Mar 7, 2014
Executives
Michael Connors – Chairman, Chief Executive Officer David Berger – Executive Vice President, Chief Financial Officer Barry Holt – Senior Advisor
Analysts
Vincent Colicchio – Noble Financial Marco Rodriguez – Stonegate Securities Justin Ruiss – Sidoti
Operator
Good morning ladies and gentlemen and welcome to the Information Services Group Fourth Quarter and 2013 Year-End conference call. Today’s conference is being recorded and a replay will be available on ISG’s website within 24 hours.
At this time for opening remarks and introductions, I’d like to turn the conference over to Mr. Barry Holt.
Please go ahead, sir.
Barry Holt
Thank you, Operator. Hello and good morning.
My name is Barry Holt. I’m a senior communications executive at ISG.
I’d like to welcome everyone to ISG’s 2013 fourth quarter and full-year results conference call. I’m joined today by Michael Connors, Chairman and Chief Executive Officer, and David Berger, Executive Vice President and Chief Financial Officer.
Before we begin, I’d like to read a forward-looking statement. It is important to note that this communication may contain forward-looking statements which represent the current expectations and beliefs of the management of ISG concerning future events and their potential effects.
These statements are not guarantees of future results and are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated. For a more detailed listing of the risks and other factors that could affect future results, please refer to the forward-looking statement contained in our Form 8-K that was furnished yesterday to the SEC and the Risk Factors section in ISG’s Form 10-K covering full-year results.
You should also read ISG’s annual report on Form 10-K for the fiscal year ended December 31, 2012 and any other relevant documents, including any amendments or supplements to these documents filed with the SEC when they become available. You’ll be able to obtain free copies of any of ISG’s SEC filings on either ISG’s website at www.isg-1.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. Non-GAAP measures are provided as additional information and should not be considered in isolation or a substitute for financial results prepared in accordance with GAAP.
For a 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 submitted yesterday. Now I’d like to turn the call over to Michael Connors, who will be followed by David Berger.
Mike?
Michael Connors
Thank you Barry, and good morning everyone. Today, David and I will review our record fourth quarter and full-year results, update you on some operating highlights, and conclude with our full-year guidance for both revenues and adjusted EBITDA for 2014, some comments about 2015, and discuss a new growth initiative we are launching.
2013 was a strong year for ISG. We reported full-year revenue growth of 10%, EBITDA growth of 24% which was at the top of our guidance, adjusted earnings per share up 48%, and importantly we generated over $21 million of free cash flow, $15 million in the fourth quarter alone.
We strengthened our balance sheet through $10.6 million in stock repurchases and debt repayments, leaving us with the strongest balance sheet since we became an operating company. Our net debt leverage ratio declined significantly from 2.2 times to below 1 times.
We are pleased to report record fourth quarter revenues of $53.4 million, up 8% versus the prior year. We continued to witness broad-based demand in the quarter, extending the favorable revenue trends recorded during the first half of the year.
Our record results were driven by the third consecutive quarter of double-digit growth in Europe, up 22% year-on-year, and the Americas up 1% after a record-setting pace through most of the year and, as expected, a small 5% decline in Asia Pacific. Our recurring revenue streams of managed services, research and the Americas public sector grew 12% over the prior year to $11 million in the fourth quarter and $42 million for the full year, up 24%.
Additionally, recurring revenue streams now account for nearly 20% of ISG’s total revenues, well on our way toward our target of 25%. The continued strong growth in Europe was driven by our BFSI vertical, which is banking, financial services and insurance, and our U.K.
public sector vertical. We are working with multiple U.K.
government agencies, including the Department for Work and Pensions, the National Employment Savings trust, or NEST, and the BBC. Key engagements in the financial services sector include Allied Irish Bank, BNP Paribas and UBS.
The Americas region grew by 1% in the quarter, 9% for the full year, with growth during the quarter in the public sector and managed services. The public sector saw year-on-year gains driven by such engagements as the States of Michigan, Louisiana, and West Virginia.
Asia Pacific had a small decline in the quarter with softness, as expected, in the Australian public sector. As I’ve discussed previously, late last year the incumbent government was defeated, and with the new government looking to lower costs and improve efficiency, we believe demand for our services will increase late in the first half of 2014.
As an example, we were just awarded last week a contract to provide IT advisory services to the Australian government’s Department of Immigration and Border Protection which we believe will begin during the second half of the second quarter. Other key clients in Asia Pacific during the fourth quarter included Qantas Airways, Leighton Holdings, and Westpac Bank.
Globally, blue chip client wins for the quarter included HSBC, Thomson Reuters, Southwest Airlines, the Frontera Group, AmerisourceBergen Corporation, and AXIS Capital. From a full-year perspective, we recorded record revenues of $211 million, up 10% versus the prior year and at the top of our guidance.
This was supported by 17% growth in Europe and 9% growth in the Americas, offsetting the anticipated decline in Asia Pacific. Revenue from our top 50 clients was up more than 20% versus the prior year and our overall EBITDA margins increased from 9.4% to about 11%.
We continue to manage this company for long-term growth and continue to focus on shareholder value by reducing the risk to our equity holders by further deleveraging the company; we retired $6.5 million in debt during the year; strengthening the balance sheet with our new credit agreement and extending that maturity to May 2018 at very attractive interest rates; repurchasing over $4 million of ISG shares, and continuing to meet with prospective new investors, a number of whom are now shareholders of ISG. Now turning to guidance, we remain focused on our internal goal of achieving about $30 million of EBITDA in 2015.
That will give you some context for what we are expecting to achieve this year. We are optimistic about our 2014 prospects and our ability to continue to advance our long-term strategy.
With our recurring revenue streams growing and our continued double-digit growth trajectory in Europe, we are beginning the year with confidence for a strong full year of 2014. So in terms of initial guidance for 2014, we are targeting revenues between $215 million and $225 million and adjusted EBITDA of $23 million to $26 million.
Like in 2013, we will update this guidance following our second quarter results. Now, unlike in prior years when revenues were essentially equally weighted between halves, we think our 2014 growth will be weighted slightly to the back half of the year.
The Americas in particular expects a stronger second half as its pipeline continues to grow, building from a first quarter in which three larger engagements are shifting from a higher level of spending last year into more of a steady run rate mode of spending in 2014. So the lower end of our guidance range assumes a longer transition to our new growth opportunities while the upper end assumes a minimal delay in the build-up to our new engagements.
Now I’d like to talk about a new development for our firm. As you recall, we have a history of success in innovation and new revenue channels: managed services, launched just a few years ago, the launch into the U.K.
public sector with our investments in 2012, and this year 2014 we are investing during the first half in a new growth area called Engineering Services Outsourcing, or ESO, what we believe is an under-advised market that offers a potential growth opportunity for ISG. After a recent initial assignment with a key client, further study on our part, and talking with prospective clients and service providers, we believe ISG is uniquely positioned to create a market in this space by leveraging our strength in traditional sourcing services and in our manufacturing and technology vertical expertise.
The global spend for R&D associated with product engineering is expected to reach $1.4 trillion by 2020 as companies like Microsoft, Cisco, Boeing, Intel and VW, to name a few, ramp up their investments in engineering and product development. An estimated 30% of the annual spend in global engineering can be outsourced, which is larger than the outsourced market for IT and BPO.
The anticipated growth over the next several years in ESO is driven, we believe, by cost reduction, faster product development life cycles demand, and access to greater talent pools. We believe this industry is ready for a leading firm like ISG to advise in it.
More to come on this ESO initiative from us late this year. So with that, let me turn the call over to David Berger, who will summarize our financial results.
David Berger
Thanks Mike and good morning everyone. Before I discuss our financial results, I would like to reiterate that ISG has presented GAAP financial results as well as certain non-GAAP financial information in our earnings release.
During this call, I 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 I will touch on today include adjusted EBITDA, adjusted net earnings, and the presentation of selected financial data on a constant currency basis.
A complete reconciliation of non-GAAP financial measures is included in our earnings release which was furnished to the SEC on Form 8-K yesterday. 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.
As Mike stated, ISG reported record revenues in the quarter and record revenues for full-year 2013. Fourth quarter revenues totaled $53.4 million, an increase of 8% on both a reported basis and in constant currency, up from $49.5 million in the fourth quarter of 2012.
Revenues were $21.3 million in Europe, up 22% from the same period in 2012, $27.1 million in the Americas, up 1%, and $5.1 million in Asia Pacific, down 5%, growth rates in constant currency. Operating income totaled $3 million for the fourth quarter of 2013.
This compares to an operating income of $1.7 million in the fourth quarter of 2012. Adjusted net income for the fourth quarter was $2.1 million, up 22% or $0.05 per share on a diluted basis compared with an adjusted net income of $1.7 million or $0.05 per share on a diluted basis in the prior year’s fourth quarter.
Reported fully diluted earnings per share were $0.03 per share compared with $0.00 per share for the same prior period in 2012. The fourth quarter 2013 adjusted EBITDA of $5.2 million compared with $4.5 million in the fourth quarter of 2012, which was an increase of 16% on a reported basis and 10% on a constant currency basis.
The 2013 fourth quarter results included a charge totaling $700,000 for a performance-based liability tied to SG&A consulting earn-out that will be paid in the future. Utilization for the quarter was 66% and 69% for the full year.
Headcount declined by nine positions in the quarter to 850. Full-year revenues of $211 million increased by 10% in constant currency and on a reported basis and was up $18.3 million from the $192.7 million in the prior year.
Full-year revenues were $114.6 million in the Americas, up 9%, and $75.1 million in Europe, up 17%, offsetting a 10% decline in Asia Pacific to $21.3 million. Growth rates are in constant currency.
Adjusted EBITDA for 2013 of $22.6 million compared to $18.2 million in 2012, up 24% on a reported basis and 21% in constant currency, and as Mike indicated, at the top of our guidance. The 2013 results included a $1.3 million accrual for the SG&A earn-out while 2012 included the reversal of a $1.9 million accrual.
Diluted adjusted earnings per share for full-year 2013 was $0.27, up 48% compared with $0.18 in 2012. The reported fully diluted earnings per share for full-year 2013 was $0.13, up from $0.02 in 2012.
We continue to maintain a strong liquidity position to support the implementation of our business plan. Cash and cash equivalents totaled $35.1 million at year-end, which was a net increase of $11.5 million from September 30.
Free cash flow, defined as cash provided by operating activities less capital expenditures of $21.2 million for the year was up $12.3 million versus the $8.9 million generated in 2012. The $15 million of free cash flow that was generated in the fourth quarter was a record quarter for ISG.
We spent $1.9 million on CAPEX during 2013 and expect to spend between $2 million and $2.5 million in 2014. We repurchased $1.1 million worth of ISG shares during the quarter, $4.1 million for the full year.
During the fourth quarter, we spent $2.5 million to pay down debt, including the retirement of $1.7 million in convertible loan notes at par which was 33% of the outstanding balance. Total outstanding debt at December 31, 2013 was $56.7 million, which compared to $59.3 million at September 30, 2013.
Our gross debt to adjusted EBITDA leverage ratio dropped from 3.5 times at December 31, 2012 to 2.5 times at December 31, 2013, and our net debt leverage ratio net of our cash balance dropped from 2.2 times to under 1 time. Due to the strong financial performance and focus on deleveraging, interest rate spread on our term loan will be reduced by an additional 50 basis points to 2.5% plus LIBOR.
Our accounts receivable balance as of December 31 was $38.9 million and our DSOs were 61 days, a drop of 13 days from the prior year-end. Our bad debt expense for the year was only $49,000.
Mike will now share concluding remarks before we go to Q&A.
Michael Connors
Thank you, David. We had a good year in 2013.
In summary, full-year revenues were up 10%, breaking the $200 million level for the first time, revenues up 17% in Europe and 9% in the Americas. Our strategy is working with our revenue streams up 24% to $42 million for the year, revenue for our top 50 clients up 21%, full-year EBITDA up 24%, EBITDA margins increased from 9.4% to about 11%.
We generated over $21 million of free cash flow, more than double the prior year. We continue to pay down debt and deleverage our company, with our net debt ratio to below 1 times and our interest rates declining.
We extended the maturity of our credit agreement during the year with improved terms. We’ve added additional research coverage; and finally, NASDAQ has asked us to ring the closing bell next Wednesday to recognize III as a top 2% best performer in stock in 2013.
We remain focused on broadening our client relationships. We have expanded our focus from a transactional approach driven by outsourcing to a much broader strategic discussion driven by the impact of emerging technologies and the need for operational efficiencies across the entire client enterprise.
Growth through innovation is the name of the ISG game. Thanks very much for calling in this morning, and now let me turn the session over to the operator.
Operator
Thank you. [Operator instructions] We’ll take our first question from Vincent Colicchio with Noble Financial.
Vincent Colicchio – Noble Financial
Good morning, guys. Nice quarter, Mike.
The European business has been really quite strong. Do you expect the growth differential between that business and the Americas to continue next year overall?
Michael Connors
Right now Europe is on fire. Our demand is very strong.
The leadership has done a terrific job in building our business. All of our key markets – Germany, France, the Nordics, the U.K.
– our demand is quite strong. Our new revenue channels with the public sector in the U.K.
that we invested in during the back part of 2012 has paid off, and we’re seeing that turn very nicely. So yes, as we look at it today, we expect the European market to continue to be robust.
Vincent Colicchio – Noble Financial
It looks like your recurring revenue was a little slower in the quarter than it was in the prior quarters. Is that just a--you know, do you expect that to start to pick up again in ’14?
Michael Connors
I think—well, I think always in the fourth quarter, things slow down a little bit; but our recurring revenue stream target is we expect that to grow 20% a year, and I believe our full-year, David, was around 24% for the full year. It was less than that in the fourth quarter – somewhat typical, but we have an internal target of getting our recurring revenue streams up about 20% per year.
Vincent Colicchio – Noble Financial
Okay, so that hasn’t changed.
Michael Connors
No, that hasn’t changed, and we fully expect over the next two years to be able to manage to that.
Vincent Colicchio – Noble Financial
So the business being slightly back-half weighted this year, in order of magnitude, is that a 2, 3% swing or how substantial is that?
Michael Connors
It’s not that much, Vince. We look at it as kind of maybe 45/55 split.
Normally we’re kind of in the 48%-plus, 52, something like that, so we expect it to be slightly less in the first half versus the second half, primarily driven by the Americas where the pipeline looks robust as we move through the year. But the first quarter, we have three clients that were on hypercharge during the back half of last year and they are now moving to a more steady state level of revenue.
Two of the three are also managed services clients for us, so we expect the Americas to come in softer in the first quarter and then build, and that’s why we’re just thinking that the weighting would be slightly different this year.
Vincent Colicchio – Noble Financial
We’ve seen very strong growth in terms of smaller IT services contracts as customers try to get more value from their providers. I would assume that’s a good thing for your managed services business.
Would that be correct, and if so, I’d like your thoughts on that.
Michael Connors
Yeah. So I think—you know, we are very bullish on our managed services business.
We are the leader. We have a share of that market that is significant to ourselves, and our biggest competitor is the internal procurement departments out there.
I think we have done a very good job of educating our large clients on how our managed services can help them become even more operationally excellent, and we saw that with companies like Marriott last year with our very large managed services contract that we had with them. I think that the whole SIAM area, which is kind of what we call Service Integration and Management, has become and is growing also, which is where you’re tying together multi suppliers into a managed services type environment, and when there’s more, as you suggest, multiple contracts, it becomes more complex for companies and that indeed drives into our managed services value proposition.
So the multiple contracts, the multiple suppliers is adding complexity. The whole SMAC environment – the social, the mobile, the cloud, the analytics, the big data – all of that plays, I think, to our strengths.
Vincent Colicchio – Noble Financial
Okay, that’s it for me for now. Thank you.
Michael Connors
Thank you very much, Vince.
Operator
We’ll take our next question from Marco Rodriguez from Stonegate Securities.
Marco Rodriguez – Stonegate Securities
Good morning, guys. Thanks for taking my questions.
Just real quick, I wanted to follow up in regard to your guidance on the revenue side. The midpoint of your range kind of implies a 4% growth rate, which is a bit of a deceleration compared to fiscal ’13.
Is just a tough comp that you’re looking at, or is there something else driving that view?
Michael Connors
No, I think we always try to provide initial guidance that we are cautious on, number one. I think number two, I think what I mentioned on the Americas is I think coming off of three very large engagements where they’re now moving to a steady state, as I said, Americas will start off soft in Q1 and build their momentum, so short of that I don’t think there’s anything else to read into it.
Marco Rodriguez – Stonegate Securities
Got it, okay. And then in terms of Asia Pacific, if I understood you correctly, it kind of sounds like expectation-wise, we kind of see a flat first half of the year and then maybe it starts to pick up in the second half.
Did I understand that correctly?
Michael Connors
I think that’s right, although we do expect during the second half of the second quarter that it will begin to pick up, so depending on what, quote-unquote, gets recorded in the second quarter will determine that. But we are now seeing signs that the government is freeing up the dollars, and as I mentioned, just last week we got our first contract with the immigration department as they are now beginning to spend the money and focus on the efficiencies that the new government has mandated.
So it will just depend on the speed in which they begin to release these contracts, but it’s a good sign that immigration has now signed and we expect that to begin during the second quarter.
Marco Rodriguez – Stonegate Securities
Perfect, and if I heard you correctly, I think you said the end of the year was a headcount of 850. What are your expectations going into ’14 for that?
Michael Connors
So our major headcount areas will be in a few skill areas, so for example the new launch of our engineering services area. We are investing in some people ahead of revenue during the first half of the year, so you’ll see a little bit of that.
Managed services, you’ll see a little bit of that, and then certain skill gaps. So we’ll continue to be very cautious to keep our utilization levels as high as possible, and we’ll supplement it with skill gaps that we need.
So we do not expect a significant increase in our resource count, if you will, during the first half of the year.
Marco Rodriguez – Stonegate Securities
Got it. And then in regard to this new growth initiative on the engineering services side, are there specialized individuals you’ll need to hire in order to ramp that up, or is it a matter of sort of training some individuals that you currently have?
Michael Connors
Yeah, so first of all, I think just so we’re all talking on the same – I mean, engineering services, we think is a great opportunity to use the current skill sets that we have on sourcing, on sourcing strategies and our relationships with the suppliers, so we think we can take a lot of our core competency and apply it and complement it with a number of more technical experts in the engineering services area, which we do plan to bring on to staff during the first half of the year. So engineering services as we define it are tasks that tend to involve kind of non-physical acts, if you will, of engineering like preparation and design and consulting and work supporting engineering.
So if you think of an example, if you think about the design of a jet engine, that might be outsourced, which some of that is today. The actual building of the engine itself would not necessarily be.
That would be an engineering function. So what we are seeing, because a lot of companies have created captives over time for this, there’s a real opportunity for some of these large companies to monetize the captives they have with suppliers, with service providers, and we are the leader in helping clients understand how to manage and monetize captives.
So we think this is a natural evolution. It is basically not advised at this stage, or very under-advised at this stage, and being the leader in this space, we think we may have a significant advantage and that’s why we are pursuing the initiative.
Marco Rodriguez – Stonegate Securities
Got it. The competitors that you would be coming up against, would they be the usual suspects or are there a different set of competitors that you’ll be looking at here for those services?
Michael Connors
There is not much advise work, Marco, going on in this space that we can identify that has any kind of share at all, so we may be pioneering some space that has not been advised for a long time.
Marco Rodriguez – Stonegate Securities
Got it. And then, Mike, last quick question if I might – can you talk a little bit about what are going to be your top strategic areas of focus here for 2014, and then also what are the top risks that you’re monitoring?
Michael Connors
So in terms of our growth initiatives, number one, we are continuing to focus on building our recurring revenue streams as we want to build that to a 25% level, and then we’ll come up with a new goal. But we want to get to our kind of 25% level, so that’s number one, so that means our managed services, that means pursuing more research and analytic work, and certainly our government advisory channel where we have multi-year contracts.
So that’s number one. Number two is we think that the whole area of the service integration and management where there are now so many more multi-supplier relationships inside clients, the need to knit those contracts horizontally to integrate them is becoming a bigger need in the IT world, and we are there with our own SIAM practice to help in that area, so that’s an area, kind of number two that we have.
Three is to continue to build out our data, our fact base, our market intelligence, which is one of our key value propositions that we have with our client base. So those are areas that we are focusing on during the course of the next 12 months in addition to our new engineering services initiative.
Marco Rodriguez – Stonegate Securities
And the top risks you’re looking at and monitoring?
Michael Connors
The top risks is always the macro environment. Right now, the macro environment I think has somewhat solidified.
We certainly are seeing the clients and the demand in Europe is much greater today than it was even 15 months ago, so we’ll continue to monitor that to be sure that that environment doesn’t shift. In the U.S., I think the demand is still there.
There is still the whole Washington policies and what that means from immigration and some of these other things for clients, so we think that’s another thing that we can continue to watch and help our clients and guide them through it. So I would say the primary risk we watch right now is our macro environment, and be sure that we are using the levers we can if that environment should shift.
Marco Rodriguez – Stonegate Securities
Got it. Thanks a lot, guys.
Michael Connors
Okay Marco, thank you.
Operator
We’ll take our next question from Justin Ruiss with Sidoti.
Justin Ruiss – Sidoti
Good morning. I have a question with ESO, not specifically with that but just along the lines of a pipeline or something like that in terms of—you know, is this the start of one thing that’s in the pipeline for you guys that you’ll be pushing out on a kind of almost new services, new product base?
Michael Connors
Yes. This is very similar to when we invested during the back half of 2012 with the U.K.
public sector. We took our DNA and our expertise from our public sector and our FTA heritage from that acquisition in the U.S., applied it into the U.K.
market, used some of our current people, brought on and invested in some people ahead of revenue there. Very similar approach here as we’ve studied this market, as we’ve spoken to prospective clients, as the service provider community has suggested in helping pull us into this space to be able to provide a balance and an understanding and market intelligence so that there can be better decision-making in this space.
So we think it’s a new initiative. It will complement our core competency and we’ll complement that with some specialists from outside the company and we will bring them in.
So it’s a fresh initiative, it’s a start-from-scratch initiative like the U.K. was, like the managed services was a couple of years ago.
Too early to call it, but we’re excited about the possibilities.
Justin Ruiss – Sidoti
Perfect. Great, thank you.
Michael Connors
Thanks very much, Justin.
Operator
This concludes today’s question and answer session. I’ll turn the call back over for any additional remarks.
Michael Connors
Thank you very much, and above all I would like to thank all of our over 800 professionals worldwide for your continued passion and dedication for excellent performance during 2013. We are beginning to see the fruits of all of your efforts and it’s leading the way as we continue to build on our market leadership in the years ahead.
Let me close by thanking all of you on our call today for your continued support and confidence in our firm. Have a great weekend, and thanks for calling in.
Operator
This does conclude today’s presentation. We thank you all for your participation.