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(NASDAQ:IIIV)
Q4 2018 Earnings Conference Call
Nov. 29, 2018 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to the i3 Fiscal fourth-quarter 2018 earnings conference call. Today's call is being recorded and a replay will be available starting today through December 6. The number for the replay is (719) 457-0820, and the code for this is 3349103. The replay may also be accessed through December 6 at the company's website.

At this time, for opening remarks, I would like to turn the call over to Scott Meriwether, senior vice president, finance. Please go ahead, sir.

Scott Meriwether -- Senior Vice President, Finance

Good morning, and welcome to the fourth-quarter 2018 conference call for i3 Verticals. Joining me on this call are Greg Daily, our chairman and CEO; Clay Whitson, our CFO; and Rick Stanford, our president. To the extent any non-GAAP financial measure is discussed in today's call, you will also find the reconciliation of that measure to the most directly comparable financial measure calculated according to GAAP by reviewing yesterday's earnings release. It is the company's intent to provide non-GAAP financial information to enhance understanding of its consolidated financial information as prepared in accordance with GAAP.

This non-GAAP information should be considered by each individual in addition to but not instead of the financial statements prepared in accordance with GAAP. This conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements, among others, regarding the company's expected financial and operating performance. For this purpose, any statements made during this call that are not statements of historical fact may be deemed to be forward-looking statements. You are hereby cautioned that these forward-looking statements may be affected by the important factors, among others, set forth in the company's earnings release and in reports that are filed or furnished to the SEC.

And consequently, actual operations and results may differ materially from the results discussed in the forward-looking statements. Finally, the information shared on this call is valid as of today's date, and the company undertakes no obligation to update it, except as may be required under applicable law. I'll now turn the call over to the company's Chairman and CEO Greg Daily.

Greg Daily -- Chairman and Chief Executive Officer

Thanks, Scott, and good morning to all of you joining us today. We are pleased with our recently completed fiscal year and look forward to delivering strong performances in the coming fiscal year. We're still a relatively young public company and are excited about our future as our team, culture and morale continue to come together. We had a strong quarter.

Our net revenues increased to $28.1 million from $20.3 million in fiscal four of '17, fueled by organic growth and several acquisitions. Pro forma adjusted EBITDA increased to $7.8 million in Q4 from $5.8 million in Q4 '17. Clay will cover these numbers in more detail in his section. We continue to achieve above-market growth rates by delivering seamlessly integrated payments and software solutions to SMB and organizations in strategic verticals.

We continue -- we currently own software in three of these verticals: education, public sector, property management. And we partner with ISVs in other verticals. We continue to focus on verticals we consider strategic, and we will make selected acquisitions in these verticals. We're excited to announce we've completed three acquisitions since our last earnings release.

I have met most of these employees within the companies, and we welcome them to the i3 team. Two of the recent acquisitions were in the public sector vertical, bringing our total acquisitions in this vertical to three within the last year. We now provide a comprehensive suite of software products within the public sector market, including software solutions for property assessment, tax collection, court payments and share of office payments, along with a government accounting solution that interfaces with other software modules. With these acquisitions, we have a platform of software solutions within the public sector vertical, and we hope to follow the road map of success in this vertical similar to what we have accomplished within our education vertical.

Our third acquisition accelerate the development of our Burton Platform. We can now offer our merchants and ISV partners point-to-point encryption for their transactions, more EMV-enabled devices, level 3 interchange rates for processing and reduced environment for PCI compliance. We've also launched unified APIs and developed -- developer toolkits for our ISV partners. We believe that the technological capabilities of our Burton Platform place us in a market leadership position.

We are pleased with the additional software capabilities our recent acquisitions provide and believe they will deliver growth within integrated payments in the coming years. Reflecting on our focus of integrated payments and proprietary software embedded payments, 45% of our payment volume was integrated in fourth quarter, up from 40% in fourth quarter of '17. We're in the early stages of development of our ISV program. We've signed five new ISV partners and have seen our pipeline of potential ISV partners expand.

We're working to onboard more ISVs, which will continue to fuel growth in our integrated payments. Three reasons we like integrated payments within the strategic verticals are lower attrition, higher margins and market growth potential. The increase in the proportion of our business coming from integrated payments give us the confidence in achieving long-term margin improvement. Following the IPO, we have a strong balance sheet with plenty of debt capacity.

Our leverage ratio on a pro forma basis for our recently completed acquisitions was less than two times as of September 30, 2018. After that financial section, Rick will spend some time on our recently completed acquisitions. Our acquisition pipeline has been very active since we completed the IPO in June. We remain committed to the same type of acquisition strategy we have executed in the past with the evidence of our rev-- our recently completed acquisitions.

The combination of strong organic growth, long-term margin improvement and strategic acquisition position us well for the future years. Clay, could you give us the financial overview?

Clay Whitson -- Chief Financial Officer

Sure. I'll focus on Q4 numbers as opposed to the full year because the first three quarters have been previously disclosed. Net revenues increased 38% to $28.1 million for Q4 2018 from $20.3 million for Q4 2017, driven by internal growth and acquisitions. Excluding acquisitions and the purchased portfolios, net revenues increased 9% organically.

Acquisitions contributed net revenues of $7.1 million for Q4 2018. Net revenues from purchased portfolios declined to $1.8 million for Q4 2018 from $2.8 million for Q4 2017, a 34% decline compared to 23% for the first nine months of the year, and I'd factor that into our guidance going forward. Adjusted EBITDA grew 36%, increasing to $7.8 million for Q4 2018 from $5.8 million for Q4 2017. Please see the press release for a reconciliation between net income and adjusted EBITDA.

It is essentially income from operations plus depreciation and amortization with the following exclusions: offering-related expenses; changes in earn-out estimates; equity-based compensation; acquisition-related expenses; state and local taxes not including -- not included in income taxes; and deferred revenue writedowns associated with acquisitions of software companies, that's a prospective item. Adjusted EBITDA as a percentage of net revenues held steady at 38% for Q4 2018 despite a 42% increase in corporate expenses principally associated with becoming a public company. Q4 was our full -- first full quarter as a public company. Our IPO was at the end of June.

These costs were anticipated and factored into our previous guidance. Pro forma diluted earnings per share were $0.19 for the quarter. This measure starts with adjusted EBITDA, deducts depreciation and amortization of internally developed capitalized software but not amortization of purchased intangibles and deducts cash interest but not the noncash amortization of deferred financing costs. We apply a tax rate of 25%, which is an estimate of our go-forward blended federal, state and local tax rate, giving effect to the Tax Reform Act of 2018 and the Up-C reorganization in connection with the IPO.

Again, please refer to the press release for a full description and reconciliation. Segment performance. Please refer to the supplemental slide titled Segment Performance on our website for reference with this discussion. Net revenues for merchant services increased 37% to $23.6 million for Q4 2018 from $17.2 million for Q4 2017.

Net revenues for Proprietary Software and Payments grew at an even higher rate, 43%, to $4.5 million for Q4 '18 from $3.2 million for Q4 '17. Adjusted EBITDA for merchant services increased 25% to $8 million for Q4 2018 from $6.4 million for Q4 2017. In Proprietary Software and Payments, adjusted EBITDA continued the transformative trend we've seen all year, increasing 153% to $1.7 million for Q4 '18 from $676,000 for Q4 2017. The principal reason for the improvement has been sustained organic net revenue growth in our flagship education vertical, along with some operational improvements, which have contained growth in costs.

The public sector acquisition completed in September contributed approximately $100,000 to EBITDA. The adjusted EBITDA margin for Proprietary Software and Payments improved to 38% for Q4 2018 from 21% for Q4 2017. The improvement in the software and payments more than offset the step-up in corporate expenses associated with being public. Outlook.

Our guidance for fiscal-year 2019 net revenues is $122 million to $128 million. Adjusted EBITDA for fiscal '19 is $35 million to $36 million; and pro forma adjusted diluted EPS, $0.84 to $0.87. We expect the 3 recently completed acquisitions to collectively contribute over $8 million in net revenues for fiscal '19 and over $3 million in adjusted EBITDA, high-margin businesses. Excluding contingent consideration, we paid $27.1 million mainly in cash.

From a balance sheet perspective, Greg mentioned our leverage ratio, less than two times. That is pro forma for recently completed acquisitions. On September 30, our term facility stood at $35 million, and we currently have $88 million available under our revolver. I'll now turn the call over to Rick for an update on M&A activity.

Rick Stanford -- President

Thanks, Clay. As we told you in June prior to our IPO, acquisitions are an important part of our overall growth strategy. To that end, we regularly consider potential acquisition partners for both platform and tuck-in deals. In addition to price, we carefully assess how they would fit with our business goals and how they would integrate with our culture.

Fit is very important to us. As a result of the recent acquisitions, we have grown our employee base from 334 to 397 strong in the last few months. These acquisitions are not two0person deals but not 100 either. While the acquisition process has a natural ebb and flow, the last 120 days have been especially busy for us, and we're excited about three acquisitions we closed during this time frame. On our Q3 call, I've mentioned that we had signed a nonbinding term sheet for a tuck-in opportunity.

That deal eventually closed in September. It's in our public sector vertical and serves courts and municipalities with proprietary software and payments. It's important to note that this business has already been merged into our technology platform as well. The second acquisition we've closed in November is a platform acquisition within the public sector vertical.

This business provides payment capabilities to courts and municipalities, like the others we have purchased, but this one also provides accounting software that their customers utilize. This additional software capability gives us a good end-to-end solution, allows us to provide a more comprehensive product suite and offers additional opportunities to extend our payment solutions. Last, we believe it gives us the scale to move into other states. Both public sector deals offer fully integrated payment solutions, which is squarely within our long-term business strategy.

Integration significantly reduces attrition and makes the sales stickier. The third acquisition we closed in November as well is a technology play in the payment space. This is a leading technology company and offers cutting-edge solutions that will augment our Burton Platform and accelerate the time to market for the full suite of tools that we plan to offer within that platform. The three acquisitions I've spoken to have shared characteristics, being small but growing, low attrition and profitable, including the technology deal we completed for the Burton Platform. We will continue to focus on finding potential acquisition partners with an emphasis on deals that would accelerate our vertical strategy, and we're extremely excited about our progress and look forward to sharing even more news about closed deals with you in the coming quarters.

This concludes my comments, Kylie. At this point, we'll open the call for Q&A, please. 

Questions and Answers:

Operator

[Operator instructions] We will now take our first question from John Davis of Raymond James. Please go ahead, sir.

John Davis -- Raymond James -- Analyst

Hey, good morning, guys. Clay, good to hear the organic growth is still 9%, still healthy, but it looks like it did decelerate a little bit. And it looks like the yield came down, but margin beat. So my assumption is the little bit weaker revenue was related to hardware sales.

Is that true? And if not, just kind of give any color you can on what drove what was a little bit weaker top line but much better margin.

Clay Whitson -- Chief Financial Officer

Yes, that's exactly right, John. We had about $1 million less in hardware sales going from Q3 to Q4. That impacts net revenue inordinately because the cost of the hardware is not factored into the net revenue. It's in other cost of services.

The other thing was payment systems, the purchased portfolios declined at a 34% rate. That's higher than we've experienced over the first nine months and that probably cost us $400,000 or so.

John Davis -- Raymond James -- Analyst

OK. And then as you look out to 2019, I think guidance increased a little bit less than the acquisition detail you gave. Is that similar lower hardware sales expected? Any color you can give on kind of the implied organic growth rate in the updated 2019 guidance?

Clay Whitson -- Chief Financial Officer

Yes. I think it's been influenced by this quarter, and the hardware business has had some market pressures to transition to more of a SaaS monthly model as opposed to big upfront expenditures. We got to live in that environment and so taking a more cautious view of equipment for 2019. Also, the purchased portfolios, that attrition I've assumed will continue until I see otherwise.

John Davis -- Raymond James -- Analyst

OK. And last one for me, maybe for Rick. Just detail on the acquisitions. Just trying to figure out from a -- were they all equal -- roughly equally sized? Was one really big? And then maybe, Clay, just where is your pro forma debt level now? I know we closed one in the quarter, and so that's included in the debt balance in the quarter.

Just trying to figure out kind of what pro forma debt looks like today.

Clay Whitson -- Chief Financial Officer

Rick?

Rick Stanford -- President

Yes. So two of the deals are in the public sector. One was about an average size, comparable to the deals we've done before; one was a little larger. The addition of the accounting software and the end-to-end solution give us a lot of confidence to be able to expand into other states, which we haven't had to date.

We're positive about all of these acquisitions. The technology play that I mentioned is going to make time to market with what we had envisioned for the Burton Platform a reality sooner than later, and we're excited about that as well.

John Davis -- Raymond James -- Analyst

OK. Any -- go ahead. Sorry, Clay.

Clay Whitson -- Chief Financial Officer

All right, yes. So we have about $57 million borrowed today, $88 million of availability under our revolver. The $57 million includes the term facility.

John Davis -- Raymond James -- Analyst

OK. And then just, Rick, any comments on the geographic expansion area like within public sector? Remind us where you are geographically today. Were these acquisitions were -- planned to expand that beyond those geographies? Do you need to do more acquisitions? Or can you just take the technology now and kind of expand that throughout the rest of the U.S.?

Rick Stanford -- President

I think we'll do both. I have additional public sector deals in my pipeline, and I continue to court. These deals were in the Southeast, similar to the ones we've done before. I see upwards, Northeast and Midwest expansion, Midwest being the primary.

John Davis -- Raymond James -- Analyst

OK. All right. Thanks, guys.

Clay Whitson -- Chief Financial Officer

Thank you, John.

Operator

We will now take our next question from George Mihalos of Cowen. Please go ahead, sir.

George Mihalos -- Cowen and Company -- Analyst

Hey, good morning, guys. Just to follow-up on John's question. Clay, can you remind us the percentage of revenue that has been coming from hardware in '18 and maybe where you see that or where your guidance implies that will go into 2019? And then as it relates to the purchased portfolios, I think those declined a little bit more than what we had expected this quarter. Should we still be thinking of an attrition rate though sort of in the mid-20s as we think about 2019?

Clay Whitson -- Chief Financial Officer

Well, I'll start with the purchased portfolios. Volume attritted 27%, but net revenues attritted 34%. And it's a lot of smaller account closures that were very fee-dependent as opposed to larger merchants with a lot of processing volume. So yes, I'm assuming that continues, that revenue attrition, into 2019.

Your question regarding our Aloha business, it's about 7% of net revenues, and I'm taking that cautious approach for 2019 as well.

George Mihalos -- Cowen and Company -- Analyst

OK. And that's related to -- is that mostly San Diego Cash Register? Is that the business that we're talking about? Or...

Clay Whitson -- Chief Financial Officer

Well, that is. But we've also -- we have another one named EMS up in Seattle.

George Mihalos -- Cowen and Company -- Analyst

OK, OK. That's helpful. And then just wanted to ask on the software acquisitions that were recently consummated. It looks like they're kind of coming in at, call it, about 38% margin.

Is there room to even improve upon that going forward? Or should we be thinking of that as kind of the run rate for the intermediate term?

Clay Whitson -- Chief Financial Officer

Well, these are very high-margin businesses. two of the three are over 50% margins, but it's lumpy. They get -- they're selling software. So they sell to large customer, and it can be very lumpy.

So it's hard to know how much of that to project, but I can say they've had very good years the last two years.

George Mihalos -- Cowen and Company -- Analyst

OK, OK. And is there any reason why we shouldn't see the revenue yield continue to increase going forward, especially given maybe some of the puts and takes around hardware and the new software revenue coming in -- or the software acquisitions, excuse me?

Clay Whitson -- Chief Financial Officer

Well, hardware helps the revenue yields because there's no volume associated with it. And so a decline in hardware doesn't help the revenue yield. The software companies do help the revenue yield. But in general, long term, we do expect the revenue yield to increase because we plan to make our acquisitions in our verticals, and they carry higher revenue yields.

George Mihalos -- Cowen and Company -- Analyst

OK. Thank you.

Operator

We will now take our next question from Peter Heckmann of Davidson. Please go ahead, sir.

Peter Heckmann -- D.A. Davidson Companies -- Analyst

Good morning. Thank you for taking my question. Can you talk a little bit about the new ISV partners and if some of those are helping you identify new verticals that you might want to enter?

Rick Stanford -- President

Yes. So as Greg had mentioned, we signed five new ISV partners. I can't speak to the specific vertical. Typically, we're looking for new ISV partners in the nonprofit and healthcare space.

These were signed and are currently integrating. I believe there's one that's actually actively placing merchants today. We'll continue to focus on nonprofit and healthcare though, Peter.

Peter Heckmann -- D.A. Davidson Companies -- Analyst

OK. That's helpful. And then did you give an overall attrition number for the consolidated quarter?

Clay Whitson -- Chief Financial Officer

We're still tracking it at 1% a month, blended.

Peter Heckmann -- D.A. Davidson Companies -- Analyst

Got it. OK, that's helpful. And then last question, was there anything notable on a trend basis within the three primary areas of proprietary software. Education, I think, had been the most rapidly growing.

But is there anything to call out there in terms of changes, acceleration, deceleration, among those verticals?

Clay Whitson -- Chief Financial Officer

We had another great quarter in education. August and September are big months for us. So that's continued right along. We're getting more and more excited about the public sector vertical now.

We now have three acquisitions, as Rick outlined, and a full product suite to roll out to new states. So our vision is for our public sector business to follow the trajectory that education once did.

Peter Heckmann -- D.A. Davidson Companies -- Analyst

All right. Great. Thanks for taking my questions.

Operator

[Operator instructions] We will now take our next question from Josh Beck of KeyBanc. Please go ahead, sir.

Josh Beck -- KeyBankc Cap Markets -- Analyst

Thank you. My first question is probably for Greg or Rick. And you've been really active obviously in the public sector over the last year, having done three deals. Just kind of wondering, what was so attractive about that vertical? And then when you think about the pipeline, are you finding other verticals where maybe you want to concentrate the M&A efforts and kind of do several in one vertical? Or do you kind of see opportunities across the board?

Rick Stanford -- President

Yes. Josh, Greg makes a good point. To your first question, we're going to follow the margin where it's greatest. We -- it's no secret we like nonprofit and public sector.

Also, typically, my best leads come from deals -- from CEOs of deals that we've previously done. So we have two new deals, and they have contacts in the space. So I'll continue to run those strings out to see what is out there. Now that we have a platform deal in public sector, you can assume that we're going to look for tuck-ins around that software to make a more complete solution.

But we do continue to call into multiple verticals. As I mentioned on the road show, B2B is an assortment of small verticals, and some of them are really cool. So we're learning as we speak about some of these new verticals and testing the market and having conversations with people for potential additional verticals.

Josh Beck -- KeyBankc Cap Markets -- Analyst

OK. Really helpful. And then when I look at the implied EBITDA multiple, at least for fiscal 2019, it looks like it's about nine times. So when you think about that multiple, is it -- is that pretty representative of what you're seeing out there in the market? Were there any unusual things that we should be thinking about when we assess the multiple of these deals?

Greg Daily -- Chairman and Chief Executive Officer

Well, I wish you hadn't asked that question because that's uncomfortably high. I'm sure some of our targets are listening, and we're trying to get seven. But I think they are smaller companies, high-growth software. Their technology is good.

Their culture was fantastic. So we paid up a little bit more than what we normally do, but I do think that, within a couple of years, the multiple looks more like four or five.

Josh Beck -- KeyBankc Cap Markets -- Analyst

OK, that's helpful. And then what about -- Clay, I don't know if you can share this or give us any rough detail, but the mix of software revenue versus payments revenue for these companies that you've acquired and maybe how that compares to some of the other verticals that you're in.

Clay Whitson -- Chief Financial Officer

Well, the one public sector we closed in September is virtually all payments. The technology company we bought is virtually all software. And for the platform public sector business, do you have an estimate?

Rick Stanford -- President

I think 20% payments and the rest, software.

Clay Whitson -- Chief Financial Officer

OK. Did you hear that? 20% payments and 80% software for that -- for the other, the third company.

Josh Beck -- KeyBankc Cap Markets -- Analyst

OK. OK, that's helpful. And then just my last question on the outlook for 2019. If you were to exclude the hardware revenue, which is obviously, I think, not a really integral part of the business long term and exclude the purchased portfolios, any sense of kind of what the underlying growth is? I mean, does it compare to the high single to low double-digit organic growth that we've seen in the second half of this year? Obviously, that's not directly comparable if you back out purchased portfolios, but just trying to get a sense of what the underlying growth is that you are thinking about next year excluding some of those factors.

Clay Whitson -- Chief Financial Officer

I'm thinking high single digits. 9% this quarter is probably representative. That's excluding the purchased portfolios. We do want to get to double digit, but I'm not -- I don't think we're there quite yet.

Josh Beck -- KeyBankc Cap Markets -- Analyst

OK. That's all I have. Thank you so much.

Operator

[Operator instructions] We will now take our next question from Chris Lago of Olean. Please go ahead, sir.

Unknown Speaker

Hi, Greg. Hey, guys. Thanks for taking my question. I just wanted to take get a quick update on the purchased portfolios and if this is continuing to wind down as expected.

Clay Whitson -- Chief Financial Officer

Well, the attrition did accelerate this quarter, and so that was not as expected. It had been running 23% for the first nine months. And so I guess, yes, that was not expected, but we're assuming that in our guidance going forward.

Unknown Speaker

OK. And then just one more question just in terms of capital allocation. Could you just remind me kind of what levels you guys are comfortable with in terms of debt as you're going to continue to do these acquisitions going forward?

Clay Whitson -- Chief Financial Officer

Well, our current credit agreement allows us to go to 3.75 times for senior debt, and we do have the ability to layer in subordinated to get a little bit higher. But where we are today, I think, long term, we're very comfortable with 3.5, and we would be comfortable flexing up temporarily to four, 4.5 with a view toward coming back to 3.5 as cash flow pays down the debt.

Unknown Speaker

OK. Great. Thanks, guys.

Clay Whitson -- Chief Financial Officer

Thank you.

Operator

It appears we have no further questions at this time. I'd now like to hand the call back over for any additional or closing remarks.

Greg Daily -- Chairman and Chief Executive Officer

Well, again, thanks, everybody, for joining us this morning. We're excited about our prospects, our team, Rick's pipeline. And we look forward to talking to you again on our next quarterly call.

Operator

[Operator signoff]

Duration: 36 minutes

Call Participants:

Scott Meriwether -- Senior Vice President, Finance

Greg Daily -- Chairman and Chief Executive Officer

Clay Whitson -- Chief Financial Officer

Rick Stanford -- President

John Davis -- Raymond James -- Analyst

George Mihalos -- Cowen and Company -- Analyst

Peter Heckmann -- D.A. Davidson Companies -- Analyst

Josh Beck -- KeyBankc Cap Markets -- Analyst

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