Earnings Call Transcript - III Q1 2024

Barry Holt, Senior Communications Executive

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 Michael Sherrick, 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 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 statement to reflect subsequent events or circumstances. During this call, we will discuss 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 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 Michael Sherrick. Mike?

Michael P. Connors, Chairman and CEO

Thank you, Barry, and good morning, everyone. Today, we will review our results for the first quarter, including an early progress report on ISG Tango, our view of the improving demand environment, and our outlook for Q2. As anticipated, the broader market for technology services remained soft in Q1. Generally, clients are taking longer to commit to new investments as they weigh economic conditions and consider how to deploy AI in their businesses. For instance, we had two major transactions that were expected to close and start delivering during the first quarter, but they were delayed. Overall, spending continues on large-scale transformations and cost optimization programs, and we are engaged in many of these projects, albeit at a slower implementation pace with contracts stretched over longer periods. Our pipeline remains solid globally; however, this quarter has been particularly challenging for conversions. The positive news for the market and ISG is that, based on our market analysis, discussions with clients, and pipeline development, the market appears to have bottomed out in the first quarter, and the worst seems to be behind us. We are noticing a gradual return of spending and anticipate further acceleration throughout the year, depending on macro conditions. There is still high interest in exploring cost efficiencies through managed services. Furthermore, we are witnessing a rise in sourcing activity, indicating that clients are starting to balance their desire for cost savings with the need to stay competitive and technologically advanced. Regarding AI, it is a net positive for ISG. Clients are looking to us as a trusted independent adviser to help them understand the impacts of AI, develop their strategies, establish guardrails, identify use cases, and build their AI ecosystems. Enterprises have ambitious AI plans but are understandably cautious given the implications and lessons learned from cloud migration. Our role involves assisting them with proof-of-concept deployments and eventually transitioning to full-scale implementation. As the market moves from the planning phase to execution for AI, significant investments will be made in infrastructure, sourcing, and implementation, and ISG will be there every step of the way to advise our clients. Concerning our recurring revenue expansion, even in a slower market, we continue to witness growth in our recurring revenues, which made up about half of our total revenues in Q1. Over the past 12 months ending March 31, we generated $126 million in recurring revenues, a 10% increase from the previous 12-month period. There is ongoing demand for our research, governance, and platform offerings. Enterprises are relying on ISG for our market intelligence and in-depth research to map out their AI and digital futures and identify upcoming opportunities. The acquisition of Ventana Research late last year has been a positive addition, further enhancing our value proposition with enterprise clients while also opening up new consulting relationships with software vendors and new research opportunities with service providers. Now a progress update on ISG Tango. Just two months ago, we launched ISG Tango, the first fully integrated digital platform designed to simplify and expedite the sourcing experience. ISG Tango aims to enhance speed to value for clients, improve the speed, efficiency, and margins of our sourcing transactions, and broaden our addressable market. Feedback from enterprises and service and technology providers has been extremely positive so far. Moving forward, nearly all of our new sourcing engagements will utilize ISG Tango. Currently, more than $2.6 billion in contract value is already running on the platform, marking good early progress. The macro environment has not favored the industry or ISG this quarter. However, we are beginning to see indications of clients willing to spend more, especially in the U.S., and we plan to take advantage of this in the coming quarters. ISG is well-positioned to meet this demand, with five key differentiators that set us apart. First, we have the industry's most comprehensive technology benchmark and sourcing contract databases, a data advantage that is hard to replicate. Second, as the long-established global leader in advising large transactions, we have elevated our services with ISG Tango, a disruptive platform that enables us to leverage our unparalleled data, proprietary tools, and intellectual property for a wider market. Third, we are integrating our extensive sourcing expertise with our knowledge of AI to assist organizations in navigating the initial challenges of AI and maximizing its benefits at scale. Fourth, our successful research business is now bolstered by Ventana Research and, combined with our platform services, will continue driving growth in our recurring revenue streams. Fifth, through our ISG Next operating model and our iFlex delivery platform, we will keep enhancing our speed, efficiency, and profitability. Now, let me shift focus to our regions, all of which reported declines in consulting revenues in Q1, consistent with the industry trend. The Americas generated $41 million in revenue for the quarter, down 16% compared to last year. Nonetheless, we experienced double-digit growth in our banking industry vertical and in research during Q1. Notable client engagements from the first quarter included Western Union, U.S. Steel, and Stanley Black & Decker. We also secured a new multimillion-dollar engagement with a spin-off of a large industrial conglomerate, through which we will assist the client in developing a technology-driven product strategy, operating model, selected ecosystem of providers, and ensuring long-term value realization. Additionally, we expanded our long-term relationship with a major cruise line by signing a $2.5 million contract to help modernize its infrastructure services across North American brands, which will enhance agility, scalability, and overall customer experience. We also entered a new agreement with a multinational banking and financial services firm to establish a scalable and long-term approach to manage its AI architecture and services and select AI partners. Turning to Europe, our Q1 revenues of $18 million decreased by 23% compared to last year. Still, Europe achieved double-digit revenue growth in our consumer and public sector verticals, as well as in our network and software businesses during the quarter. Key client engagements included Allianz, BASF, and Wintershall. We continued to expand our work with a high-tech facilities company, recently agreeing to a $2.5 million engagement to assist with a major IT transformation program involving infrastructure, cloud, workplace, security, and applications. We are also collaborating with this client to implement an AI and digital-first strategy for their engineering function. Additionally, we won a $2 million engagement with a public sector client in Switzerland, focusing on developing a new operating model aimed at enhancing cost efficiency. Moving on to Asia Pacific, our Q1 revenues of $6 million decreased by about $1 million. However, we saw double-digit growth in our banking, consumer, and manufacturing sectors. Key clients included the Australian Taxation Office, the Department of Home Affairs, Endeavour Group, and Insurance Australia Group. During the quarter, we captured a significant contract with a major public university in Australia to assist in selecting a new ERP platform provider and systems integrator, which will lead to the modernization of their human capital management and finance systems. Now, about our guidance. As mentioned earlier, we anticipate the market will accelerate throughout the year, starting in the U.S. as macro conditions improve, the backlog of technology projects increases, and clients further develop their AI strategies. With this perspective, we expect sequential growth for Q2, targeting revenues between $65 million and $67 million and adjusted EBITDA between $7 million and $8 million. We remain confident in our strategy and believe that with some market momentum, we will return to our growth and margin goals as we advance through the year.

Michael Sherrick, CFO

Thank you, Mike, and good morning, everyone. Revenues for the first quarter were $64.3 million, down 18% compared with the first quarter last year. Currency had a modest $300,000 positive impact on reported revenues. I would note that we faced a particularly difficult comparison with last year when we generated our highest quarterly revenue ever. In the Americas, reported revenues were $40.8 million, down 16% versus the prior year. In Europe, revenues were $17.8 million, down 23%. And in Asia Pacific, revenues were $5.6 million, down 20%. First quarter adjusted EBITDA was $4.4 million, down from $11 million in the year ago period, resulting in an EBITDA margin of 6.9% as compared with 14% in the year ago quarter. ISG had a first quarter operating loss of $2.4 million compared with operating income of $7.1 million in the prior year. Excluding the impact of severance from the workforce actions taken in the first quarter, operating income would have been $0.5 million. Our reported net loss for the quarter was $3.4 million or a loss of $0.07 per fully diluted share as compared with net income of $3.5 million or $0.07 per fully diluted share in the prior year. First quarter adjusted net income was $0.7 million or $0.01 per share on a fully diluted basis compared with adjusted net income of $6 million or $0.12 per fully diluted share in the prior year's first quarter. Headcount as of March 31, 2024 was 1,561, down 67 positions compared with the prior year, but up 43 professionals from Q4. I would note the sequential change was driven by the addition of Ventana Research employees and resources we assumed from a client to support a new recurring revenue training-as-a-service contract. Normalizing for these two factors, our headcount was down 109 professionals compared with the prior year. For the quarter, consulting utilization was 70%, up 555 basis points sequentially from the fourth quarter and down 40 basis points compared with the prior year. Based on the workforce actions taken to date and our expectation of improving demand as we move through the year, we expect utilization to improve from current levels, which will contribute to our expected margin expansion. For the quarter, net cash provided by operations was $2.3 million, a strong $5.7 million swing from a $3.4 million usage a year ago. We ended the quarter with cash of $14 million, down from $22.6 million at the end of the fourth quarter. During the first quarter, we paid dividends of $2.4 million, repurchased $2.5 million of shares, and paid down debt of $5 million. Our next quarterly dividend will be paid on July 5 to shareholders of record on June 14. We ended the first quarter with a debt balance of $74.2 million, down $5 million from Q4, and our average borrowing rate for the quarter was 7%, up from 6.3% last year. We ended the quarter with 49.7 million fully diluted shares outstanding. Overall, our balance sheet continues to provide us with the flexibility to support our business over the long term. And importantly, we remain comfortable with our debt-to-EBITDA ratio.

Michael P. Connors, Chairman and CEO

Thank you, Michael. To summarize, after a difficult first quarter, the market is showing signs of improving, and we see growth ahead. ISG is ideally positioned to capitalize on this market with the data product, services, and talent to meet client needs and ensure our long-term success. Our recurring revenue businesses continue to grow both in size and share of overall revenues. Research, governance, and platforms will remain important drivers of this growth. And we continue to invest for the long term with offerings like our ISG Tango sourcing platform and our enterprise AI advisory services. Overall, we have a strong business plan and operating model in place to enhance our growth and profitability this year and in the years ahead. 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.

Operator, Operator

Today's question-and-answer session will be conducted electronically. Your first question comes from the line of Marc Riddick with Sidoti.

Marc Riddick, Analyst

I wanted to follow up on your comments about demand, Mike. Could you provide a general idea of what you’re seeing? You mentioned that the banking sector in the Americas showed some strength in the first quarter. Is that trend likely to continue for client industry verticals in the Americas going forward? I also have a couple of follow-up questions.

Michael P. Connors, Chairman and CEO

As we progress through this year, Mark, we are noticing that certain industry verticals are gaining momentum, specifically energy, health care, manufacturing, and consumer. I anticipate these four sectors will perform well in the upcoming quarters, particularly in our U.S. pipeline. I mentioned earlier that we expect the U.S. to grow faster than other regions, and that is how we are strategizing for the next few quarters.

Marc Riddick, Analyst

And then I was wondering if you could talk a little bit about some of the initial early feedback that you're getting from customers regarding Tango. It certainly seems encouraging sort of how it started. Maybe you could sort of talk a little bit about some of the special sauce of Tango, if you will, that's really resonating with the early adopters?

Michael P. Connors, Chairman and CEO

Thank you for the question. We are very pleased with how quickly the ISG Tango platform has been adopted. There are two key factors contributing to this. First, it's a digital platform that connects enterprise clients with technology providers and ISG, enabling collaboration among all three parties throughout the sourcing transaction lifecycle. For instance, when a large enterprise seeks to enhance their infrastructure or applications, they may invite multiple providers to participate. This platform facilitates their joint efforts, supported by a virtual secure data room that allows data access with the necessary permissions. In just the first several weeks since its launch, we have accumulated around $2.6 billion to $2.7 billion in contract value on the platform. The integrated approach speeds up the value delivery for our clients, allowing them to realize savings more quickly than traditional processes would permit. Enterprises facing significant costs for these pursuits find this method efficient and effective. For us, it enhances margins as it reduces the labor needed to complete tasks and reach the final outcome. Ultimately, this creates a win-win situation for everyone involved. We're optimistic about the early adoption and plan to monitor progress, expecting that in the next 18 months almost all our transactions will go through this platform.

Marc Riddick, Analyst

I have one more question for now. Mike, how do you feel about the potential for acquisitions? Are there specific thoughts you have regarding what you would like to add at this point? You have your new service offerings in the pipeline, but could you share some insights on what the acquisition pipeline looks like for you right now, such as valuations and the availability of attractive targets?

Michael P. Connors, Chairman and CEO

You bet. So again, kind of our approach is a string of pearls approach that we've been using for a number of years. We are always in active discussions, and we are as well on areas that we can improve our digital assets and/or recurring revenue streams and use our channels into the C-suite to drive more value, whether that's Ventana Research or whether that's an enterprise change to put a wrapper around all the technology changes occurring in enterprises. I would say on a valuation front, I do think the valuation expectations are a little softer today. That's an advantage. At the end of the day, most everything we work on are owner-operated. So, it's a dance, and it's both a financial and a relationship type of acquisition. They do take time, but that's how I would describe the environment right now, Mark.

David Joseph Storms, Analyst

Hoping I could ask about the demand in the pipeline, kind of how you're thinking about how pent-up it is. When that demand starts coming back, do you anticipate that it's going to come back in a wave or more in a steady flow with clients remaining a little hesitant as things get onboarded?

Michael P. Connors, Chairman and CEO

So Dave, the pipeline is really pretty strong. I don't expect it to have a dam burst. I do think it will be measured timing. What we are seeing is, A, the pipeline is strong and all things still around transformation and optimization, with the emphasis on optimization. We see that being informed by the number of sourcing transactions that are now coming through our pipe. What I think will happen is it will be a measured approach. They're asking us to spend more time upfront. They're asking us to take more time for the execution. It's kind of a little counterintuitive because you would think that if I can save money, I want it as quickly as possible. On the other hand, it also costs money to save money. They are using a more paced, a more measured approach. Things are taking a little longer. The good news is with our platform, if it's a sourcing transaction with Tango, it can move as fast as the client wants it to. But again, we will just have to follow the lead of the clients. We like our pipeline. We would love to have it burst out at a faster speed, but I think it will be measured. I do think the U.S. is going to see it at a faster clip than the rest of the world.

Michael Sherrick, CFO

So obviously, the big lever that remains is utilization. And as our utilization improves, as I noted throughout the rest of this year, we'd expect to continue to see benefits to the gross margin, right? We should be able to drive revenue without material change in the direct cost.

Joseph Gomes, Analyst

I just wanted to take a step back here for a second and kind of see, maybe you can give us a little bit of color here. You released fourth quarter at the first week of March. At that point, the guidance was for $65 million to $67 million in revenue and adjusted EBITDA of $6 million to $7 million. Just trying to figure out what happened in the last three weeks of the quarter that adjusted EBITDA came in at $4.4 million. So just looking for a little more information there.

Michael P. Connors, Chairman and CEO

Look, primarily, it was around a couple of projects that we expected to start, complete, and recognize during the first quarter. Two of those projects did not only not get started, completed, and recognized; one of them actually got pushed out until the month of June. One of those is a gain share that we don't recognize until everything is done and signed. That did not make it into Q1. That was also a factor. We always do the best we can with the most information that we have at the moment. We expected something to close and deliver and recognize that did not happen in Q1. That's the reason primarily, Joe.

Joseph Gomes, Analyst

And then last quarter, you talked about you're bullish on the public sector. I'm just trying to get your feeling for today.

Michael P. Connors, Chairman and CEO

So the public sector, let me start with the U.S., is growing. The public sector grew not a large amount, but did grow in the first quarter. What we are seeing is there is a lot of interest and exploration around AI in the public sector. They're not the first to adopt almost anything, but they are very interested in exploring, creating some proof-of-concept types of areas. We are helping a few states in that regard. There's also some work going on up in some of the Northeast states that we're operating in. They want us to help them understand the guidelines, the guard rails around the use of AI and who would be liable and how it would happen if they introduced it into their motor vehicle system or if they introduced it into their toll system. It's created a new demand area for us, which fits in perfectly with our AI advisory business. We're seeing a pickup in that area here in the U.S. I expect the Australian government, just going around the globe, to be a little sluggish for a few quarters because they kind of go in cycles, and when they go in cycles, they go in big chunks. There's not any larger kind of RFPs in the system at the moment. They usually sometimes skip a quarter or so. But that's how I would see the Australian government. That government work there, I think, could be a little sluggish for a quarter or two. And then in Europe, we're seeing some good strength in Italy, somewhat less strength in Europe, and we're seeing some strength now in the German market. The only exception in Australia was that we got a large deal with a large university in Australia as they want to kind of retool their whole human capital and financial systems. That is a project that will begin late this quarter. That’s kind of how I'm perceiving the overall market.

Joseph Gomes, Analyst

And just one more on Tango since it is so exciting here. Can you kind of size the number of clients that are using the platform today and maybe kind of revenue generation you see coming from Tango?

Michael P. Connors, Chairman and CEO

Look, a couple of things. We're not going to talk about the exact number of clients on Tango. We'll talk about it in terms of contract value, but I will put it in this context. The sourcing component of our business, which is really the foundation of how ISG was built. Think about it on a revenue standpoint. It's kind of in the one-third of our business type area. If you think about it that way, and you have 900 clients, that's one way to look at it, Joe.

Vincent Colicchio, Analyst

So most service providers seem to say that Generative AI, given complexity risk and other related issues, it's taken some time to get started here. There's a handful that are saying they're off to the races, but that seems like a little bit of an exaggeration to me. I think you're a good measure of where things are. So I don't know, this may not even be a useful question, but it may be useful in a meaningful way. What is your read on when it becomes a meaningful contributor? Is it a '25 issue?

Michael P. Connors, Chairman and CEO

Yes, that's a very good question. Here's how we view it. If we look back at cloud adoption from about 10 years ago and consider how it has evolved, today we see around 50% to 55% of the workloads that could migrate to the cloud actually in the cloud. That’s a key point after a decade. When we look at AI, it's still in its early stages and is expected to be revolutionary. However, it necessitates a lot of education and proof of concepts. People need to comprehend what AI is and its capabilities, which includes understanding how data architecture integrates with AI models. Additionally, there are liability concerns for tech providers. For instance, if a provider develops an AI model for a client and something goes wrong, such as with an insurance claim, the question arises as to who is responsible. There are many legal aspects surrounding AI model usage that will take time to clarify. Currently, we are in the pilots and experiments phase. The excitement surrounding AI is currently much greater than the reality, and I believe this trend will continue for about the next 12 to 18 months. I don’t anticipate seeing significant AI differentiators in that time frame. The enterprises we are engaging with are asking us to incorporate AI into their sourcing decisions. They want to know how companies like Accenture and Capgemini are approaching AI. From the enterprise perspective, they are looking for ways to benefit cost-wise, as they want to extract value from AI instead of letting tech providers gain all the advantages. This conversation will continue to evolve over the next year or so. There is a clear imbalance right now, where the excitement exceeds the actual progress, which is not surprising.

Vincent Colicchio, Analyst

And then could you highlight the top three practices that should lead growth going forward?

Michael P. Connors, Chairman and CEO

Well, number one for us is the recurring revenue streams. In that recurring revenue stream, we have our research, governance, platforms, ProBenchmark software platform, and our GovernX platform. So, number one is around our recurring revenue streams. Number two is, I believe that the sourcing component where clients are looking at the sourcing element to help them optimize costs and possibly use some of those savings for growth initiatives will accelerate. We're seeing it in our pipeline right now. So that will be a second area. And thirdly, the transformation journey is still in a long way to go. Transformation is still going to be ongoing. The pace of those transformations has been slowed because of the macro cloud. I think if we start to see a cut or two in the U.S. from a Fed rate or from the European theater over the course of this year, that might also change the sentiment among some client buyers that, okay, maybe the worst is behind us because one day, there's no cuts. The other day, there are cuts. One day is, wait a minute, are we moving toward a recession? The other day is no recession. There's a lot of noise out there. Until we see an affirmative movement that might help free things up late this year as we turn into 2025, that would be our take. I think that because we are the global leader in sourcing transactions, and we've said this before, we have a greater than 50% share of that marketplace. Number one, they're going to go to ISG no matter what. That's step one. What the platform enables is that it enables a client to also understand that they may be able to achieve a faster speed to value using the ISG platform, allowing them to achieve savings at a quicker pace, if they choose. It also enables the technology providers that we deal with every day to understand that there will be a likely outcome, and that outcome might come a little sooner, and therefore, they might be a little more aggressive in their pricing, which will benefit the enterprise. I think it's the combination that we have the leadership position, and we're now adding a strong, efficient platform. Together, I think that is why we will continue to lead in this space.

Michael Mathison, Analyst

So obviously, a challenging environment. Just a couple of questions about your income statement in the quarter. SG&A was $24 million. I know that included some severance costs. Can you quantify how much of that was severance and what a good working figure would be for modeling going forward?

Michael Sherrick, CFO

So the severance in the quarter was $2.9 million. So, you remove that, you're down around that 21.5% level, and we would expect to remain pretty consistent with that as we look at our outlook for Q2.

Michael Mathison, Analyst

Now secondly, coming back to Tango, like everybody else, I'm pretty excited about the possibilities there. Particularly since you're now having your own analysts do their work on Tango, you mentioned you're getting some efficiencies out of that. Your current gross margin is kind of high 30s, 38, 39, 40 sometimes. Do you have any sort of target of what kind of a lift you would get from the increased efficiency? Nothing to pin you on, but are we talking 2:1 or 10%, something like that?

Michael Sherrick, CFO

Yes. I think it's early in the process, Michael. We clearly expect to see better efficiency and therefore, better profitability. But as Mike said, we're still in the early stages, a little over $2.5 billion of volume that's on it. We want to really see how it matures and what goes into it before we really put a number against that.

Operator, Operator

And I am showing no further questions. So, I will turn the call back to Mr. Mike Connors for his closing remarks.

Michael P. Connors, Chairman and CEO

Thank you. Well, let me just close by saying thank you to all of our professionals worldwide for your dedication to our clients and for working together as a global team to drive our long-term success. Our people have a passion for delivering the best advice and support to our clients as they continue their digital journeys in both good times and uncertain times, and I could not be prouder of them. I want to thank all of you on the call for your continued support and confidence in our firm. Have a great rest of the day.

Operator, Operator

And ladies and gentlemen, this concludes today's teleconference.