Zalaris ASA

OSE:ZAL

Earnings Call Transcript 2019-Q2

[Hans-Petter Mellerud]

Good morning. My name is Hans-Petter Mellerud, and I am the CEO of Zalaris. Thank you for joining us for this webcast presentation of Zalaris' 2019 Q2 results. Nina Stemshaug, our CFO, is also here to support me answering questions at the end of the presentation.Please observe that the presentation is being recorded. You will find a link to the recording on the Investor Relations part of our website.Let's go straight to the presentation. As usual, all numbers referred to are in Norwegian kroner, unless otherwise stated.Revenues in the first (sic) [ second ] quarter 2019 were NOK 188 million, representing a slight reduction year-on-year. Our operational EBIT amounted to NOK 4.4 million, giving an EBIT margin of 2.4%. Our strong market position was confirmed during the quarter with the signed renewals of long-term contracts with key clients like Nordea, Finnair, ABB and Bilfinger. With several new contract discussions and bids ongoing, the pipeline for the second half of 2019 is looking solid.As we continue to work towards improving our profitability, this is not compromising our growth capacity. We are strengthening our sales and marketing efforts significantly to capitalize on the continued strong market and boost revenue growth. As we disclosed in the presentation of our Q1 results, we have initiated several actions to improve our EBIT margin to a target level of 10% by ultimo 2019, that is going into 2020. We are on track to achieving this target, and I will give you an update on the progress and time line later in the presentation.Now let's take a quick look at the numbers. As mentioned, we achieved group revenues of NOK 188 million, a year-on-year decline of 0.7%. Our adjusted EBIT was NOK 4.4 million, up from NOK 1.5 million in the same quarter last year. This improvement is mainly driven by that our combined businesses post acquisition is stabilizing, with less resources spent on internal integration efforts. The decline in revenues and EBIT quarter-on-quarter is in line with normal seasonal variations primarily due to the reduced number of working days from Easter being in Q2 this year versus Q1 last year.Then let's look at our 3 regions. Northern Europe. Revenues grew 3.7% year-on-year to NOK 113 million, with the increase mainly driven by launch of new customers in Managed Services and annual recognition of project revenue. This region showed strong activity in terms of contract renewals in the quarter, confirming our strong market position.Central Eastern Europe. Revenues decreased by NOK 9.6 million to NOK 66.5 million in Q2 partially due to the Easter effect as previously mentioned. We are still seeing a negative impact of fewer consultants for our operations in Germany, but there was a positive recruitment trend in Q2 that has continued into the third quarter. U.K. and Ireland. The strong growth continues, with revenues more than doubling year-on-year to NOK 8.2 million. In addition to increased utilization, the positive pipeline trend in this region has really started to materialize.Let's take a closer look at the key financials in the second quarter of 2019. Revenues for Q2 amounted to NOK 187.5 million, slightly down from Q2 '18. In addition to the mentioned seasonal variations, our year-on-year growth was negatively impacted by a number of renewals of key contracts that carried price reductions. However, as always, these renewals include options for increased scope of work over the duration of the contract. They also ensure long-term recurring revenue for the company.Group EBIT for the quarter was NOK 4.4 million compared to NOK 1.5 million in Q2 '18. As already explained, the increased profitability year-on-year is mainly due to positive cost and efficiency effects of our combined business refocused on market-facing activities. The utilization of both internal and external resources for post-merger integration activities is now reduced to a minimum. The seasonal variations in the second quarter of the year negatively impacted the group profits in Q2 '19 compared to previous quarter.Managed Services shows a steady EBIT increase during the last 4 quarters both in nominal terms and margin-wise, although this varies in each region. Increased utilization of offshore resources as well as increased scope of work to existing customers and timing of recognition of project revenues contributes to this margin improvement. The Professional Services segment has improved utilization of capacity, resulting in an improved EBIT within this segment compared to last year. A high portion of capacity within this segment delivered services for project and change orders within the Managed Services segment in the quarter.Group EBIT for the first 6 months of the year was NOK 10.9 million, and the corresponding EBIT margin was 2.4% (sic) [ 2.9% ]. Currency effects impacted the year-to-date EBIT negatively with NOK 0.6 million and 0.1% margin-wise.Total assets amounted to NOK 724.8 million at the end of the second quarter of 2019, up NOK 96.4 million year-on-year, with the increase mainly explained by our refinancing in Q3 '18 and the adoption of IFRS 15 and 16 as of 1st of January. Equity decreased by NOK 5.5 million year-on-year to NOK 100 million at the end of the quarter. The decrease mainly relates to our ongoing share buyback program as well as currency effects. The equity ratio was stable at 14% during Q2. The adoption of new accounting standards had a negative impact on the equity ratio compared to previous year approx 2.4 percentage points.Net interest-bearing debt decreased from 214 -- sorry. Net interest-bearing debt increased from NOK 214.6 million at the end of the same quarter last year to NOK 308.7 million due to the increase in debt from refinancing. The increase of net interest-bearing debt since the end of financial year 2018 is due to negative cash flow in the first half of 2019. The cash balance declined in the quarter due to investment amounting to NOK 7.1 million. Ongoing investment projects mainly relate to new and improved functionality primarily in Zalaris portal and mobile app system solutions.We will then turn to the segments and add some further comments to explain details in our operations.For the Managed Services segment, revenues in Q2 '19 amounted to NOK 139 million compared to NOK 135 million same quarter previous year, a year-on-year growth of 3.2%. The growth reflects an increased number of employees served at existing customers in the Northern Europe region. There were also positive effects from the full launch of new BPO customers like Aker BP, DNB in the Northern Europe region and Statkraft in Ireland. The decline in revenues compared to Q1 '19 of NOK 4.3 million is, as already mentioned, in line with seasonal variation as additional year-end services to BPO customers are delivered in the first and somewhat fourth quarter each year.Revenues in the Professional Services segment decreased by NOK 5.6 million to NOK 48 million in this quarter compared to Q2 '18. The decline is mainly caused by a reduced number of consultants in Germany. In addition, a higher portion of the consulting capacity delivered services for project and change orders within Managed Services. The consulting capacity in the U.K. has improved its utilization and has increased its revenues compared to last year.Managed Services. The Managed Services segment had an EBIT of NOK 17.9 million in Q2 '19 compared to NOK 17.2 million in the same quarter last year. The segment has achieved a steady nominal EBIT increase in the last 4 quarters. Northern Europe and Central Eastern Europe showed increased utilization of offshore resources compared to both the same quarter last year and previous quarter and thus improved margins. In U.K. and Ireland, the segment had lower utilization, which is expected to improve in Q3 with the launch of new customers and increased scope of work to both Veolia and Compass.Professional Services. EBIT in the Professional Services segment amounted to NOK 3 million compared to a negative EBIT of NOK 0.1 million in the same quarter last year. The improvement is a result of increased utilization of consulting capacity for the group, although this has varied for each region. Compared to previous quarters, the EBIT declined with NOK 4 million as a result of seasonal variations, especially in Central Europe and U.K., Ireland.Now I would like to share with you an update to our EBIT improvement program. Our EBIT improvement program has started to show results. As communicated in our last quarterly presentation, our target is to improve our EBIT primarily through reducing monthly costs with NOK 4.7 million per month to reach a 10% consistent EBIT going into 2020. Key initiatives include full cost synergy realization from our acquisitions addressing both operational and overhead costs, simplifying our organization, increased use of near and offshore capabilities and converting internal-focused resources to market-facing capacity. As of Q2, we see the effects of around 14% of our target in our numbers. We expect to reach 40% of the target towards the end of Q3, 70% by the end of Q4 and 100% by Q1 2020.To better help you understand the priority and the effect of our initiatives, we have summarized our segment information in the following table, showing revenue per segment and region and the corresponding contribution from operation. Contribution from operation is a key KPI measuring the contribution from our regional business units, including all direct revenue, project costs, segment management, et cetera. For our Managed Services platform-based services, the cost composition is around 35% to 40% fixed costs, and the rest variable with revenue. For our Professional Services segment, approximately 90% of the costs are variable with revenue. And keep in mind that the majority of revenue in our Managed Services segment is recurring and based on long-term contracts. About 60% of the revenue in Professional Services -- actually a little bit higher, are coming from long-term application maintenance outsourcing agreements with customers that we typically renew before contract expiration. A key advantage of long-term agreements is that we can work on optimizing delivery arrangements over time and develop our relations through the offering of additional services supporting the customer strategy.Allocated regional and country overhead include sales and general and admin to manage our country and region, and these are fairly fixed/semi-fixed costs. Group overhead is the unallocated cost from the group and includes all group management and support functions. This is also a fairly fixed cost.We have identified 5 focus areas for our EBIT improvement programs then focusing on these numbers. First is to continue improving margin of our Managed Services organization through: Operate Managed Services as a global organization. This supports us in standardizing processes and standardizing delivery models, driving down costs. Then two, consolidate service centers to strategic locations. In other words, we are reducing the number of service centers and improve our cost positions. We are establishing a partner model to improve profitability of small-volume countries. We are also introducing Zalaris 4.0 operating model that better leverages scale and harmonizes service delivery for multi-country customers. And last but not least, we are stepping up our near and offshore ambition.The second initiative, focus on improving profitability of Managed Services in our Central Eastern Europe region, with the goal to reach the same levels as in Northern Europe. A key action is to consolidate our BPO and our AMO services to our Leipzig innovation center. Another large project is to consolidate our 2 customer-facing SAP infrastructures into 1 based on the Zalaris cloud solution. This will reduce direct costs, improve security and free up resources that can be turned into market-facing capacity. This project is ongoing since summer.Then utilizing our near and offshore capabilities is another key action. Currently, only a small amount of our service operations in Germany and Poland is offshore. Certain key customer contracts have been renegotiated to better rates, resulting in better margins. And last but not least, we see our German operations in a great position to utilize our robotic process automation capabilities as another way to improve operational efficiency.Looking at the Central Eastern Europe region, it is apparent that regional and country management costs are too high for our current trading volume. We have initiated a number of activities to reduce this, including moving the finance and accounting function into our group shared services organization where a large part of the accounting activities are performed offshore. We are in the process of consolidating 6 legal entities, of which 4 in Germany and 2 in Poland into 2, 1 for each country. Needless to say, this enable us to simplify structures and reduce administrative and audit costs, and this is an ongoing process. Another important point is to focus our product and service portfolios such that we use our business development and implementation resources to our core offerings and thereby strengthen sales and marketing.We are experiencing good demand in the German market for professional services and are working actively to build on our position. In Q2, we have initiated work to organize our Professional Services unit as a global business unit similarly as our Managed Services unit. The Professional Services unit is led by our Central Europe Executive Vice President, Harold Goetsch. Our goal is that this will enable us to better utilize our capabilities across the group. We will continue recruiting to support demand. As a result of integration of our businesses in Germany, we have lost some people. This has now stabilized. And we are seeing a positive inflow of new capacity, as previously communicated, now with 12 new resources just in the last couple of months alone. With the strong demand, we are also able to increase hourly rates with both new and existing customers. And this is a new trend in Germany and hasn't happened for a long time and is a very good sign, as again it has been very difficult in the past. Using Professional Services capacity from our offshore locations, particularly related to the configuration and maintenance of SuccessFactors, is another key area of focus.As you have seen, our unallocated group overhead of around NOK 18 million for the first half year is another position we have set targets. A key element is consolidating and moving more of our group support functions to our head office and near and offshore locations. Streamlining and renegotiating agreements with existing suppliers is another obvious action that we have initiated with significant suppliers. Addressing a large cost component, as travel expenses, is another one.So to sum up. The key priority for Zalaris in 2019 remains to return to margin levels from before the 2017 acquisitions. We are on track with our target to produce a consistent 10% EBIT going into 2020. There are several ongoing initiatives to increase efficiency and reduce costs. At the same time, we are increasing our sales and marketing efforts to capitalize on continued strong demand for outsourcing in our core markets and boost revenue. Zalaris currently expects to achieve moderate revenue growth year-on-year in 2019 and full effect of cost-cutting programs from Q1 2020.Thank you for listening, and we will open up for questions.

[Unknown Executive]

Thank you, Hans-Petter.We now open up for questions. Please note that you can also submit questions through [e-mail].

[Unknown Executive]

Now to the first one. Hans-Petter, can you expand on how the competitive landscape has evolved for your business in the last 12 months and also what you expect in terms of consolidation activity in the industry going forward?

[Hans-Petter Mellerud]

In general, I would say we haven't seen that much change in the competitive landscape, but we see a shift in customer priorities from doing -- from focusing more on implementing, say, cloud, new cloud solutions. And then I think that's -- and in that segment, we see a different set of competitors than those that we have been used to work with in the past.

[Unknown Executive]

Your activity in the U.K. continues to show strong growth. Can you point to any special factors driving this positive trend for this segment?

[Hans-Petter Mellerud]

Yes. I think in the U.K. we have an extremely competent and motivated management team in place that are really cutthroat focusing on developing our business. We have refocused and -- our business. Also we have brought the Zalaris portfolio of services and been able -- together working with the U.K. team, we have been able to generate a common understanding of our targets. And we see very positive results particularly in our pipeline, in selling the -- say, the core Zalaris' cloud and BPO solutions into the market. And this has really invigorated the U.K. team. And we see -- we're very positive to the potential in the U.K. at the moment.

[Unknown Executive]

What is the capacity for the existing organization in U.K. to continue this growth?

[Hans-Petter Mellerud]

Well, I think the U.K. organization has needed capacity. And it's under continuous, say, outlook to build additional capacity when needed. But I think we are also -- a key recognition in also reaching our targets is that we must be better at managing, say, resources and utilization of resources to demand. And I think at the moment, the U.K. team has been able to find a pretty good model in balancing this with a good composition of their existing workforce.

[Unknown Executive]

Thank you. That's concludes the presentation. We will report back in October with our Q3 report.

[Hans-Petter Mellerud]

Thank you. And again, if you have any further questions, do not hesitate to contact us via [e-mail]. Thanks a lot. Thank you.