Enghouse Systems Ltd

TSX:ENGH

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the Enghouse Q2 of 2023 Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. [Operator Instructions] This call is being recorded today, Tuesday, June 13, 2023.

And I would now like to turn the conference over to Mr. Stephen Sadler. Please go ahead, sir.

[Stephen Sadler, Chairman and Chief Executive Officer]

Good morning, everybody. I'm here today with Vince Mifsud, Global President; Rob Medved, VP, Finance; and Todd May, VP, Legal Counsel.

Before we begin, I will have Todd read our forward disclaimer.

[Todd May, Vice President, Legal Counsel]

Certain statements made maybe forward-looking. By their nature, such forward-looking statements are subject to various risks and uncertainties, including those in Enghouse's continuous disclosure filings such as its AIF, which could cause the company's actual results and experience to differ materially from anticipated results or other expectations. Undue reliance should not be placed on forward-looking information. The company has no obligation to update or revise any forward-looking information, whether as a result of new information, future events or otherwise.

[Stephen Sadler, Chairman and Chief Executive Officer]

Thanks, Todd. Rob will now give an overview of the financial results.

[Rob Medved, Vice President, Finance]

Thank you, Steve. Good morning, everyone.

I'll be going through our financial and operational highlights for the three and six months ended April 30, 2023 compared to the three and six months ended April 30, 2022, as follows:

Revenue achieved was $113.5 million and $219.9 million, respectively, compared to revenue of $106.3 million and $217.4 million.

Results from operating activities was $25.6 million and $55.5 million, respectively, compared to $31.1 million and $66.8 million.

Net income was $12.5 million and $29.6 million, respectively, compared to $17.9 million and $39.5 million.

Adjusted EBITDA was $30.2 million and $62.5 million, respectively, compared to $33.8 million and $72.3 million.

Cash flow from operating activities, excluding changes in working capital, was $28.9 million and $61.5 million, respectively, compared to $34.5 million and $73.3 million.

Revenue for the second quarter reflects an increase of 6.7% compared to the same period in the prior year and was positively impacted by $3.6 million as a result of foreign exchange, which also adversely impacted cost of revenue and operating expenses by $2.2 million. Consistent with our strategy, revenue growth was largely driven by recent acquisitions.

Net income for the quarter was $0.23 per diluted share compared to $0.32 per diluted share last year. This decrease was primarily a result of incremental operating costs related to acquisitions as we integrate them into Enghouse, combined with higher third-party costs and special charges related to acquisitions.

Adjusted EBITDA was $0.54 per diluted share compared to $0.61 per diluted share in the second quarter of 2022.

Year-to-date revenue was positively impacted by foreign exchange, which also increased costs. Year-to-date results from operating activities reflect increased revenue and costs related to acquisitions as well as increased third-party costs of providing services. Year-to-date, adjusted EBITDA was $1.13 per diluted share compared to $1.30 per diluted share last year as a result of the initial margin compression related to increased acquisition activity as well as increased third-party costs of providing services.

As previously announced, Enghouse completed two acquisitions, purchasing Qumu Corporation on February 8, 2023 and Mobi All Technologies S.A ("Navita") on February 9, 2023. Qumu's video engagement platform provides video creation, content management and highly scalable delivery solution that complement Enghouse's enterprise video suite of products. Navita offers a comprehensive suite of products focused on managing and controlling critical mobile assets as well as telecom and IT expense management. The results from both acquisitions are included in the Interactive Management Group. The efforts to integrate and onboard these acquisitions were substantially completed in the quarter.

Yesterday, the Board of Directors approved the company's eligible quarterly dividend of $0.22 per common share, payable on August 31, 2023 to the shareholders of record at the close of business on August 17, 2023.

I'll now hand the call back to Mr. Sadler.

[Stephen Sadler, Chairman and Chief Executive Officer]

Thanks, Rob. Vince will now give some operational highlights of the quarter.

[Vince Mifsud, Global President]

Thank you, Steve. Just a few highlights around our overall financial performance for the quarter.

We are pleased to have reached a turning point on revenue, achieving an increase in Q2 of 6.7%. Revenue grew both quarterly and on a year-to-date basis and was positive in all revenue streams, except for hardware, with recurring revenue driving most of the improvement, which was up 12.3% over last year, hitting $71.6 million in Q2. This is driven by our growing SaaS revenue.

Early in Q2, we completed the acquisitions of both Qumu and Navita and executed our acquisition integration plans quickly. And as a result, both businesses were profitable immediately in Q2. If you followed Qumu as a public company, you would have seen it was operating at a significant loss over several years. So, having turned the business profitable in less than 90 days speaks to our ability to integrate companies effectively. There's still some additional work needed to achieve our normal margins, but both Qumu and Navita had good overall immediate results.

Navita, which provides mobile device and expense management software, is a growing SaaS business, operating in a market segment that is seeing strong demand, driven by security requirements over mobile devices and companies needing to manage their telecom expenses.

Gross margins were negatively impacted in the quarter by the acquisitions and the use of third-party contractors for our large public safety projects, which are still in the implementation stage. During the implementation stages, our margins are generally lower, but once the projects are live, we expect to generate our higher margin support revenue over an expected 10-year period. And just as a reminder, these two public safety projects are quite large relative to other Enghouse projects, with over $80 million of expected revenue over the term of these contracts.

Given all the market attention around AI and ChatGPT, I thought I'd say a few comments about how Enghouse is thinking about this area. We see the benefit of AI tools in two ways. Firstly, we're going to use AI-powered business applications to help Enghouse improve overall internal efficiency. And the second piece is to provide AI products to the market, which will drive more value to our customers. In terms of using various AI tools internally, we are starting with our Demand Gen team and have future plans to use AI across most areas of our business.

When it comes to Enghouse products provided to customers, we have developed various products which have integrated and leveraged market-leading AI technology, and have also developed some of our own proprietary AI products. Just to give you a couple of examples.

We have a product called Vecko, which analyzes all of the company's customer interactions that occur in a call center and provide powerful insights such as customer sentiment, product ideas, common customer issues. And all of these insights are aimed at helping a business improve their products and services from leveraging the voice of the customer dataset.

We also developed a product called SmartQuality that uses AI to automate agent evaluations. SmartQuality will ingest the customer interaction, automatically complete an agent evaluation, provide recommendations to the agent without needing supervisors to listen into calls.

We are just starting to adopt these AI tools internally, and the demand for our customers for our AI products is still relatively early.

Our Asset Management division continues to perform consistently, with quarterly revenues being maintained at approximately $49 million in both Q2 2022 and 2023. And we continue to see stable overall market conditions for both networks and transportation segments with no significant shift to the cloud, and we also are seeing some good growth in areas like IPTV.

The contact center market trends are in line with what we discussed last quarter. Competitors are still mostly horizontal cloud providers. Some competitors that historically offered both on-prem and cloud have mostly sunset their on-prem products. And based on our review of a number of public companies in the sector, many of them are still operating at a loss.

And in terms of industry recognition, there's some meaningful improvement for Enghouse within the industry analyst community. We were historically viewed by the contact center market analysts as an on-premise provider, but recently have received more industry recognition from several analysts around our SaaS offering. This should ultimately help us win more SaaS deals.

Overall, we were pleased with the performance in the quarter, turning the corner on revenue growth, good expansion of our recurring revenue, and seeing the payback of the previous investments we made in systems, standardizing our onboarding processes, improving how efficiently we can integrate acquisitions.

Let me turn the call over to Mr. Steve Sadler.

[Stephen Sadler, Chairman and Chief Executive Officer]

Thanks, Vince.

With respect to acquisitions, the actionable pipeline remains strong. Valuations continue to decline in this environment of increasing global interest rates and the possibility of a recession. As Vince noted, we completed two acquisitions Qumu and [Navita] (ph), early in the second quarter. Both acquisitions are performing slightly better than expected, but not at our historic EBITDA margins being the first quarter as part of Enghouse. Qumu was successfully combined with our video business and the substantial losses previously realized by Qumu were eliminated. Nativa had minimal restructuring and is operating profitably as part of our expense management business. We have taken action to improve the EBITDA of these acquisitions and expect them to increase our revenue and EBITDA in future financial quarters. As Rob noted, at the end of Q2, our cash and -- on hand remains over $234 million after paying for the acquisitions and our increased quarterly dividend.

I would now like to open the call for questions.

[Operator]

Thank you, sir. [Operator Instructions] Your first question will come from Stephanie Price at CIBC. Please go ahead.

[Stephanie Price, CIBC]

Hi, good morning. I just wanted to touch on margins for a second. Just in terms of the year-over-year margin decline, just curious, integration, obviously, an impact in the quarter given the two recent deals. But then, I think Vince also mentioned higher third-party costs around the transit project implementation. Just curious about how we should think about margins in terms of how much was just this quarter from acquisitions and how much maybe in the next few quarters just given these third-party costs?

[Vince Mifsud, Global President]

Yes. So, just specifically to the transit projects, as I mentioned, they're multiyear projects. Both of them are still in implementation stages for another couple of quarters. And then, the support revenue, which is the higher margin piece, kicks in over a 10-year period. So that's sort of where those projects are at. Most of that $80 million I talked about is in the support piece.

On the acquisitions, we've taken action, as we mentioned, both Steve and I, in the quarter. But some of the actions still trickle in, in the next one or two quarters to get to our normal gross margin and operating margins.

[Stephen Sadler, Chairman and Chief Executive Officer]

Stephanie, the other thing you've got to realize is, as analysts and investors, everyone like SaaS. SaaS margins are lower than on-prem margins, when you have maintenance versus the cost of revenue that goes into the margins on a SaaS type operation. So, as we do more SaaS, the margins have come down a little bit.

[Stephanie Price, CIBC]

Okay, that's good color. And then, congrats on the recurring revenue. As you noted, Vince, it was up quarter-over-quarter, and for, I think, the third quarter in a row. So, just curious if you can give us an update on video here and how we're kind of thinking about the buckets in that recurring revenue piece.

[Vince Mifsud, Global President]

Yes. So, on video, the revenue for video is both SaaS and on-prem as I think I've mentioned in previous quarters. The revenue stream for video is stabilized now, but we've added Qumu to the mix. Last year, we added other products to the mix on video. Still focusing on the telehealth market, and we've gone beyond the simple use case of doctor-patient video collaboration into more complex workflows like virtual nursing, virtual monitoring of patients. So, we're looking at differentiating ourselves relative to like Zoom and Teams that do more basic doctor-patient telehealth into more complex use cases.

[Stephanie Price, CIBC]

Great. Thank you very much.

[Stephen Sadler, Chairman and Chief Executive Officer]

Stephanie, another item I'll add to that because it's sort of a little different for us. Vince describes what we're doing operationally, which is good, stabilization. But understand that industry is going into a lot of challenging times. You can see it by the big competitors, for example, Zoom. That -- for us, as a capital allocator, that does give us opportunities which are not normal in just the day-to-day operations, but the ability to take advantage of leap frog, shall we say, in some of our revenue and some of our results by taking advantage of those companies that are struggling because they haven't operated profitably in the past. So again, there's a plus and minus for all our operations.

Operations, yes, have stabilized. I think that's everyone wanted to know. But what we would say from the acquisition side, you can see there's some opportunities there that will help us in the future, i.e., motivated sellers who can't raise money now because the market has not looked upon as favorably as it was a year ago. And that still is an advantage for us as our two-pronged approach, both growth internally and by acquisition.

[Stephanie Price, CIBC]

Great. Thanks for the color.

[Operator]

Your next question comes from Paul Treiber at RBC Capital Markets. Please go ahead.

[Paul Treiber, RBC Capital Markets]

Thanks very much. Good morning. Just want to follow up again on the margin side. There's a couple of, it seems like, temporary impacts, but then you did acknowledge that SaaS margins are lower. Now, how do we think about the target go-forward margins from here? Like I think historically, it's been in a 30% range. Is 30% still the right number? Do you think you can do that even with a higher mix as SaaS?

[Vince Mifsud, Global President]

Yes, I think we can achieve that. We are targeting that. The one positive thing on the SaaS side is as you get more volume, you have a little bit more leverage over the cloud providers. So, you can improve your margins as you get more and more revenue into the cloud. So, you'll see improvement there through our sort of negotiation leverage with the cloud providers. And they are being very aggressive. They're basically all fighting for market share. So we take advantage of that. One of the things we do is we make sure all of our products are cloud-agnostic. So, a key to our strategy is to not tie ourselves to any one cloud vendor, which gives us a lot more negotiation leverage to maintain margins. But yes, 30% is still our target.

[Paul Treiber, RBC Capital Markets]

Okay. Great. And secondly, just on -- you're acquiring the assets of Lifesize. Obviously, you probably can't speak specifically to the acquisitions. But can you speak, in generally, to acquiring assets from businesses in Chapter 11? And specifically in terms of how you think about the profile of margins when you make an acquisition like that versus acquiring a full business?

[Stephen Sadler, Chairman and Chief Executive Officer]

You've got a -- it isn't much different than a whole business. You've got to remember, they're in exactly the same space as us, contact center and video. So they face the same video challenges that we face and the whole market is faced. They're virtually all SaaS, and they took on a lot of debt to expand aggressively by internal growth, which didn't work out so well. As many -- Avaya, the largest player in the market, also has the same problem. So this whole thing of getting revenue at any cost, it might not be the best strategy, at least it hasn't worked out very well for many in the marketplace, and we can take advantage of that today. But it's exactly the same profile as us. We'll have it on the same profile as what Enghouse operates if it closes and when it closes.

[Paul Treiber, RBC Capital Markets]

And just lastly, just in terms of M&A in general. I mean, obviously, there's been a lot of disruptions in the market on the financing side. You mentioned your pipeline is quite strong. How do you think about your internal ability to make acquisitions? You've done two this quarter, this past quarter, and potentially one in the next quarter if it closes. Is there a limit that to the number that you can do per quarter or on an annual basis?

[Stephen Sadler, Chairman and Chief Executive Officer]

From the acquisition side, we can do many acquisitions, but we integrate in. Other companies that you follow don't integrate in. And that, over time, can be an issue. We integrate them in and try and position ourselves with a lot more solid company for the future. So yes, it's mostly by the integration, but we have added to the acquisition team and we've added to the team to [also do] (ph) integration. So, we can do more acquisitions for sure and integrate them in, in a quarter.

[Paul Treiber, RBC Capital Markets]

Okay. Thanks for taking my question.

[Operator]

[Operator Instructions] Your next question will come from Rini Sharma at BMO Capital Markets. Please go ahead.

[Rini Sharma, BMO Capital Markets]

Good morning. So I wanted to touch upon the gross margins again. Actually, I was wondering if you could maybe provide a little bit of color in terms of the relative impact to margins from the third-party services, the integration costs, as well as, was there any higher professional services that impacted margins this quarter? And how we should be thinking about the relative impact going forward?

[Vince Mifsud, Global President]

I think I caught most of that. In terms of the gross margins, the impact of the third-party contractors that we talked about is basically we've got a couple of more quarters of that before the support -- higher-margin support revenue kicks in. And when it comes to the acquisitions, we did most of the work in the quarter. And again, we'll see the benefits of that into Q2 -- the next quarter and the following quarter. So in both cases, it's a couple more quarters where we get back to our normal gross margins.

[Stephen Sadler, Chairman and Chief Executive Officer]

The one thing you've got to be careful of and I would, everyone likes SaaS recurring revenue, but the margins are not as good. That's why there's some -- when they can't get funding, for example, we're seeing some benefit of that today. We also, as Vince said earlier, expect to improve our margins because as you get bigger, you can cut new deals with public cloud vendors, et cetera, to improve your margin a little bit.

And again, in our margins, there are some professional services, two big projects that we are undertaking, where the margins would probably be, for sake of a rough number, zero, maybe 5%, very small. And they'll turn into margins when we're finished of maintenance, which is probably 90%. So, margins, as those projects finish, will improve, and as we expand the SaaS business, it will improve as well. And again, we've taken on some of that business directly.

We were very high in doing SaaS revenue in the past, but we did it through the telcos. Through the telcos means revenue is less but margins are good. We don't have the negative and all the costs that other players had. We changed that over because the telcos weren't rolling it fast enough. So, we've changed our strategy to improve that a little bit, but it does impact margins. So, every time you think of SaaS and, yes, recurring revenue, think of lower margins for everyone as well because that's just the reality of what happens.

[Rini Sharma, BMO Capital Markets]

Okay. That's helpful. And then, the other question I had was related to the higher operating costs, sales and marketing, R&D, there's also some higher amortization costs. How should we think about that now that the integration is largely complete? Like should we expect it to be elevated or normalized in the next few quarters?

[Vince Mifsud, Global President]

I think you're talking about amortization costs, which are directly related to the acquisitions typically. So, if we do more acquisitions, you'll see more -- generally more amortization costs.

[Stephen Sadler, Chairman and Chief Executive Officer]

They're non-cash, but they're also going to have amortization costs from acquisition we did five years ago that are going to stop. But again, if we increase the acquisition activity, the amortization costs should increase.

[Rini Sharma, BMO Capital Markets]

Right. And how should we think about the OpEx now that Qumu is largely integrated and Navita is largely integrated?

[Vince Mifsud, Global President]

In terms of OpEx, our target is to achieve the 30%. That's our target OpEx that we've discussed, I think, several times historically and continues to be in terms of our EBITDA as a percentage of revenue.

[Stephen Sadler, Chairman and Chief Executive Officer]

And again, that's generally with some acquisitions being done, which lower the EBITDA initially when you're doing, which we've explained over the years many times that when you do an acquisition, we put a lot of our costs through the acquisition. For example, if we're replacing some software, we have a double cost of software they were using plus the software we're using until we get them off their software. So like we've said this many times that in the first quarter, you can expect these acquisitions to be profitable initially. But over the four quarters, we will definitely have them up to our margin -- normal margin level. But it's the same that's been for years, like -- so there's no change.

[Rini Sharma, BMO Capital Markets]

Yes. Okay. Thank you very much. That's all for me.

[Operator]

There are no further questions at this time. So, I will turn the conference back to Mr. Stephen Sadler for any closing remarks.

[Stephen Sadler, Chairman and Chief Executive Officer]

Well, thank you for attending the call and your continued support. We have the resources to continue our capital allocation strategy while supporting internal sales and software development.

[Operator]

Ladies and gentlemen, this does conclude your conference call for this morning. We would like to thank you all for participating and ask you to please disconnect your lines.