Presidio, Inc. (PSDO) Q2 2019 Earnings Conference Call Transcript

PSDO earnings call for the period ending December 31, 2018.

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Presidio, Inc.  (NASDAQ:PSDO)
Q2 2019 Earnings Conference Call
Feb. 06, 2019, 5:00 p.m. ET

Contents:

Prepared Remarks:

Operator

Greetings, and welcome to the Presidio Second Quarter Fiscal 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. (Operator Instructions)

I would now like to turn the conference over to your host, Elliot Brecher, Presidio's General Counsel. Thank you. You may begin.

Elliot Brecher -- Senior Vice President, General Counsel and Secretary

Good afternoon, everyone, and welcome to our second quarter fiscal 2019 earnings call. Today's conference call is being broadcast live via webcast. In addition, a replay of the call will be available on our website following the call. By now you should have received a copy of our press release and supplemental earnings presentation that was distributed this afternoon. If you have not, they are available on the Investor Relations section of our website.

Before we get started, I'd like to note that certain comments made on this call will contain forward-looking statements regarding future events or the future financial performance of the company. Any such statements, including statements regarding our outlook for fiscal 2019 or any other future periods, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are not guarantees of future performance nor should they be relied upon as representing management's view as of any subsequent date. The company does not undertake any duty to update any forward-looking statements.

Forward-looking statements involve significant risks and uncertainties and events or results could differ materially from those presented due to a number of risks and uncertainties. Additional detailed information concerning these risks regarding our business and the factors that could cause actual results to differ materially from the forward-looking statements and other information we'll be giving today can be found in our Form 10-Q and our Form 8-K filed today with our press release, which are available at www.sec.gov as well as the Investor Relations section of Presidio's website at presidio.com.

During the call, we'll also discuss our non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles in the United States. A reconciliation of the GAAP and non-GAAP results is provided in today's press release.

Our presenters today are Bob Cagnazzi, our Chief Executive Officer; and Neil Johnston, our Chief Financial Officer. Bob will begin with his perspective on the second quarter fiscal 2019 performance and provide a discussion on our ongoing strategic initiatives. Neil will then review our financial results and future outlook in more detail before we open the call up for your questions. Bob?

Bob Cagnazzi -- President and Chief Executive Officer

Thank you, Elliot, and good afternoon, everyone. Thank you for joining us for our second quarter fiscal 2019 earnings call.

I'm very pleased with our performance in the second quarter, which reflects our ongoing execution against the strategic priorities that we had outlined in our Investor Day last September. Our robust revenue backlog and our increasing mix of services revenue and recurring revenue has sustained our positive momentum in fiscal 2019, as we remain focused on delivering consistent financial results for our investors and world-class projects and implementations for our clients.

Based on our strong performance in the first half of fiscal 2019, we have raised our revenue outlook for fiscal 2019, as we now expect total revenue growth of 5% to 7% for the full year. During the second quarter, we achieved record quarterly total revenue of $768 million, an increase of more than 18% over the prior year, driven by strong growth across all of our client segments and growth across all of our solution areas, as we focus on designing and deploying agile secure infrastructure platforms to enhance our clients' businesses.

We saw continued positive momentum in Digital Infrastructure revenue, which increased 20%. We continue to see an increased traction for next-generation, software-defined infrastructure that's leading to greater client demand for network upgrades. The increase was led by infrastructure sales across all of our market segments, with strong growth in government clients, especially state and local government entities.

Security revenue increased 8% during second quarter, which is on top of a very strong growth of 19% in the prior year quarter. The increase was driven by the growth in managed security services, especially around security incident and event management, along with security architecture and technology solutions.

Our customers are increasingly turning to Presidio to help navigate the complex world of security and the plethora of vendors within the security solution set. Cloud revenue increased 16% in second quarter, driven by increased interest in our multi-cloud offerings.

We saw strong growth in our public cloud offerings, resulting in a continued shift to Cloud revenue from a point-in-time model to recurring model. We also saw growth in our hyper-converged offerings as clients look to move to multi-cloud models, leveraging both on-prem and hyperscaler offerings.

We remain focused on growing our recurring revenue, which is up 27% for the quarter, driven by the investments in our public cloud initiative as well as growth in our managed services offerings. We saw significant growth in recurring revenue backlog of 86% over prior year. Our recurring revenue backlog is now 38% of our overall backlog and that's up 34% from the end of the first quarter of FY '19.

Recurring revenue now represents 6.4% of our total revenues. Our strong performance flowed through to the bottom line, as we also delivered strong earnings growth. Second quarter pro forma adjusted net income increased 9.2% to $33 million, and pro forma diluted EPS increased 25.8% to $0.39.

Our business continued to generate strong cash flow in the second quarter. Cash flow from operations increasing 79% over the prior year and free cash flow increasing 45% over the prior year. We prepaid an additional $25 million of our outstanding term loan in the second quarter, bringing our year-to-date voluntary prepayments to $50 million.

We also paid a $0.04 dividend in the quarter. We continue to capitalize on our strong free cash flow profile to pursue strategic accretive acquisitions, such as Red Sky, which is performing ahead of expectations today, and to deliver shareholder value creation with our share repurchase transaction in the first quarter and our ongoing quarterly cash dividend.

In summary, we have delivered record quarterly revenue in back-to-back quarters and believe we are well positioned for the second half of fiscal 2019. We continue to see strong demand for our solutions orders from clients, which is reflecting the strong increase in our backlog of 13% sequentially and 23% year-over-year. Our performance to-date and the positive momentum that we continue to see for our business provides us with the confidence to increase our outlook for total revenue growth of 5% to 7% for fiscal 2019.

Now, let me turn it over to Neil, who will walk you through our financial performance in greater detail. Neil?

Neil Johnston -- Chief Financial Officer

Thanks, Bob, and good afternoon, everyone. I'll start with a summary of our financial results for the second quarter and the first half of fiscal 2019, and then finish with our revised outlook for the full year.

Just as a reminder, we adopted the new revenue recognition standard ASC 606 on July 1, 2018, and elected the full retrospective method. Accordingly, all of our historical results have been adjusted. Please refer to the ASC 606 materials located on our Investor Relations website for additional details.

For the second quarter, total revenue was $768 million, up 18.3% over prior year revenue of $649 million, driven by revenue growth across all of our client horizontals and across all of our solution areas. The growth was led by several large infrastructure projects delivered in the quarter, that including a significant amount of product, which drove a 23.3% increase in product sales in the second quarter. Service revenue decreased 3% to $121 million, driven by lower revenue recognition, largely attributable to the extension of a number of large projects.

However, the accelerated delivery in product in the second quarter has led to strong growth in services backlog of 9%, both sequentially over the first quarter and over the prior year, as the services associated with these products have not yet being completely delivered. We saw strong growth across all of our client segments and growth across all of our solution areas, with Digital Infrastructure up 20%, Security up 8% and Cloud up 16% for the quarter.

We remain focused on growing our recurring revenue, which was up 27% for the quarter, driven by the investments in our public cloud initiatives, as well as growth in our managed services offerings. Recurring revenue now represents 6.4% of our total revenue.

By customer horizontal, we saw strong growth in both our government and large enterprise horizontals with an increase of 63% and 17%, respectively, while our mid-market clients also showed robust demand, up 11%. With government, we saw strong traction with state and local clients, as well as growth of federal clients in the quarter as compared to the prior year. We continue to experience accelerating growth in our backlog orders.

At the end of the second quarter, our revenue backlog increased to $724 million, an increase of 23% over the prior year and up 13% sequentially over the first quarter. The growth in backlog was driven by strong growth in both product and services, and we saw significant growth in recurring revenue backlog of 86% over the prior year.

Our recurring revenue backlog is now 38% of our overall backlog, up from 34% at the end of the first quarter. In the second quarter, total gross margin decreased to 20.1% from 21.2% due to the lower-margin product revenue included in Digital Infrastructure Solutions and lower revenue recognition on services engagement, due primarily to the extension of a number of large projects.

Adjusted EBITDA increased 16.3% to $58 million in the second quarter and our adjusted EBITDA margin was 7.5%, down 20 basis points from the prior year due to the lower gross margins, mostly offset by higher efficiency in SG&A.

SG&A as a percentage of revenue decreased 60 basis points to 13.4% for the quarter, driven by leverage from our strong revenue growth. On a GAAP basis, net income was $5.6 million and diluted EPS was $0.07 in the second quarter.

As a reminder, the positive impact of US tax reform was recorded in the prior year and included an $89 million non-cash reevaluation of deferred taxes. Accordingly, Q2 net income and diluted EPS declined compared to the prior year, primarily due to this impact of US tax reform.

Our pro forma adjusted net income of $33.1 million was up 9.2% over the prior year, and our pro forma diluted EPS of $0.39 was an increase of 25.8% over the prior year, including the accretion from the share repurchase completed in the first quarter of fiscal 2019.

Turning to the half-year results. For the first half of fiscal 2019, we saw strong revenue growth of 9.9%, driven by a 12.1% increase in product sales, while services revenue was flat due to extension of some of our client projects, which reduced revenue recognition in the period.

By solution area, Digital Infrastructure was up 14%, Security up 6%, Cloud decreased 2%. We continue to experience the shift in revenue recognition in our Cloud business from recognition at a point in time to recognition over the period of the customer contracts.

The success of our public cloud initiatives as well as growth in managed services, drove our recurring revenue up 26% over the prior year and recurring revenue represents 6.1% of our total revenues in the first half of fiscal 2019. We saw growth in all customer horizontals, with government up 37%, large enterprise up 23% and mid-market up 2%. Within government, we saw significant growth with state and local clients.

For the first half of fiscal 2019, total gross margin decreased to 20.7% from 21.3%, driven by strong growth in infrastructure solution sales, which outpaced both Cloud and Security sales and had lower margin profile, as well as lower services revenue attributable to the lower revenue recognition associated with the longer delivery time on projects.

Adjusted EBITDA increased 2.6% to $120 million in the first half of fiscal 2019, while adjusted EBITDA margin of 7.9% was in line with our expectations for the first half of the year. On a GAAP basis, net income was $20.4 million and $0.23 in the first half of fiscal 2019. As I mentioned when describing the second quarter, the positive impact of US tax reform was recorded in the prior year.

Accordingly, both net income and diluted EPS declined compared to the prior year. Our pro forma adjusted net income of $69.8 million was up 4.8% over the prior year, and our pro forma diluted EPS of $0.81 was an increase of 17.4% over the prior year, including the accretion from the share repurchase completed in the first quarter of fiscal 2019.

Turning now to our liquidity and cash flow metrics. We continue to produce strong free cash flow. During the second quarter, we generated $28.4 million in free cash flow, after $10 million of cash outflows for public cloud resale and managed services investments. This takes our year-to-date free cash flow to $46.5 million, after $17.7 million of year-to-date cash outflows for public cloud resale and managed services investments.

Moving to the balance sheet. We continue to enhance our financial flexibility and capital structure, and find opportunities to create value for shareholders. During the second quarter, we made an additional voluntary prepayment of $25 million on our term loan for total voluntary prepayments of $50 million on our term loan year-to-date. We finished the quarter with total net debt of $766 million and net total leverage of 3.4 times.

In addition to continuing to delever our balance sheet, the strength of our free cash flow model has allowed us to pursue strategic and accretive acquisitions, such as Emergent and Red Sky, while creating value for our shareholders as demonstrated by our accretive share repurchase transaction in the first quarter and our ongoing quarterly cash dividend.

Turning now to our outlook for full year fiscal 2019. Based on our strength of our results for the first half of the fiscal year, we've raised our full year total revenue expectation to the range of $2,910 million to $2,950 million from $2,850 million to $2,900 million, which implies 5% to 7% year-over-year growth as compared to our previous expectation of 3% to 5% year-over-year growth. We reaffirm our adjusted EBITDA margin outlook for the year to be approximately 8%, and our pro forma diluted EPS growth for fiscal 2019 to be in the mid-to-high teens, including the impact of the repurchase.

As per our previous guidance, we expect free cash flow before the impact of investments in public cloud and managed services to be approximately $120 million for the full year. We expect these investments to average $10 million per quarter.

In the third quarter, we will see an increase in working capital due to a change in supplier terms. As a result, we expect free cash flow in the third quarter to be lower than free cash flow in the fourth quarter. We continue to expect that our leverage will be in the low 3 times range at the end of fiscal 2019, before the impact of any potential strategic acquisitions.

Thank you, again, for joining the call today and for your continued interest in Presidio. I'll now turn the call over to the operator so that we can take your questions. Operator?


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Questions and Answers:

Operator

Great. Thank you. At this time, we will be conducting a question-and-answer session. (Operator Instructions) Our first question is from Frank Atkins from SunTrust. Please go ahead.

Frank Atkins -- SunTrust Robinson Humphrey -- Analyst

Thank you for taking my question. Wanted to ask a little bit about the outlook on the margin side. You reiterated the -- approximately 8% EBITDA margin. Can you talk a little bit about some of the margin dynamics as you go into the last couple of quarters of the year?

Bob Cagnazzi -- President and Chief Executive Officer

Sure, Frank. As we've seen, we expect the -- approximately 8% to continue through the back half of the year. As you can see, our SG&A is getting more efficient as we grow our revenue, but we are seeing a slight decline -- we did see a slight decline in our services gross margin as a result of projects just moving out.

We don't expect that to continue. We expect that -- we expect the margins on both services and product to be very similar to what they've been through the six months and the back half of the year. So, we would expect margins to remain at roughly the same level in the back half consistent with the front half and consistent with our guidance.

Frank Atkins -- SunTrust Robinson Humphrey -- Analyst

Okay. That's very helpful. And then in your prepared remarks, you touched on the government and state and local clients having the strength in the quarter. But as you look in the guidance, especially this next quarter to be reported, should we expect any impact from the government shutdown?

Bob Cagnazzi -- President and Chief Executive Officer

The government really affects our Fed business, which is not a large part of our business. Essentially, our Fed business is approximately 3% of our overall revenues. Year-to-date, we've seen the Fed slightly down. It's down, I think, 11% year-to-date.

Even if it were to be down that same level in the back half of the year and we hope it's not. But even if it were to be at that level, it doesn't affect our overall growth rate all that much. It's sort of around less than 0.5%. So, we don't think that it is going to be a -- certainly a big risk as we look at our guidance in the back half of the year.

Frank Atkins -- SunTrust Robinson Humphrey -- Analyst

Okay. That's helpful. Thank you very much.

Bob Cagnazzi -- President and Chief Executive Officer

Thanks, Frank.

Operator

Thanks. Our next question is from Rod Hall from Goldman Sachs. Please go ahead.

Ashwin Venkat -- Goldman Sachs -- Analyst

Hi. This is Ashwin on behalf of Rod. Thank you for taking my question. You guys talked about continued strength in next-generation, software-defined infrastructure, driving network upgrades. Kind of related to that, I wanted to check on your expectations about supply situation, as it relates to one of the key flagship products. And how are you thinking about its impact on guidance for fiscal second half?

Bob Cagnazzi -- President and Chief Executive Officer

Yes. So, what we saw through Q2 was a normalization of supply chain around the Cisco 9000, Cisco 9k platform, which is their flagship entry into software-defined networking, their ACI platform along with the Cisco 9k hardware. So, we saw a normalization of supply chain. So, when we take a look at quarter -- versus quarter one, our backlog actually went down 23% versus what it was in Q1 for the Cisco 9k.

However, the backlog year-over-year demonstrates the continued acceleration in this refresh cycle. The backlog year-over-year is up 76%. So, continued strong growth in the product set, but much more normalized shipping. So, we would talk -- we had talked about this for two to three quarters and we saw that normalize in Q2. And we believe it'll just be on a normalized basis going forward.

Ashwin Venkat -- Goldman Sachs -- Analyst

Got it. Just one more question on seasonality for the March quarter. Looks like lot of verticals are doing really well. Heading into the quarter, do you feel like -- are you going to experience better seasonality than what you have in the past? Any comments there?

Bob Cagnazzi -- President and Chief Executive Officer

Yeah. So, when we take a look at -- again, at the backlog, we're bringing into this quarter, it's up 23% year-over-year. It's up 30% (ph) for Q1. The bookings in January -- and we spoke about the bookings actually last year on this call for January. Those bookings were up about 12% in the first month of the quarter. So, we do feel there's a lot of momentum into Q3. And the sense that we're getting from serving our customers is that they are still bullish on their investments in projects, especially in larger projects.

Ashwin Venkat -- Goldman Sachs -- Analyst

Okay. Thank you.

Operator

(Operator Instructions) Our next question is from Tim Yang from Citi. Please go ahead.

Tim Yang -- Citigroup -- Analyst

Hey. Thanks for taking my question. A follow-up on the margin question. So, can you maybe just talk about why your margin guidance is roughly unchanged but your revenue guidance is higher? Why there is no top line leverage? Thanks.

Bob Cagnazzi -- President and Chief Executive Officer

Sure. We are making investments. So, I think there are sort of two things that are driving our margins as we look out in the short term. We do expect margin to expand in the medium term and what we said about the medium-term. But in the short term, there are really two factors.

The first one is the fact that we are seeing some inflation as an increasing costs around, particularly engineers as we compete for top talent. We spoke about that a couple of quarters ago in connection with the tax reform. We said we were going to be investing in talent. And so, that is a little bit of what's affecting our service margins.

And then, secondly, we did see a project move out. I mean, project move out, basically, we didn't recognize much revenue in the quarter and as a result, the margins declined. That will also correct itself, as we catch up with these projects. That revenue doesn't disappear. It's just the amount of revenue recognition that we recognized between the quarter.

Tim Yang -- Citigroup -- Analyst

Yeah. Thanks for the clarification. I guess, one more question on the customer behavior. Are you seeing any customers that are buying ahead of schedule because they want to avoid price increase from the product -- from the tariffs? Thanks.

Bob Cagnazzi -- President and Chief Executive Officer

We don't believe so. Again, the change in the timing on the tariffs in our Q2 was, let's say, about midway through the quarter. So, had people been thinking about pulling ahead a material amount of orders for Q2 from Q3 because of the tariff increase that they were talking about, if I would've done so as close to the end of the quarter as possible. So, we don't believe we saw anything. And we have not heard clients talking about that in earnest in this quarter.

We did hear it as chatter with our clients at the beginning of Q2. Given that we did see a number, we did see a small portion of the order book that was expected to book in Q3 coming in Q2, about $20 million in revenue or so. And those were just not related to tariffs. They were really just related to the budgeting and the end of the budget year and just a number of other things. But about $20 million in bookings that we expected to come in January came in December.

Tim Yang -- Citigroup -- Analyst

Thank you so much.

Operator

(Operator Instructions) And if there are no further questions, I'd like to turn the floor back to Mr. Cagnazzi for any closing comments.

Bob Cagnazzi -- President and Chief Executive Officer

Thank you. Thank you, and thank you for joining us again this quarter. We have been talking about some of these strategic initiatives pretty much since we went public and certainly over the last five quarters about how we're investing in becoming not just a project provider to our clients but more of a services provider.

The hedge you're seeing, the growth using that technology, you're seeing the growth in recurring revenue streams. The priorities that we laid out at Investor Day around recurring revenue and around revenue growth and backlog momentum, we have met or exceeded all of those metrics. I think it is a great sign that the clients are starting to see us more as a service provider as opposed to just a project relationship. And we talked about it.

Over time, as our recurring revenue grows and our relationship becomes more encompassing, that will smooth out our revenue streams as we go forward to make the business a lot more predictable. And we believe we'll start to see the scale on the margins over time.

So, what you're seeing is really the manifestation of what we've been talking about the last four quarters. And what we are seeing looking ahead into FY '19 H2 is continued momentum around all these same opportunities. As we mentioned, we've got great metrics going into Q3 and really good confidence from the client base.

So thank you, again. And we look forward to speaking with you through the quarter.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

Duration: 27 minutes

Call participants:

Elliot Brecher -- Senior Vice President, General Counsel and Secretary

Bob Cagnazzi -- President and Chief Executive Officer

Neil Johnston -- Chief Financial Officer

Frank Atkins -- SunTrust Robinson Humphrey -- Analyst

Ashwin Venkat -- Goldman Sachs -- Analyst

Tim Yang -- Citigroup -- Analyst

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