ICF International, Inc. Q2 FY2023 Earnings Call

Welcome to the Second Quarter 2023 ICF Earnings Conference Call. My name is Tess and I will be your operator for today's call. I will now turn the call over to Lynn Morgen of Advisory Partners. Lynn, you may begin.

Thank you, Tess. Good afternoon, everyone, and thank you for joining us to review ICF's second quarter 2023 performance. With us today from ICF are John Wasson, Chair and CEO; and Barry Broadus, CFO. Joining them is James Morgan, Chief Operating Officer. During this conference call, we will make forward-looking statements to assist you in understanding ICF management's expectations about our future performance. These statements are subject to a number of risks that could cause actual events and results to differ materially, and I refer you to our August 3, 2023 press release and our SEC filings for discussions of those risks. In addition, our statements during this call are based on our views as of today. We anticipate that future developments will cause our views to change. Please consider the information presented in that light. We may, at some point, elect to update the forward-looking statements made today, but specifically disclaim any obligation to do so. I will now turn the call over to ICF's CEO, John Wasson, to discuss second quarter 2023 performance. John?

Thank you, Lynn, and thank you all for joining us to review our Q2 results, the transactions we announced this afternoon and our business outlook. As there's a lot to discuss today, I will focus on the highlights of the second quarter and then quickly move on to recent developments and comment on the growth initiatives underway at ICF. There are several key takeaways from our second quarter performance. First, this was an excellent quarter for ICF. Revenues increased 18%, indicative of how well aligned our services and capabilities are with market demand. Second quarter revenue growth was led by strong year-on-year comparisons in our key growth markets and represented 10% organic growth, together with the SemanticBits acquisition we completed in mid-2022. Second, contract awards were up 28% year-on-year, and we expect second half contract wins to be quite strong. Over 80% of our second quarter wins represented new business in various sectors, another indication of ICF's competitive positioning in areas of priority spending. Our trailing 12-month book-to-bill ratio of 1.3 is among the highest in the industry and supports our expectations for significant revenue growth this year and into 2024. Third, we ended the quarter with a record business development pipeline of $10.3 billion, which represents almost 20% growth compared to year ago levels. This growth is attributable to our expanded capabilities, our ability to bid on larger contracts, thanks to our increased scale and the opportunities that are emerging from recent legislation. Lastly, we executed transactions that strengthened ICF's position in key growth areas and support our long-term growth strategy. Our energy environment, infrastructure and disaster recovery market, which spans our government and commercial client set, continue to be a standout performer in the second quarter. Revenues increased nearly 18%, primarily representing organic growth, and this market accounted for slightly over 40% of second quarter revenues. Commercial Energy represents a large part of that market and includes advisory work for utilities, global energy developers and investors, implementation of energy efficiency and distributed energy programs for utilities and environmental services for utilities and other energy providers. Commercial energy revenues increased 22% in the second quarter and are up 20% year-to-date. We expanded our energy efficiency programs for several large utility clients and saw greater demand for advisory expertise and our environmental and planning services as clients plan their renewable projects in light of funds and tax credits made available through recent legislation. This was also a strong quarter of new contract awards in the commercial energy arena. There was particular strength in multiple innovative pilot programs focusing on electrification, financing and energy equity. A significant portion of the new work that we won is to provide services necessary to analyze, finance, permit, construct, connect, monitor and operate renewable projects across the country and offshore. The Federal Energy Regulatory Commission issued an order last week that should expedite the interconnection of new wind, solar and storage resources to the grid, which should drive additional demand for our advisory work. In today's release, we announced the acquisition of CMY Solutions, which will expand our addressable market within the electrical sector. CMY Solutions is a power and engineering firm that provides next-generation technology solutions and data analytics that drive more informed decision-making on grid modernization and investments. CMY has a team of about 50 electrical engineers who work with utilities and developers across the U.S., Europe and Asia, including investor-owned utilities, electric municipalities and electric cooperatives. We have successfully partnered with CMY in several projects and together have an excellent track record of delivering positive results for our clients, which made this a compelling transaction for us. CMY expands our addressable market by giving us the ability to support client needs for renewables interconnection, substation and distribution upgrades and grid resilience, and providing us new technology and data management capabilities that we can offer our commercial energy clients as well as our government clients. In addition to commercial energy, we also experienced strong demand in the second quarter for our Climate and Environmental Services, which, as you know, cut across all of our client categories. Second quarter growth in our Climate business was driven by new expanding projects at NASA, EPA, DOE, USAID and 3 large East Coast utilities. ICF has one of the leading, if not the leading climate practice in the country, and we are seeing strong demand resulting from funding for decarbonization programs, including assessment, disclosure and management of risk in the private sector and large-scale programmatic funding by government entities. Our environmental planning and monitoring services and disaster management account for over 80% of our state and local revenues, which in total increased over 27% in the second quarter. Pent-up demand post-COVID and recent legislation are driving significant new infrastructure planning and investment, and environmental scopes of work that are required at the front end of such projects are increasingly considering climate risk, energy equity, resilience, fire, flood and sea level rise, which demonstrates the growing interconnections that benefit ICF's competitive advantages. Revenues from our disaster recovery market continued to grow at a double-digit rate in the second quarter. We continued our recovery work in Puerto Rico and just announced a new $32.1 million contract with the U.S. territory to provide disaster management consulting services to accelerate federally funded recovery efforts across the territory. Our others market is health and social programs, which is where our public health and most of our IT modernization services reside. This market is primarily comprised of work for the federal government, with a small part representing services to state, local and international government clients and minor contributions from commercial clients. In the second quarter, its revenues were up 30%, reflecting both organic growth and the acquisition of SemanticBits in this market accounting for 41% of total second quarter revenues. We continue to see strong year-on-year growth in public health and IT modernization in the second quarter. Public health and IT modernization are two areas that historically have garnered bipartisan support and have been well funded. We see significant runway to increase our market share of the Department of Health and Human Services, capitalizing on specific opportunities for revenue synergies tied to the SemanticBits acquisition, which we expect to bid over the next 6 to 9 months. Additionally, our greater scale is opening more and larger opportunities for us at HHS and across our federal government client set. Similarly, our pipeline of federal government opportunities increased 21% from the same period last year and 6% sequentially, supporting our outlook for continued growth in the federal arena. Furthermore, with regard to federal government opportunities, we are seeing increased interest in the use of AI among our federal government clients, and ICF is well positioned to benefit from this trend. In fact, we have been deploying AI and machine learning for years with our federal clients. As a leader in the shift to low-code and no-code platforms into open-source solutions, our 1,800 technologists have been and will continue to take advantage of AI capabilities embedded in these platforms, including developing novel generative AI approaches to automate co-generation and enhance developer productivity, and leveraging AI to enable more efficient migration of technology to modern platforms. At the same time, we see generative AI as a way to improve the productivity and experience of our own employees and streamline various corporate functions at ICF. In fact, at the beginning of this year, we established a generative AI enablement team to identify and develop use cases for generative AI that can be utilized to increase productivity for both client-related work and efforts internally within ICF. Lastly, in today's earnings release, we announced that ICF recently signed a definitive set of agreements to sell our commercial marketing group. Included in the sale were our commercial loyalty programs and integrated communication services for consumer and financial clients. This group has been important to ICF's capabilities, contributing to the growth of the engagement and communication services we provide to our government and utility clients. As we increased our focus on key growth markets and mission-related areas within our government and commercial energy client sets, however, this group has become less central to our operations, prompting the decision to divest the business. We are especially pleased that the group's senior leadership and staff have been offered positions by the acquirer. The transaction is expected to close in the third quarter, and Barry will provide additional details on the net effect of this divestiture and the CMY acquisition in his remarks. With that, I'll turn the call over to our CFO, Barry Broadus, for a financial review. Barry?

Thank you, John, and good afternoon, everyone. I will now share additional details of our financial performance in the second quarter of 2023. As John noted, we had strong second quarter revenue performance, which was a result of our 10% organic growth, coupled with the acquisition of SemanticBits last July, driving our year-over-year revenue increase of 18.2% to $500.1 million. Revenue growth was broad-based, showing double-digit increases from federal, state, local government, and commercial energy clients, which together made up 88% of our second quarter revenue. Subcontractor and other direct costs of $137.7 million accounted for 27.6% of total revenue, consistent with the previous year's second quarter. Gross margin for the second quarter was 34.9%, down 150 basis points from the same period last year. Several factors contributed to this decline, including last year's acquisition of SemanticBits, which has a lower gross margin but higher EBITDA margins, along with the timing of certain project and contract ramp-ups. We anticipate sequential improvements in gross margins in the latter half of this year. Year-over-year, adjusted indirect expenses fell 140 basis points to 24.6% of revenue due to expanded scale and effective management of our indirect expenses. While we continued to invest in personnel and technology to support long-term growth, our indirect and selling expenses increased 10.6% year-on-year to $126.5 million, which was a significantly slower rate than our revenue growth. Second quarter EBITDA rose 19.2% to $47.5 million, and adjusted EBITDA increased 15.3% to $51 million year-over-year. Interest expense for this quarter was $10.2 million, up by $6.1 million from last year's figure. The second quarter acquisition of CMY, which was not factored into our previous forecasts, combined with rising interest rates, led to an unexpected increase in our interest expenses. However, the negative impact of increased interest expense on second quarter EPS was more than offset by benefits from our tax optimization strategies. We expect these additional benefits to help counteract the projected higher interest expenses for the rest of this year. Net income was $20.3 million or $1.07 per diluted share in the second quarter, which included $3.5 million or $0.13 per share related to tax-affected M&A and severance charges. Our second quarter net income and diluted EPS had a $0.21 per share incremental tax benefit beyond our estimated full-year tax rate used in our year-end guidance. In the second quarter of 2022, net income was $18.4 million or $0.97 per diluted share. Non-GAAP EPS grew by 18.8% to $1.57 per share, reflecting the advantages of the company's long-term tax strategies. We are very pleased with our cash flow generation for both the second quarter and year-to-date. Cash flow from operations in the second quarter amounted to $36.7 million and $19.9 million on a year-to-date basis, significantly outperforming our first half 2022 results. Our ongoing cash management initiatives played a key role in this favorable performance, contributing to our improved days sales outstanding of 73 days, down from 82 days in last year’s second quarter. Year-to-date capital expenditures, mainly related to technology investments, totaled $13.2 million, compared to $11 million in the first half of 2022. Our debt stood at $601.8 million at the end of June, consistent with our debt balance at the end of the first quarter. This second quarter debt includes the funding for the CMY Solutions purchase, which was primarily financed through cash flow from operations generated during Q2. Our adjusted net leverage ratio was 3.11 at quarter end, slightly up from 3.09% at the end of the first quarter. Assuming no further acquisitions this year, we expect our year-end leverage ratio to decrease by about 1 turn, factoring in the expected net proceeds from divesting our commercial marketing group. During the quarter, we executed an additional $100 million in interest rate swaps, increasing our fixed-rate debt to around 60% of total debt. With these new swaps, our all-in average interest rate is now 5.25%. Our capital allocation priorities include reducing debt, investing to support organic growth, paying dividends, repurchasing shares to mitigate the effects of employee incentive programs, and considering strategic acquisitions. We spent $18.1 million in the first half of this year to repurchase 180,000 shares and have $93.7 million remaining under the current stock repurchase authorization. We also announced a quarterly cash dividend of $0.14 per share, payable on October 13, 2023, to shareholders of record on September 8, 2023. To assist with your financial models, I want to emphasize that our second half revenues will be essentially flat compared to the first half due to the divestiture of our commercial marketing group, which will be partially offset by the revenue from the CMY acquisition. The combined effect of the divestiture and acquisition will reduce our revenue by about $15 million, weighted towards the latter part of this year. As John previously stated, we are reaffirming our revenue and non-GAAP EPS guidance for 2023, which includes both the CMY acquisition and the upcoming divestiture of our commercial marketing group. Furthermore, any potential gain associated with the commercial marketing group divestiture and the one-time non-cash charge related to stranded facilities will not affect our non-GAAP EPS guidance. Moving on to other key guidance metrics, we expect depreciation and amortization expenses to be in the range of $23 million to $25 million. Amortization of intangibles is projected to be around $36 million. Interest expenses are now forecasted to be between $37 million and $39 million, up from our previous estimate of $32 million to $34 million due to higher interest rates and increased average debt levels, as mentioned earlier. Our expected tax rate for this year is approximately 17%, compared to the 23.5% previously projected, with the second half estimated to be around 19%, particularly with the third quarter projected at about 12%. We anticipate operating cash flow to be $150 million. Our fully diluted weighted average share count is expected to be around 19 million, and capital expenditures are anticipated to range between $26 million and $28 million. Finally, we have discontinued the non-GAAP financial measure of service revenue, as it no longer aligns with recently issued SEC guidelines. Service revenue will no longer be included in our public filings, investor presentations, or other published reports and documents. The company will continue providing insights into our subcontractor and other direct costs. I will now turn the call back over to John for his closing remarks.

Thanks, Barry. We are pleased to reaffirm our full year guidance. We expect 2023 total revenue of $1.93 billion to $2 billion, and we anticipate subcontractor and other direct costs will be approximately 27% of total revenue. EBITDA is estimated to range from $210 million to $220 million and GAAP EPS is projected at $4.75 to $5.05, exclusive of special charges. Non-GAAP EPS is expected to range from $615 to $6.45. Operating cash flow is expected to be approximately $150 million in 2023. In the second quarter, we continued to invest in people and technology that enabled ICF to execute effectively on our existing contracts while positioning us to capture an even greater share of future growth opportunities. The sale of our commercial marketing group was a strategic decision to streamline our business and deploy our resources to support the key growth markets we have identified. The acquisition of CMY fully aligns with the increased demand we anticipate from our commercial energy clients. Our industry-leading trailing 12-month book-to-bill ratio of 1.3, together with a record $10.3 billion business development pipeline, points to continued growth ahead. Additionally, we are proud of the impact that ICF and its people are having on society through the services we provide clients in support of energy saving, carbon reduction and natural resource protection programs, as well as health, education, development and social justice programs. I encourage all of you to review our recently released corporate citizenship report, which highlights our impacts in these areas. With that, operator, we'll open it up for questions.

Our first question will be from Joseph Vafi from Canaccord Genuity.

Hey, everyone. Good afternoon. Congratulations on the solid and steady results. I thought, John, I would just circle back to your opening comments where you said that you expected a strong second half in bookings. I know there's a lot of tailwinds out there relative to the environment and recent legislation. But unless the deals are signed, it's a little bit unlike you to say it's going to be solid. So just any color there, perhaps some solid bookings already happened in July? And then I'll have a follow-up.

Sure, Joe. I appreciate the question. Well, first of all, I'd say, obviously, as you saw and heard in the results, we have a very strong pipeline, a record pipeline. As you know, the timing of our awards, Q3 is generally our far and away strongest quarter for awards, driven with the end of the government fiscal year. Q4, certainly last year and over the last couple of years has also been quite strong, again, with wins in the federal sector, but also across commercial and state and local. Given the size of the pipeline and the significant amount of the pipeline that is in proposals submitted leading to awards or is in final negotiation on those opportunities, I think we do have a high degree of confidence that the wins and sales for Q3 and Q4 will be quite strong, much like last year, where Q3 and Q4 were particularly robust with corresponding strong results. So I think that's what's driving the confidence. Again, I think we have clear visibility of how those awards should play out.

Got it. And I know you mentioned having the size and scale for bigger bids, but it feels like you've had that size and scale for a while. I mean, you're kind of a scale player in many verticals. I wanted to drill down into your comments relative to your size and the average deal size you’re seeing these days. And then I might sneak one more in.

Sure. The area where the size and scale over the last several years is really helping us is on the IT modernization and technology front. We've come a long way there. As I mentioned in our remarks, we have 1,800 technologists. We have approximately $500 million of revenue from our technology business. I think that's an area where we are seeing larger opportunities, and we are increasingly able to pursue and capture larger opportunities. In addition, with the acquisition of SemanticBits, that really has given us scale and position within CMS to bid for larger opportunities and combine the technology capabilities that legacy ICF has on low-code and no-code with the open source, bringing deeper ICF capabilities into CMS. We can also leverage SemanticBits' open-source capabilities into our broader civilian client base. I would emphasize that scale is significant especially with respect to technology. Our energy business has also shown strong growth, with a 22% increase in commercial energy. We have scale there and continue to see opportunities in the area of energy efficiency.

Got it. Just one more. I know that there are some puts and takes in the P&L here in the second half with M&A and divestitures. EPS has been reiterated, so I wanted to drill down a bit and ask if there was enough core business performance — perhaps core business was doing a little better than expected, providing upside to guidance without any M&A. Any color on how we reconcile reiterating EPS amidst those moving parts?

Joe, thanks for the question. I think as I stated, we are strong on reaffirming the non-GAAP EPS guidance for this year. We think that given the divestitures and the various moving parts, including the tax strategies we implemented will certainly help offset any of the lost EPS from the divestiture. So we feel solidly positioned for this year.

I would just add on that, while Barry gave guidance on how the revenues would shift given the divestiture of the commercial marketing group and the CMY acquisition, I would highlight that from an EPS perspective, the commercial marketing business had margins in the low to mid-end of our federal business. In contrast, CMY is a smaller business than what we're divesting, and it fits within the high-end margin expectations for commercial energy. So the bottom line from an EPS perspective shouldn't vary significantly given the relative margins of the revenues.

Thanks. If you look at your expectation for strong contract wins in the back half of this year, are those related to the recent legislation and/or climate bill? Is that what makes them strong, or is it more the typical budget spending by your customers?

At a high level, Tobey, I think that we are seeing growth in the pipeline and the awards across our five growth areas. The expansion is broad-based across federal, commercial, state and local entities. While we do see positive momentum on the climate initiatives driven by recent legislation, we believe that the momentum we’re experiencing reinforces our outlook. Specifically, we are reporting a pipeline for IIJA (Infrastructure Investment and Jobs Act) opportunities approaching about $270 million and nearly $70 million in awards. The Infrastructure Investment and Jobs Act and IRA (Inflation Reduction Act) are positively impacting our market and potentially set us up for further growth heading into 2024.

What does your guidance assume from a fiscal federal 2024 budget or continuing resolution? I know you can't predict it, but what kind of assumption do you have looking into the fourth calendar quarter?

We haven't provided guidance for 2024 yet. We do have a long-term goal we articulated at our Investor Day around high single-digit organic growth and the potential for double-digit growth by leveraging our balance sheet over time through 2024. Generally speaking, we assume that a budget will be passed or that we will have a continuing resolution. This gives us optimism for the federal side, especially as public health and IT modernization have historically been bipartisan priorities and remain so. Given the contract awards we have in place, we anticipate strong performance in the federal arena. Any unexpected situations like a government shutdown or severe expenditure cuts are not something we expect. However, generally, we assume there will be either a budget or a continuing resolution.

Good afternoon. I just wanted to ask about the divestiture of the commercial marketing group. You mentioned that they helped with your engagement and communication services for government utility clients. Will you retain some of those capabilities within the company post-divestiture?

Yes, let me clarify, Kevin. Within our government business, we have a separate group providing marketing and communication services to our federal clients, which is a business that exceeds $100 million and remains within ICF. That segment continues to play a critical role in our operations. We have core staff that supports our commercial energy business with communication efforts, particularly for energy efficiency and other utility programs. Those personnel will remain with ICF. Moreover, our international marketing communications business out of Brussels will stay with us. The core commercial marketing services business being sold includes areas like hospitality, innovative marketing, and some business transformation consulting for sectors that do not align closely with our offerings. Thus, we will keep the vital capabilities and skills while divesting that which is less central to ICF.

Understood. Just also wanted to inquire about service revenue, although you mentioned it won't be part of investor communications anymore. Will you still look at that internally to monitor business health?

Yes, Kevin, happy to clarify. We consider service revenue an important metric, and we will continue to monitor it as it effectively reflects the core business's performance. We will provide the Street with information on subcontractors and other direct costs so that calculation remains feasible, and this will be included in the 10-Q when we file it.

Hi, good evening, everyone. I wanted to circle back on your prepared remarks about AI, discussing the opportunities and talent needs arising there. How are you progressing in that area?

Certainly! As mentioned, we have a robust technology business focused on IT modernization. Much of that business has utilized AI and machine learning as part of our work for clients in the federal sector for years. We continue to explore generative AI and evaluate how to best implement those capabilities to meet client needs while improving our internal productivity. Our technologists are engaged in various projects, emphasizing machine learning and predictive AI, a trend we've been following for years. Talent acquisition is paramount; recruiting talent in our technology department remains a priority. That area is highly competitive, but we have significant investments in recruitment strategies to secure the talent we need for our ongoing initiatives.

Great! Lastly, could you discuss the pricing environment and challenges related to implementing price increases?

There hasn't been a significant change to the pricing environment. As with any competitive business, we must compete for contracts. While price remains important, the quality of our capabilities and past performance takes precedence. We gave significant raises in March, and typically maintain built-in escalators in fixed-price contracts to reasonably cover any increases. Contracts are variable; however, we focus on improving our pricing strategies and managing our contracts effectively to pass costs onto our clients appropriately.

I'm showing no further questions in the queue. At this time, I'd like to turn the call back over to John for closing remarks.

Thank you for participating in today's call, and we look forward to connecting with you at future conferences and events. Have a good rest of the summer. Take care.

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.