Zalaris ASA

OSE:ZAL

Earnings Call Transcript 2018-Q3

[Hans-Petter Mellerud]

Good morning, everyone. My name is Hans-Petter Mellerud, I am the CEO of Zalaris. Thank you for joining us for this webcast presentation of Zalaris results for the third quarter 2018. Please note that the conference is being recorded. You will find a link to the recording on the Investor part of our website. I normally have my good colleague and CFO, Nina Stemshaug, with me for the quarterly presentations. She is still in recovery and has asked me to give all of you her regards. We expect to have her back from November 1. Now let's turn to the report. You may already had a first glance at the numbers. And I suspect that your initial reaction might have been disappointment. Rest assured, an operating loss of NOK 5.5 million is also clearly below our own expectations. But there is more to this report than meets the eye. We have made great achievements and investments that we are confident will produce significant returns. We are keen to demonstrate that the financial results in the third quarter represent a temporary low and that the fourth quarter will be significantly better. We are enthusiastic to see that the now much larger Zalaris is gaining speed and here is why. With the technical integration of new businesses completed, we are now again turning our full attention to customer relations, business development and operational improvements with the goal of meeting our profitability targets. Whereas these efforts have not yet resulted in improved profits, we already see a much firmer pipeline of new opportunities and improvements. We have signed several memorandums of understanding and letters of intent in the Nordics alone. We are in the process of finalizing contract extension with 3 of our largest HR Outsourcing customers. They represent a significant part of our group recurring revenues. In the U.K., we are about to confirm new agreements involving SAP SuccessFactors cloud solutions. In Germany, we have successfully gone live with a new global HR solution based on SuccessFactors for Exyte, a leading global engineering firm with more than 5,000 employees worldwide and the rollout is continuing. We have likewise supported one of the leading not-for-profits, Caritas, in moving their solutions to SAP's S/4HANA and are in the process of implementing a Zalaris platform-based HRO solution for Kuraray, the German subsidiary of the Japanese industrial market leader for production startup in 2019. In the Nordics, we are well underway with implementing state-of-the-art HR solution for companies as DNB and Aker BP. Our new joint group capabilities are cited as instrumental to win and deliver these type of projects. This is a significant trend shift for our new and integrated businesses in the region. It should also be noted that we have spent time well during integration. We have rolled out new systems and procedures that are providing much greater insight and control of the business. We can easier detect and initiate action to correct deviations and continually improve. And we have made a platform that will allow us to further grow. I believe such underlying organizational improvements and strong market prospects were at least part of the reason why bond investors offered us financing at competitive terms when we recently raised EUR 35 million in a senior secured bond. Now let's take a quick look at the numbers. As already mentioned, we have invested to grow. Revenues for the first 9 months this year were up 55 -- 54% compared to last year. This is mainly due to the acquisition of sumaram and ROC. Similarly, revenues in the third quarter, which is marked by the usual seasonality effects increased by 17%. Year-to-date profits were marked by integration activities in the first half of this year and in the third quarter P&L, there are some items that you should be particularly aware of. First of all, timing of our cloud revenues have reduced revenues and operating profit compared to last year. Revenues are not lost and will be recognized in later quarters. Second, we have renewed a contract, which we believe has significant growth potential long term but which has a short-term negative impact. Third, amortization has increased after the acquisitions. The purchase price allocated to customer relationships is amortized by NOK 2.4 million per quarter and is a noncash effect. Finally, the third quarter this year was also impacted by some severance costs, corrections from previous periods and additional project start-up costs. So all in all, the results could and should have been better. But as I said, we are keen to demonstrate [ acute ] our geographic presence across Europe as this chart shows. In the Nordics and Baltics, revenue declined from NOK 103 million in Q3 last year to NOK 99 million this year. This is where we see the effect of the timing of cloud revenues and contract renewal that I mentioned on the previous slide. On the other hand, the HRO contract renewed secured a significant share of the group and in revenues for years to come and opens the potential for up-selling of additional services. In Central Europe, third quarter revenues in Central Europe grew by NOK 22 million last year to NOK 70 million this year, mainly due to the ROC acquisition at the end of 2017. Currently, strength is seen in the German Consulting business coming out of ROC while the Polish business is somewhat struggling. The pipeline is, however, strengthening in Poland and the business is expected to grow into profitability in Q4. U.K. and Ireland. Before ROC, we had no business in this region. Activity and external sales in the region has varied through the year and is in fact now on a lower level than before it became part of Zalaris. But this trend is now shifting. Compared to Q2 this year, revenues in Q3 are 49% up to NOK 5.8 million. And as mentioned, the pipeline in the region continue to firm up. And we are looking at a potentially strong Q4 this year. Let us now have a closer look at the key financials for the quarter. We start by looking at the operating revenues for the group. And as usual, all numbers referred to are in Norwegian kroner unless otherwise has been stated. The third quarter is historically the weakest quarter of the year, mainly due to summer vacation period in the Consulting segment. As most of Europe slows down during summer, the number of potential chargeable working days are reduced. Revenues in the third quarter was NOK 176 million, a 17% growth compared to Q3 last year. The growth reflects the acquisition of ROC in the fourth quarter 2017. Change in timing of cloud revenues to later quarters and price reductions on an HR Outsourcing agreement that was extended during the quarter negatively impacted revenues. I have mentioned this before. The price reduction is linked to efficiency gains from implementing a new cloud-based solution and share to the customer upfront while Zalaris needs some time to realize the savings on our end and in turn receive significant up-sell potential for Cloud Services. The growth is below our ambitions. However, we expect to see significant improvements in Q4 and the effects of our sharpened customer focus is materializing. As mentioned, group operating results in Q3 was a disappointing loss of NOK 5.5 million. I've already explained the main reasons for the weak performance. However, I would like to add that while the strengthening of the group and regional structure is an enabler for profitability and growth, it is also associated with a cost. Currently, the organizational ramp-up is preceding the revenue growth and as such, is contributing to the margin decline. Net financial cost was NOK 3.1 million, including an accountancy loss -- currency loss of NOK 1.1 million, mainly related to euro debt. Tax on ordinary profit was positive NOK 1.2 million and net loss for the period was NOK 7.3 million. As shown in the graph, cash and cash equivalents were NOK 108.6 million as of the end of Q3, up from NOK 37.4 million as of Q2. Cash generated from operating activities after interest payments amounted to NOK 8.4 million, sufficient to fund investment activities of NOK 1.5 million. Cash flow from financing activities reflects the receipt of funds from the bond issue, EUR 35 million, less capitalized arrangement fees. Most of the funds were used to repay bank debt and the overdraft facility. Total assets increased by NOK 64 million to NOK 628 million in Q3. While equity decreased from NOK 106 million to NOK 96 million, equity ratio was consequently reduced from 19% to 15%. Total assets have increased as a result of the bond issue of EUR 35 million. The net loss for the period of NOK 7.3 million and negative translation differences of NOK 2.8 million explains the decline in equity. Net interest-bearing debt decreased from NOK 257 million at the end of the quarter last year to NOK 253 million due to positive cash flow from operations. We will then turn to the segment and add some further comments to explain details in our operations. Third quarter revenues in the HR Outsourcing segment amounted to NOK 108 million this year, up nearly 18% compared with the same quarter last year. The increase is mainly related to growth in the German HRO business, partly attributable to the reclassification of revenues between segments. Growth in the HRO business in U.K. and Ireland also contributed positive while revenues in Northern Europe temporarily declined mainly because of the contract renewals. Revenues in Consulting grew by NOK 16 million to NOK 45 million in the third quarter this year. Last year's acquisition of ROC was the main reason for growth. Because of acquisitions, the group share of Consulting revenue has increased and hence, introduced higher seasonal volatility, mainly coming from the number of available working days per quarter. This is defined by the number of public holidays and vacation days that are typically aligned with school holidays. The Cloud Services revenues in the third quarter this year were NOK 23 million, down from NOK 26 million in Q3 last year. Nonorganic growth related to the Q4 '17 acquisition of ROC was offset by change in timing of revenues resulting from a contract extension and reclassification of customers from cloud to the HRO segment following up-selling of BPO services. Operating profits for the HR Outsourcing segment in the third quarter this year was NOK 8.1 million, corresponding to a 7.5% margin. Margin in the same quarter last year was 14.6%. The decline in profitability is mainly related to price reductions for efficiency savings awarded customers under the renewed contract, as mentioned earlier, employee severance payments and start-up costs of new and renewed BPO agreements. The Consulting Services segment had an operating profit of NOK 0.3 million in the third quarter. Despite lower revenues due to seasonality with much the same cost base, the segment still delivered positive operating results. The Cloud Services segment had an operating profit of NOK 1.4 million in the third quarter compared to NOK 3.8 million in the same quarter last year. The decline reflects the changing in timing of revenue, as discussed previously. And yes, I think we've said enough for that now. Now so let's round off and as a part of my concluding remarks, I would like to share with you some of the material that we shared with our bond investors on our road trip in September, including market data and intelligence that has been gathered by recognized market analysts, primarily Everest Group and Gartner. First, the HR function was long the last bastion of change resistance. This has rapidly changed as a result of key market trends. Instead of a process focus, employers are increasingly centering services around the employee with the goal of increasing the overall workplace experience. In parallel, we see an increasing number of employees, particularly in the younger generation preferring looser gig-type relationships. As one has realized how key it is to recruit and retain the right people and the cost of doing otherwise, there is an increasing focus on the whole process from recruitment, engagement and retention. Add to this, the availability of cloud-based platforms promising simplified best practice processes out-of-the-box and increasing focus, even in the C-suite, on the potential of intelligent automation and artificial intelligence. It is an environment where technology is saying, "We have the solution, where is the problem?" And the HR department is listening. These trends are driving the market that we operate in. Zalaris was an early player and we are continuously changing and adapting to the changing needs. Looking at Everest Group's market predictions. We see that we are part of markets with high growth, starting with a multi-process HR outsourcing market, this is defined as the market where customers are outsourcing more than one process, for example, the responsibility for both payroll and travel expenses. The European market is estimated to grow with 8% to 10% with a market value of $1.3 billion per annum. A faster-growing market is the multi-country payroll outsourcing market, defined as agreements covering 2 or more countries. This is estimated to grow with 21% to 23% and is valued at about $0.8 billion per annum. Both of these markets have been Zalaris' stronghold since inception as it was the key element of my business idea in 2000 to serve large companies wanting to operate their human capital seamlessly across borders. Our one common solution on platform-based approach has allowed us to compete successfully and is still serving us well with solutions covering all aspects of HR with a particular focus on mobile first. The Business Process as a Service market is a market defined as services sold on the top of cloud solutions as SuccessFactors or Workday. This market is growing at high double-digit rates with SuccessFactors' Business Process as a Service market estimated to grow with as much 75% to 80% per annum. With Zalaris' combined capability, we are perfectly positioned to take our share of this European market. Looking at the competition. We find ourselves competing well on 2 dimensions. One, we have the leading platform base on SAP and SuccessFactors, allowing us to deliver one common IT solution across the geographies where our customers are located. In addition, and this is contrary to many of our global competitors, we have interest digitization efforts by local governments that require significant local interfacing expertise and increased focus on employee experience. This is good news for Zalaris. This supports HR functions with all their tech and process needs such that HR at customers can focus on faster developing their employee-centric organizations of the future. With this in mind, remember that we are coming from a remarkable growth journey, 18 years of uninterrupted growth. We have proven our ability to continuously adapt to the market needs and our ability to deliver results. At the same time, we have developed long-term relationships serving our customers. Our focus has always been putting customer service and quality first with the goal of delivering good quality and value to the customer. This because we have seen this is key to maintain long-term customer relationships and that investments in quality pays off over time with higher margins. This has and will remain the backbone of our growth strategy, working to be seen as a long-term, dependable service provider to the HR function with corresponding predictable revenue streams, allowing us to invest in continuous improvement and margin-enhancing activities that also support customers reducing their costs over time. So to sum up. With the rebranding and technical integration of acquired businesses now completed, Zalaris is coming out of a transformational stage. We accepted that this would have a temporary negative effect on margins and decided to invest in a disciplined way in new and improved corporate systems and other infrastructure. We have also secured financial flexibility that will allow us to grow further through funding of customer transformation projects, product development and targeted acquisitions. From the third quarter this year, we have gradually shifted focus. We now concentrate on customer relations, business development and operational improvements and the pipeline of new business is firming up. As said, we expect this will convert into several contracts in the coming months. U.K., in particular, is showing a solid pipeline and is likely to finalize a number of important agreements before year end. Good opportunities are also seen in other geographies and across industries and verticals. As this report for the third quarter shows, it takes time to convert business opportunities to revenues and improved margins. Being known for our endurance and long-term focus, we are determined to demonstrate that the financial results in the third quarter represents a temporary low and that we will see a much improved fourth quarter. Thank you for listening, and we will open up for questions.

[Unknown Executive]

Please note that you can also send to [e-mail]. Mellerud, can you please comment on the businesses you acquired in 2017?

[Hans-Petter Mellerud]

Yes, the businesses that we acquired in 2017, ROC and sumarum. First of all, we would have done the same acquisitions over again, knowing what we know now. It has been a much more complex and -- complex integration journey than what we had envisioned. Coming out from having grown organically over 17 years, we had not much integration expertise, so acquired businesses. But we have somewhat, I think, learned the hard way. And it has costed us somewhat more than what we had expected. But all in all, I think we are pleased with the results that we see. If you look at the actual results of the businesses themselves, we also see that the integration efforts have also taken a toll on their focus in the marketplace. Some have performed exceptionally well, for example, the ROC Consulting business in Germany that have delivered stellar margins. While others, like the U.K. business of ROC has been struggling. We think it might be due to some, say, Brexit uncertainty in the regions, temporarily halting projects. But this, we see now seems to be loosening up. And we have seen somewhat of a catch-up effect. However, that might be also due to that the management of the business now put all their efforts into the marketplace and not only integration activities. In the sumarum business, also Consulting is performing exceptionally well. We see a great potential for utilizing Zalaris's HR Outsourcing expertise to further streamline and improve the BPO business by -- we have fantastic experience, processes and procedures that both focus on customer experience and improving quality and margins. And this, we are in the process of also getting in place in our German operations. So all in all, it's a -- it's been quite a challenging journey. But we are getting there.

[Unknown Executive]

Yes. It appears that integration takes longer than expected and that you have increased cost level. Can you comment on this and what we should expect going forward?

[Hans-Petter Mellerud]

Yes, I think it's clear. As mentioned in the last Q2 presentation, we've had a number of direct costs related to integration. But it's also clear that we have also increased our, say, overhead or call it business support or whatever tag you put on it, to actually support running a larger organization that is almost twice as large as our old Zalaris organization. We should also keep in mind that having grown organically from 0 to where we were in 2017, we were also a fairly, say, stretched Zalaris organization with limited free capacity to manage a bigger business. So in order to both manage the combined, much larger entity in a disciplined and controlled way and to have capacity to grow -- to continue the growth journey, we have invested significantly in, say, finance and accounting and controlling capacity as well as more focus on HR, not wanting to be the shoemaker's son. So all in all, we have a platform now with somewhat of a higher cost than what we used to have, but that can take on a lot more growth without further cost increases. Having said that, I think we also see somewhat of a double of costs in the -- as we also run parallel organizations. For example, partially in the finance and accounting function in the acquired companies and now on a group level, that we are in the process of realizing the synergies through moving everything into our shared service center-type of concept.

[Unknown Executive]

Thank you. And we will be back in February next year with our Q4 report.

[Hans-Petter Mellerud]

Thank you.