Enghouse Systems Ltd

TSX:ENGH

Earnings Call Transcript 2019-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to the Enghouse Systems Limited Q3 2019 Earnings Call. As a reminder, today's conference is being recorded. At this time, I would like to turn the conference over to Steve Sadler, Chairman and CEO. Please go ahead, Mr. Sadler.

[Stephen J. Sadler, Executive Chairman & CEO]

Good morning. I'm here today with Vince Mifsud, Global President; Doug Bryson, VP, Finance; and Todd May, VP, Legal Counsel. Before we begin, I'll have Todd read our forward disclaimer.

[Todd M. May, VP & General Counsel]

Certain statements made may be 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 expectations. Undue reliance should not be placed on these forward-looking statements and 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 J. Sadler, Executive Chairman & CEO]

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

[Douglas C. Bryson]

Thanks, Steve. Yesterday, Enghouse announced its unaudited third quarter financial results for the period ended July 31, 2019. Third quarter revenue was $101.3 million, a 16.8% increase compared to revenue of $86.7 million in the third quarter of the prior year. The revenue increase primarily reflects contributions from acquisitions. Results from operating activities were $27 million compared to $26.7 million in the prior year's third quarter, which reflects the impact of changes in product mix and gross margin and as expected, lower operating margin contributions from acquisitions in their initial period after acquisition. Net income for the quarter was $14.7 million or $0.27 per diluted share with increased amortization and a foreign exchange loss. Adjusted EBITDA for the third quarter was $28.1 million or $0.51 per diluted share compared to $27.4 million or $0.50 per diluted share last year, with the increase being attributable to incremental revenue contributions from acquisitions. On a year-to-date basis, revenue was $276.5 million compared to revenue of $257 million in the prior year. Results from operating activities were $79.4 million compared to $75.9 million in the prior year-to-date, an increase of 4.7%. On a year-to-date basis, adjusted EBITDA was $81.6 million or $1.48 per diluted share compared to $78.1 million or $1.43 per diluted share last year. Operating expenses before special charges related to restructuring of acquired operations were $42 million compared to $34.1 million in the prior year's third quarter and reflect incremental operating costs related to recent acquisitions. Noncash amortization charges on acquired software and customer relationships from acquired operations were $8.5 million for the quarter compared to $7.2 million in the prior year's third quarter. The company generated cash flows from operating activities of $13.9 million compared to $29.3 million in the third quarter of fiscal 2018. On a year-to-date basis, cash flows from operating activities were $59.6 million. This relates to unfavorable working capital adjustments from new acquisitions which, when acquired, had severance obligations and significant payable balances that have since been settled. Enghouse closed the quarter with $141.3 million in cash, cash equivalents and short-term investments compared to $193.9 million at October 31, 2018. Cash balance was achieved after payments of $15.8 million for cash dividends and $94.2 million net of cash acquired for acquisitions concluded in the current fiscal year and $1.1 million for acquisitions closed in prior years. During the quarter, Enghouse completed the acquisitions of Vidyo, Inc. and Espial Group Inc. for an aggregate purchase price of $68.7 million net of cash acquired. These acquisitions reported revenue consistent with expectations and were accretive to earnings in the quarter. Yesterday, the Board of Directors approved the company's eligible quarterly dividend of $0.11 per common share payable on November 29, 2019, to shareholders of record at the close of business on November 15, 2019. I'll now turn the call back to Mr. Sadler.

[Stephen J. Sadler, Executive Chairman & CEO]

Thank you, Doug. As Doug noted, we closed the quarter with $141.3 million in cash, cash equivalents and short-term investments after spending $68.7 million net of cash acquired on acquisitions. Cash flow before changes in working capital was $28.5 million and $13.9 million from operating differences -- operating activities. The difference is mainly working capital, which reflects payment of liabilities and restructuring as Doug mentioned, which was implemented just prior to our acquisition of Vidyo and Espial. Revenue as expected, other than for our Asset Management division, which had some revenue delayed to Q4. We expect revenue to increase in Q4 and to improve EBITDA profitability over Q3 as a result of recognizing the delayed AMG revenue and recognition of a full quarter of revenue and EBITDA from recent acquisitions. It's also noted that foreign exchange negatively impacted revenue compared to Q2 by $1.1 million and cost was positively impacted by $500,000, and compared to last year, foreign exchange negatively impacted revenue by $1.5 million, and $1 million positive for operating costs compared, again, to Q3 of 2018. In terms of acquisitions, as noted on our last quarterly call, we purchased in May Vidyo and Espial with an objective to be EBITDA positive on these acquisitions, but not achieved our normal EBITDA margins in the first 2 quarters. We are happy to report, excluding purchase price adjustments, both acquisitions were profitable in Q3. Espial had limited profitability as we need to continue to invest in IPTV, where although we have interested customers, we do not anticipate revenue until Q2 2020. Vidyo had profitable results in Q3 due to restructuring done just before the acquisition was completed and some additional restructuring has been done since the acquisition. We expect both revenue and operating income will improve further in Q4 when a full quarter is recognized in our financial results. For Vidyo, we intend to invest in improving revenue on a global basis next fiscal year 2020 and, therefore, will require some investment from our increased profitability. It is very satisfying that both these businesses were brought to a positive EBITDA position in Q3 since as a business, they had substantial losses for many years prior to their acquisition. We hope to build on this success. Economic and market conditions in our service industries continue to be favorable for acquisition strategy and meeting our acquisition financial payback criteria with a strong return on invested capital. We continue to focus on our capital deployment activities as well as positioning to improve internal growth in future years. Our integration of both Vidyo and Espial is substantially complete. I would now like to open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Stephanie Price of CIBC.

[Stephanie Doris Price]

I wonder if you could expand a little bit on the Asset Management division in the quarter. You mentioned some delayed revenue. Wondering if this -- it has since closed?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. I mean we expect it to close soon. As I've stated in the past, sometimes the Asset Management Group, which has larger deals, can be a little lumpy from one quarter to another. We tend to look at it on a yearly basis and it has done pretty good year-to-date, but there was a couple of deals that have moved to Q4. So when you look at our Asset Management Group, you'll find its revenue, in my opinion, isn't as good as it should have been. But it's not from the acquisitions, it's from -- it's basically from these delayed revenue being recognized.

[Stephanie Doris Price]

Great. And then in terms of Espial, can you talk a little bit about this IPTV opportunity that you see going into next year?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. IPTV is an up and coming item. They are very good on the cable side, but they didn't really have a completed IPTV full software package to provide. So we're working on that. And that will really -- no revenue from it yet, but we do expect by early next year that we will have some revenue and we already have interested customers, i.e., they committed that they would like to take it. But, of course, you can't recognize revenue until you give it to all.

[Operator]

Our next question comes from Paul Steep of Scotia Capital.

[Paul Steep, Analyst]

Steve or Vince, maybe you could talk a little bit about the DemandGen initiatives. I guess we've been a year into it. No, we are not looking for forward forecast, but talk about some of the trends you've seen in lead flow. And I know you invested more in going mark-to-market directly. What have you seen in terms of the conversion there? And maybe what are some of the future opportunities?

[Stephen J. Sadler, Executive Chairman & CEO]

I'll let Vince take that one.

[Vincent Mifsud, President]

Okay. Different divisions are at different stages on the DemandGen side. But generally speaking, the Interactive Group is progressing well on DemandGen. We're seeing good bookings and you saw -- you're seeing it translate into results. And then on the network side, again, that's pretty new on DemandGen. We have more opportunity there. I think it's in the area of cross-selling. We've got a lot of products, a great customer base. So we hope to see more progress there in the next few quarters.

[Paul Steep, Analyst]

Okay. And I guess, Steve, on the M&A side, it looks like you're trying to hire some additional resources. Maybe talk about where you're at in terms of team size as well as what the pipeline looks like in terms of just coverage and growth now that you've had, I guess, now 2 or 3 quarters of having some extra resources on that file?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. I'm not sure we are adding a lot of resources. I think we're looking to hire one person to do outbound calling. And otherwise, it's a pretty stable group, a good group that been a lot of the time on acquisition. It's also integrating them into our current operation. But other than looking for one person, really no change there. It's a pretty solid group.

[Paul Steep, Analyst]

Great. And then just one last clarification for me. How much revenue is from acquisitions in the quarter, Steve?

[Stephen J. Sadler, Executive Chairman & CEO]

About $14 million.

[Paul Steep, Analyst]

Perfect.

[Stephen J. Sadler, Executive Chairman & CEO]

Again, the acquisitions were okay. I was hoping for a little more revenue, but the Asset Management side is down a little bit from our networks' delayed revenue.

[Operator]

Our next question comes from Deepak Kaushal of GMP Securities.

[Deepak Kaushal, Director and Technology & Communications Analyst]

I have a couple of follow-ups and a couple of minor ones. Steve, just on this AMG delay, have you guys started delivering the product and you just can't bill it for revenues? Is there some sort of unbilled revenue here? Or it is -- is there everything kind of on hold?

[Stephen J. Sadler, Executive Chairman & CEO]

Generally, you deliver it with larger accounts. Sometimes, it takes a little longer than we would expect to get all the sign-offs and therefore, get the PO to record the revenue. So we do -- it isn't like we're looking for the revenue. We have some interested prospects ready to go, but it takes time to get all the approvals done. And we haven't got them done yet. So there's still some risk in that quarter to get them done, but I expect that we will improve the revenue there.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. And on the cash drag, I know you said the integration is done on the acquisitions, but -- on the cash drag from that, is that now complete? Or should you get back to normal run rate going forward here?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. We should be hopefully better than normal run rate. So again, the 2 companies had a lot of losses and had some financial issues. We had to pay a lot of fees and straighten some stuff up. That's all being done, so we should be back to a normal run rate in Q4.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. And then, I think, I saw mention of a higher hardware mix. Is that a temporary thing? Is there a trend going on? Or is it from the acquisitions? Maybe you can shed some light on that and how that should trend? And then I've got more a interesting question, perhaps.

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. I do expect the hardware side has picked up a little bit. Vidyo had some hardware come in with it because they -- to do video, there's hardware involved as well and they like one-stop shopping. So the hardware mix, there'll be a little bit more hardware. If you start doing the percentage though, I would think the other parts of our revenue mix will also improve. So mate, I don't think the percentage will go up, but as an absolute dollar thing, I do think you will have a little higher hardware mix.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. Great, that's helpful. And then just on -- I think earlier in your comments you mentioned investing in global revenue with Vidyo. I was just wondering if you could talk a little bit about the go-to-market strategy for Vidyo globally. And if you might be able to get synergies between Vidyo on the enterprise side with your contact center side of your business? And -- just a bit more on the strategy and how you grow that business?

[Stephen J. Sadler, Executive Chairman & CEO]

There's a couple of questions there. Our objective in the quarter was let's get it to profitability, let's generate cash flow. And once we got it stabilized, then how do we invest some of that cash flow to build the business. If you look in our current contact center, we do service some of our competitors because the products are very secure and good in that area. So again, yes, we hope to build that into our own systems as well. But outside that, remember, one of the great advantages we have is, we have a global structure with people in many countries. So we want to take the product, again, we want to get some of the issues cleaned up first, but we want to take the product, adding a few people in those countries to each of those countries and therefore, expand the product globally, which they did not really have that many people in other countries, where we have 50-plus in many countries, as you know. So we're going to try and use our global structure to see if we can sell more of the Vidyo in those countries. If you look at what's happening today, everyone is putting a bubble over themselves in the countries. The best example is the U.S. So again, once we can show we have people in the country supporting the software in the country, we believe that's an advantage that we can -- we should see results from in the future. So that's our intention, but we want the software really solid before we do that expansion and we are working on that now.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. And so the investments for both Vidyo and Espial, should they be done by Q2 next year? Or would they just be ongoing as part of normal course of business?

[Stephen J. Sadler, Executive Chairman & CEO]

With Espial, it's clear now.

[Deepak Kaushal, Director and Technology & Communications Analyst]

You're investing in both of them, right, as you mentioned?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes. But the Espial is going now in R&D to actually get the product ready and -- for market by early next year. For Vidyo, we would have to add, what I'll say, call DemandGen sales and marketing in our other countries. Probably that will start November to December with results next calendar year.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. So put in...

[Stephen J. Sadler, Executive Chairman & CEO]

With the whole budget process now to see how to do this and now -- probably get sorted out, but you do have to hire people, you do have to set up. So my guess is that will be done not by the end of October, but by the end of December and results starting in next year if it's successful, which we hope it will be.

[Deepak Kaushal, Director and Technology & Communications Analyst]

Okay. And so put it in a different way, then the target to get back to corporate average margins for both of these companies, can we say that's the end of 2020 or does it stretch up beyond that?

[Stephen J. Sadler, Executive Chairman & CEO]

I'd say I was going to start first quarter of 2020, starting November 1. Because all these things, remember, if I'm doing the Vidyo, shouldn't cost that much more, maybe we can use some of our current resources to do it. So that's okay. And the IPTV should be bringing in some more revenue, again, in the second quarter of next year, but I also have those delayed results. Our margin should have been better this quarter. So I expect Q4 will be better, never mind, next year.

[Operator]

[Operator Instructions] Our next question comes from Paul Treiber of RBC Capital Markets.

[Paul Treiber, Associate]

Just in regards to Vidyo, in terms of product portfolio, my understanding is that they have several different platforms. Is there a strategy to support all of them going forward or will you prioritize some over the others?

[Stephen J. Sadler, Executive Chairman & CEO]

Well, we actually have 3 main areas that they're in. They do hospitals and financial institutions, which are vertical markets. They've enterprise, which is a more general. And they have sort of a platform IO to let people write programs on and use the basic fundamentals of the platform. They were doing a new system as well and we've actually curtailed that and decided to improve their current one, rather than keep developing the new one. So we're trying to put more resource on the current one to build faster versus splitting the platforms up. So it's not really a wide variety of platforms right now the way we positioned it.

[Paul Treiber, Associate]

Okay. And I assume based on your prior comment about taking it globally, the ones that you're investing in, I assume you believe would be scalable into other geographic markets?

[Stephen J. Sadler, Executive Chairman & CEO]

Yes, I believe that to be true. And in long run investing and you should also understand it's both in the cloud and on-premise. They were trying to just build it on -- in the cloud type system. The one we have with some improvements can do both. So we think that's an advantage. And we just got to clean it up a bit, put a little more investment in it because they had stopped investment for a couple of years and we have to catch that back up if we're going to go that route. So we're working on that now and probably will have some more resource working on that rather than dividing the resource up into 2 parts.

[Paul Treiber, Associate]

And then just broadly in terms of the R&D strategy and also the competitive environment, in the past, a couple of years ago, you characterized your R&D spending as industry-leading. And then -- since then, it's come down a bit. It sounds like you may be going through a little bit more of a cycle here with the R&D spending, maybe, a bit higher. How do you see -- what's in priority for R&D? Do you see that as a competitive differentiator at this point? And then related to that, the competitive environment, there has been concerns for the last couple of years, but the cloud competitors went on. Could you provide an update on the competitive environment and how you see these new acquisitions fitting in there?

[Stephen J. Sadler, Executive Chairman & CEO]

Okay. So you have a couple of questions there that aren't all related, but let me do the R&D side first. If you look at this quarter and look at the R&D spend to revenue, generally, we were running previously around 14%, you'll note this has jumped up to 16% plus. So that R&D spend is already in the quarter with the 2 new acquisitions, which I already explained why it's there. Over time, that percentage should come down, hopefully, because we have more revenue. So if you have -- the costs are okay, maybe up a little bit, but hopefully revenue is up more. So we've already done that part. From the competitive side, it's pretty much the same. Different divisions have different competitors, but the sad side on the contact center still there, has been for a while. The part that we hope to bring out soon as well is our team's integration, and again, we see that coming by, let's say, the end of the calendar year. We're making good progress there. That should improve some of our issues we've had over the last 18 months with our Microsoft, Skype for Business operation. So yes, a lot of things are being positioned and hopefully coming together for a good next year.

[Paul Treiber, Associate]

And maybe, what would tie my couple of questions together is, from a competitive perspective, do you see the investments that you're making in the product would either close the competitive gap or extend your lead versus competitors? Or do you think more is needed there? Or do you think it's sufficient where it is?

[Stephen J. Sadler, Executive Chairman & CEO]

We think they're all pretty much a commodity in some way, some do some things better than others. So you can't do everything for everybody. Right now in the 2 products, the IPTV is important to get that done, that would be new. In the Vidyo side, they are pretty good with their system that they have, but we have to clean it up. We want to make it more stable, clean up any issues that might have and make it really robust. So anyone using it can do it without any issues. So that's more of, I'll call it, a bug cleanup versus trying to do a lot of new things in there because it's pretty competitive as it is today. It's secure. It's done some interesting things compared to competitors who are getting better traction in the market like Zoom. We believe our software is more secure than theirs and we are quite competitive already, but we have to catch up a little bit from the -- getting the software more robust and cleaned up because they've fallen a little bit behind in the last couple of years.

[Operator]

[Operator Instructions] There are no questions in the telephone queue at this time.

[Stephen J. Sadler, Executive Chairman & CEO]

Okay. Thank you, everyone, for your continued interest in Enghouse. We look forward to completing our October 31, 2019, fiscal year and reporting our Q4 and annual progress.

[Operator]

Ladies and gentlemen, this concludes the Enghouse Q3 2019 Conference Call. Thank you for your participation. You may now disconnect.