Information Services Group Inc. Q1 FY2023 Earnings Call

Good morning, and welcome, everyone, to the Information Services Group First Quarter Conference Call. This call is being recorded and will be available on ISG’s website within 24 hours. Now I would like to turn the call over to Mr. Barry Holt for his opening remarks and introductions. Mr. Holt, 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 first quarter conference call. I’m joined today by Michael Connors, Chairman and Chief Executive Officer; and Humberto Alfonso, Executive Vice President and Chief Financial Officer. Before we begin, I’d 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 last night 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’ll 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 statement to reflect subsequent events or circumstances. During this call, we will discuss certain non-GAAP financial measures, which ISG believes improve 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 last night with the SEC. And now I’d like to turn the call over to Michael Connors, who will be followed by Bert Alfonso. Mike?

Thank you, Barry, and good morning, everyone. Today, we will review our record revenue for the first quarter, our significant recurring revenue growth, our 2025 targets for margins and recurring revenues under Phase 2 of our ISG Next operating model. The increase in our dividend and our outlook for the second quarter. ISG delivered a strong start to the year with revenues reaching an all-time quarterly high of $78 million, up 12% in constant currency and led by 17% growth in the Americas, our largest region. We continue to expand our recurring revenues, reaching a record $33 million, up 27% versus the prior year and representing 42% of our firm-wide revenues this quarter. Recurring revenues were driven by double-digit operating growth in our GovernX vendor compliance and risk management business and in our research business. Our adjusted EBITDA reached a first quarter record of $11 million. As you recall, we decided to further invest during the second half of last year in hiring additional talent in anticipation of growing client demand in the next couple of years. That decision is beginning to pay off in our top line growth. We expect this group to blend in from a productivity standpoint by midyear. The client demand environment is being driven in two areas: ongoing transformation, both digital and business; and secondly, cost optimization. Transformation is focused on key digital areas, including customer experience, future workplace, cloud, cybersecurity, application modernization and data analytics. In the end, it’s all about creating a secure, intelligent connected enterprise. Clients are also prioritizing transformation projects that focus on cost takeout, productivity and quick returns. When it comes to cost optimization, they are taking one of two approaches: taking out cost and dropping the savings to the bottom line or utilizing the savings to grow the business through digital initiatives. ISG is in an ideal position to help our clients power through in the current environment. Our portfolio of digital transformation, digital sourcing and cost optimization services, supported by our proprietary research and SaaS platforms continues to be a winning combination for our clients. Under our ISG Next operating model, we have realized tremendous results over the last two years. We have grown our adjusted EBITDA by more than 50% and our adjusted EBITDA margin by more than 30% or about 375 basis points, due in large part to our efficient iPlex delivery network and higher-margin portfolio of solutions. We have also grown our client base by more than 20% to over 900 clients, thanks to our enhanced value proposition and solution-centric approach. ISG Next has served us and our clients very well during the pandemic years. Now in the post-pandemic era, we are ready to embark on Phase 2 of ISG Next. By the end of 2025, we aim to expand our adjusted EBITDA margin by a further 200 basis points from the end of 2022 to approximately 17% and accelerate the growth of our recurring revenues to $150 million after surpassing our previous target of $100 million last year. We are excited about the future of ISG and look forward to our next phase of growth as we prepare our clients now for the post-pandemic digital economy. We are already seeing early glimpses of what lies ahead. Chat GPT and other types of generative AI are grabbing headlines, but that’s only the tip of the spear among the new technologies being developed today that will transform our world tomorrow. At ISG, we are harnessing our growing expertise in AI and applying it to our own operations and product development. For example, in 2022, we acquired a company called Agreement and its AI-driven smart contracting tool. We are now using Agreement to help drive recurring revenue growth in such areas as our flagship platform solution, ISG GovernX. There will be many more such developments going forward as we look to build out our repeatable platform capabilities, improve our efficiency and deliver more value to additional segments of the market. ISG is built on a culture of innovation and entrepreneurship. I’m confident our unrelenting drive to excel will carry us into the future and allow us to capture the growth opportunities ahead and meet the 2025 targets we are unveiling today. Now turning to our regions. The Americas had an excellent Q1, delivering $48 million of revenue, up 17% versus the prior year on the strength of our digital cost optimization and market-leading sourcing offerings. During Q1, we saw double-digit growth in our consumer, banking, insurance, manufacturing, energy and utilities industry verticals. And among our services network, software advisory and GovernX were also all up double digits. Key client engagements during the first quarter included Bell Canada, CNO Financial Group, Owens & Minor and Centene. During the quarter, a global IT service provider renewed its subscription to Pro benchmark, our market-leading pricing research service for three years in a deal worth more than $1 million. We also won a multimillion-dollar technology cost optimization engagement with a major managed health care provider covering many of our services, including operating model design, automation, benchmarking, network, software and cybersecurity. Our holistic approach, we expect to save this client more than $100 million annually. In addition, we extended our ISG automation services and licenses for three years with a large Canadian telecommunications provider. Now turning to Europe. Our Q1 revenues of $23 million were up 5% in constant currency over last year. For the quarter, Europe delivered double-digit revenue growth in our media, energy, utilities and manufacturing industry verticals and in our GovernX network, software advisory and research businesses. Key client engagements in Europe in the first quarter included Hydra, Munich Re, Union IT Services and Belfius Bank. During the quarter, the Ministry of Finance of one European country awarded ISG a $1 million engagement to modernize their legacy application architecture. Scope includes IT service management and an identity and access management framework. We also won a $1 million engagement with a major European banking company to redesign their technology delivery model and select new partners to support their future business and digital strategy. And we secured a significant extension with an oil and gas company in Germany to provide advisory and project management services on an SAP engagement. Now turning to Asia Pacific. Our Q1 revenues of $7 million were down about $200,000 in constant currency or essentially flat with last year. We generated double-digit growth in our network, software advisory and GovernX businesses. Key clients in the quarter included the Australian Department of Home Affairs and the Insurance Australia Group. In a very positive development, we very recently won a new $5 million contract with long-time client, the Australian Taxation Office, or ATO, to revamp their provider ecosystem and lay the groundwork for their digital future. Now turning to our dividend. In our ongoing commitment to reward shareholders, I am delighted to announce our Board of Directors has authorized a 12.5% increase in our quarterly dividend. The new quarterly rate, $0.045 per share or $0.18 per year will be reflected in our dividend payment on June 30 to shareholders of record as of June 7. This decision reflects our continuing long-term progress and outlook for the business. Now let me turn to guidance. Even in an uncertain macro environment, demand for our services remains strong. Enterprises continue to invest in digital to maintain and build competitive advantage. And they are looking for ways to fund those investments by optimizing their technology and business environments. This is right in our sweet spot. ISG is the go-to partner for helping clients create their digital futures and achieve operational excellence. We are optimistic and energized by our prospects. We are also mindful of the economic factors that could impact the timing of client decision-making, including inflation, possible recession, geopolitical and banking concerns and talent shortages. In consideration of all of this, for the second quarter, we are targeting revenues of between $73 million and $75 million and adjusted EBITDA between $10 million and $11 million. So with that, let me turn the call over to Bert, who will summarize our financial results. Bert?

Thank you, Mike, and good morning, everyone. As Mike mentioned, ISG delivered all-time record revenues and recorded first quarter adjusted EBITDA to start the year. Revenues for the first quarter were $78.5 million, up 8% on a reported basis and 12% in constant currency compared with the first quarter of last year. Currency negatively impacted reported revenues by $2.1 million versus the prior year. In the Americas, reported revenues were $48.4 million, up 17% versus the prior year. In Europe, revenues were $23.1 million, down 2% on a reported basis and up 5% in constant currency. And in Asia Pacific, revenues were $7 million, down 8% reported and down 3% in constant currency. First quarter adjusted EBITDA was $11 million, up 3% from last year, resulting in an EBITDA margin of 14%, down 68 basis points compared with the prior year’s first quarter. In constant currency, adjusted EBITDA was up 8% compared with the prior year. First quarter operating income was $7.1 million compared with $7.7 million in the prior year. Net income for the quarter was $3.5 million or $0.07 per fully diluted share compared with net income of $4.9 million or $0.10 per fully diluted share in the prior year. First quarter adjusted net income was $6 million or $0.12 per fully diluted share compared with adjusted net income of $6.4 million or $0.12 per fully diluted share in the prior year’s first quarter. Headcount as of March 31, 2023, was 1,628 up 29 professionals or 1.8% from Q4. Consulting utilization for the first quarter was 71%, impacted by our additional second half hiring last year and the time needed to onboard billable resources. Our balance sheet continues to have the strength and flexibility to support our business over the long term. For the quarter, net cash used from operations was $3.4 million. We ended the quarter with $23.7 million of cash, down from $30.6 million at year end. During the first quarter, ISG paid dividends totaling $2 million and repurchased $0.6 million of shares. Our next quarterly dividend will be payable on June 30 to shareholders of record on June 7. Our debt balance is at $79.2 million, unchanged from the year-end, and our debt-to-EBITDA ratio remained in great shape at 1.8 times. Our average borrowing rate for the quarter was 6.3%, up from 2% last year, and we ended the quarter with 48.4 million shares outstanding. Mike will now make some concluding remarks before we go to the Q&A. Back to you, Mike.

Thank you, Bert. To summarize, ISG is off to a strong start in 2023, delivering record revenues, record recurring revenues and record adjusted EBITDA in the first quarter. Our portfolio of digital transformation, sourcing and cost optimization services, research and SaaS platforms continues to be a winning combination for our clients. We have tremendous growth opportunities ahead as we help our clients prepare for the next wave of the digital economy and become secure, intelligent connected enterprises. Capitalizing on those opportunities, we plan to deliver an additional 200 basis points of margin improvement and reach $150 million in recurring revenue by the end of 2025 under Phase 2 of ISG Next. And we continue to reward our shareholders, raising our dividend 12.5% to $0.18 per share annually. 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 the operator for your questions.

We will now take the first question from Joe Gomes with Noble Capital Markets. You may proceed.

Hi, this is Joe Gomes on the call. I wanted to start with a question. I noticed that while revenues are increasing, direct costs and advisory services have also risen, likely by 200 basis points. Should we expect those costs to decrease, or could this be a new normal for us?

Yes, Josh, let me sort of cover that for you on the operating income. Our direct costs, as you mentioned, we’re up about $5 million or 200 basis points. We had some small offset to that on the SG&A side, we were down about 60 basis points and we had a little bit of higher amortization as well. But we typically have some higher costs in Q1. They tend to be payroll tax related as they come back in. But our expectation, and we also commented on the utilization rate, which is at 71% is really on the low end of our targeting. We have tended to be in the mid-70s, and our expectation is that we will bring that back into the mid-70s as the hiring that we did in the back half of last year, which was more concentrated in Q4, come up to speed in terms of full potential for our global resources. So we do expect that to improve into the second quarter and certainly into the back half.

Okay. Perfect. And so now that we’re just kind of a quarter into the year, what are you guys noticing just in the trend regarding just in-person events? And what is the expectation do you guys have for just the rest of this year?

Did you say in-person events?

Yes.

Yes. Yes. So no, we definitely have a full roster of events planned for the full year. We’ve held a few of those during the first quarter, all in person, and we have a series of events in each of the next three quarters that we are planning to do both here in the U.S. as well as in Europe.

Okay. Perfect. Lastly, regarding the pipeline for acquisition, I know you mentioned last year that you are more focused on recurring revenue prospects. How is that shaping up? Also, has the economic uncertainty affected pricing, making it look better or worse? Please provide some insights on that.

On the M&A front, we are continuing with our strategy, which focuses on bolt-on acquisitions in areas such as recurring revenue and enhancing our digital capabilities. We are still in discussions with potential targets. Regarding pricing, we maintain a disciplined approach, and I wouldn't say there has been a significant change in pricing recently. Owner-operators still have their own valuation expectations. While the market conditions are somewhat softer, if their business remains stable, we haven't observed much decline in pricing. Overall, there may be a slight dip, but it isn’t materially significant in my opinion.

Okay perfect. Yes, congrats on the quarter again, guys.

The next question comes from the line of Marc Riddick with Sidoti and Company. You may proceed.

Good morning. I wanted to dive right into a few points. First, it was a nice surprise to see the Phase 2 announcement. You’ve hinted at various elements regarding how we might progress. I was curious if you could discuss the strength of the recurring revenue in relation to the ramp-up of new hires from last year. Could you elaborate on the opportunities for margin expansion and what gives you the confidence to announce Phase 2 at this time?

Thank you for the question, Mark. We had a strong quarter with recurring revenue exceeding $30 million. We are actively enhancing our research capabilities and developing our platform, which is primarily supported by GovernX, our risk management platform that clients appreciate for addressing supply chain and regulatory challenges. Additionally, Pro benchmark, our pricing platform, along with our long-term contracts, especially in the public sector, underpin our progress. We are leveraging our AI platform acquired from Agreement last year, which enhances our ability to analyze contracts and has positively impacted our GovernX operations. As we consider subscriptions and solutions in these areas, we are confident in our ability to reach $150 million, as we previously stated in 2020 regarding our aim for $100 million. While the exact path may not be clear, we have a solid strategy, and we anticipate continued success in these businesses, which is why we felt it was important to share our direction today.

Great. I was curious if you could discuss the new accounts you mentioned in your prepared remarks. It's certainly encouraging that these new accounts are emerging for both offensive and defensive reasons. Can you elaborate on whether these are primarily driven by cost optimization rather than growth? Also, can you share insights on the sales cycle? Is it similar to the traditional sales cycle, or are you sensing an acceleration due to the macroeconomic environment?

Yes, that's a great question. Let me break it down. We're observing different trends across various industry segments. For instance, companies focused on stabilizing, such as specialty retailers, media, airlines, and high-tech firms, are prevalent. In contrast, industries like pharmaceuticals, medical devices, utilities, and manufacturing are seizing opportunities and progressing at a faster pace, rather than stabilizing. This creates two distinct paths: one focused on cost optimization, which is typically necessary for those needing stability, and the other emphasizing transformation with energy. While the speed of cost optimization is accelerating—sometimes leading to urgent requests from CIOs for significant cost reductions—transformation efforts are advancing at a slower pace. Both strategies are vital for us and have fueled our significant growth in the first quarter. I hope this clarifies things for you.

No, it definitely does. No, that’s very, very helpful, thank you. I guess the last one from me. I was wanted to talk a little bit about we had the headcount additions last year that have ramped up. Do you get the sense that you’ll need to add more folks to take advantage of these new wins and new opportunities that you’re seeing? And if so, can you sort of maybe give an update as to maybe the availability of talent that you see out there? Thanks.

Yes, I believe that the efforts we made in the latter half of the year will support us through 2023. There will be exceptions for some specific hires in areas like digital or cyber. Additionally, we may need to bring on groups of employees if we successfully implement requests from clients interested in our new training as a service offering. We are currently negotiating with a major Fortune 20 company that is considering outsourcing their training organization to us. Such an arrangement might require hiring around 10 to 25 individuals, although not all of them would be necessary for the service. This forms the only significant exception we anticipate regarding headcount changes this year, as we have several clients interested in our training as a service model and exploring alternative paths within their organizations. Regarding talent availability, our business model, which incorporates a mix of cash and stock, makes us appealing to potential hires. This is why we were able to add over 225 employees since the first quarter of last year. We believe that the talent we need is accessible if required.

Sounds good. Thank you very much.

Good morning, gentlemen. Congratulations, great numbers across the board. I have a couple of questions. Your year-over-year comparisons have been hurt for a long time due to currency headwinds. When you look across your geographic mix, should we be lifting our long-term revenue forecast with the dollar stabilizing a bit or possibly trending down?

Yes. Thanks, Michael. Thanks for the question. First quarter certainly was a downshift from the fourth quarter. We had over $3 million of impact in Q4 and down to about 2% in Q1. To your point, we see the second quarter being not really heavily impacted on the downside. And so while we may have some negative impact with the euro up around 110 and the pound at 125, it’s starting to approach numbers that we saw last year. And so we think the second quarter will be somewhat benign. We could see some tailwind, if you want to describe it that way in the back half if the trend continues and again, that assumes that the Fed will be finished around midyear and the European bank still has a little ways to go because they have a bit more energy inflation than we do. But we’re not projecting that right now, to be honest. We’re thinking it sort of levels out in Q2 and stays reasonably flat to year-end. We don’t think there’s going to be a big impact one way or another in the back half. But we certainly don’t see the headwind that we’re seeing in the first quarter continuing.

Great. Very helpful, thank you. Last one for me. In most quarters, ISG’s assets generate a lot of operating cash flows. This quarter was an exception, negative $3.4 million. Would you comment on what drove the swing?

Yes, we did experience a slight decline in net income this quarter, primarily due to our working capital needs, as first-quarter sales reached new highs. This was somewhat exacerbated by a strong finish in March, which increased our receivables by approximately $3.4 million compared to the previous quarter. We also saw a minor rise in payables, partly due to additional payroll taxes typically associated with the first quarter. Overall, our receivables are in excellent condition, with nearly 90% of them current, and we have no concerns about collectability. We haven't had to set aside any significant reserves. Therefore, the issues we faced were mainly related to working capital, and as mentioned earlier, our net income was slightly lower this period, but there were no tax implications, and it was roughly on par with last year.

Okay. Great. Very helpful explanation, thanks and congratulations again on the quarter.

Yes. Nice quarter, Mike. I have a couple of questions. So is there anything systematic in terms of why the Americas was so relatively strong this quarter? And perhaps Europe and APAC are seeing slower sales cycles or anything like that or maybe there was a big deal in the Americas market? And should we continue to see the Americas outperform in the balance of the year?

Yes, thank you for the comments. In the Americas, there wasn't a significant deal this quarter. The U.S. environment is somewhat different, as the digital transformation work is progressing steadily. The optimization efforts are supporting the digital transformation in the U.S., and both of these areas are performing well. Cost optimization is facilitating reductions, which are then being redirected to digital initiatives in the U.S. In Europe, the situation is a bit different; while cost optimization is happening, it's often being used to boost the bottom line. Companies in Europe are facing a bit more softness and macro challenges compared to the U.S. This has led to increased demand for optimization and sourcing efforts, although the pace of digital transformation in Europe is slower. As for Asia Pacific, I wouldn't conclude anything specific; there have been fluctuations, and they had strong comparisons in the first two quarters. We anticipate Asia Pacific to meet its historical performance for the year. The area we are monitoring closely is Europe, particularly the tougher macro environment in the U.K. compared to other regions.

And if you look at your sales pipelines for the areas that you mentioned were demand sweet spots are digital transformation, digital sourcing cost optimization. Does that give you confidence that we could see a healthy second half versus the prior year?

Yes. I mean I think we are confident in our full year. Of course, they always the health warning I always give is we don’t know what the macro environment has ahead of us. So we just used that as a bit of a caution. But if that is somewhat neutral and nothing goes off the path too far, then we feel very good about the demand environment and our role to help execute against it for the full year.

And on your recurring revenue objective of $150 million I assume a portion of that is going to be acquisitions. How fast do you think the recurring revenue can grow organically in the next two years?

Yes. So that $150 million is organic. If we were able to do any acquisition, then that would be additive to that, Vince. But we think on an organic basis that we can reach around that number in the timeframe we described. So we’re quite confident in how we are building that business.

That’s a fairly impressive number. So could you give a little detail on which areas you think are the most important growth drivers?

Yes, I believe there are three main growth drivers. First, our research business is thriving because we provide proprietary insights that others cannot access due to our significant market share in the sourcing environment. We lead in that area, giving us valuable real-time engagement data, which is a strong asset in the market. We expect this segment to grow faster than the overall company. Second, our GovernX platform, which focuses on risk management and supplier management for large enterprises managing their significant technology contracts with companies like IBM and AT&T, is also positioned for growth. The integration of our AI smart contract technology, acquired a year ago, has significantly contributed to this business, and we anticipate this trend will continue in the coming years. Lastly, our larger multiyear contracts in the public sector are an area of focus. As governments, both state and local in the U.S. and major governments in countries like the U.K., Italy, Germany, and Australia, face aging legacy technology and an older workforce, the need for modernization becomes more critical. We believe we are well-positioned to address these needs. When we combine all these factors, we are very optimistic about our ability to generate recurring revenue.

Thank you. And Bert, one quick one for you. I don’t want to leave you out. What was the contribution of acquisitions in the quarter?

Acquisitions contributed about $1.5 million.

Thank you. The final question comes from the line of Dave Storm with Stonegate Capital Markets. You may proceed.

Good morning. Just wondering if you could touch on your revenue came in above guidance, as you mentioned, rest on that. Just wondering if you could touch on what the main drivers of that outperformance was. Was it a timing thing? Was there something systematic? Any guidance? Anything else you can give us there would be helpful.

Thanks, David. Look, I think the demand environment around our portfolio was higher than we would even have expected. And as I mentioned earlier, there’s kind of two forks in the road that companies are taking at the moment. One is around deep optimization of cost, and the other is to continue or accelerate their digital transformation journey, both of which are our sweet spots. And on the cost optimization because it is a bit of a faster decisioning than the other, and when cost optimization increases, which it has during the first quarter, then decisions are made faster and you can start sooner, and therefore, the revenue generates maybe earlier than a normal sales cycle goes because the need to take the cost out is more immediate than a more transformation journey, which takes some time. So those would be probably the key drivers that we would see during the first quarter that kind of drove the outperformance.

Very helpful. And then lastly, could you just talk a little bit more about your current leverage levels? You have a lot of pet form before hitting your confidence. Just curious as to how you’re thinking about either using or not using that liquidity?

Thank you for the question, David. In the first quarter, we announced the renewal of our credit agreement, and we are currently utilizing the full revolver. We have maintained a trailing EBITDA net debt ratio below 2%, approximately 1.8%, which we are very pleased with. We believe this positions us as under-leveraged, providing us with optionality for acquisitions that we do not include in our forecasts. The revised credit agreement also offers us additional flexibility. Previously, we had mandatory principal payments of just over $1 million per quarter, which are no longer required. While we may continue to pay down debt as cash flow allows, we currently feel we have that optionality. We continue to explore the market for potential opportunities to grow through acquisitions. For the right strategic acquisition, we are comfortable with a leverage level of 2.5% plus if it aligns with our growth and profit generation goals. We are satisfied with our leverage and believe it gives us more options in the future, which is beneficial for us and our shareholders.

That’s very helpful. Thank you and congrats on the strong quarter.

Thanks, David.

There are no additional questions waiting at this time. So I would now like to pass the conference back to the management team for any additional or closing remarks.

Well, let me close by saying thank you to all of our professionals worldwide for their dedication to our clients and for working together as a global team to achieve our record first quarter results. Our people have a passion for delivering the best advice and support to our clients as they continue their digital journeys, and I could not be prouder of them. And thanks to all of you on the call today for your continued support and confidence in our firm. Have a great rest of the day.

That concludes today’s conference call. Thank you for your participation. You may now disconnect your lines.