Information Services Group Inc. Q3 FY2020 Earnings Call

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

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

Thank you, Barry, and good morning, everyone. We had a very strong third quarter even in the face of this global pandemic. Revenues were up 7% and EBITDA up 11% sequentially, with the Americas, in particular, coming in strong, with revenues up 11%. Cash remained strong with operating cash for the quarter of $10 million and our cash balance growing to $38 million, up 21% over Q2. In the last 12 months, ISG has generated $52 million of cash, a testament to the cash-generating power of our business and our disciplined operating approach. Much of our success this quarter is due to the extraordinary efforts of our global team. The ability of our people to quickly adapt to new ways of working, provide continuing high-quality services to our clients and win new business in a work-from-home environment has been outstanding. Our Go Digital strategy launched well before the pandemic is helping us weather this economic and health crisis. Our results demonstrate the relevance of this strategy, the resilience of our business and our people, our disciplined management and the power of our relationships with the world's leading companies. During the third quarter, we saw bright signs in a number of our industry segments. Our insurance, public sector, retail and telecom verticals were all up double digits over the prior year. And sequentially, we saw double-digit growth in our energy, life sciences and tech verticals. On the flip side, hospitality, banking and manufacturing were all down double digits versus prior year. Our pandemic-ready services from cost takeout and captive monetization, supplier governance and pricing benchmarks to cloud automation, data analytics, next-gen workforce solutions and networking are helping clients adapt to the current situation and prepare for a digitally turbocharged future. Virtually every enterprise knows digital is the future and the best way to improve efficiency, reach customers, find new opportunities and keep employees connected even when working apart. That's why many of our clients continue to invest in digital. The pace of that investment may vary depending on the industry, but it is continuing. With these market and industry insights as a backdrop, let me further detail our financial performance. Revenues, EBITDA and EPS for the quarter all exceeded expectations. Revenues were $62 million, up 7% sequentially over Q2. On a year-to-year basis, revenues were down only about 6% when you exclude the billable T&E that was absent due to the ban on travel. This is a result of continued softness in the travel, transportation and hospitality industries. And as mentioned last quarter, we are working with a number of clients in distress like our cruise lines and hotels to offer reduced rates and extended terms. During the quarter, we served 434 clients. That's up 6% since the beginning of the pandemic. And we generated $19 million in recurring revenues, representing 31% of our firm-wide total. From a profit perspective, our adjusted EBITDA of $8.2 million was up 11% from Q2, thanks to our early and aggressive cost actions and our higher-margin mix of products and services that are helping clients weather this downturn. We will likely continue to see revenue pressure in the near term as clients delay spending on major technology initiatives even as demand remains focused on our higher-margin pandemic-ready services. As a result of our actions and our resilient portfolio, our capital position continues to grow even stronger. As I mentioned, we generated $10 million in cash flow from operations in the quarter, bringing our year-to-date total to $37 million. And we ended the quarter with a cash balance of $38 million versus $14 million last year at this time even after investing $2 million from the Neuralify acquisition. As discussed last quarter, in July, we acquired Neuralify, a market leader in intelligent automation enablement solutions and services. Since then, Neuralify's operations have been fully integrated into ISG Automation. We are already benefiting from the combination with Neuralify's solutions providing a strong market differentiator for our ISG Automation business. Now turning to our regions. The Americas delivered $35 million in revenue in the quarter, up 11% sequentially, down 13% versus the prior year. A reduction in client billable T&E contributed about 500 basis points of this decline. As mentioned last quarter, we accommodated a number of clients in the U.S. on rate reductions, extended terms and other areas in some of the harder-hit segments like automotive, travel and hospitality. We did see good sequential growth in our higher-margin services of cost takeout, automation and in industries like energy, life sciences and tech, all up double digits sequentially. Key client engagements in the third quarter included Corning, Centene, Hydro One, U.S. Steel, British Columbia Public Health and National Grid. Among our significant wins, ISG signed a 3-year GovernX deal for close to $2 million with a major financial services firm. ISG will migrate more than 1,000 contracts for this client to our GovernX software platform. We also were awarded a $2.5 million 29-month GovernX contract with a major health care company, one of the leaders in the fight against COVID-19. And all of this was done in a remote selling and delivery environment at a time when we have seen an uptick in our client satisfaction scores. Turning to Europe. Our Q3 revenues of $21 million were in line with Q2, down 7% from the prior year. During the quarter, EMEA more than doubled its network services revenue and delivered double-digit revenue growth in our research business. Among our industry segments, consumer, energy, life sciences and financial services were up, offset by a decline in manufacturing. Key client engagements in Europe in the third quarter included Allianz, Wintershall, Aldi, Volkswagen and New Day. Among our wins, ISG has been awarded a $1 million contract in Germany with a multinational optics and medical device manufacturer to support their client's global strategic sourcing program. In addition, a leading global pharmaceutical and life sciences company has engaged ISG to lead the modernization of their enterprise landscape. The win for nearly $1 million follows the successful delivery of an HR tech engagement with the client earlier this year. Finally, in Asia Pacific, we reported double-digit sequential growth with revenues up 19% to nearly $6 million, driven by the public sector, tech, financial services and insurance industry verticals. During the quarter, ISG was awarded a $1.4 million GovernX engagement with a Japanese multinational brewing and distilling company. This contract represents the largest total contract value annuity deal to date for ISG in Asia, and it builds on our success supporting this client through 10 engagements over the last 2 years. Other key clients in the quarter in this region included Rio Tinto; the Australian Taxation Office; the Department of Defense; the Department of Home Affairs; insurance company, IAG; AMP Services and ANZ Banking Group. Now let me turn to guidance. As we indicated last quarter, we're working through a still difficult COVID environment. And while it's too early to predict the trajectory for the recovery, we continue to plan for a return to prior levels of activity. The crisis, as we all know, is far from over. Although there has been some flattening of the curve in some countries, we continue to see surges, and this is impacting our clients' decision-making, especially those in consumer-facing industries. This crisis likely only begins to subside with the introduction of vaccines. Apart from the pandemic-induced impacts on client demand, in Q4, we are looking for a continued reduction to near 0 of client T&E reimbursable expense, which usually runs about 4% to 5% of our revenues. And though we are planning for our live ISG-produced destination events to eventually return, we are not forecasting any revenue from in-person events for the balance of the year. On the upside, as mentioned previously, we are seeing strong client interest in our rapid cost optimization services, supplier and risk management, network capability and resiliency, digital workplace solutions and business recovery planning. Longer term, we think the pandemic will accelerate client demand for and investment in digital transformation services ISG provides. Balancing all of this, we will continue to provide guidance on a quarterly basis based on assumptions we are making on a continuing volatile environment. For the fourth quarter, we are forecasting revenues of between $56 million and $58 million and adjusted EBITDA between $7 million and $8 million as a result of the cost actions we have taken and in anticipation of higher-margin services being delivered in the quarter.

Thanks, Mike, and good morning, everyone. To reiterate what Mike said, we managed through a difficult operating environment and delivered a solid third quarter. Revenues for the third quarter were $61.6 million, up 7% sequentially. This compared with $68.1 million in the prior year, down 10% on a reported basis and 11% in constant currency. Currency positively impacted reported revenues by $1.1 million versus the prior year. Excluding reimbursable client travel costs of $2.4 million, which accounted for approximately 350 basis points of the year-to-year decline, revenue was only down 6% versus last year. Reported revenues were $35 million in the Americas, up 11% sequentially and down 13% versus the prior year; $20.9 million in Europe, flat sequentially and down 7% on a reported basis and 11% in constant currency versus the prior year; and $5.7 million in Asia Pacific, up 19% sequentially and up 8% on a reported basis versus the prior year and up 4% in constant currency. Third quarter 2020 adjusted EBITDA was $8.2 million, up 11% sequentially and compared with $10.3 million in the prior year's third quarter. We reported third quarter operating income of $3 million compared with operating income of $5.7 million in the third quarter of 2019. Net income for the quarter was $2.1 million, up 19% compared with net income of $1.7 million in last year's quarter. Reported fully diluted income per share was $0.04, flat with the prior year. Adjusted net income for the third quarter was $5.2 million or $0.10 per share on a fully diluted basis compared with adjusted net income of $4.4 million or $0.09 per share on a fully diluted basis in the prior year's third quarter. Utilization for the third quarter was 69%. Quarter end head count was 1,261, down slightly versus last year. Our balance sheet continues to have the strength and flexibility to support our business over the long term. Net cash provided by operations for the third quarter was $10 million and $37 million year-to-date versus less than $6 million in the prior year's 9-month period. We have generated $52 million of cash flow from operating activities over the last 12 months. We spent $2.3 million on the acquisition of Neuralify, and we ended the quarter with $38.1 million of cash, up from $18.2 million at year-end and $14.2 million in 2019 Q3. We repaid $1.1 million of debt in the quarter and $7 million year-to-date, lowering our debt to $79.9 million. Our average borrowing rate for the quarter was 2.6%, less than half of last year's rate, and we had 48 million shares outstanding as of October 31.

Mike will now share concluding remarks before we go to Q&A. Thank you, David. To summarize, ISG continues to gain momentum in the face of COVID-19, and I think it's a testament to our resilient operating model and pandemic-ready portfolio. Our revenue, EBITDA and EPS beat expectations, thanks to our early and decisive actions and improved mix of higher-margin products and services. We had $38 million in cash at quarter end after generating an additional $10 million of cash in the quarter, and we continue to pay down debt with our debt down 8% since the end of last year. We continue to serve our clients without interruption and deliver the higher-margin services they need to contend with this downturn. Longer term, we see the pandemic being an accelerator for our clients' digital transformations and demand increasing for our digital services in 2021. As always, we are focused on creating shareholder value for the long term, and we are steadfast in our mission to deliver operational excellence to our clients. So thank you very much for calling in this morning. And now let me turn the session over to our operator for your questions.

Our first question will come from Joe Gomes with NOBLE Capital.

Nice quarter. Just a couple of quick technical ones here. So it looks like for the quarter, the EPS beat, so to speak, was driven by a lower tax rate in this quarter versus the year ago quarter. Just if you can give a little more color on that and what we could expect possibly for the fourth quarter in terms of tax rate.

Yes. Thanks, Joe. So yes, there was a reduction in foreign unremitted earnings related to tax law change in India, which favorably impacted the quarter. I think for the fourth quarter, if you use an effective tax rate of around 50%, you'd be good.

Okay. And again, kind of on the technical part here real quick. So nice build in the cash, assuming some of that is the deferral of payroll taxes, which eventually do got to be repaid in '21 and '22. Just wondering how much of the payroll taxes have been deferred, so we could kind of get an idea of how much of that cash actually just needs to go back to the federal government on a delayed basis, but does need to go back to them.

Yes. The U.S. federal taxes will be paid over a two-year period starting at the end of next year. So the impact is not significant, not that big. Some of the foreign taxes that were delayed were actually repaid in the third quarter. Therefore, we expect cash to increase slightly in the fourth quarter.

Okay. And Mike, last quarter, you talked about this integrated delivery platform that you were going to talk a little bit more about in the future. And wondering if you might be willing to give us a little more insight into that, provide some more color and detail into what that integrated delivery platform can mean for the company.

Thank you, Joe. Yes, we are in the process of implementing this. Essentially, we are taking our global workforce and instead of operating in specific geographies, we are now primarily a work-from-home model. This allows us to pool our workforce together, making everyone available to every client worldwide. This means that our experts in the U.S. can assist clients in Germany and Australia, and vice versa. As a result, we expect to improve our margins by better managing resources and reducing productivity losses associated with travel. We will discuss this further in March when we review 2021, but this is a significant development for us. We are calling it ISG Next, our operating model moving forward, and we believe it will greatly enhance our profitability as we progress through 2021.

Okay, I have one last question, and then I’ll get back in the queue. One of the concerns regarding the pandemic is the state budgets. I know you weren’t expecting a slowdown, as mentioned last quarter. I’d like to know how the market looks today in terms of selling to states and their budgets.

We have identified three key areas of government work for us. The first is in the U.S., focusing on state and local governments, excluding federal. In Europe, we typically engage with federal governments, such as the Ministry of Defense in the U.K. and the Ministry of Interior in Italy. Additionally, we work with the Australian government. Overall, our public sector segment experienced a double-digit year-over-year growth globally, nearing 20%. In the U.S., state-level engagement also increased, although at a lower rate, in the low teens compared to last year. We are closely monitoring these developments. Previously, we noted a slowdown in public sector spending. State and local governments are recognizing the need to reduce costs owing to budget pressures exacerbated by the COVID-19 pandemic and prior tax issues. This situation may create opportunities for us, as our services often focus on cost management, and we are seeing positive signs. Therefore, we remain cautiously optimistic about continued growth in the public sector in the fourth quarter.

Our next question comes from Vincent Colicchio with Barrington Research.

Nice quarter. I'm just curious, what are your expectations per your guidance by geography sequentially? And do you expect some of the same vertical market drivers as you saw this quarter?

Okay. So look, I think on a global basis, I would say the U.S. is faring a bit better only because you can tell where the surges are happening in the moment in Europe. So U.K., France, Germany are all in a kind of semi-lockdown for the month of November. So if we were looking at our geographies, I think you'll see that Asia Pacific, with the public sector spending the way it is, is going to be in good shape. We think that the U.S. will also be in good shape and Europe likely would be more in the flat arena. And depending on how the lockdown pursues in December, we'll keep an eye on that. We've taken all of that into consideration in terms of trying to get to what we think is a good guidance number for everyone for the quarter.

Okay. And your margins are 40%-ish gross margin. They're down year-over-year, pretty similar sequentially. I'm just curious, is the decline all volume? Or is there any pricing pressure you're seeing?

Last year, Q3 was a record quarter for the company, primarily due to gaining market share in the network services area, which contributed to last year's margin. We expect the margin to remain consistent with that. However, last year was unusual because of the two deals that boosted the margin. Additionally, during the quarter, licenses related to our automation business increased, but those margins are typically lower than our firm's average.

Our EBITDA margin has increased by about 50 basis points for the quarter compared to Q2. This improvement is due to a combination of our margins and the early stages of our integrated delivery platform, Vince.

And recurring revenue, I may have missed it, how did that perform in the quarter? And what are your thoughts about that going forward?

Yes, it performed well. We achieved approximately $19 million, which is about 31% growth for the quarter. I would say that our repeatable platform sales continue to resonate and grow. For instance, our GovernX platform for software and contract management is a comprehensive SaaS cloud-based solution that leverages our AI data and best practices. Since the pandemic began, we have seen the number of contracts we manage triple. Last quarter, we had around 10,000 users on this software platform, and now we have just over 12,000. This significant increase is related to our work with suppliers, supply chain management, and risk management for many of our enterprise clients. We remain confident that our research business, particularly in these two areas, will continue to drive our recurring revenue streams.

Our next question comes from Marco Rodriguez with Stonegate Capital.

Mike, I was wondering if maybe you could talk a little bit more about GovernX. It kind of sounds like you guys had a lot of success in the quarter kind of with that service. What do you attribute perhaps to that strength there? Was it just maybe some timing issues or additional marketing efforts that you guys underwent?

Since COVID hit, many enterprises experienced disruptions in their supply chains, facing various industry-related issues. GovernX offers a solution to manage risks associated with supply chain management and contract oversight. We've seen significant interest in our GovernX platform from large enterprises. It is a cloud-based SaaS solution that allows these enterprises to centralize all their contracts and manage risk related to their supply chain challenges experienced during the pandemic. The pandemic has significantly accelerated interest in this area. We gained over 2,000 new users in the last quarter, bringing our total to 12,000 users, compared to around 4,000 to 5,000 before the pandemic. This growth highlights the increasing usage of our GovernX software, making it a valuable asset and a key source of recurring revenue.

Got it. Would you attribute that strength to customers moving more towards digital solutions, possibly accelerated by the pandemic? I'm trying to understand the revenue strength you experienced in the quarter compared to your guidance. The results were very strong at the top line, and I want to clarify where the significant surprises were.

Yes. The recurring revenue streams were strong, and we saw significant interest in research and GovernX. We experienced growth in various industry segments in the U.S., particularly in insurance, the public sector, and technology, contributing to an impressive 11% growth quarter-over-quarter. When we consider third-party risk and enterprise spend management, everything fits together. Additionally, cloud adoption has accelerated in the last several months, largely due to enterprises struggling to access their data centers effectively while working from home. The e-commerce sector has also evolved significantly, with clients gaining valuable insights over the past six months, especially platforms like Shopify and Squarespace. As traditional retail faced challenges, e-commerce filled the gap. The healthcare industry is experiencing turbulence due to factors like vaccines and the overall impact of COVID. Numerous factors are coming together, allowing us to tailor our products and services to support cloud adoption, supply chain management, and assist clients on their digital journey, which many began before COVID but is now speeding up. Different industries will adopt these changes at their own pace; for instance, hospitality, travel, and automotive are moving a bit slower, but ultimately, they will adapt as they navigate the current environment. That's what is driving our results.

Got it. Very helpful. Then just kind of shifting here toward cash flows. Obviously, very strong results here year-to-date, driven looks like primarily through some, obviously, liquidation of working capital. Just kind of wondering how should we be thinking about cash flows from operations, free cash flow. As we kind of head into fiscal '21, where do you think that sort of normalizes? Obviously, assuming that the environment normalizes in fiscal '21, you guys have revenue growth. Working capital will obviously have to be there to support that growth. But just any sort of color or any sort of drivers that you can talk about to help us think a little bit more about cash flow from ops in fiscal '21 would be helpful.

Yes. As you mentioned, the main factor affecting this year's cash flow is a change in our working capital. Our strong collection efforts have led to an increase in cash generated. Additionally, our tax payments have been quite low, totaling $2 million over the first three quarters. Moving forward, you can expect our cash flow to be more in line with around 50% of EBITDA, which would represent a normalized cash flow for the business.

Our next question comes from Marc Riddick with Sidoti.

So very encouraging, a lot going on that's moving in the right direction given everything that's taking place out there. So wondering if you could talk a little bit and maybe touch on Neuralify a little bit on some of the things that have taken place since the acquisition. And then give a sense of maybe how that then leads you to think about kind of where we are with the acquisition pipeline and what that prioritization might look like going forward to fit the portfolio and service offerings.

Okay, first of all, Neuralify is the key asset we aimed to acquire because it offers what we consider to be an industry-leading digital enablement platform that allows enterprise clients to quickly scale the adoption of robotic process automation (RPA). Given that many people are working from home, having a digital platform to facilitate this process couldn't be more timely. This is the asset we sought from Neuralify. The reason is that when combined with the services we offer at ISG Automation, adding this digital platform gives us a unique selling proposition in the market. We experienced this in the third quarter when we managed to secure a deal with a client we had been pursuing unsuccessfully. By incorporating the digital enablement platform, we successfully closed a business deal worth over $1 million in September with a Fortune 20 company, and this platform was crucial in achieving that. We believe it sets the standard for hands-on, continuous digital learning in RPA. Additionally, Neuralify brings us a code quality analyzer, which we refer to as CQA, allowing enterprises to automate their code review process and accelerate the scaling of RPA. These are the two main reasons we pursued Neuralify, which we fully integrated within the first 30 days of the acquisition in July. Overall, our automation business has a strong pipeline. However, we believe this asset is undervalued in the market, and we will continue seeking ways to enhance its value for our shareholders. In our opinion, Neuralify has already started to deliver on our expectations in its early days.

Okay. Great. I wanted to ask about the cost-cutting measures implemented earlier this year. Could you provide an update on your perspective regarding these cost actions? Additionally, I'd like to know which of these measures you believe will have a lasting impact versus those that may be temporary until other revenue opportunities arise.

You're talking about for ISG or with our clients?

For ISG.

We've significantly reduced discretionary spending and eliminated internal travel. Most clients are allowing us to work from home, with a few exceptions for on-premises work. This reduction in travel impacts our expenses, and in the future, we will discuss our revenues on a net basis to reflect year-to-year comparisons, excluding travel expenses, as we anticipate those will not be relevant for a while. We've also cut back on marketing expenses. During COVID, we seized the opportunity to adapt our business model, which led to the launch of ISG Next. This initiative includes restructuring our cost base through an integrated delivery platform, and we will provide more details in March regarding our plans for 2021. As we move ahead, we believe we have established a solid cost structure. Additionally, we've exited several markets, including Spain, and phased out some products and services. While this means those revenues will not return, they were not very profitable, and we believe these changes will enhance our profitability. Moving through 2021, we anticipate our margins will continue to improve.

Okay, great. Lastly, I would like to discuss a broader topic. Could you elaborate on the consumer-facing clients that are experiencing timing issues with their decision-making and activities due to the onset of the second wave? I’m interested in understanding the differences you observe among industries and customers that are making progress. What strategies are being implemented by those who are further along in their digital transformation compared to those facing more challenges with consumer-facing issues?

Certainly. To compare, some sectors like travel, hospitality, manufacturing, and automotive are still facing challenges. On the other hand, industries such as health care, health sciences, pharmaceuticals, and certain retailers that have embraced e-commerce are performing well. The companies that are progressing are primarily focusing on transitioning their operations to the cloud. Before the pandemic, cloud adoption among enterprises was roughly at 20%. Now, there's a concerted effort to boost that to 40% or 50%. Some organizations were already moving quickly before COVID, but now everyone is striving for rapid cloud integration, which demands significant time, effort, and investment. The return on investment is considerable, but those less affected by the current issues are advancing quickly in cloud adoption, while others are lagging behind. Furthermore, with more individuals working from home, there has been immense pressure on networks, pushing some to operate at over 95% capacity, making it tough for many enterprises to meet their networking needs. It’s essential for us to assist our clients in navigating the realities of the modern workplace from a technological perspective. Our network capabilities are performing well, and we anticipate continued success as we head into 2021. Additionally, there's noteworthy monetization happening, particularly with Azure and AWS acquiring data centers from enterprises. Large companies that own physical data centers are finding opportunities to monetize these assets with major providers, which is generating cash for their businesses. We are recognized leaders in asset monetization and are currently collaborating on several projects with significant clients. In summary, those organizations that can swiftly adapt are prioritizing digital transformation, cloud adoption, asset monetization, and preparing for the future workplace.

I'm currently showing no further questions at this time. I will now turn the call back over for closing remarks.

Okay. Well, let me close by saying thank you to all of our professionals worldwide for stepping up to the challenges presented by this health and economic crisis around the world. But even working remotely, there has been no letup in our passion for delivering the best advice, support and products and services to our clients. And thanks to all of you on our call this morning for your continued support and confidence in our firm. Stay well, everyone. Thanks very much.

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.