Sterling Check Corp. (NASDAQ:STER) Q3 2023 Earnings Call Transcript

Sterling Check Corp. (NASDAQ:STER) Q3 2023 Earnings Call Transcript November 11, 2023

Operator: Hello everyone and welcome to the Sterling Third Quarter 2023 Earnings Call. My name is Seth and I will be the operator for your call today. [Operator Instructions] I will now hand over to Judah Sokel to begin the conference. Please go ahead.

Judah Sokel: Thank you, operator. Welcome to Sterling’s third quarter 2023 earnings call. Joining me today on the call are Josh Peirez, Chief Executive Officer of Sterling and Peter Walker, Chief Financial Officer of Sterling. The slides we will reference during this presentation can be accessed on Sterling’s IR website under News & Events. The slides have been posted to our website and a replay will be made available on the website. After prepared remarks we will open this call to questions. Before we discuss our results, I encourage all listeners to review the legal notice on Slide 2, which explains the risks of forward-looking statements and the use of non-GAAP financial measures. Additionally, please refer to our most recent Form 10-K and 10-Q filed with the SEC for a discussion of risk factors that could cause actual results to differ materially from these forward-looking statements.

Our slide presentation and discussions on this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures are in the appendix to the presentation and in our earnings release issued this morning. I’ll now turn the call over to Josh Peirez.

Joshua Peirez: Thank you, Judah. Good morning and thank you for joining us. Before we begin I want to provide an important update. Since July 2019, I have had the pleasure of working in partnership with Peter Walker, Sterling’s Chief Financial Officer. As we announced in late September, Peter has found an exciting new role outside of Sterling, and I couldn’t be happier for him to pursue this opportunity. Peter has played a critical role at Sterling in so many ways over the past four and a half years, including leading our successful IPO two years ago. Peter has put in place a very strong team, culture and finance discipline that sets us up well for the future. I am grateful for all he has done to make Sterling the great company it is.

While Peter will be missed when he leaves at the end of this week, we are in the midst of a CFO search process and we feel confident that we will find a CFO, who will guide Sterling into the next chapter of the company’s leadership and growth strategy. In the meantime, I am happy that Theresa Strong who is here with us today will serve as Sterling’s Interim Chief Financial Officer during this transition period. Having joined Sterling through our acquisition of TalentWise in 2016, Theresa has nearly 20 years of experience leading finance teams and plays an instrumental role at Sterling as Chief Accounting Officer. I am looking forward to working with Theresa in this capacity. Turning now to Slide 4, the third quarter of 2023 was a quarter of successful execution towards our long-term strategy and 2023 goals.

We continue to focus on what is in our control, a strategy that has produced meaningful results, both on the top line and our cost profile as well as in several other critical areas I will talk more about shortly. In the third quarter we delivered revenues of approximately $181 million, including strong year-over-year trends within new client growth, up-sell and cross-sell and customer retention. At the same time, our Q3 revenues came in below our prior expectation due to lower base hiring volumes resulting from a softer macro than we anticipated in the second half of the quarter. However, thus far in Q4, we have seen an improvement in our year-over-year based trends, leading us to expect that the fourth quarter will see year-over-year total revenue growth at the midpoint of our revised guidance range.

Even in the face of the challenging macro, our clients continue to hire at a steady pace and recognize that background screening is a critical component to helping them keep their employees safe while hiring faster and smarter. While cyclical hiring trends will come and go, the long-term health of this industry and our business is exciting. Clients are increasingly adding more services to their background screening packages. In particular, both prospective and existing clients are attracted to our innovative solutions within identity verification, pre-hire screening and post-hire monitoring. As a result, we continue to drive strong market share gains and larger deal sizes on both new and existing clients. Our Q3 adjusted EBITDA margin was in line with our prior expectations despite the revenue shortfall, a result we are very proud of and which was driven by our progress on cost optimization efforts.

We expect these strategic initiatives centered around focused automation, efficiency and process re-engineering to result in a stronger, more scalable and more profitable company for the long-term. We are on track to deliver a $10 million savings in 2023 and our full cost savings target of $25 million in annualized savings. I couldn’t be prouder of the Sterling team as we took significant steps forward in Q3 toward achieving our goals. Beginning with our first goal organic revenue on Slide 5. Our culture of innovation, technological excellence and elevated client experiences, once again enabled strong results in Q3 on the revenue drivers in our control. Despite the macro environment remaining choppy and uncertain, we are proud to have delivered over 10% year-over-year organic revenue growth in Q3 from the combination of new clients and up-sell/cross-sell consistent with our prior expectations.

We have achieved this double-digit growth from these two factors for 12 of the past 13 quarters, which is a compelling reflection of the market share gains we have been able to consistently generate regardless of the macro environment. During the third quarter, we saw increased win rates, more signed enterprise logos and improving customer retention year-over-year. This success is the result of hard work by the entire team as we continuously use a customer centric lens to deliver the technology, service and solutions the market craves. With that in mind, we are pleased to have just announced a new partnership with Konfir, a leading provider of instant employment verifications for U.K. workers leveraging payroll, tax and open banking data instantly.

We expect this partnership to transform employment verifications for Sterling U.K. clients by enhancing and otherwise manual fulfillment process and greatly improving turnaround times. Beyond the initial U.K. launch, we are working with Konfir toward rolling out similar offerings in select international markets. Additionally, we are leveraging our comprehensive offerings to strategically expand the size of deals we are winning, both for new clients and up-sell of additional products and services to existing clients. This approach is also amplifying our market opportunity to displace niche vendors due to our ability to consolidate more specialized services as a single vendor solution. The right side of Slide 5 shows an example of one such win, our largest up-sell in company history.

By selling additional products and enhanced workflows beyond pre-employment screening, we expect to substantially increase this client spend with us. The new program began ramping during Q3 and is expected to grow our total revenue from this client by over 200%. Our API driven technology and drug & health screening suite played critical roles in this up-sell and is one example of the products through which we are expanding our services to clients. As we look to the future, we see strong evidence that we can continue executing on the organic revenue drivers in our control. In particular, we are excited by our robust opportunity pipeline representing new clients, up-sell and cross-sell deal both in the U.S. and international. Even as we continue to close new deals, the pipeline of prospects keeps building through our targeted sales and marketing efforts, a trend which supports our expectation that we will return to our 7% to 8% long-term target range for new client growth by year-end.

Turning to Slide 6. Our relentless focus to innovate and bring unmatched solutions to our clients has enabled us to significantly grow our addressable market and our right to win. As we’ve shared in recent earnings calls, our investments in faster-growing and higher-margin identity and post-hire solutions are paying off. We are pleased to see another quarter of positive outcomes including a third consecutive quarter where these two areas comprise more than 10% of our revenues combined. Starting with identity. We have seen significant success over the past couple of years due to our identity first workflow solutions that enhance pre-employment screening and strengthen hiring practices. During Q3, we saw continued growth in global identity adoption on a year-over-year and quarter-over-quarter basis in the U.S. and internationally.

Clients are becoming acutely aware of identity as an essential step in the background screening process and in Q3 we saw an approximate increase of 80% in active U.S. identity clients. Furthermore, we grew our advanced stage U.S. opportunity pipeline by over 100% compared to Q2. Our clients are recognizing that the foundation of a reliable background check lies in the careful verification of candidate’s identity. By incorporating our identity verification workflow at the beginning of the background check clients can guard against the escalating threat of identity fraud. Furthering that point, Sterling’s identity solutions generate a significant and quantifiable return on investment by helping our clients make more informed hiring decisions and keep their workforces safe.

In particular, our data shows that adding identity verification at the beginning of a workflow can increase the amount of criminal records discovered by approximately 45%, a striking data point which resonates significantly with clients. Shifting to post-hire on the right side of the slide. Sterling was one of the first CRAs to introduce worker monitoring services several years ago. Through continued investment, we’ve transformed our post-hire screening, and we are optimistic about our consistent progress to grow our monitoring footprint and penetrate this large and growing market opportunity. During Q3 demand continue to grow for our subscription based monitoring solution which enables clients to monitor among other things, criminal arrests and conviction records, motor vehicle registry records, licensing and credentials and social media.

While clients from all industries are benefiting from Sterling’s monitoring solution, we are thrilled to see particularly strong growth opportunities in the gig industry as those companies especially benefit from effortless compliance monitoring through a scalable and API-driven solution. Moving on to Slide 7. We are focused on driving long-term meaningful cost savings and efficiency gains. Over the course of 2023, we have been executing on a comprehensive cost optimization program aimed at building a more scalable, effective and profitable company now and into the future. Our cost initiatives fall into three key pillars: one, reducing our cost of revenue through a focus on labor and data costs; two, decreasing our facilities cost by leaning even more into our virtual-first strategy; and three, reducing SG&A costs by streamlining our organization and enhancing functional alignment.

We also continue to maintain strong focus on opportunities to drive further fulfillment process improvement, including increased automation and the use of generative AI. Finally, turning to Page 8, I will discuss M&A, the final goal. Our strategic acquisitions of Socrates and A-Check in the first quarter remain well on track to hit their integration timelines and drive the expected cost synergies and geographic expansion benefits. As we’ve shared in previous earnings calls, we continue to target the completion of these deal integrations by the end of 2023 for Socrates and the end of second quarter 2024 for A-check. We continue to view M&A as a key element of our growth strategy. Given our success with EBI, Socrates and A-check, we are confident in our ability to execute on future M&A opportunities.

We will continue to pursue deals that enable us to expand our addressable market and grow revenue with accretive margins, either as tuck-ins, geographic expansion opportunities or the strategic in-sourcing of our supply chain where we can create competitive advantages and operational efficiency. In conclusion, I am proud of what we accomplished this quarter and excited for the opportunities in front of us. Our customers continue to be impressed with Sterling’s industry-leading and highly differentiated suite of products that empower clients throughout the full employee lifecycle from pre-hire to post hire. We’re excited about the growth of the global market and believe that our strong competitive advantages, innovation-led culture and financial discipline will help us remain at the forefront of the industry for years to come.

With that, I will hand it over to Peter Walker, our CFO, to take you through our financial results. Peter?

Peter Walker: Thank you, Josh, and I appreciate your kind words. I’m so proud of the Sterling team and all we’ve accomplished together over the last four and a half years. I have strong conviction for Sterling’s future success, and I look forward to cheering the company on from the sidelines. Turning now to an overview of our financial performance, starting with revenues on Slide 10. During the third quarter of 2023, reported revenue was approximately $181 million, a 9.4% decline compared to the third quarter of 2022 on a reported basis and a 11.9% decline on an organic constant currency basis. The third quarter included a 2.4% contribution from M&A and 10 basis points contribution from foreign currency translation. These organic results were below the expectations we provided on our August earnings call due to softness in base hiring volumes in the second half of the third quarter, driven by continued macro choppiness.

We also lapped a very strong Q3 2022 during which we reported revenues of $199 million and an 18% growth rate. As Josh mentioned, we expected year-over-year trends in base revenue to improve sequentially during Q3. Specifically, we expected base revenue to be down approximately 10% year-over-year, but base revenue remained down in the mid-double digits for Q3 comparable to our trend in the first half of the year. However, thus far in Q4, we are seeing improvement in our year-over-year base trends, leading us to expect total revenue growth in the fourth quarter. Outside of base softness, we delivered strong year-over-year performance in Q3 and the revenue drivers in our control, namely new client growth, up-sell/cross-sell and customer retention.

Let me provide some details on those 3Q revenue drivers. First, we saw growth from new clients of approximately 5%, in line with our expectations. Notably, Q3 growth for new clients in both revenue dollars and on a percentage basis was the best quarter we’ve had so far in 2023. Based on deals already live and deals ramping before year-end, we expect new client growth to further increase and return to our 7% to 8% long-term target range by end of year. Second, we maintained strong growth with up-sell and cross-sell and our long-term target range of 4% to 5%, an accomplishment we are very proud of, given client base volumes are lower year-over-year. Client adoption for both newer and differentiated solutions as well as ancillary services is growing at a robust rate.

Our comprehensive product suite and unique global capabilities are expanding our ability to grow market share regardless of the macro environment. Third, our LTM client retention was 95%, also within our long-term target range, and it was even higher during Q3 at 96% as we maintain a client-centric lens to deliver best-in-class technology and service to our customers. As we’ve mentioned in past quarters, it’s important to view our results relative to history as current industry hiring volumes remain strong on that basis and are down year-over-year only when measured against 2022’s record levels. Looking further back, our 3Q 2023 revenues grew at a 15% CAGR over the past 3 years since 2020, demonstrating strong segment quarter we’ve delivered through this cycle.

Looking at revenues by region. Revenue performance in the U.S. was led by our healthcare vertical in the third quarter. Within the U.S., we have a diversified and attractive vertical mix, which has been instrumental in supporting our compelling revenue growth in recent years. We saw softness in some verticals, including financial and business services, industrials and tech and media. Revenue performance in our international business was led by our EMEA region, where we saw strong new client growth. Similar to the U.S., base volume declines offset good trends in the revenue drivers we can control. Our international business is benefiting from a consistent trend of clients looking to consolidate globally to a single-scale provider. In the third quarter, we delivered 2.4% of inorganic revenue growth from Socrates and A-Check, the two acquisitions we closed in Q1 of this year.

We continue to be pleased with both companies’ results in line with our initial expectations. As Josh described, our integration work is on track to target integration timelines with cost synergies being realized throughout 2023. Our continued success in integration gives us increased confidence to execute on additional M&A when attractive synergistic targets become available at the right valuations. Turning to Slide 11. Our third quarter adjusted EBITDA was $47.6 million, a 10.4% decline compared to last year due to the base revenue declines. We are very pleased that our adjusted EBITDA margin this quarter was 26.3%, in line with our expectations despite the revenue shortfall in the quarter. This positive outcome was a direct result of continued progress on our cost optimization initiatives and financial discipline.

As we’ve described in past calls, we are focused on our cost optimization program aimed at driving meaningful cost savings and efficiency gains. We’re on track to generate $10 million in savings in 2023 and $25 million in annualized savings. We plan for these initiatives to drive permanent reductions in our cost profile and position the company to scale efficiently and profitably over the long-term, creating the foundation for significant margin expansion when our base revenues inflect positively. In the third quarter of 2023, we had adjusted net income of $25 million or $0.26 per diluted share, representing a year-over decline in adjusted EPS of 10%. This year-over-year change was primarily driven by the decline in adjusted EBITDA with a lower tax rate, offset by higher interest expense.

Turning to Slide 12. Free cash flow year-to-date was approximately $51 million, a 12% decrease from the prior year period. The decrease was primarily driven by lower operating income and higher interest expense. Our net leverage at quarter end was 2.4x net debt to adjusted EBITDA at the lower end of our 2 to 3x target. Year-to-date, we have spent $49 million of net cash on our 2 acquisitions and $46 million on share repurchases, including $20 million during the third quarter. Our net leverage remains at an attractive level and as mentioned in our last call, would have fallen below 2x without our M&A or buyback activity. We ended the quarter with total debt $500 million, cash and cash equivalents of $50 million and approximately $200 million available under our credit facility, providing us with ample capacity to execute our growth strategy of reinvesting in organic revenue growth and pursuing M&A.

This year, we have also enhanced our capital structure to the implementation of an interest rate hedging program, which fixed approximately 60% of our floating rate debt. Our capital allocation priorities remain investing in organic revenue growth, pursuing M&A and maintaining a healthy balance sheet. This includes opportunistic share buybacks under our previously announced share repurchase program. These priorities hold true in a lower growth environment as we see macro uncertainty as an opportune time to build the foundation for future success. On Slide 13, we show our updated guidance. For 2023, we expect to generate revenues of $720 million to $730 million, representing a year-over-year decline of 4.5% to 6%. Adjusted EBITDA of $186 million to $191 million, representing year-over-year decline of 4% to 6% and adjusted net income of $95 million to $99 million represent a year-over-year decline of 7% to 11%.

Our revenue guidance range includes full year organic constant currency revenue decline of 7% to 8.5%. For Q4 specifically, the implied revenue guide is flat to positive 6% year-over-year with growth of 3% year-over-year at the midpoint. We continue to see a solid growth in items within our control, including new client wins and up-sell/cross-sell and we expect an improvement in those revenue drivers from Q3 to Q4. We’re particularly optimistic about growth from new clients where we expect to return to our long-term target range of 7% to 8% by year-end. As we mentioned in previous quarters, we will benefit in Q4 from a significant number of larger new clients that have gone live as a result of our industry-leading innovation and sales engine.

In Q4, we also expect revenue growth to meaningfully improve because of easing comps in our base business. In particular, we expect the year-over-year declines in base revenues to moderate in Q4, driving the total revenue growth to be positive year-over-year. As Josh mentioned, we’ve seen this trend thus far in October and the beginning of November. Importantly, we are not forecasting an increase in base hiring volumes in our current run rates. Included in our total reported revenue guidance is approximately 2.5% of inorganic revenue growth from our two M&A deals. We are also assuming no material impact for foreign currency in line with our previous assumption. Our guidance reflects the expectations for substantial margin expansion in Q4 of approximately 170 basis points to 26%, driven by our revenue growth, the benefits from our cost actions ramping and easing of year-over-year margin comps.

To further help with your modeling, we’ve included a page in the appendix with our updated assumptions for 2023 and a detailed breakdown of our revenue guidance. In closing, we are reaffirming our long-term targets on Slide 14. Over the long term, we are targeting 9% to 11% organic revenue growth levels with margins expanding to 29% to 32% plus and adjusted net income growth of 15% to 20% per year. Even in the absence of revenue growth this year, we expect 2023 to be a healthy step towards achieving our profitability targets. That concludes our prepared remarks. At this time, operator, please open up the line for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question today comes from Mark Marcon from Baird. Please go ahead.

Mark Marcon: Good morning and thanks for taking my questions. Josh, I’m wondering if you could talk a little bit about just the base volume trends. When did it slow down a little bit more than expected in the third quarter? And can you give us what the numbers were in terms of the base volumes for October and the first week of November? And how we should think about that if the economy slows a little bit further in this year and going into next year?

Joshua Peirez: Hi Mark, thanks for the questions. So I think as we shared in the prepared remarks, we have been expecting the base growth to still be down double-digits, around 10% in Q3. And what we saw in the last half of Q3, really kind of mid-August through the end of September was that the base growth was worse than we expected and it led us to have a minus 17% on base growth in the quarter. What we’ve seen so far in Q4 is actually consistent with the guidance that we’ve provided here today, which is a — an improvement, which is what we had expected all along in Q4 based on the comp from last year. We’re not expecting the volumes to improve at all through Q4. We’re expecting the normal seasonal trends, but we are expecting, based on the comp from last year to see that improvement throughout the quarter.

So we do anticipate our normal seasonality. We have not seen an improvement in October or November in terms of the volumes themselves from what we saw in the back half of Q3. But because of the relative comp from last year, we do see a significant improvement in the year-over-year decline in Q4 on those base growth trends.

Peter Walker: And Mark, if we look back at 4Q of ’22, that was the first time the base growth went negative for us, and that was negative in the low double-digits. So if you kind of back into a base growth assumption for 4Q based on the guidance, again similar to based on what we saw negative [indiscernible]. So it really is the comp that’s helping there along with stronger performance on new business, cross-sell/up-sell and maintaining our industry-leading retention rate.

Mark Marcon: That’s great. And then can you talk a little bit about the new contracts that are starting in Q4, have all of those already started? And can you talk a little bit about what the source of the wins were in terms of whether they were coming from some of the other members of the big three or were they coming from smaller players? Any sort of characteristics there? And what sort of — what level of up-sells did you have in terms of identity and post-hire for those new contracts that are rolling on?

Joshua Peirez: Great questions, Mark, thank you. So I think, first of all, the deals that we’re seeing in Q4 that we’re relying on to return to our 7% to 8% long-term target by the end of the year are deals that are already implemented or implementing as we speak and ramping up. They never — they don’t come on necessarily big bang on day one. So they are in the continued ramp-up and implementation phase. So we’re pleased about that and feel confident there. In terms of where we win deals from, it’s consistent with what we’ve said before. We win some deals always from the other big players, but we also tend to win a lot of deals from that mid-tier and smaller players, particularly as clients are looking for broader sets of services, consolidating to a single vendor or looking for better technology and better interfaces for their teams.

So we’re very pleased with those wins continuing. We don’t talk about wins in a quarter ever. We always talk about the actual revenues as they’re appearing because there’s a time lag between winning a deal and when you see those revenues and you also never quite know exactly how accurate the revenues are going to be from what a client gives you. So we’re giving you that information. But again, I think we’re in a strong industry. There’s a lot of opportunity and the trends are really in the favor of us and other bigger players who are able to provide those services that some of the smaller and mid-tiers can play. So we continue to win deals from competitors of all sizes, including our public peers, but we continue to see great opportunity to consolidate and take share down market in the smaller and mid-tier players.

Mark Marcon: And did you see an increasing adoption of identity and post-hire among those new contracts that you just recently signed and that are in the implementation right now?

Joshua Peirez: Yes. We continue to see the strong trends we’ve been seeing more than half of those deals continue to contain identity in particular. Post-hire is typically more of an up-sell that’s separate. It’s not usually part of the same package because the package itself is to get the person on board and then the monitoring is across an entire employee base, not just the people are being hired typically. So those are usually a separate up-sell that would occur, but we are seeing the pipeline for those continue to grow, as we shared in the remarks as well as the deals to close. And in particular, in the gig industry, we’re seeing a lot of opportunity on that post-hire side in addition to the areas like healthcare and financial services that have always had that as part of their [indiscernible].

Mark Marcon: Thank you.

Joshua Peirez: Thank you.

Operator: Our next question comes from Manav Patnaik at Barclays. Please go ahead.

Ronan Kennedy: Hi good morning. This is Ronan Kennedy on for Manav. Thank you for taking my questions. Josh and/or Peter, can I ask for your take on the macro versus expectations? I think it was consistent with regards to the choppiness. I know you referred it to cyclicality coming and going. But just kind of your take on the macro versus expectations, what we’re seeing in the BLS reports, whether it be quits, hires, churn employment? And what can happen from here under various scenarios?

Judah Sokel: Yes, thanks Ronan, I’ll go first, and then if Josh or Peter wants to jump in. So I think what we’re seeing was the macro itself actually get a little bit worse in the back half of Q3 than what we expected. We expect — and that was based on what we had been seeing in early August, as we had shared on the call because we had seen June and July have kind of a drop off as well. And then what we have seen continue through October till now is consistent with what we saw at the back half of Q3, which is why we felt that it was prudent and necessary to change the guidance as we did to reflect our new expectations of that continued trend through the rest of the quarter. So I think for us, we are happy to get to the point where we have now gotten through our toughest comps and to be at the beginning of where we saw the weakness starting last year. And so that’s really what’s reflected in the revised guide and why we do feel like we’ll see growth in Q4.

Peter Walker: I think if you think about the guidance at the midpoint of range versus the previous guidance range, we had call it 1/4 of that impact 3Q and that we’ve taken the remaining 3/4 of that and is impacting 4Q resulting in a lower guide all driven by change in base growth assumption.

Ronan Kennedy: Okay. And with regards to Project Nucleus, the cost optimization initiatives, et cetera. If you could talk about that as a lever and further levers that could potentially be pulled if things were to decelerate further and how kind of you would change — if you would make any changes in go-to-market or look to execute more M&A, et cetera, in same type of question varying scenarios going forward.

Joshua Peirez: Sure. So I think, first of all, we’re pleased with where we are on our cost optimization efforts in terms of achieving the $10 million in savings that we had targeted for this year and expect to achieve that as well as the $25 million run rate saves that we expect to have as we go into next year and expect to fully achieve those somewhere in the beginning part of the year. In terms of additional levers, as I mentioned in the prepared remarks, we continue to see additional opportunities for automation, opportunities around AI, which I’m happy to get into more detail on. And I think one thing to remember, of course, is that we do have a highly variable cost in our cost of goods sold, in particular, 80% of those are just data costs that we don’t incur if we don’t actually fulfill the service.