 2021, even considering a slower second half.

That's helpful. That's all I have. Thanks.

Thank you. Our next question is from Vincent Colicchio with Barrington Research. You may go ahead.

Yes. Ted, my first question is what gives you confidence in a recovery on the Oracle and SAP side? I believe you mentioned the second quarter of next year.

Just the activity that we've seen even in the third and what we see in the pipeline going into the fourth quarter. And some of the sizable engagements that we said that we signed as we exit Q3 and enter Q4 impacted one of those two groups. So it's just the activity that's why I didn't back off on the activity or demand around digital transformation. But we know that their clients are facing other considerations, and it will impact pipeline velocity and conversion, and we should plan for it, but the activity itself remains a very strong impact. We've seen clients in industries that have been incredibly affected by some of both the COVID and geopolitical issues that they faced not only in 2021 but in through 2022 continue to invest in these digital transformation initiatives in spite of those I'll call it headwinds that they're facing. So that's why I continue to say that demand is going nowhere. Look, we're just going to have some headwinds as clients decide how it's impacting their respective businesses, and we'll have to manage through that. We think we'll do so successfully.

Could you give us an update on how many IPs or service deals you're currently in negotiations with?

Currently, we are working on contracting pilots and similar initiatives, with two to four that are active at the moment. We hope to secure some signed agreements before the year's end and anticipate seeing additional opportunities in 2023.

Are you noticing a growing demand for offshore support in software implementation due to economic pressures, and could this potentially impact revenue for those businesses?

No. But anyone delivering technology-related services needs to have a suitable mix of offshore resources to remain competitive. I believe our offshore resources are likely nearing 50% of our total resources in our Oracle and SAP groups, and that percentage is on the rise. These resources not only assist us in managing wage increases globally, but they also help us maintain a strong competitive edge regarding any rate or pricing issues that clients may present.

Thanks, Ted.

Thank you. The next question is from George Sutton with Craig-Hallum. You may go ahead.

Thank you. Guys, I'm stunned the question hasn't been asked yet very bold move with the Dutch auction at this time in the economy and this time in the market. So could you just give us some perspective of why now versus say, why not six months ago? What are you seeing that's given you the increased conviction? And by the way I love it.

Okay. It has been a consideration throughout the entire year. We launched it this year knowing it would be a strategic alternative while we evaluated other options. Although we couldn't complete it as quickly as we wanted, when we assess our cash flow generation and the volatility of our shares, it seemed unnecessary to keep it on our balance sheet. The interest expense we're incurring will be largely mitigated by the elimination of dividends on the repurchased shares and the tax effects of the interest expense. Therefore, our net dividend and tax interest expense will remain very low. Considering all these factors, I personally advocated for this, especially as we explored other strategic opportunities, including acquisitions throughout 2021. I didn't want to let the year pass without taking action given the strength of our operations and the cash flow we are generating. So we decided to move forward with it.

So in other words, you have actively looked at strategic opportunities from an M&A perspective and found that your own shares are the best investment, I guess that would be the logical summary?

That is correct. Especially, when you look at what we believe are the growth prospects from our research-related offerings, IPaaS licensing, all of the above, we think it's a great investment.

So you mentioned a new research advisory platform to launch in early 2023. Can you provide some insight into the potential additions and how this platform will differ from what we currently have?

I’m embarrassed to admit that the existing member portal has taken a backseat to the significant investments we made in Quantum Leap and digital transformation over the last three to four years. We probably should have started this earlier, but it was deprioritized in favor of other platforms, which George has shown to be very important to our current offerings. However, as we assess our spending to grow programs and expand the sales force around those research programs, we realized that we need to implement a state-of-the-art member platform throughout 2023. Let's hope we can get that first version out early in 2023. Our members certainly deserve it.

Super. Thanks, guys. Appreciate it.

Thank you, George.

Thank you. And at this time I show no further questions. I will now turn the call back over to Mr. Fernandez.

Well, I'd like to thank everyone for participating in our third-quarter earnings call. We look forward to updating all of you when we report the fourth quarter. As Rob said, you will see press releases that will be going out tomorrow along with the details of our Dutch tender offer that will go out before the market opens. Thank you again for participating.

Thank you. That does conclude today's conference. Thank you all for participating. You may disconnect at this time.