Zalaris ASA

OSE:ZAL

Earnings Call Transcript 2022-Q2

[Hans-Petter Mellerud, executive]

Good morning. My name is Hans-Petter Mellerud. I am the CEO of Zalaris. Please do also welcome our CFO, Gunnar Manum, who is here with me today for this webcast presentation of Zalaris Q2 2022 results.

We are using Teams for this purpose and hope that we will deliver on your expectations. There is a Q&A function that you can use to ask questions that we will respond to 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 part of our website. Without further ado, let's move on to the presentation.

Let's first look at the highlights of the quarter. The NOK 150 million of annualized contract value that we sold last year continued materializing as recognized revenue in Q2 as planned. This resulted in an all-time high quarter to date with a revenue of NOK 210.2 million, representing 15% growth from Q2 last year in constant currency. Add to this almost NOK 17 million deferred revenue from implementation projects, up from NOK 11.4 million last year; and the signing of StoraEnso, who immediately enters our top 10 largest contract list; and a continued strong pipeline, you find a Team Zalaris that continue experiencing success in the market.

We delivered an EBIT of NOK 10.2 million or 4.9% before costs related to investing in greenfield establishment in the Asia Pacific region, or APAC, of NOK 3.4 million. EBIT margin was temporarily negatively affected by onboarding of new customers, recruitment and training and optimization of resources to handle the increased volumes going forward. Margin is expected to improve in H2 this year from the utilization of built-up capacity and a cost reduction program to deliver on our 10% target.

We see excellent progress in the pipeline of opportunities in our new geographical region, APAC. Our first major contract was signed this month for the implementation of a PeopleHub-based HR solution for seafood company, Sealord. With this, EBIT contribution from APAC is also expected to be positive from Q3 this year. With the strategic redirection of vyble completed, we have engaged an investment bank to divest the company. We believe a new owner with a dedicated SME focus can faster realize vyble's market potential and allow Zalaris to focus entirely on its PeopleHub and SAP-based mid and enterprise market where we currently experience strong demand.

As already mentioned, Team Zalaris in Q2 continues its win streak in the market. In the Nordics, we signed Finland-headquartered StoraEnso. Stora is a leading global provider of renewable solutions in packaging, biomaterials, wooden construction and paper. We are transforming Stora's transactional HR function through implementing Zalaris' PeopleHub payroll and time fully integrated with their global Workday-based HR solution to serve their 6,000 Finnish employees. 19 FTEs transferred to us in June, and Stora moves straight into our top 10 [ deal list ], as previously mentioned, and immediately strengthened our position in the global production industry vertical. Revenue effect, however, with moderate margins in the transition phase is included from June.

In our new APAC entity headquartered in Sydney, Zalaris, along with our local partners, signed now in August a 5-year contract with Sealord to provide a full suite of HRIS solution as a part of their HR transformation program. Sealord is one of the largest seafood companies in the southern hemisphere with over 1,200 employees across New Zealand and Australia. We will deliver our leading PeopleHub solution powered by SuccessFactors to Sealord.

In Poland, we added significant new additions to our agreements with Hitachi Energy and ABB for global Application Maintenance Services. In Germany, we won a new 4-year agreement with German state Rhineland-Pfalz for Application Maintenance Services with an estimated annual contract value of NOK 20 million. Managed Services Germany experienced rapid increase in demand, resulting in a solid pipeline of deals in contracting stage, delivering between NOK 20 million to NOK 60 million of annual contract value. We are happy to report that we yesterday closed one of these deals with Italian hearing aid manufacturer Amplifon for the provision of PeopleHub-based payroll services to their 2,100 employees in Germany, to be fully integrated with Amplifon's Oracle-based global HR solution.

So let's take a look at our segments. Managed Services revenue grew by 22% compared to last year when adjusted for currency movements. The inclusion of ba.se added 9.5%, while 12.5% relates to new customers and volume increases. Net new signings with annual recurring revenue amounted to NOK 14 million during the quarter. Churn was immaterial, and we have renegotiated agreements in Germany at improved rates. More than 90% of revenue is recurring based on long-term agreements, while the remaining somewhat less than 10% relates to change orders. Leaving the quarter, our pipeline continued to stay strong in all markets. And let me repeat that we are well underway to secure our target of additional NOK 100 million recurring annual contract value this year, supporting continued delivery of our 10% organic growth target and becoming a NOK 1 billion company in 2023.

Then it is time for Professional Services or our consulting practice. Adjusted for currency movements, Professional Services revenue were in line with the levels last year of NOK 58.6 million, down from the previous quarter mainly from Q2 having fewer working days due to Easter and public holidays. Add to this, deferred project revenue from supporting Managed Services implementation project of approximately NOK 17 million for the quarter. We strengthened our resource situation, adding several trainees and associate consultants, contributing to healthier cost levels. In addition, we added significant resources in our Poland and India delivery centers. This has short-term impact on our margins but will allow us to increase change order revenue and reduce the use of expensive external consultants, resulting in improved margin in quarters to come.

And again, let me remind you, in Professional Services, we see that the Application Maintenance Services, AMS, helping customers maintain their payroll and HR systems mostly on long term or subscription basis, continue generating more than 55% of our total revenue. We are progressing well in developing AMS services as a group-wide offering out of our Polish Professional Services practice, as mentioned earlier, with new significant wins with Hitachi and ABB and services sold to the [ likes as Rhineland ] last quarter. Our long-term relationship with customers continued being visualized through 84% in our Q2 revenue in this segment coming from customers that were also customers in Q2 last year.

We are continuously evaluating how we can scale our platform investments through gaining access to new markets with the aim of strengthening our multi-country payroll value proposition and be seen as a player with global capability. Research from Everest show that 64% of European-headquartered multi-country deals had an Asia Pacific footprint. We increasingly see these opportunities coming our way. Many of our existing customers do have significant footprint in APAC. To date, we have mainly entered new countries following our customer strategy. Finland, Poland and Ireland were established in this manner. The challenge with this strategy is that unless the customer has sufficient scale, margins will be diluted until you reach critical mass. This requires winning new customers in a country where you most often are relatively unknown, it can take time.

Another alternative is to establish [ versus ] greenfield and leverage our partnership with SAP, selling and implementing cloud solutions based on SAP success factors, making our brand known and generating customer relationships that later can be converted into managed services and be a [ base over ] incoming multi-country deals from our existing organization.

With our new operations in Australia and Singapore, we are attempting this. With a 20-plus year industry veteran, Mike Ellis, in the role as Executive Vice President, APAC at the helm, we now have an experienced 16-person team in the region that has started selling our services. In addition to our first agreement with Google Australia sold in Q1, we closed deals with Sealord and learning company Go1 now in August. In addition, we have secured some hourly based consulting work to ensure utilization of our team. In Q2, we have significant one-off costs setting up the unit. We expect positive EBIT contribution from APAC now in Q3.

We acquired vyble earlier this year with an ambition to become a significant player in the German SME market. During the second quarter, Zalaris stabilized the business and focused vyble on being a SaaS provider, selling directly to customers and through partners. Target is to grow to a run rate of EUR 2.5 million in revenues by end of 2023, which is the level at which the company will be cash flow positive. With renewed focus and a revamped website, we see increased sales and higher conversion rates in both sales channels. We believe in the great potential for vyble going forward, addressing the huge EUR 3.2 billion German market.

However, for Zalaris, we have realized that it is important to focus our resources on our fast-growing PeopleHub and SAP-based core business serving the mid- and enterprise market. We have, therefore, decided to divest vyble and seek a partner to support funding vyble to faster realize its potential. We have engaged an investment bank and aim at closing a transaction by Q4 this year. vyble is therefore reported as an asset held for sale and therefore not included in the reported revenue and EBIT numbers.

Let me remind you again what a company Zalaris has become. Our business model with long-term agreements and recurring revenue is favored among many investors. We have offered Software as a Service, business process as a service and outsourcing delivery models since we were founded 22 years ago. And to reiterate, more than 90% of revenue in Managed Services and around 55% of revenue in professional is recurring.

Delivering payroll and HR services based on one common IT platform, the Zalaris PeopleHub, supported by local competent resources has been key to success and 22 years of growth. We are being seen as one of the leading global players in our industry. From the outset, our goal was to help customers reduce their direct process costs by 20% to 30% by outsourcing their payroll and HR processes to us, at the same time, enabling them to operate seamlessly across borders. Our approximately now 990 employees deliver services from 16 countries. In addition, we can deliver to 150 countries through partners with our PeopleHub concept.

Our short-term aim is to deliver services with own solutions and service centers for all European economic area and G20 countries. We see large companies across the globe prioritize investments toward solutions that enable unified access to payroll and HR data for analytical purposes, digitization of workflows, reduction of costs and securing business continuity of business-critical payroll. Working from anywhere has become the new normal, driving the need for fully digitized people processes. Team Zalaris is extremely well positioned with our innovative product and services portfolio that cover the whole payroll and HR value chain.

Our services are built around our PeopleHub concept, enabling customers to manage their human capital across borders in one common cloud-based system solution with functionality covering the whole employee life cycle. The solution is offered as Software as a Service with various layers of business process as a service and outsourcing and can be integrated to all major global HR solutions.

Our organization is structured in 2 business units. Managed Services deliver solutions and services based on PeopleHub. Professional Services is an SAP partner focused on advisory and implementation services of the SAP Human Capital Management suite and S/4HANA product portfolio. Professional Services is also responsible for implementing new Managed Services customers. Managed Services currently accounts for 2/3 of our revenue and is growing more than 15% per annum. Professional Services products, the remaining -- produces the remaining 1/3 of revenue and is growing in single digits.

Our largest market unit is Germany, delivering 35% of revenue. Germany and the U.K. are our markets with the largest potential. In addition to being about 7x size to our Nordic home market, a higher number of sweet spot customers with more than 1,000 employees are located here. We see strong growth in the Managed Services from Germany as our brand is increasingly better known. Poland and U.K. are our fastest-growing market units. Poland has doubled revenue since our acquisition in 2017 and is now 100 employees plus strong. Poland is particularly excelling in professional services and application maintenance segments. U.K. is rapidly turning into a more Managed Services-oriented organization from experiencing strong interest in its cloud and outsourcing offerings. The Nordics is still generating more than 50% of our revenue, delivering continued solid results and recurring revenue growth.

This is a slide that reminds me of what fantastic customer base we have. We have a diverse portfolio of customers in most industry segments, some of the leading brands in the regions where we operate, many of these with a significant upside in supporting them in continuing digitizing their people processes, simplify work life and achieve more.

With this, I hand over to our CFO, Gunnar Manum, who will take you through the financial part of the presentation.

[Gunnar Manum, executive]

Thank you, Hans-Petter. Revenue from the second quarter was an all-time high quarterly revenue and increased by 15% year-on-year in constant currency and 13% as reported. The increase is an effect of the inclusion of ba.se and from new contracts that have gone live and other volume changes. Managed Services revenue increased by almost 21%, while Professional Services had a smaller reduction when adjusted for the currency effect mainly due to Professional Services resources, particularly in Germany, being utilized on the implementation of new customers. This results in deferred revenue which will be recognized as revenue in later periods.

In the last quarters, we have tried to visualize how the large number of new customer contracted in Managed Services during the last 12 months will impact the revenue going forward. In the second quarter this year, a further NOK 21 million in annual revenue was contracted. In the top graph on this slide, we show on the left the current annual recurring revenue for Managed Services of NOK 560 million based on the revenue figures for the second quarter. On top of that, we have NOK 51 million in annual revenue from contracts that have not yet gone live. After deducting non-churn of NOK 7 million, the contracted annual recurring revenue going forward is NOK 604 million. The timing of this additional NOK 44 million in annual revenue is shown in the bottom graph with some of the large new signings expected to go live in the first quarter of 2023.

On top of the recurring revenue of NOK 604 million within Managed Services, we normally have change orders of approximately 10% of the recurring revenue, that is approximately NOK 60 million; and revenue from Professional Services of NOK 241 million based on the figure for the last 12 months. This gives an estimated future annual revenue for Zalaris just above NOK 900 million based on signed long-term Managed Services contracts. This is 17% higher than the total revenue for 2021.

As we have shown in the previous quarters, we are spending considerable resources on implementing new customer contracts, and the activity level remains high as can be seen from the graph on this slide, which shows the amount of revenue and costs deferred during the last 12 months. This shows that the volume of new customers being implemented has increased quarter-by-quarter on a rolling 12 months basis. The implementation projects are invoiced to our customers and generate cash through milestone payments with the revenue and the costs are deferred and recognized in the P&L from the go-live date and over the contract period. For the second quarter, the amount of revenue deferred was NOK 18 million compared to NOK 11 million last year. This also has some negative impact on EBIT and EBIT margin short term as the resources spent on these projects do not generate an immediate margin.

The adjusted EBIT for the second quarter was NOK 10.2 million, a decrease of 10% year-on-year. This is before the EBIT from the APAC region of minus NOK 3.5 million. The APAC region has a positive EBIT target from Q3 this year. The adjusted EBIT margin ex APAC was 4.9% compared to 6.2% last year. The EBIT margins are temporarily affected by the onboarding of new customers and the recruitment and training of resources for new contracts. High travel and related costs also contributed negatively. The new contracts that go live in the second half of this year and in 2023, exemplified by the NOK 51 million in additional annual revenue shown earlier, will support an increase in the EBIT margin.

In addition, several initiatives are ongoing to improve margins, including the further transfer of work to nearshore and offshore locations with a lower cost structure, an operational improvement program to bring customer margins in Germany to the levels seen in the Nordic region and increased utilization which will partly come through the volume increases mentioned. Our EBIT target margin is 10%. The EBIT for Managed Services was NOK 10.7 million compared to NOK 16.1 million last year and was impacted by the factors noted earlier as well as additional costs for establishing our Application Maintenance Service center in Poland. The EBIT for Professional Services was NOK 4.9 million, an increase of NOK 1.3 million year-on-year.

Moving on to some of the other key P&L items. With the increased revenue and ongoing transformation projects for new customers, the number of FTEs have increased by around 188 year-on-year, including ba.se. A large share of the new FTEs has come from nearshore and offshore locations. NOK 5 million of the NOK 20 million increase in personnel costs year-on-year was due to a reclassification from other operating expenses related to the first quarter.

Other operating expenses increased by NOK 6 million when adjusted for the reclassification just mentioned. The increase was mainly due to high use of external SAP consultants utilized on revenue generating projects and travel costs and the inclusion of ba.se. Included in other operating expenses last year was a one-off M&A expense of NOK 5 million.

Adjusted EBIT was NOK 6.8 million for the quarter. The bridge between the adjusted EBIT and the EBIT of NOK 1.2 million are share-based payments of NOK 1.8 million, the amortization of excess value on acquisitions of NOK 2.9 million and the investments in the buildup of the Application Maintenance Service center in Poland of NOK 0.9 million.

As mentioned by Hans-Petter, vyble will be sold and has been reclassified to assets held for sale and reported as discontinued operations. The net loss for vyble was NOK 4 million for the quarter. Net loss for the period was NOK 21 million compared to a loss of NOK 6.4 million last year after unrealized currency loss on the bond loan of NOK 21.2 million compared to a loss of NOK 7.3 million last year.

We continue to have a strong cash position. The operating cash flow was positive NOK 3 million. We made a dividend payment of NOK 7.6 million and had normal CapEx of NOK 6.5 million and lease and debt payments of NOK 7.3 million, resulting in a cash balance of NOK 116.8 million at the end of the quarter. The net interest-bearing debt at 30 June was NOK 254 million.

And that concludes the financial section, and I'll transfer over to Hans-Petter to give you some perspective on our markets and outlook. Thank you.

[Hans-Petter Mellerud, executive]

Thank you, Gunnar. So let's round out looking at the market and sum up. As mentioned earlier, we see a strong interest in our payroll and HR business process outsourcing services. This has resulted in a significantly strengthened pipeline and record high signed agreements over the last 12 months. This sentiment is also confirmed by industry analyst Everest Group in their 2020 Key Issues Survey reported that 57% of senior European stakeholders and key buyers in large European companies expected the use of HR business process outsourcing to increase in the time to come.

Triangulating this with the results of a recent NelsonHall industry analyst report expecting the market for multi-country payroll to grow with 10.7% to 2023 and a market size of around $6 billion. NelsonHall states that growth is driven by international expansion requiring a global footprint for payroll, [ which ] to reduce the number of payroll suppliers' need of increased visibility of the global workforce supported by advanced analytics and ability to seamlessly integrate payroll with new global HR solutions. Zalaris has operated with the vision supporting international businesses delivering multi-country payroll since our inception 22 years ago. This is bread and butter for us, and we are well positioned for this market.

With inflation increasing and stories about the great resignation and inflated salary expectations, I would like to comment on how this is impacting us. We see some costs inflation and wage pressure but are well protected through contract price indexation clauses in the majority of our agreements. In addition, we still have sufficient room for margin improvement in our customer agreements through increased automation and use of lower cost near and offshore. This will help us maintain margins in the event salary increases surpass this indexation of prices. In macro environments with recession and crisis-like tendencies in the past, we have seen increased demand for outsourcing solutions as customers are focusing on their core business, looking to reduce and variabilize costs.

And a fact is that we are providing a service that all customers in business need, that is, payroll. There is no business without payroll. It's our license to play. We have a diversified customer base of very solid companies, representing various geographies and a broad spectrum of industries, including some large public organization in markets as Germany. We are monitoring the position closely with the aim of maintaining and further improve our competitive cost position.

So again, arriving at my last slide, let's sum up. With all-time high revenue reported in Q2, we are well on our way to implement our [ NOK 115 million ] annual contract value sold in '21 and delivering on our 10% growth target. New contract wins 2022 year-to-date and geographic expansion supports our aim of becoming a NOK 1 billion company in 2023. We have seen a temporary margin setback in Q2 as we help front load the costs [ to cater ] for our strong growth and [ expand them ] into new geographic areas. As revenue from our new agreements start to be recognized and our cost improvement programs take effect, we will see improvement over the next quarter and maintain our target of 10% EBIT.

Our investment in APAC was significant in Q2, and we are well on our way to deliver a profitable Q3 and H2 with our recent signed contracts in the region. With vyble stabilized and refocused, we have contracted an investment bank to divest the business by Q4 this year. This will allow vyble to faster expand in the large German SME market and allow Zalaris to focus on our core business, serving increased demand for PeopleHub and SAP-based mid- and enterprise-based solutions. We and Team Zalaris are very proud of our achievements and optimistic about the future. We are endurance fighters constantly working on besting ourselves.

Thank you. And with this, we open up for questions.

[Gunnar Manum, executive]

Yes, Hans-Petter, we will start with -- immediately with some questions. How is the company positioning itself for growth in North America and South America?

[Hans-Petter Mellerud, executive]

Currently, we are not selling any direct activities in neither South nor North America. But we have a number of larger global deals in our pipeline where we can serve these regions with partners and our existing solutions.

[Gunnar Manum, executive]

Now given the current unemployment rates and the macro outlook going forward, how do you expect the employee bases among customers to affect contract values?

[Hans-Petter Mellerud, executive]

At the moment, we do not see any major changes in employee bases of customers. I think customers have reduced the number of employees somewhat over the last years through various means as nearshoring of operations, outsourcing of operations and also somewhat slim their workforce through the COVID period. So if I was to guess, I would rather expect to see growth as many of them are in strong industries. And as well, we see many of them are acquirers of new businesses, bringing new volumes to us.

[Gunnar Manum, executive]

With today's low market pricing, for the company that is, does the company fear being acquired by competitors or PE firms?

[Hans-Petter Mellerud, executive]

Well, I guess I can say we fear not much. But clearly, we find ourselves undervalued at the moment also with comparing with peers. To me, it seems like analysts and the market totally disregard the fantastic growth that we have and the wins of customer base and the market shares that we win and do not give us credit for our ability to generate margins on these contracts over time. History shows that we are very capable of delivering great margins on customers that we are able to keep for a long time. And with the churn as low as it is, I'm very confident that we will bring the margins on the contracts that we have recently won to very, very healthy levels.

But I shall also admit that we have been somewhat eager to cater for the growth now in Q1 and Q2 by employing maybe somewhat too many people in our near and offshore centers. But over the medium term, we think this will pan out as a fantastic investment, enabling us to sell more to existing customers and to take on the -- somehow these large contracts that we are -- that we have sold or are in the process of selling in the market.

[Gunnar Manum, executive]

And thank you for that. And I think that concludes the Q&A session.

[Hans-Petter Mellerud, executive]

Okay. Thank you, again, for joining us. Please feel free to contact us at [e-mail] if you have any further questions or would like some more details on how we can support you. Thanks a lot. See you next time.