Sterling Check Corp. (NASDAQ:STER) Q4 2022 Earnings Call Transcript

Sterling Check Corp. (NASDAQ:STER) Q4 2022 Earnings Call Transcript March 2, 2023

Operator: Good morning or good afternoon, all and welcome to the Sterling Fourth Quarter 2022 Earnings Call. My name is Adam and I’ll be your operator for today. I will now hand the floor over to Judah Sokel, Head of Treasury and Investor Relations to begin. Judah, please go ahead, when you’re ready.

Judah Sokel: Thank you, operator. Welcome to Sterling’s fourth quarter and full year 2022 earnings call. Joining me today 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 Investor Relations website under News and 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, filed with the Securities and Exchange Commission 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. Sterling’s 2022 was a great year and I am very proud of the accomplishments and results the team delivered. Reflecting on the year, there is a lot to highlight. Slide 4 shows some of the key 2022 accomplishments, I’ll talk about today. I’ll be discussing our strategy to refresh, innovation, M&A and financial success before ending with our 2023 priorities. I’ll then hand it over to Peter, for a more detailed analysis of our full year and fourth quarter results and to provide our 2023 guidance. Starting with Slide 5, this year we completed a strategy refresh and organizational realignment which we expect to lay the groundwork for the company’s continued long-term success.

Our strategy includes doubling down on our competitive strengths and increasing our revenues with existing clients, acquiring new clients, growing market share internationally and utilizing M&A to supplement our organic revenue growth. We also remain at the forefront of industry innovation and our bending our trajectory with newer solutions such as identity verification, concierge services and post-hire services like monitoring and I-9. Turning to Slide 6. The next area I’d like to highlight is our innovation. Throughout our history we have pioneered many industry leading solutions, such as criminal fulfillment technology, arrest record and incarceration alert products and AI enhanced record review and validation processes. In the past few years, we have only increased our focus on innovation and Project Ignite has enabled us to launch products more rapidly to meet immediate client needs.

In 2022, we had over 300 product releases, nearly 20% more than what we released in 2021. Examples of recent developments include our enhanced global language support capabilities and proprietary core I-9 offering and we released our comprehensive global identity verification solution through our partnership with ID.me in the U.S. and with Yoti internationally. We have been very pleased to see that our identity offerings consistently grew through 2022, with full year transactions up approximately 250% over 2021. Our fingerprinting business also experienced similar growth, with 2022 fingerprint transactions being up by nearly 300% over 2021. Another recent product innovation is the continued enhancement of post-hire monitoring solutions, which track among other things healthcare sanctions, medical licenses, recent arrests and motor vehicle registration monitoring.

In 2022 we released our new enhanced industry-leading monitoring solution, providing a fully integrated criminal monitoring experience, including arrests and convictions for our clients. Historically, this industry has delivered monitoring in the form of transactional re-screening orders. Our new solution is subscription-based and enables multilayered monitoring that will scale globally for our clients around the world. We also made significant progress towards unifying the client experience by moving approximately $140 million in client revenue from legacy platforms onto our single unified platform. We now have over 85% of our global revenues on our core platform. Finally, we increased our automation integrations with well over 3,000 APIs and RPA bots, powering our fulfillment platform to deliver high accuracy, low hiring costs and faster time to higher rates.

Over 90% of our U.S. criminal searches are automated and we now complete 50% of U.S. criminal searches within the first five minutes, 65% within the first 15 minutes, over 70% within the first hour and 90% within the first day. Turning to Slide 7, the next accomplishment I’d like to highlight is M&A. 2022 was also a year of great success on that front, starting with the EBI acquisition at the end of 2021. We completed our integration of EBI ahead of schedule and are pleased that the results exceeded our initial estimates. We realized meaningful cost and revenue synergies from the deal, as clients were enthusiastic about switching to the Sterling platform and gaining access to our additional solutions. We employed this strategy in 2018, with the acquisition of National Crime check to expand in the APAC region, and the Socrates deal now expands our global presence into Latin America to serve the rapidly growing hiring needs of multinational and local clients.

With operation centers in Brazil, Colombia and Mexico, the Socrates team has built a highly reliable operational model and suite of screening services, guided by their people first client centric values that are a perfect fit with the Sterling culture. We are excited to work with the Socrates team to build on Sterling’s proven model of bringing deep regional expertise and localized innovative solutions, to deliver growth in the Latin America region. Our other acquisition was of A-Check, a highly complementary deal we just announced yesterday. The purchase of A-Check builds on our successful M&A strategy of growing market share in the U.S. through accretive tuck-in deals. The company possesses a high quality enterprise focused client base, diversified across attractive verticals, including healthcare, industrials and tech media.

As with EBI, we expect this deal to yield significant synergies from platform migration, SG&A rationalization and cross-sell of Sterling products. In particular, we expect an integration period of 12 to 15 months with A-Check’s adjusted EBITDA flow through, reaching 45% to 50% once clients are integrated onto our platform and technology consistent with our playbook for U.S. based tuck-in deals. We messaged similar ambitions when we bought EBI and can say now that we achieved those targets ahead of schedule, we aim to do the same with A-Check. Our business and strategic accomplishments throughout 2022, resulted in strong financial results. As shown on Slide 8, we set new company records this year for annual revenues, adjusted EBITDA and adjusted net income, as we continue to execute against the strategy we implemented in 2019.

Our 2022 revenues grew by 19%, including 14% on an organic constant currency basis, even while lapping 2021’s exceptional 41% revenue growth. Our long-term target for organic revenue growth is 9% to 11% per year, and 2022 was the second consecutive year above that range. To our knowledge, our organic revenue growth in 2022 was industry-leading and reflects the investments we have made since 2018, to prioritize profitable organic revenue growth. Our growth in 2022 was driven by all four of our organic revenue drivers, which were each at or above their long-term targets. In particular, our continued focus on new client wins, resulted in $57 million or 9% revenue growth in 2022, marking the fourth consecutive year at or above our long-term 7% to 8% target.

To our knowledge, our growth from new clients is industry leading. We also increased our wallet share with existing clients through upsell and cross-sell and prioritize exceptional client service to ensure optimal client satisfaction and revenue retention rates. And I’m proud to say that the efforts certainly paid off. Slide 9 shows that our strong results in 2022 are a continuation of our strong performance. From the time we launched our strategy in 2019 through 2022, our revenue has grown at a 14% CAGR, including 11% on an organic constant currency basis. We saw a pull back in 2020 due to COVID 19, but otherwise, our results of increased each year as we gain market share, increase spend amongst existing clients and benefit from multiple secular trends driving increased background screening adoption.

We believe our trajectory is particularly compelling when viewed over multiple years. 2021 and 2022 were are not simply recovery from 2020s trough, but rather a natural continuation of the trends we started in 2018 and 2019. As shown on Slide 10. Our success over the past four years has been notably consistent in the revenue drivers we can control. New client wins, cross-sell upsell and retention. We have deployed strategies and tactics focused on these drivers including setting targets for our vertical and regional teams around these metrics. And our Project Ignite tech transformation has yielded countless benefits across the company. As a result of the sustained focus we have grown organically at a 10% CAGR since 2018, from the combination of these three drivers, solidly ahead of their 7% to 8% combined target.

Even during the 2020 COVID downturn, we still hit our long-term target and grew by 7% on this basis, as we achieved our new business and upsell cross-sell targets and our retention improved by 300 basis points year-over-year. Moreover, as you can see on this slide, we have improved our gross retention rate through the period, increasing from 88% in 2018 to 91% in 2019% and 94% in 2020, followed by two consecutive years at 96%. This demonstrates that our solid strategy and execution have enabled us to perform well in the areas, most within our control even during challenging economic times. Turning now to our strategic focus areas in 2023 on Slide 11. Despite an uncertain macro environment, 2023 presents a lot of promise and we expect to continue the journey we started when I joined in 2018.

In particular, we expect at the midpoint of our guidance to set new company records again this year, with revenues of $760 million to $800 million, adjusted EBITDA of $198 million to $218 million and adjusted net income of $106 million to $121 million. We plan to deliver these results by remaining focused on the long-term strategic elements which have driven our compelling success in recent years. These include organic revenue growth with new and existing clients, expanding our industry-leading identity verification products built around our exclusive ID.me and Yoti workflows and M&A. Our 2023 priorities also include a laser focus on margin expansion through increased automation, process improvements and cost reduction measures. Last quarter, we discussed the playbook, we implemented when we saw our base growth begin moderating.

We removed the surplus in our fulfillment labor that we have been carrying to support our 40% average growth since the beginning of 2021. We also completed a realignment of our senior leadership and functions to elevate our go-to-market strategy and accelerate our technology and product innovation. And we launched Project Nucleus, an initiative that we expect to drive long-term meaningful cost savings and efficiency gains by reengineering processes, driving fulfillment labor cost reductions and identifying and executing on additional automation opportunities. Some of these initiatives are complete, some are underway and still others remain on the near-term horizon. The common denominator is that all of these actions will position the company in the future for growth and market share gains, regardless of the macro environment.

Photo by Tyler Franta on Unsplash

And they will enable us to expand adjusted EBITDA margins for full year 2023 and over the long term. In conclusion, I am really proud of the Sterling team for continuing to deliver through uncertain times. We navigated successfully through COVID and the subsequent recovery while building for the future. And I strongly believe we will deliver on share gains and margin improvements in 2023’s uncertain macro environment as well. With that, I will hand it over to Peter Walker, our CFO to take you through our financial results and 2023 guidance. Peter.

Peter Walker: Thank you, Josh. And good morning everyone. Turning now to an overview of our financial performance starting with revenues on Slide 13. During 2022 we set new company records for annual revenues with approximately $767 million. This was a 19.5% increase over 2021 and included 14.4% organic constant currency revenue growth. We’re very proud of these results, which we delivered even while lapping 2021 explosive 41% revenue growth. The year also included a 6.5% contribution from M&A, partially offset by 140 basis points drag, due to foreign currency translation. The organic revenue increase included growth from new clients of approximately $57 million or 9% and growth from existing clients of approximately 4%, including base growth, cross-sell upsell and net of attrition.

To our knowledge, our growth from new clients is industry-leading. Our investments in technology and products coupled with our best-in-class turnaround times and customer-first focus, enabled our gross revenue retention rate remain strong at approximately 96% for the year, our second consecutive year at that level. Additionally, pricing was relatively stable across the period and not meaningful to the change in revenues. We are encouraged that 2022 strong results were driven by all four of our revenue drivers performing at or above the target range. We are seeing success in the areas of our business most within our control, including strong growth from new clients, cross-sell upsell and revenue retention rates. These areas are our greatest focus and we feel that our momentum in winning market share and wallet share can help offset the unpredictability of base growth over time.

Turning to Q4, overall revenue was down 2% year-over-year, driven by a 4% decline on an organic constant currency basis, a 140 basis point drag due to foreign currency, partially offset by 4% of inorganic growth. Q4 continued the positive trend in the drivers within our control, including growth from new clients of approximately $12 million or 7%, our ninth consecutive quarter at or above our 7% to 8% long-term target. At the same time, revenue from existing clients was down 11%. The revenue shortfall in Q4 was driven by two main items. The first was slower hiring by clients who were cautious to bring on additional headcount, before the New Year and some return to seasonality. Importantly, we have seen some uptick thus far in 2023 based on these factors.

The second item was signed new business implementations pushed out to late Q1 2023, over time we expect the current normalization in growth rates and modest pullback in hiring to be followed by a return to the historical 2% to 3% base rate and for our total organic revenue growth to return to our 9% to 11% target. Looking at 2022 revenues by region. Our U.S. business grew 23% compared to 2021. We saw broad-based strength in our industry verticals with particularly strong results in our industrial, healthcare and FinBiz verticals. As shown on Slide 14, we have a diversified and attractive vertical mix. This mix has been instrumental in supporting our compelling revenue growth in recent years, including our industry leading growth from new clients.

Our deep market expertise into these industries and geographies we serve has allowed us to develop a client base that is diversified across size, industry and geography with a minimal concentration. In particular, we have intentionally increased our exposure to health care, industrials and financial and business services, which together comprise over 60% of our U.S. revenues and has seen solid demand trends despite the uncertain macro environment. Turning to international, revenue in our international business grew 10% in 2022 on an organic constant currency basis. International growth was led by the APAC region, which exhibited broad-based strength primarily in Australia and Singapore, due to new client wins and strong underlying performance.

International also showed resilience during the fourth quarter, growing by 3% on an organic constant currency basis and demonstrated the benefit of our global scale, with 17% of our revenues generated outside of the U.S. during the quarter. In 2022, we delivered 6.5% of inorganic revenue growth from EBI, our November 2021 acquisition. We were very pleased with EBI’s performance in 2022 with results solidly above our expectations, both on a top and bottom line. We delivered this outperformance by completing the deal integration ahead of schedule and delivering client retention above our initial expectations through proactive strategies. The resounding success of the EBI deal has increased our confidence to pursue additional synergistic M&A. And we were excited to close on two more deals so far in 2023, I will touch on the impact of those deals shortly.

Turning to Slide 16 in 2022, we set a company record for adjusted EBITDA with a $199 million a11% year-over-year increase compared to 2021, reflecting an adjusted EBITDA margin of approximately 26%. We continued to invest in organic revenue growth while also focusing on cost discipline, automation and process improvements to drive long-term margin expansion. As a reminder, our cost structure is highly variable, with 80% of our cost of revenues tied directly to third party data costs, we only incur as revenue as recognized. An additional 16% of our cost of revenues are tied to labor cost, we can quickly scale up and down as required. 2022 margins were below the expectations we shared on our Q3 call, primarily because of the greater-than-expected moderation in December revenues.

We were able to achieve a significant amount of our cost savings in the quarter. This was partially offset by higher fulfillment head-count cost in the quarter, due to lower revenue and higher non-class settlement costs. Like with our revenue and adjusted EBITDA, our 2022 adjusted net income set a new company record of $29 million or $1.08 per diluted share, representing a year-over-year increase in adjusted earnings per share of 11%. This year-over-year increase was slightly higher than our adjusted EBITDA growth, due to lower D&A. For the fourth quarter, our adjusted net income was $20 million or $0.20 per diluted share. Q4’s year-over-year decline in adjusted EPS was primarily driven by the base revenue moderation discussed earlier. Turning to Slide 18.

Our cash flow from operations in 2022, was $104 million, an increase of 52% over 2021. Higher operating income and positive trends in cash collections was partially offset by higher cash interest and tax payments, as well as significant cash outflows to complete Project Ignite and M&A diligence and integration. On November 30, our Board authorized a $100 million share repurchase program, as we continuously seek to increase shareholder return, while taking advantage of attractive equity valuation. As of February 28, 2023 we have used approximately $22 million to repurchase Sterling’s shares, leaving us with approximately $78 million of capacity to continue executing the program. We ended the year with total debt of $505 million and cash and cash equivalents of $103 million.

Our net leverage at quarter end was two times net debt to adjusted EBITDA at the low end of our two to three times net leverage target. Our net leverage continues to decline due to our strong cash flow generation and adjusted EBITDA growth. As a result of our rising cash position, we were well positioned to use cash on hand for our two M&A deals in 2023, at a combined net purchase price of approximately $50 million. Socrates is an asset that we’ve been working with and looking at acquiring for a long time and we are pleased to see the price return to attractive levels. We expect this acquisition to drive growth for us with both global and local clients. In the case of A-Check, we paid approximately four times adjusted EBITDA on a pro forma synergized basis, solidly within our M&A pricing framework and even lower than the multiple we pay for EBI.

Following these two deals, we are well positioned to continue pursuing M&A to supplement our organic revenue growth and make further compelling investments. In addition to our ongoing cash generation we have ample capacity under our new credit facility, including approximately $195 million available under our revolver at year-end. During the fourth quarter, we completed a successful debt refinancing with a new term loan and revolver, which extended our maturity profile to 2027, increased our credit capacity to $700 million and reduced our interest expense spread. The new five-year credit facility was oversubscribed, despite a challenging environment for many borrowers, a point which we believe reflects the credit markets recognition of our successful growth strategy and maturation as a public company.

We also recently implemented an interest rate hedging instrument to fix approximately 60% of our floating rate debt. Our capital allocation priorities remain investing in organic revenue growth, pursuing M&A and maintaining healthy balance sheet. This includes opportunistic share buybacks under our previously announced share repurchase program. We see macro instability as an opportune time to build the foundation for success. On Slide 19, we provide our guidance for 2023. For 2023, we expect to generate revenues of $760 million to $800 million, representing year-over-year growth of minus 1% to positive 4%. Adjusted EBITDA of $198 million to $218 million, representing year-over-year growth of 0% to 10% and adjusted net income of $106 million to $121 million, representing year-over-year growth of 0% to 14%.

Our guidance includes full year organic constant currency revenue growth of minus 3% to positive 1%. As we discussed earlier, we continued to see solid growth in items within our control, including new client wins. These are being offset by base revenue declines. Based on what we’ve seen in the first two months of 2023, December 2022 appears to be the low point for negative base growth, with an uptick so far in January and February. We are not assuming a material change in the macro environment over the course of the year. If there is a material shift for the better or worse, we would reflect those changes in updates to our guidance. For total organic revenue growth, we expect year-over-year declines during the first half of the year. This will likely include 8% to 10% organic constant currency revenue declines in Q1, marking the low point for 2023, followed by narrow declines in Q2.

We expect the second half to show year-over-year growth, with improvement each quarter. Our guidance is based on several items. One, new clients on boarding through the year, two, ramping client hiring plans, three, upsell and cross sell based on our pipeline and four, easing year-over-year comps. Our industry and regional diversification is providing us some protection against the verticals most impacted by the current environment. For example, our healthcare vertical in APAC region are showing resilience so far in Q1, helping offset declines in some other verticals and regions. From the combination of our two M&A deals we expect 2 to 3 points of inorganic revenue growth in 2023. Note that the EBI acquisition anniversary during Q4 2022 and the revenues became fully organic starting in December.

For the impact of foreign currency fluctuation, our full-year 2023 guidance assumes 40 basis points of benefit. Turning to profitability, our 2023 guidance implies adjusted EBITDA growth of 0% to 10%, the midpoint of this range implies a full year adjusted EBITDA margin of 26.7%, reflecting a notable margin expansion over 100 basis points versus 2022, muted by approximately 30 basis points drag from our two M&A deals. We expect margin expansion for the full year, even in the absence of robust organic revenue growth, through the cost measures we’ve put in place, as well as the variability of our cost structure. We expect margins to contract in the first quarter of 2023 followed by improvement through the year with healthy margin expansion in the second half, as our revenue trends improve and the benefit from our cost actions ramp.

As I mentioned earlier, we have several initiatives both completed and underway, designed to automate our workflow, improve processes and optimize our cost structure. These are expected to drive margin expansion during 2023, and set up Sterling to scale more profitably over the long term. Finally, turning to our adjusted net income growth guidance of 0% to 14%. We will benefit this year from reduced D&A, which should drive growth to the bottom line in excess of our adjusted EBITDA growth. We remain encouraged by the leverage in our financial model driving adjusted EBITDA growth during 2023 ahead of our revenue growth and driving adjusted net income growth ahead of our adjusted EBITDA growth. To further help with your modeling, we’ve included a page in the appendix with our assumptions for 2023 and a detailed breakdown of our revenue guidance.

In closing, we are reaffirming our long-term targets on Slide 20. We have significantly outperformed our topline targets during the past two years and are reaffirming our long-term target of 9% to 11% organic revenue growth levels, with margins expanding towards 29% to 32% plus and adjusted net income growth of 15% to 20% per year. 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. The first question today Mark Marcon from Baird. Mark, your line is open. Please go ahead.

Mark Marcon: Good morning. Wondering, if you can give us a little bit more color with regards to what you’re hearing from some of your key clients with regards to their plans for the year, given the uncertainty in terms of the macro and any sort of additional color that you might provide with regards to just the differences that you’re seeing in terms of the vertical areas? Thank you.

Joshua Peirez: Thanks, Mark. It’s Josh, let me go first, Peter if you want to add to it. So first, let me just start with, we continue to hear from our clients in our strategic growth verticals like health care and industrials, that they’re continuing to hire as they have been, they’ve been growing throughout last year, including in the fourth quarter. So these are verticals where we expect to continue to see our clients on the trajectories they’ve been on and maybe even improve. In terms of some of the other verticals where we saw the slowdown in Q4, what we heard from them at the time and now we’re hearing this year, is that they sort of put things on pause as I mentioned in our last call for Q4 as they waited to get through the year, get their budget set, and now even with the macro as it is, they have their hiring plans for the year in place and they’re starting to post those jobs, ramp those hiring positions and expect to hire those.

So we have today baked into our plan and our guidance the view from clients on what their hiring is going to be in the current macro with its current uncertainty. And again that’s why Peter shared that we expect Q1 to be the lowest point in the year, as they have starting to get those positions rolling now and ramp that up through the year. We also expect them to continue to buy new products in our cross-sell and upsell efforts and to see that continue to grow through the year and also for our new client on-boarding to ramp up through the year, as we would typically see, but we saw that pause a little bit in Q4 as well. Notwithstanding that, we did hit our long-term target in the quarter for new growth.

Mark Marcon: Great. And then can you give us a little bit more color with regards to this the specifics with regards to Socrates and A-Check, with regards to revenue and margin profiles that they currently have. And then the plans for integrating them, you obviously did a great job with EBI, so just thinking through like over the 10 months to 15 months integration period, where the margin improvement could come on those two acquisitions? Thanks.

Joshua Peirez: Sure. Thanks, Mark. I’ll go first and then Peter maybe will give you some more specific on the numbers, but let’s just start with A-Check, I think that you should think about this as being very similar to EBI and we’ve incorporated what they’ve been seeing in the macro into the price we paid and into our expectations for the year. That’s part of why we were able to make this acquisition at 4 times of pro forma adjusted synergized adjusted EBITDA, which is cheaper than what we paid for EBI. And we expect the cadence to be somewhat similar, in terms of how we’re able to improve the profitability for those clients, as we migrate them over to our platform and our systems and our fulfillment. So again, you should think about that happening sort of starting to happen around the middle of the year and then the benefit from that ramping through the end of the year.