Information Services Group, Inc. (III) CEO Michael Connors on Q4 2018 Results - Earnings Call Transcript

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Information Services Group, Inc. (NASDAQ:III) Q4 2018 Results Conference Call March 15, 2019 9:00 AM ET

Company Participants

Barry Holt - Senior Communications Executive

Michael Connors - Chairman and Chief Executive Officer

David Berger - Executive Vice President and Chief Financial Officer

Conference Call Participants

Vincent Colicchio - Barrington Research

Sarkis Sherbetchyan - B. Riley FBR

Marco Rodriguez - Stonegate Capital Markets

Joe Gomez - Noble Capital

Operator

Good day. And welcome to the Information Services Group Fourth Quarter and Year End 2018 Results Conference Call. Today's conference is being recorded and a replay will be available on ISG's Web site within 24 hours.

At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. Barry Holt. Please go ahead sir.

Barry Holt

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 fourth 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'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, which was furnished this evening 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 for the fiscal year ending December 31, 2017, 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 Web site at www.isg-one.com or the SEC's Web site 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 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 last evening with the SEC.

And now, I'd like to turn the call over to Michael Connors, who will be followed by David Berger. Mike?

Michael Connors

Thank you, Barry, and good morning, everyone. Today, we will review our record fourth quarter and full year revenues; brief you on our key operating and client highlights; discuss the increasing value of ISG automation; provide our guidance for 2019 revenues and EBITDA; and discuss our capital deployment plans. But let me get right to the headlines.

We delivered record revenues of $68 million in the fourth quarter and record revenues of $276 million for the full year. Europe was a key driver. Reported revenues were up 18% in Q4 and 15% for the full year. Digital continues to be a growth engine for the firm. It accounted for 45% of our revenues in the fourth quarter and for the year surpassed $100 million for the first time. Automation is a key part of our digital business and continues to grow in value for our clients and our firm. We lowered our debt by $18 million in 2018 and delivered strong operating cash flow, $8 million in the fourth quarter and $19 million for the year, our best performance in five years. And we have a plan to return more of our cash to our shareholders in 2019.

We have great momentum in our business and with strong demand for all things digital bright prospects for the long-term. There isn’t a client conversation now that doesn't include some element of digital and we are responding by building digital capability into each of our service lines. ISG FutureSource, our next generation digital sourcing solution is one example. Launched just over a year ago, ISG FutureSource reinvent our traditional sourcing services and addresses the need for speed, agility and mastering the increasing complexity of today's digital sourcing environment.

We also see a future where we are able to deliver certain offerings using Software-as-a-Service or Platform-as-a-Service business model. This model has the potential to add significantly to our subscription-based recurring revenue, enable us to reach new client markets and up-sell our advisory services to new platform clients. We have already begun our SaaS journey through the launch of ISG platform that includes such software-based services as ISG GovernX, our digital managed services offerings; ISG InformX, our new Data-as-a-Service offering; ISG ProBenchmarks, our online market pricing tool; and our online ISG Momentum Contract KnowledgeBase.

We see software platform subscriptions and related services becoming an even bigger part of our offering set going forward. In addition to the SaaS platforms I just mentioned, we are driving revenue growth through our RPA software subscription, configuration and implementation services and our software advisory services. By the end of 2020, we expect software-related revenues to be about 10% of our total. Since the start of the year, we have launched ISG GovernX 2.0 and enhanced and expanded version of our groundbreaking platform-based digital managed services solution. Version 2.0 delivers the full suite of ISG managed services solutions, through enhanced user interface with intuitive features on a new portal. It also provides mobile access via iOS, Android and Windows mobile devices. We have signed clients such as Jabil, Xylem and Marriott to this platform already.

We are also developing new ways to monetize our industry-leading market intelligence and benchmarking data through our ISG data and analytics business. The center piece is our recent launch of our ISG InformX platform. This groundbreaking software-based Data-as-a-Service solution leverages the world's most robust validated IP data depository to deliver instant intelligence on how enterprises performing against its peers, as well as key market and industry indicators for cost, quality and productivity. We are taking ISG InformX for market now, after successfully beta testing it with five Fortune 500 companies. This subscription-based platform should add to our recurring revenues in the second half of this year and into 2020. Then there are the services that we have that are born digital, such as ISG automation business. I will speak more about that in a moment.

Another born digital service is ISG Blockchain Now, our new advisory and sourcing solution that enables our clients to improve the efficiency, accuracy and security of their business processes through distributed ledger technology. We expect our Blockchain business to evolve overtime. But as with automation, ISG is entering the arena now to create use cases with clients in preparation for when this technology becomes even more mainstream over the next few years. Recurring revenue streams continue to be a focus of our firm. These annuity-like offerings, managed services, research, our long-term public-sector software, software-as-a-subscription and benchmarking-as-a-subscription, now we’re approaching $80 million in annual revenue up from as low as $20 million a few years ago. From a client perspective, we serve nearly 700 clients in 2018, including such enterprise a Humana, Allianz, Volkswagen, and Caterpillar. To reach even more clients, we invested more than $3 million in the fourth quarter and early this year in additional go-to market executives. This is the single largest investment we've ever made in adding new ISG partners at one time to help turbo-charge our grow. We made this investment in anticipation of the stronger client demand for digital that we expect to see over the next 24 months.

Next, let me focus a moment on our ISG Automation business, which is growing in value for both our client and our firm. ISG Automation is one of our faster growing businesses, reflecting strong market demand among enterprise clients who see robotic process and cognitive automation as a way to reduce cost, improve productivity and increase speed, all areas critical to competing in an increasingly digital economy. We expect to see this business exit 2019 with run rate revenues of over $30 million after exiting 2018 at over 20 million plus. I will remind you this was in an infant stage just two years ago. Last month, we formed a partnership with WorkFusion. And during the fourth quarter of 2018, we formed a partnership with UiPath to leverage their software and helping ISG clients automate key business processes across the enterprise. The addition of WorkFusion and UiPath means ISG is partnering with four of the world's top automation software companies to bring the benefits of business process automation to ISG clients.

The ISG Automation business with its combination of services and recurring software subscriptions is becoming increasingly more valuable to our firm and to our shareholders. As we discussed last quarter, valuations of our software partners range from $1 billion to $3 billion and advisors like ISG have been sold for a price in the range of 3 times revenue. Clearly, the true valuation of our Automation business is currently not reflected in our share price today. We believe the value of our RPA business alone is with more than the $74 million we paid to acquire Alsbridge two years ago. Given this hyper growth and demand in valuation, during 2019, we plan to explore bolt-on acquisitions and other avenues to create further value in this entity.

Turning to our region, in Europe, we reported strong fourth quarter revenue, up 21% in constant currency. For the full year, revenues were up 11%, in constant currency and 15% on a reported basis. Our full-year performance was driven by double-digit growth in each of our key clients, Germany, the UK, the Nordics and France. We continue to see a nice turn around in the UK with constant currency revenue growth of 23% in the quarter and 18% for the year, driven by demand for digital and automation services. In our industry segment, we saw a good growth in our insurance, manufacturing, technology and energy industries. Key client engagements in Europe in the fourth quarter included Volkswagen, BMW, Fresenius, BASF and the U. K. Ministry of Defense. Among our notable wins, ISG has been selected by a leading healthcare provider in Europe to implement a global agile enterprise infrastructure strategy.

Our ongoing transformation of this client's digital backbone triggered an organizational redesign that turned into a multi-million-dollar engagement for ISG.

We also are engaged with the European bank to help automate their trading debt processes, freeing up time for them to focus on revenue generating activity. Through a number of automation pilots, we were able to demonstrate significant productivity savings. In the Americas, revenues declined 3% for the quarter and 2% for the full year. Revenues were impacted by sluggishness in the U.S. public-sector, the timing of several client engagements and a reduction in spending by one of our largest U.S. automotive clients due to changing business models in that industry. This client will remain, however, a top five ISG client in 2019 even after the change in their spending level.

Our U.S. public sector business was soft in the quarter and the full year. This was due to reduction in demand and slower spending, driven primarily by the large number of gubernatorial elections last year, which impacted nearly three quarter of U.S. states. As I mentioned previously, we expect this business to return to growth in the U.S. as soon as the second quarter.

For the year in the Americas, we had especially good growth in the energy, life sciences healthcare and manufacturing industries. Key client engagements in the quarter included Humana, Refinitiv, Archer Daniels Midland, Caterpillars and Caesars. Among our notable wins, we were awarded $1 million engagement to create a digital workplace for a major global financial services organization. This engagement leverages our workplace of the future, strategy, business process rationalization and technology expertise. In another example of account expansion through cross-selling, ISG was selected by a leading auto-parts retailer for an ISG future source transaction, an engagement that was later expanded to include organizational design and enterprise agility services. The expansion led to $1 million of new business for the firm. ISG also leveraged a range of services, including enterprise agility, digital strategy, benchmarking and sourcing to develop an IT and future state operating model for a leading global auto manufacturer.

Finally, our smallest region, Asia-Pacific, representing about 8% of our global business, saw its revenues declined $1.4 million for the quarter and $3.3 million on the year. This was due to a slow Australian public sector and an unfavorable comparison with the prior year, which included revenue from a large engagement in Asia that was completed at the end of 2017.

Before turning to our 2019 guidance, I wanted to spend a moment on our balance sheet. Our cash balance at year-end was $19 million, up 38% from September. During 2018, we paid down $18 million in debt and repurchased $3 million in ISG shares. During the fourth quarter, we generated $8 million in cash flow from operations and $19 million for the year, which is up 8% from the prior year. This was our best result in five years.

Now turning to our 2019 guidance. ISG is positioned for long-term growth with our expanding digital capability and portfolio of products and services, including new platform solutions, software subscriptions and recurring revenue. And the automation market remains hot. We believe our investment in our sales capabilities with new partners and in all-things digital will continue to yield strong results. Here is how we see our year unfolding. Like other multinations, we are facing some significant currency headwinds in the first and second quarter. We expect currency will have a negative impact on our results, lowering our reported revenues in the first half by a projected 400 to 500 basis points.

Q1 in the UK will be slightly through the Brexit noise, but our sales pipeline has picked up dramatically this quarter and Q2 should see the UK returning to the strong growth we saw in all of 2018. In addition, we have taken into consideration a reduction in spending of approximately $1 million a quarter in the Americas from one of the larger clients that I mentioned earlier. This will result in essentially a flat Q1, but with growth escalating after that. Given this outlook, combined with our cautious view of the macro environment around Brexit trade and some uncertainty created by the U.S. political environment, we are targeting 2019 revenues between $276 million and $285 million and adjusted EBITDA between $33 million and $35 million. We plan to update our forecast in August once we have actual results for the first half and greater visibility into the second half and the macro environment.

Now, turning to how we plan to increase shareholder returns. After the filing of our first quarter results in May, we anticipate being able to accelerate the return of cash to our shareholders, including through share repurchases under our current $12 million board authorization.

So with that, let met turn the call over to David Berger who will summarize our financial results.

David Berger

Thanks Mike and good morning everyone. Fourth quarter revenues were $67.9 million compared with $66.6 million in the prior year, which was an increase of 4% in constant currency and 2% on a reported basis. Currency negatively impacted reported revenues by 2% or $1.1 million in the quarter. Reported revenues were $25.3 million in Europe, up 21% in constant currency from the same period in 2017 and 18% on a reported basis; $38.1 million in the Americas, down 3% and $4.5 million in Asia Pacific, down $1.4 million.

Fourth quarter 2018 adjusted EBITDA was $8.6 billion, which compares to $8.9 million in the prior year. We reported fourth quarter operating income of $3.3 million compared with operating income of $4 million in the fourth quarter of 2017. The net loss for the fourth quarter was $900,000 compared with a net loss of $2.7 million in the fourth quarter of 2017. Reported fully diluted loss per share was $0.02 compared with a fully diluted loss per share of $0.06 for the same period in 2017. Included in the net loss was $1.6 million and $2.1 million of income tax expense for the fourth quarters of 2018 and 2017 respectively related to changes in the U.S. federal tax code under the Tax Cuts and Jobs Act. Adjusted net income for the fourth quarter was $2.3 million or $0.05 per share on a diluted basis compared with adjusted net income of $100,000 or $0.01 per share in the prior year's fourth quarter. Utilization for the quarter was approximately 64% and 66% for the year. Quarter end headcount was 1,310.

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 year was $19.1 million versus $11.4 million in the prior year and $8 million for the quarter. In 2018, we invested $4 million in capital expenditures, repurchased $3 million in shares and repaid $18 million in debt. On the balance sheet, we ended the year with $19 million in cash, which was up 38% from the $14 million in Q3. Total debt outstanding was $99.1 million after paying down $2.1 million during the quarter and $17.6 million for the full year. We plan to pay down an additional 8% to 10% of our debt in 2019. Our average borrowing rate for the quarter was 5.2% and we had $45.8 million shares outstanding as of March 1st.

In terms of modeling for 2019, we are looking at interest expense between $6 million and $6.5 million, depreciation expense between $3 million and $3.5 million, intangible amortization of around $4 million, stock compensation of around $11 million, cash taxes between $5 million and $6 million, capital expenditures of approximately $4 million and an effective tax rate between 32% and 34%.

Mike will now share concluding remarks before we go to Q&A.

Michael Connors

Thank you, David. And let me summarize for us. We delivered record revenues of $276 million, including a record $68 million in the fourth quarter. We generated 18% revenue growth in Europe in the fourth quarter and 15% for the year. We continue to grow our digital services revenue, which accounted for more than 45% of our total for the fourth quarter and a record $100 million plus for the year. We delivered strong growth in ISG Automation and expect strong double-digit growth again this year as demand remains high and we explore avenues for creating further value in this business.

We generated $19 million of cash from operations, our best result in the last five years. And our cash balance is at $19 million after paying down $18 million in debt and buying back $3 million in shares. We will look to return more of our cash to shareholders in 2019, including accelerating our share repurchase program. As always, we are focused on shareholder value for the long-term and we are steadfast in our mission to deliver operational excellence to our clients. Overall, our foundation is solid, recurring revenues, digital and automation services, subscription software, a growing list of blue chips clients and a talented global team of 1,300 professionals on the ground in the middle of the digital revolution.

Thanks very much for calling in this morning. And now let me turn the session over to the operator for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] We will take our first question from Vincent Colicchio with Barrington Research.

Vincent Colicchio

How large is the RPA practice today and could you remind us how margins compares to the company average?

Michael Connors

First of all, we exited 2018 at greater than $20 million and our plan is that we would exit 2019 at greater than $30 million. And in terms of margins that is a business that’s a combination of both advisory and recurring revenues around software. So we have both the software and the services combined. So when you look at the two together, I would say it's just a bit greater than the overall firm average margins.

Vincent Colicchio

And then on the government side of the business. I mean, you had some slippage versus expectations. I assume of course you knew that there will be some politics and some noise there. Is there anything else you think that's affecting that business?

Michael Connors

I think there are two things. One, we expect closure on a few deals, and I will mention states of Michigan, states of Indiana, which have closed subsequently that did not close, we did not start work. There was also a higher education big university that closed, but not during when we thought it would in the fourth quarter. So that is really the issue. We see that work starting up now, but we will see the flow through for growth, we believe starting in the second quarter of this calendar year.

Operator

Your next question is from Sarkis Sherbetchyan with B. Riley FBR.

Sarkis Sherbetchyan

Can you remind us what recurring revenues were for 4Q?

Michael Connors

It was $17 million from 4Q, $76 million for the full year.

Sarkis Sherbetchyan

And with regards to this layer of business, do you expect year-over-year growth for '19?

Michael Connors

Which business, Sarkis?

Sarkis Sherbetchyan

Just for the recurring revenue…

Michael Connors

Yes. We think the recurring revenues will grow double-digits in '19.

Sarkis Sherbetchyan

And if I recall correctly, your goal was to get to $100 million in recurring revenues in the next few years. Does your line of thinking change on that?

Michael Connors

No, we think we’re still right on target to get there as we enter 2021. So we've got one year down, two to go. And based on what we’re seeing with our change of trying to push more into annuity streams with our ISG platform services, with more software offerings, we think we will get the target of $100 million on the timeline that we've described.

Sarkis Sherbetchyan

And if I take the guidance for EBITDA, as well as revenues for the year it looks like you would expect essentially flat margins. Can you just give us the puts and takes on the reason why and also if you see weakness in certain areas of the business, which are offset by some big growth here, just try to give those drivers?

Michael Connors

I think the way to look at it is first quarter is going to be flat and then you are going to see the growth and I think you will see margin change as we go through the year. So, I think we’re being as conservative as we can be at the moment, considering the other areas. But internally, we would like -- we are targeting that margin number to grow in '19 over '18. But at the moment, we put the investment in some people. We’re putting the investment in our ISG platform, all of which should service to get to the $100 million plus in recurring. So those factors are the ones that we factored in and we also are losing a million bucks a quarter with one of our top client. We added that all up and that’s how we ended up with our guidance.

Operator

We will take our next question from Marco Rodriguez with Stonegate Capital Markets.

Marco Rodriguez

I was wondering if you can maybe talk a little bit more about the RPA business. Your commentary on looking for I guess strategic alternative acquisitions, other activities that could help drive value there, vis-à-vis I guess where your software partners are getting much higher valuations. Can you just talk a little bit more about that and talk about, I suppose the valuation disconnect that you're seeing there?

Michael Connors

So we know we’re building a very valuable asset with automation, it is a hot area. We know that valuations for the software, pure software players like Blue Prism, which is public like Automation Anywhere, UiPath, WorkFusion, they are all out there in the public domain, have some explosive values. We also know that firms that are emerging in the services and software space like our ISG Automation business are selling at around 3 times revenue, because we've been in the market. We've see some of the assets. There was a recent public sale through Sykes, which is a public company and others. So, when we look at all of that, we say, well, wait a minute, we don't think we're getting the value of our assets certainly reflecting at the moment in our share price. We also think that this business, through expansion, could become even more valuable. So we’re going to look at a number of areas created as a legal entity during the course of the year, and we'll see what the best options are for us.

Marco Rodriguez

And maybe if you can talk about, I guess acquisition landscapes for you guys in terms of the RPA business or anything else that maybe somewhat attracted to you. If you can maybe talk about opportunities that are out there, maybe numbers and what valuations might look like?

Michael Connors

We’re always on the hunt on acquisitions. Our focus is around digital analytics and things that we can attach to our platform, as well as recurring revenues that we can put through, if you will, our distribution channel. That’s the focus of any bolt-on acquisition. I will put the Automation acquisitions aside for a second. But rest of them, we have always been disciplined in terms of the value that we would pay and its usually at the levels that sit, if you will, a bit below where we trade at. But we also have a pretty good model that we have I think well versed in, which is a combination of a little bit of cash, a little bit of stock and some earn-out. And that model does resonate with the candidates that we are looking out on the outside. So, I think the pipeline is good. I think the market is good. I think the ISG platform is well respected in the market. And we will continue to look at something and if something made sense then we would jump at it.

Marco Rodriguez

And last question and I will jump back in the queue. Just coming back to U.S. public sector and its impact in the Americas, I know we've talked about this last quarter. As far as some of that weakness there, I guess, it seems to be bleeding in here. And I think if I heard you correctly, your expectation is that Q2 '19, a lot of choppiness should abate. Just wondering what gives you confidence in this forecast there for the U.S. public sector.

Michael Connors

So we have a good pipeline. The pipeline was turnspit. It turned back on kind of toward the beginning of the year as the new governor all took office, freeing up some RFPs, which the RFP traffic is higher than it was in the past. We've also won a few pieces of work in a couple of state in higher education. We also have a few things that are in the pipeline that we expect solutions on within 30 days. So you add all that together, we think that the public sector has hit its bottom and it will go back to some normalized, if I can say, in this political environment but a normalized spending pattern. And therefore, we envision public sector returning to growth in Q2. So that’s where we get our confidence level.

Operator

And your next question is from Joe Gomez with Noble Capital.

Joe Gomez

Just wanted to circle back here about some of the uses of cash, you guys are talking about for this year; you're paying down debt; increasing the rate of buybacks; potential bolt-on acquisitions. Just trying to get a better feel or idea of how you guys think you’re going to be able to fund all of that?

David Berger

Well, this year we generated -- in 2018, we generated $19 million of cash flow, which has similar cash characteristics in 2019. So that was funded. As you know our acquisition, we tend to fund through a combination of cash shares and earn out. So that enables us to spread the cash over a number of years. So that’s how we do the three items you mentioned.

Michael Connors

One other factor, Joe, is that keep in mind that we paid back about $18 million of debt in 2018. And our projection is to spread the wealth, if you will, on the cash. And our debt, we would take down 8% to 10% during '19 and that of course frees up some additional cash to do the buybacks and other things, so keep that in mind.

Joe Gomez

And I might have missed this and if I did, I apologize. But in the last quarter you were talking about some network revenues you're expecting to get about $2 million the quarter that had been shifted to the right. Did that occur?

Michael Connors

Yes, we had very strong sequential network growth, call it in the 25% range for the quarter. And that did come to fruition. And we think our network business, just to add one of the components here. With the dramatic changes going on, which I’m sure we’ve all seen with AT&T, Verizon and others, who are essentially blowing up their current business model and changing it. We think that our network business, although, it’s a little choppy we think that the network business over the next couple years could be a new broader growth driver for us nothing more at the moment. But with those business models changing and with our expertise and data that we have, we think we could be even a large player in the network space. So we are working on some new initiatives during the first half of this year. And as we develop those, we'll be back in touch. But the network business, in our view, is a growth opportunities. Though, it is a little choppy quarter-to-quarter, it’s a little higher margin. And we think there's some uplift on the growth rates over the next couple of years to take advantage of the business models that are changing.

Operator

It appears there are no further questions at this time.

Michael Connors

All right, thanks very much. Let me just close by saying thank you to all of our professionals around the world for their individual and collective contributions, and continuing to write the chapter in our growth story and for the strides that they are taking on behalf of the firm on our road ahead. And let me thank all of you on the call for your continued support and confidence in our firm. Thanks for joining us and have a great day.

Operator

This concludes today's call. Thank you for your participation. You may now disconnect.

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