Information Services Group, Inc. (NASDAQ:III) Q2 2023 Earnings Call Transcript

Information Services Group, Inc. (NASDAQ:III) Q2 2023 Earnings Call Transcript August 4, 2023

Operator: Good morning, and welcome, everyone, to the Information Services Group Second 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.

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 second quarter conference call. I’m joined today by Michael Connors, Chairman and Chief Executive Officer; and Bert 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 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 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?

Michael Connors: Thank you, Barry, and good morning, everyone. Today, we will review four areas. First, our top-line growth including our record second quarter revenues, record first half revenues, and the demand environment driving our performance; second, our growing recurring revenue streams; third, our commitment to returning capital shareholders; and finally, our view on how the third quarter is shaping up. ISG continued, its strong start to the year in Q2, we generated record second quarter revenues at $75 million, up 6% over the prior year. Capping a first half that saw us generate a record $153 million of revenues, up 9% on an operating basis. Demand for our unique combination of cost optimization, digital transformation, and platform services remain strong as evidenced by our first half top-line growth.

Our cost optimization services have experienced a surge in demand this year as we successfully help our clients reset their overall cost baseline for the long-term. Our holistic approach to cost takeout includes sourcing, network, software and automation. We are also seeing renewed interest in outsourced infrastructure services, data centers, and private cloud. As companies look to reign in public cloud expenses that balloon during the pandemic, these efforts free up much needed budget to allow organizations to more aggressively fund their high priority digital initiatives. And to that point, our expertise in digital transformation continues to be an area of strong client engagement and demand. Key areas of focus include customer experience, cybersecurity, cloud, application modernization, and data analytics, all of which helps our clients become secure, intelligent, connected enterprises.

Now, a comment about profitability in the quarter, our EBITDA was impacted by a negative $400,000 in the quarter due to an unexpected healthcare expense related to our self-insured status. This was a unique circumstance of major health expenses hitting all at once that we do not expect to be repeated. In addition in the quarter, we optimized our resource levels slightly downward and had a severance expense of approximately $1 million with a majority of that in Europe. This will enhance our profitability during the back half of the year. Now turning to our recurring revenues, our recurring revenues continue to be robust of 21% in the quarter to $32 million driven by demand for our research and platform services, and an overall increase in our multi-year contracts.

For the first half, recurring revenues reached $65 million or 42% of our firm-wide revenue. To put this in perspective, this is nearly the same amount of recurring net revenues we had for all of 2019. As a reminder of what we announced last quarter under Phase 2 of ISG Next, by 2025, we’re aiming to expand our adjusted EBITDA margin of further 200 basis points from the end of 2022 to approximately 17% and accelerate the growth of recurring revenues to $150 million after surpassing our previous target of $100 million last year. Now moving to shareholder returns, our commitment to shareholders is demonstrated by our discipline management approach that allows us to continue returning cash to our investors. During the quarter, we paid a quarterly dividend for the eighth quarter in a row since we instituted a cash dividend in 2021 and after raising it by 12.5% earlier this year.

Our commitment is further reflected in the $25 million expansion of our share buyback program that we announced in our earnings release. We now have nearly $29 million earmark for share repurchases. Beyond dividends and share buybacks, our disciplined capital allocation strategy includes reinvesting in our business, reducing debt, and supplementing our organic growth, which strategic acquisitions to drive long-term shareholder value. On that last point, we continue to actively look at acquisition targets and explore avenues to unlock the value of our automation unit. Now, turning to our regions, the Americas had a solid Q2 delivering $42 million of revenue, up 7% versus the prior year on the strength of our cost optimization, enterprise change, and research services all up double-digits.

For the half, revenues for the Americas were up 12%. During the quarter, we also saw double digit growth in our consumer, banking, health sciences, media, and public sector industry verticals. Key client engagements during the second quarter included Exelon, AIG, Constellation Energy and Cognizant. During the quarter, a leading global healthcare technology company awarded ISG, a new million dollar ISG GovernX contract. The contract extends our scope of services with this client, which has 140 active GovernX users and manages about $400 million of supplier contracts via the ISG platform. We also added nearly $2 million of business with an existing insurance client, helping them streamline the development and maintenance of more than 1,000 apps in their portfolio with targeted savings in excess of $40 million.

ISG also expanded its relationship with a major U.S. clean energy company to support its spinoff and set up a new provider ecosystem for the newly divested company and engagement worth about $1 million to ISG. Now turning to Europe, our Q2 revenues of $24 million were up 5% over the last year. For the quarter, Europe delivered double-digit revenue growth in our health sciences, energy, utilities, and public sector industry verticals and in our automation business. Key client engagements in Europe in the second quarter included Volkswagen, TalkTalk, Danske Bank and Allianz. During the quarter ISG continued to expand its long standing relationship with a leading global automotive manufacturer. We are serving seven major brands within the Company and generated more than $5 million in first half revenues with this client.

Our latest work includes helping the client source infrastructure and product lifecycle management providers for its battery manufacturing subsidiary, whose batteries power the Company’s new electric vehicles. We also want $1 million engagement with a company that designs engineers and builds high tech facilities for the semiconductor pharmaceutical and data center industries. The one IT program we developed for the client covers sourcing organization and governance model design and IT service management. In addition, we extended our ISG automation services and licenses for two years with a UK based broadband provider for another million dollars in revenue. Now turning to Asia Pacific, our Q2 revenues of $8 million were flat compared with last year.

We generated double-digit growth in our research and GovernX business. Key clients in the quarter included the Australian Taxation Office, the Australia Department of Home Affairs, the insurance company Bupa, [Hygrid] and VicRoads of state government agency in Victoria, Australia. In a very positive development, we recently were awarded the largest GovernX engagement to-date in Asia Pacific, a multimillion dollar contract with one of the largest independent payment solution providers for the Australian financial services sector. This contract begins in the second half of this year. Now, let me turn to guidance. We are energized by our record top-line growth and the scaling of our recurring revenues underscoring the strength of our portfolio as we had into the second half of this year.

From cost optimization and cybersecurity to digital transformation and enterprise change, our unmatched set of solutions addresses the needs of our clients today. So far this year, we have served 660 clients including more than 100 new clients at the halfway mark. Organizations that are trusting ISG with their most critical initiatives and with good reason, we advise our clients at every step navigating technological and organizational change that leads to greater operation, operating efficiency, and faster growth. On the strength of our portfolio and our market opportunities, we see continued growth ahead. We are also mindful of the current economic uncertainties that may affect enterprise decision making in the near-term. In consideration of all this, for the third quarter, we are targeting revenues in between $73 million and $75 million, up 9% at the top end and consistent with our high single digit growth objective and adjusted EBITDA between $10.5 million and $11.5 million.

The highest quarterly guidance range we have ever given. As you know, we recently announced that Bert Alfonso is retiring this month from his role as Executive Vice President and Chief Financial Officer of the firm. Michael Sherrick, who is with us in the room today, will become the new CFO of ISG. Michael brings a strong industry and operating background to ISG most recently serving as COO of Cognizant Software and platform engineering. I want to personally thank Bert for his many contributions to our firm, his leadership, and for his friendship. And I want to welcome Michael to the team. So with that, let me turn the call over to Bert, who will summarize our financial results. Bert?

Bert Alfonso: Thank you Mike, and good morning everyone. It has indeed been an honor and a privilege to serve as CFO of ISG and to work with all of you over the past two years, and I thank you for your support. And now on to the quarter, as Mike mentioned, ISG delivered record second quarter revenues. Revenues for the second quarter were $74.6 million, up 6% compared with the second quarter last year. There was essentially no FX impact in the quarter, and the Americas reported revenues were $42.3 million, up 7% versus the prior year. And Europe revenues were $24.4 million, up 5%, and in Asia Pacific revenues were $8 million flat versus the prior year. Second quarter adjusted EBITDA was $10.1 million, down 6% from last year resulting in an EBITDA margin of 14%.

Second quarter operating income was $4.9 million compared with $7.4 million in the prior year. Net income for the quarter was $2.3 million or $0.05 per fully diluted share compared with net income of $5 million or $0.10 per fully diluted share in the prior year. Second quarter adjusted net income was $5.3 million or $0.11 per fully diluted share compared with adjusted net income of $6.8 million or $0.13 per fully diluted share in the prior year’s second quarter. Head count as of June 30, 2023 was 1,597 down 31 professionals or 1.9% from Q1. Consulting utilization for the second quarter was 72%. Our balance sheet continues to have the strength and flexibility to support our business over the long-term. For the quarter, net cash generated from operations was positive by $2.8 million, and we ended the quarter with 19.6 million of cash, down from $23.7 million at the end of Q1.

During the second quarter, ISG paid dividends totaling 2.2 million. We purchased $2.9 million of shares and made 1.5 million of earn out payments related to the 2022 acquisition of Change for Growth. Our next quarterly dividend will be payable on September 28th to shareholders of record on September 6th. Our debt balance at the end of the second quarter was 79.2 million, unchanged from the prior year-end, and our debt to EBITDA ratio remained in great shape at 1.8 times. Our borrowing cost for the quarter was 6.6%, up from 2.4% last year, and we ended the quarter with 48.5 million shares outstanding. Mike will now share some concluding remarks before we move on to the Q&A. Over to you Mike.

Michael Connors: To summarize, ISG is off to a strong start in 2023 delivering record revenues for the second quarter and first half. We have good growth opportunities ahead as we help our clients optimize their businesses and prepare for the next wave of the digital economy. Demand for our platforms and research continues to push our recurring revenues higher. Now, over 40% of our firm-wide total, we aim to deliver $150 million of recurring revenues at the end of 2025 after crossing the $100 million threshold last year. We look to resume our margin growth in the second half on our way to our year-end 2025, target of 17%, up 200 basis points from last year. And we continue to reward our shareholders with our regular quarterly dividend and by increasing our share repurchase authorization by $25 million.

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.

Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Dave Storms with Stonegate Capital Markets. Your line is open.

Dave Storm: Just wondering, if we could start with the M&A market and kind of what you’re seeing there now that rates are starting to hopefully stabilize inflation coming down. Is there any appetite, any size, price you’re looking to take, anything like that?

Michael Connors: Yes. On the M&A environment, we are active as we have been for really our whole history. We are continuing to focus on our string of pearl strategy, which is on a kind of a bolt-on strategy. We are focused on recurring revenue frames to continue to increase that and also on all things digital. So yes, we are in the market, we continue to talk with possible targets. These things are always a journey, and you always try to balance what you think is fair value. So that all ends up with a win-win situation, but we are active and we will, if we find something that makes financial sense for the firm and fill some of the channels that we would like to be able to accelerate our growth, and we will act on those.

Dave Storm: And then just one more from me, when you think about your recurring revenue streams, great to see that it’s up over 40% well on track to hitting your $150 million goal, do you have an efficient frontier mind where you would want recurring revenues to be X amount of revenues or if possible, would you want it to be a 100% of revenues? How do you think about that going forward?

Michael Connors: Well, look, I’d love to have a 100% recurring, but that really is not our business model. I’m hesitant to do a percentage because if I do that, then the other parts of the business I don’t want them not to grow at the rates that we would like to have them grow. So that’s why we use kind of an absolute number. We’ll see how the rest of the firm performs as well. But you know, as we approach at some point, if we could get to a level of in or around 50% recurring revenues, I think that the multiple expansion for our firm is significant from where we are today, even at 40% of recurring revenues. So if we continue to have that climb over time, then again, I feel like we are undervalued and we have both margin and multiple expansion ahead of us.

Operator: Your next question comes from the line of Michael Matheson with Singular Research. Your line is open.

Michael Matheson: So, particularly in annually recurring, I’m just not seeing that in the other companies that I cover, so, very impressive. One thing to ask about though, while revenues are up, gross margin is down by 290 basis points from the 40% levels in 2022, for our modeling purposes, do you see gross margin at current levels going forward, or a return to those 40% levels?

Michael Connors: Yes, thanks for the question Michael. In the second quarter, you’re quite right, our direct costs were higher. They were higher by a bit over 4 million and that clearly impacted us. SG&A was really only up about 2%. It does include the $1 million that we talked about in terms of severance and while that applies across the board from an accounting perspective, it gets accounted for SG&A. And so, it looks a little higher, but SG&A was actually fairly well controlled and we do a good job on that part. But yes, no, our objective is clearly to be at 40% or more. As we were in the first quarter, first quarter we were at about 14.5. So when you look at the onetime severance, which is in that number as well as the 400,000 that we talked about on the medical, it was below our expectations in the quarter. So our objective and clearly where we’re heading in the back half is to get to that 40% plus. You’re quite right.

Michael Matheson: My final question just comes back to geographic trends that you observed. Your release mentioned that your separations were concentrated in Europe. I didn’t see revenue growth being flat in Europe. It looked like it was up. Where are you seeing Europe kind of for the second half of the year?

Michael Connors: So, if I think about Europe in the context of the U.S. The Europe I think has had a bit more of challenge from a macro environment than the U.S. has had in. We had really good growth in Europe at 5% on operating basis for the quarter, despite the macro environment. But we would anticipate that that would be higher for the back half of the year. And the reason is primarily driven by the demand environment around optimization and around some of our recurring revenue streams, our platforms, our research, our GovernX. So, we feel like the pipeline is, their decision-making is a bit slower, but it’s about the timing of the decision, not if there will be a decision. So, we’re optimistic on the back half of the year that Europe will continue to grow and likely at a higher pace.

Operator: Your next question comes from the line of Vincent Colicchio with Barrington Research. Your line is open.

Vincent Colicchio: Question on APAC, what are your thoughts for the balance of the year and also on the America side, which I think led this quarter, should that grow in the second half?

Michael Connors: On Asia Pacific, I always say on Asia Pacific, look at it kind of in its holistic full year. We expect our normal kind of double-digit growth for that region on a full year basis or thereabouts each year. So, there’s some ups and downs, a little bit on some of the governments by quarter. So I would read nothing into flat second quarter in Asia Pacific, but think about it as a growth region, and we expect it to look that way during the back half of the year. For the Americas, yes, we think Americas is, they had a great first half, 12% growth on the top-line. I don’t know if we can do that level of growth continuously, but the America’s demand environment looks good. Decision-making, of course, a bit slower than normal, but the demand is there, so it’s a matter of decisioning there. So we feel good about the Americas as well.

Vincent Colicchio: Any general question, from last quarter this quarter, any change in sentiment, sales cycles, anything of that nature across the board in your geographies?

Michael Connors: No, I would say, it’s the same they are, it is measured in terms of its timing, but I don’t think it is different timing now than it was earlier. But it’s not sped up either. I think still is moving at a bit of a slower pace. It takes a few more approvals to get things done. But what we like about it is that the demand is there. There’s not a lack of demand, it’s just the timing of some of these things and how long they take to close and get started.

Vincent Colicchio: Everyone as you know is talking about generative AI still early a lot of companies doing proof of concept. Are you being retained for any work now? And if you were, I would assume it’d be minimal. But I’m just curious your thoughts on if next year could be a, you could see a meaningful tailwind from generative AI related work?

Michael Connors: I mean, here’s how we think about it. Enterprises right now are starting what is likely to be a decade long kind of transformation similar to what cloud was 10 years ago. So think about it in that regard. The through line here is speed allowing more to be done in kind of less time and this puts ISG right in the center of kind of advising our clients on how to harness AI. We are doing that. Right now, we have a number of use cases. We’re tracking offerings from the providers so that we can ensure our clients can best navigate. We are creating an ecosystem there. And I think this is especially important because with AI there are some kind of treacherous elements that can damage an enterprise brand if it’s not handled with expertise.

So yes, we are focused on that. From a client standpoint, we are working with clients. It’s early stage. The one other aspect I would add to this, Vince, is in terms of how do we as ISG use AI. And we’ve used AI for years with our GovernX platform, beginning with Watson and then developing our own AI for contract data extractions where it combs through hundreds of pages and extracts deliverables and obligations, we call them DNOs terms and so forth. And you’ll recall we did an acquisition first quarter last year, a tech company called Agreement. And we did that because they had some AI technology around smart contracting and we have now incorporated that into our GovernX model. So I think you’ll continue to see announcements from ISG over the next months ahead on this topic.

I would say ranging from research to advisory to contract management around automation. So keep an eye out for that, but it’s early stages and this will build over time. And again, I would look at the cloud 10 years ago and use it as an analogy with AI. Vince, I hope that helps.

Operator: Your next question is from line of Joe Gomes with Noble Capital. Your line is open.

Joe Gomes: The first one I just wanted to get a little better understanding here. Last quarter, you guys talked about the second half of 2022 hiring and it was beginning to pay off. And in this quarter, obviously you took a restructuring or severance charges. Just trying to figure out how that all fit together as to the beginning to pay off in your commentary last quarter to, hey, we’re doing some severance this quarter.

Michael Connors: Yes, no, look, let me reconcile that for you. As you know, we hired up over a couple a 100, 200, 250, last year. That is helping drive the 9% top line growth in the first half of this year. What we did in the third quarter is just like we do with our clients, we’re always looking to upgrade our resources and skill base. And we decided to optimize our resources a bit in Q2 to improve our overall skills and performance levels, if you would. So if you think about the numbers of people, it’s a fairly small number. If you think about what our head county is versus prior quarter, I think it’s kind of net down a little over 30. And compared that to the 250 we brought in, I think you’d see that there’s really, it’s complimentary to that. But look at it as kind of our overall trimming that we normally do each year. We just concentrated it here in the second quarter and really at a small number. But because it’s Europe, the severance is a little bit outsized.

Joe Gomes: And then one of the things you had talked about in the past, but I’ve been — don’t recall you talking about too much here lately, the training as a service option. I was wondering maybe you kind of give us an update on how that is unfolding?

Michael Connors: Yes, that is very hot. We have found that the close cycle, the sales cycle is a little bit longer than we anticipated. We have a significant one in the, that we’ve been trying to get closed, frankly, for over 45 days, that we think we hope will close during the third quarter. But yes, we are very hot on what we call pass training as a service. It’s resonating. We have some very large blue chip clients that we also use as references. Again, this is an early stage emerging, but this is a definite growth opportunity for our firm and we’ll grow at outsized growth rates from the overall firm growth rate. So yes, we are very much on it and I hope to have something in the third quarter to say.

Joe Gomes: And one more for me, Michael, earlier your answer to one, a previous question, you were talking about how you feel the stock is undervalued. You noted the 25 million increase in the buyback, any thoughts about getting a little more aggressive on a quarterly basis with the buyback? Are you still thinking going to stick more in that 2 million to 3 million level here, at least in the near-term?

Michael Connors: No, good question. Last year, obviously we were a bit more aggressive earlier this year or late last year, obviously we made the acquisition. So we’ve had some acquisition costs. And so really it’s a matter of how we allocate across the capital allocation. We increased the dividend by 12%. So, we’re always focused on, what our cash flow looks like and how we deploy it for our shareholders. The increase, obviously, you should take that as a signal that the buyback is important to us. And philosophically and I’ve said this before, our objective is to shield our investors from any dilution from our stock based compensation. We’re not necessarily trying to drive the share account down in any significant way, but that will continue to be our objective and you’ll see more of that from us in the future.

Operator: Your next question comes from the line of Marc Riddick with Sidoti. Your line is open.

Marc Riddick: Bert, thank you for everything in all your efforts over the last couple years, it’s certainly been a pleasure working with you and hope you enjoy your retirement going forward.

Bert Alfonso: Thank you.

Marc Riddick: Well, since my AI question was already taken, I did want to sort of maybe shift gears a little bit. Maybe you could share a little bit on, maybe what you’re seeing around client vertical behaviors certainly with a lot of the detail that you’ve given and some of the growth drivers and some of the cost savings efforts. Just wondering, if there were any particular industry verticals that you’re seeing stand out either positively or negatively?

Michael Connors: Yes, no, good question. First of all, maybe the hot ones, consumer services, very hot. Life sciences and healthcare, very hot, surprisingly to some degree public sector, very hot; media technology hot. I would say BFSI overall relatively flat. Energy’s decent, manufacturing, I would call it, just tick above kind of a year ago. So that’s how we would think about the different segments. One other point on the industries is that we, we look at the industries in kind of a four box scenario where there are clients that are in a stabilization phase with the macro environment, and that, that those are things like media, like tech, a little bit now on kind of travel and tourism. A lot of work with the airlines on op cost optimization, et cetera.

Then you’ve got kind of the other side of the spectrum, if you will kind of the top right box type spectrum where you have, the healthcare, you have the pharma, you have the medical devices that are all seizing kind of growth opportunities that they see out in the market. And then you have the rest of them kind of in between there. So, I would say that cost optimization is still the lead and they’re using it to take cost out in a more swift manner, but also using it so that they can free up funds for their budget to drive their digital initiatives, which is really what’s going to drive their growth in the future. So that’s how we would think about the different industry verticals little more.

Marc Riddick: And then I was sort of wondering, and this is maybe a little further down the road, but we’ve seen like this period of time where M&A activity, global M&A activity, just big picture wise have certainly come down from record highs from a couple years ago. I was wondering though it seems as though it’s maybe picked up a little bit sequentially, I was wondering if you’re seeing anything along those lines driving any interest or driving any potential green shoots going forward? Thanks.

Michael Connors: Again, on the M&A, we’re active, we’ve always been, I would say there’s always. I don’t think there’s much difference in terms of the seller thinking that their asset is worth greater than the buyer. So I think that’s still a phenomenon that remains maybe, the delta between those two is a little bit tighter now with this environment than it had been a couple of years ago. But overall, I think, when we think about the assets that that we look at, we know it’s both a financial consideration, but it’s also an emotional consideration. And we think that what we have, which is a combination of cash, stock and earn-out component and the ability to scale the business that we would acquire are the attractive elements that when we consummate a transaction and you ask an owner, why did you choose ISG? Those would be the reasons. So we still feel very good and confident about those in our M&A work.

Operator: I am showing no further questions in the queue. I’ll turn the call back to Mike Connors for his closing remarks.

Michael Connors: Well, let me 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 deliver our strong top-line results in the first half. 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….