Totvs SA

BOVESPA:TOTS3

Earnings Call Transcript 2018-Q4

[Operator]

Good morning, and welcome to TOTVS conference call to discuss the results for the fourth quarter and full year 2018. With us today, we have Dennis Herszkowicz, CEO; and Gilsomar Maia, CFO. [Operator Instructions]

The audio is being simultaneously webcast at ri.totvs.com.br.

Before proceeding, we wish to clarify that any forward-looking statements made during the conference call related to the business outlook, operational and financial projections and targets of TOTVS are based on beliefs and assumptions of the company's management as well as on information currently available. Forward-looking statements are not guarantee of future performance. They involve risks, uncertainties and assumptions as they refer to future events, and hence, depend on circumstances that may or may not occur. Investors should understand that general economic conditions, industry conditions and other operational factors could affect the future performance of TOTVS and could lead results to differ materially from those mentioned in such forward-looking statements.

I will now turn the call over to Mr. Dennis, who will begin the presentation. Mr. Dennis, please go ahead.

[Dennis Herszkowicz, executive]

Good morning, everyone. Thank you for participating in our conference call. As highlighted on Slide 3, on November 26, the company announced to the market my election as the new CEO, and the election of Laércio as the new Chairman. I am very pleased with this opportunity to lead the largest software company in Latin America, and I am also confident that we are starting a new and very successful journey for TOTVS. Today is my 80th day at the company, and I am having the pleasure of sharing with you the performance in the fourth quarter and the full year of 2018.

First of all, the company approved the payment of interest on equity of BRL 13.1 million, corresponding to BRL 0.08 per share to be paid on May 9, 2019. With this resolution, the payout in 2018 was 77%.

I now hand over the presentation to Maia for his comments on the quarterly results, starting from Slide 4.

[Gilsomar Sebastião, executive]

Thank you, Dennis. Good morning, everyone. Software revenue grew 8.2% year-on-year in the fourth quarter and 5.9% in 2018, accelerating strongly compared to the year-on-year growth of 2.7% in 2017. As a result of this acceleration, software revenue surpassed the mark of BRL 2.1 billion in the year. This performance of software revenue is largely due to the recurring revenues, which came to BRL 1.5 billion in 2018, growing 5.6% year-on-year in the quarter and 5.4% in the year, mainly due to the sale of subscriptions and license, which generated new maintenance revenues and inflation pass-through during the period. In addition to license revenues, the pace of services sales and increased efficiences in project deliveries also contributed to the year-on-year growth in nonrecurring revenues of 16% in the fourth quarter and 7% in 2018.

Now moving to Slide 5, we have the annual recurring revenue, which came to BRL 1.7 billion in Q4 '18, up 3.3% from the third quarter and 8.3% from the fourth quarter '17. These amounts represent the net addition of BRL 55.8 million in the quarter and show the company's sales capacity to expand its solid base of recurring revenues, which reflected in the client renewal rate of 97.9% this quarter.

Recurring revenue in the company's premium revenue stream is directly related to the scalability of this software business model. As you can see on Slide 6, recurring revenue growth accounted for 2/3 of the absolute growth in the software revenue in 2018. The acceleration in software revenue growth associated with greater operating efficiency led to adjusted EBITDA growth of 17.9% with adjusted EBITDA margin of 16.4%, increasing 160 basis points from 2017, which reflects the recovery of our software margin.

Software costs increased 3.3% in 2018, lagging the growth in software revenue of 5.9%, resulting in the increase of 90 basis points in gross margin in the year. The increase in gross margin resulted from the greater efficiency in service and project deliveries, despite the additional costs incurred over the year in support activities to meet increased demand arising from the new regulations implemented during 2018.

Total software expense also increased at the lower pace compared to software revenue, reflecting the gains in operating efficiency in selling and administrative expense, despite the negative effects of increase in research and development expense related to investments made in innovation during the period, development efforts related to new regulations and the FX rate impact on the structure of TOTVS Labs' in California, and also provision for contingencies. Compared to the previous quarter, the 13.3% decline in adjusted EBITDA mainly reflects seasonal effect such as salary adjustments we've seen from collective bargain agreements and expense with advertising marketing campaigns, in addition to the lower level of nonrecurring revenues and higher concentration of provisions for contingencies in the quarter.

Moving to adjusted net income on Slide 7. You can see that year-on-year growth is mainly due to the increase in adjusted EBITDA and the decline in amortization expense. Compared to the previous quarter, the decrease of 18.4% in adjusted net income reflects the seasonality inherent to the period as evidenced from the decrease in EBITDA, which was partially offset by the improved net financial results and the reduction in effective income tax rate.

On Slide 8, cash flow and debt. You can see that free cash flow grew 13.5% year-on-year in 2018, primarily due to the 29% increase in operating cash flow generation, in addition to higher investments in acquisition of equity interest and fixed assets in the period. The decrease of 30 -- of 23% in free cash flow compared to the previous quarter is mainly related to seasonal effects, as already mentioned for EBITDA in Q4, in addition to the seasonal increase in working capital investments due to the payment of 13 salary -- of 13th salary, vacations and taxes.

Finally, net debt decreased 84% year-on-year and 51% quarter-on-quarter. The decrease resulted in a ratio of 0.1x net debt to the last 12 months adjusted EBITDA. Despite a payment of dividends and interest on equity, which is reflected on that cash from financing activities in Q4, which appears in the company's solid financial position and readiness for new growth cycles.

I now turn the presentation back to Dennis for his closing remarks on Slide 9.

[Dennis Herszkowicz, executive]

Thank you, Maia. In 2018, TOTVS resumed the acceleration of software revenue organic growth, which came to 8% in 4Q '18 and 6% in the year, despite an economic scenario of slow and gradual recovery. The acceleration of revenue associated with greater operating efficiency led to an increase of 18% in adjusted EBITDA from software in the year and the increase of 160 basis points in EBITDA margin from software.

The software operation is the priority for TOTVS, and we will continue to invest in it. That's why we have started to report software and hardware results separately down to the EBITDA margin. The results show that TOTVS has already built its subscription model that combined with its licensing and maintenance model represents a solid base of recurring revenues, which have already surpassed BRL 1.5 billion in 2018 and accounted for 73% of software revenue combined with high levels of client renewal rates.

Accordingly, we have prepared ourselves for a new growth cycle, sustained by a better -- by the better and broader portfolio of management solutions available, besides seeking opportunities in new markets, which will enable us to advance in the value chain of our clients.

Finally, the significant progress in our financial position in 2018 with an increase of 14% in free cash flow and the ratio of net debt to EBITDA of 0.1x has left us prepared to take advantage of new inorganic opportunities.

We started 2018 focused as usual on the satisfaction and success of our clients, maintaining the entrepreneurial spirit and believing in our view that makes it happen, innovate and produces. This energy of making it happen, delivering on our promises and even redoing, if necessary, always in a smart and balanced manner, will be put into each move, customer interaction, sale and projects we work on.

Now -- we are now available for the questions and answers session. Thank you.

[Operator]

[Operator Instructions] Our first question comes from Guilherme Haguiara with Bradesco.

[Guilherme Haguiara, analyst]

My first question is regarding the recurring service revenue, which -- I mean, we know that there is some part of was previously just under service revenue that's now part of the recurring. And we would just like to have some more visibility on what type of revenue this comes from? And what would be the margin differential between the recurring service revenues and the pure software margins?

[Gilsomar Sebastião, executive]

This is Maia speaking. So actually that recurring revenue was already disclosed in previous quarter. And the difference between the total recurring revenue we have putting together maintenance and subscription in the total software recurring revenue is related to some recurring software revenues -- services revenues that we sum up together there. Those revenues are related to services like Cloud services, AMS, so Application Management Software services, and also services related to managing customization. So things that -- when a client subscribes software-as-a-service, those services are already part of our subscription fee. So in terms of nature, we are talking about revenues with the same characteristics. So in the end, we're putting together things that have a similar profile is related -- they have a much higher margin comparing to all the traditional implementation service. So overall, it does not change that much the visibility we have in terms of profitability of our recurring margins. And also the remaining services that you see as nonrecurring, they're more specifically related to implementation services. Does that make clear, doesn't it?

[Guilherme Haguiara, analyst]

Yes, yes, that's very clear. And if I may just have a follow-up question. As we are kicking off 2019, we were wondering if you have already seen some improvement in the day-to-day negotiations with clients and if you have seen the better sentiment in results turning into actual contracts? And also, if -- when we look at the renewal rate you're showing for 2018, how much of that was related to client mortality? And how can that improve with a better macro scenario?

[Gilsomar Sebastião, executive]

Okay, good. So the -- first of all, it's important to call your attention to the delinquency rate we had in the quarter that was much lower than we had in previous quarter. And in previous quarter, specifically, we have some relevant accounts that individually they affected negatively the results, but excluding those exceptional cases, we were seeing the declining of the delinquency rates. Those delinquencies are positive in terms of results for this quarter specifically. And connecting that with our renewal rate, we see that level of activity on a quarterly basis is not so relevant, in our view. So because we have a very high retention rate, so close to 98%, 98.5%. So it's really high retention rate. A portion of that is, as you mentioned, related to mortality, you're right. So if we allocated 100% of that -- of renewal rates in the policy that might be even low, but of course, it's not totally related to mortality rate. But a relevant portion of that is related to mortality, yes.

[Dennis Herszkowicz, executive]

Just to complement what Maia said, the reason -- the main reason for us to put the renewal rate starting in this quarter, and we will do it in other -- the coming quarters, it is because we want the market to know that we have a very high level of lock-in with our clients. That -- the main reason for us to lose a client is to lose because the client is closing its door. So if you consider 98%, 98.5%, which is the average that we had in the last 4 quarters that we provided the information, I mean, it is a very high level considering that there is a natural rate of mortality among more than 30,000 clients that we have. So regardless of what we do, that will be a minimal amount of mortality among the clients. So when you put these into perspective, I mean, again, the main message here from us is that the level of lock-in that we have with our clients, and obviously, this translates into the level of recurring revenues that we have is very, very high and very, very healthy.

[Operator]

[Operator Instructions] Our next question comes from Eric Wolff with TOTVS (sic) [ Hawk Ridge ].

[Eric Wolff, analyst]

A few quick questions on some of the new disclosure, which is helpful, on especially breaking out the software margin. I think, last year, it looks like you had some improvement, I mean, 16% -- going to 16% from 14%. I think if we look back previous weeks -- the deal, you were at kind of at mid-20s. Dennis, how do you see the margins trending in software over the next couple of years? And do you think it's feasible to get back to historical profitability levels there?

[Dennis Herszkowicz, executive]

Eric, This is Dennis. Look, it's may be a bit early to give the visibility for 2 years, but I can say to you that I feel that the trend is positive. I mean, we have been increasing the software margins. It was very important for us, as we said, to start to report the EBITDA margins down to the separation between software and hardware because, obviously, right now, the hardware is a drag on the consolidated EBITDA margin. So yes, I think that the trend is positive. It's very difficult to say exactly what we envision for these 2 years, but the message is positive that we see room for improvement.

[Gilsomar Sebastião, executive]

Eric, it's a good complement. This is Maia speaking. As Dennis said so, of course, it's hard to give you exactly the course of our margin, but if you take a look on the full year figures, there's some message in that. In my view, especially related in terms of cost control that was 1 year that we could show more clearly the efforts made here in order to have a much stronger control on costs. Of course, taking as advantages on actions we took in 2017, in terms of integration of our operations, but if you take a look on our software revenue growth that was about 6% in 2018. And our total expenses grew about half of that. So even though our provision for delinquency and contingencies came very -- in a very high pace. So even considering those provisions in a high level, the total expense came about half of the growth of top line. So it's still too early. We see no reasons to say that the margin will not grow. So of course, the natural process of softwares are very scalable business is to see a margin improvement all the time.

[Dennis Herszkowicz, executive]

And just to add to what Maia said, Eric, of course, we do have -- we continue to have room for improvement in cost control, synergies and so on. So yes, there is room for this and -- if it comes during the coming quarters, as it has come in the previous quarters as well. But the main focus will be and this message is very important to be clear, the main focus of the company will be on growth. I mean, as Maia said, software is a very scalable business. If we accelerate the growth, if we find the new streams to generate additional recurring revenues for the company, this by itself without any cost control, but obviously, it has cost control and synergies, it will be even better. I mean, just the acceleration in terms of the top line growth, this will result in better margins if it is based on recurring revenues.

[Eric Wolff, analyst]

Got it. That's very helpful. One quick follow-up to that. Can you give any commentary, I know it's early in the year, but it seems like a lot of the kind of macro indicators in Brazil have gotten materially more positive over the last few quarters -- I'm sorry, over the last, I guess, 2 or 3 months in particular, didn't show up a ton this past quarter. Just curious any comment you have looking out into this year, any thoughts on potential acceleration in license revenue or recurring revenue?

[Dennis Herszkowicz, executive]

Okay, Eric, this is Dennis, again. Look, to be honest with you, I think that the performance in terms of revenues and sales in the fourth quarter was not, obviously, great. But it was a very decent performance in terms of software. I mean, the acceleration of the growth to more than 8% organically when you compare with the fourth quarter of 2017, I mean, again, considering the low level of inflation, still low level, the low level of economic activity during the whole year, and even in the fourth quarter with the election and so on. I mean, very honestly, I think it was a decent performance in terms of revenues and of sales for software. Obviously, if we took -- if we take into consideration, hardware it is what it is. Looking into this year, as we said in the Portuguese call, I think that the first outlook is good. We had our sales convention in the second week of January. The energy there was very, very positive. I was very impressed with what I saw. I mean, more than 2,000 people that represent the full distribution platform of TOTVS. Both our own offices and obviously, the franchisees as well, the channels. So I think that we will have a better year in 2019. It is still maybe too early to say how better it will be, because unfortunately, in the last 2 years, we thought that -- we all thought that the economy would really improve and it didn't, at least not as much as we thought. So we hope that this year is better for the economy. And in any case, I think that this year will be better for TOTVS. It's simply difficult to say precisely how much it will be this year.

[Gilsomar Sebastião, executive]

And as a quick complement, again, even with this macro scenario in 2018, mentioned by Dennis, we grew 6% organically in software. Of course, it's not the growth rate of our dreams and it doesn't translate a potential of our company market. But it's more than the double that we grew in 2017. So even with that economy scenario -- economic scenario, we were able to accelerate the growth of the company. And when you look at the annual recurring revenue, you see also that we had a good performance in Q4, very strong one, and that's coming especially from the new sales we closed in that quarter, especially after the election process ended and also coming from new clients and new accounts we closed in that period. So we are optimistic about the future. Of course, we have to see more that general optimism in the market being translated into more -- transactions into more deals. But in general, our sales, people and clients are more optimistic about the year.

[Eric Wolff, analyst]

Okay. And if I can, just one quick final one. The -- Dennis, you talked a little bit about all the opportunities you see within TOTVS to potentially grow out additional products. I know you kind of hinted at fintech offering at some point, perhaps I think in one of the answers in the morning called out potential payroll opportunities. It just seems like there is a lot of untapped opportunity. Just curious how you're thinking about attacking those opportunities and when we might get a clearer picture of what you have in mind there?

[Dennis Herszkowicz, executive]

Sure, Eric. Again, look, yes, there are lots of opportunities. We mentioned payroll and obviously, it is one of the main opportunities that we have, considering that we cater to around 1/3 of all the registered payrolls in the entire country. I mean, we are talking about -- around 10 million employees having their payroll processes in our softwares. So yes, this is one of the opportunities, but it is not the only one. I mean, what we have here is the opportunity to, on one hand, continue to protect and to improve the core that we have with the copies and payroll, also to synergize and to deepen our knowledge and our solutions in terms of the segments in which we operate. And on the other hand, obviously, look for additional cross-selling opportunities that we have inside this huge base of clients. I mean, we are talking about more than 30,000 clients, which had revenues -- combined revenues of more than BRL 1.6 trillion in the last 12 months. I mean, this is 1/4 of the GDP of the country that are being processed in our solutions. But the -- I mean, the opportunity goes beyond this score, goes beyond these segments, goes beyond these cross-selling opportunities and it means that we have new markets in which we can operate. So this is one of the things that we will start to focus from now on. Never forgetting about these platforms that we have. I mean, all the new opportunities, all the new markets in which we will operate, and fintech, obviously, is one of them, they have to be connected and they have to leverage on this platform of core and segments that we already have. This is the main stronghold that we have. The 30,000 clients, the BRL 1.5 billion in recurring revenues, the level of relationships that we have with our clients. And obviously, the distribution platform that we have with our own offices and the dozens of different channels that we have all over the country.

[Operator]

Our next question comes from Guilherme Haguiara with Bradesco.

[Guilherme Haguiara, analyst]

Just touching upon the importance of growth you've mentioned and also in the Portuguese call, in the release you mentioned that education and agribusinesses grew quite considerably. And we were wondering how much of these relatively smaller segments within your portfolio can add to overall growth with an accelerated performance? What is the strategy in these niches? And on a more broader aspect, how can we can see a pick up in the corporate market in the license sales already in the first quarter?

[Dennis Herszkowicz, executive]

Guilherme, this is Dennis again. Look, in terms of the segments, obviously, this is a stronghold, this a strength that TOTVS have. I mean, to operate in all these segments is very, very important, gives us a lot of opportunities. It helps us whether the different economic scenarios that we have. So we are not focused in just one. And if this one segment does not perform, we will suffer as much as the segment. So this is a strength. But on the other hand is the other side of the coin. Obviously, when you have maybe 10, 11 segments, you don't necessarily have the focus and the resources to be the leader and to be the best guy in all of the segments. So right now, we are, obviously, analyzing and discussing which segments we are good enough, which segments deserve our attention, our focus and our investments. It might be that all of them do. It might be that a portion of them do. It might be that we want to be in all of them, but we accept that we will be leaders in some -- and not necessarily leaders, and we will adjust the level of investments in some of them. We still don't have the final answers on this regard. I think it's too early, at least since my arrival here. It's not that we were not analyzing these before, obviously, we were. But since I arrived, I wanted to take a deep dive in all of these analyses. So maybe in the short to medium term, we will come to the conclusions in this regard. And I am very confident that we will find the right answers and that we will leverage in the segments that we feel that we have the best portfolio and that we have the best expertise and opportunities for this leverage. Specifically, in terms of the education, just as an example, we have a very, very good market share in terms of higher education -- in education. So this means that we have, for example, more than 3.5 million students using our solutions, schools and universities using our solutions. This is a huge opportunity, for example, in terms of feedback. The level of penetration for credit cards in this payment, in this TPV is close to 0. So it's a huge opportunity. So in addition to all the opportunities that we have in selling the core solutions and selling the software-focused solutions that we have, in addition to all these, we also have the opportunities for new pockets, for new moneys inside the budgets of our clients, to advance in the value chain that we provide to them and to capture a higher level of take rate among the expenditures of these clients. With regards to license sales, I don't know if Maia wants to add to this.

[Gilsomar Sebastião, executive]

Okay. So in the last 2 years, we had a very, very strong performance of corporate model in Q1. If I'm not wrong, it was like 30% over 30% sequentially in the last 2 years. I see as -- which was probable to see a growth in that pace. It's always important to remind that corporate module has an incremental license fee just when clients grow. So if I -- even if I'm not having growth that way in terms of incremental license revenue in Q1, it doesn't mean that clients didn't grow. So for sure, we would have an incremental licensee being charged. I don't believe we will have that pace of growth we had in previous years. But I believe we have a reasonable level of incremental license fees from corporate model in Q1.

[Operator]

[Operator Instructions] I would like to turn the call back over to Mr. Dennis for his closing remarks.

[Dennis Herszkowicz, executive]

Well, I want to end the call on a positive note to give an optimistic message to all of you. Obviously, to thank you all for participating and for the confidence in the company. And this positive note comes from the fact that I have found here a great company, a company with lots of strengths represented, as I said, by more than 30,000 clients that it has, the more than BRL 1.5 billion in recurring revenues that it has and it's been accelerating these recurring revenues. But also about the team that I have found here. I mean, the team is a very, very confident team. It is a team that is motivated that is looking for a new growth cycle, and I hope that I will be able to help this company and this team -- this magnificent team to enter into this new growth cycle. So again, thank you very much. We will be available for the questions. Thank you. Good day.

[Operator]

This concludes TOTVS conference call for today. Thank you very much for your participation, and thank you for using chorus call.