i3 Verticals, Inc. (NASDAQ:IIIV)
Q2 2019 Earnings Call
May 14, 2019, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to i3 Verticals second quarter 2019 earnings conference all. Today's call is being recorded, and a replay will be available starting today through May 21st. The number for the replay is (719) 457-0820, and the code is 391-5262. The replay may also be accessed for 30 days at the company's website. At this time, for the opening remarks, I would like to turn the call to Mr. Scott Meriwether, Senior Vice President, Finance. Please go ahead, sir.

Scott Meriwether -- Senior Vice President, Finance

Good morning, and welcome to the second quarter 2019 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 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.

Gregory Daily -- Chief Executive Officer and Chairman

Thanks, Scott, and good morning to all of you. We're pleased with our performance of our second fiscal quarter of 2019, and we're excited about our accomplishments for the first six months of the fiscal year and how they will impact our ability to deliver strong future performance. We had a great quarter. Net revenues increased to $31.4 million from $27.1 million in Q2 of '18, fueled by organic growth and several acquisitions. Pro forma adjusted EBITDA increased to $8.7 million in Q2 of '19 from $7.7 million in Q2 of '18. Clay will cover these numbers in more detail in his section.

We continue to achieve above-market growth rates by delivering seamless integrated payments and software solutions to SMBs and organizations in strategic vertical markets. We currently own software in three of these verticals -- education, public sector, and property management -- and we partner with ISVs in the other verticals.

We will continue to focus on verticals that are strategic to us and make selective acquisitions in these verticals. We've been active in M&A. Since our last earnings call, we closed the three deals that we previously noted that were in due diligence, and in addition to these three acquisitions, we also are pleased to announce a recently completed acquisition within our government vertical. This makes seven acquisitions since our IPO and six this fiscal year. Five of the post-IPO acquisitions are in the public sector vertical. The public sector vertical is core to i3's strategy, and we will continue to focus on that space.

We remain committed to the same acquisition strategy we executed in the past and have plenty of that capacity to support that strategy. Later, Clay will speak to the details of our new $300 million credit facility. This new facility enables us to pursue our acquisition strategy, and we appreciate the support of our bank group.

Integrated payments and proprietary software-embedded payments remain our focus. Forty-nine percent of our payment volume was integrated during Q2, up from 39% during Q2 of '18. Integrated payments results in lower attrition, higher margins, and greater market growth potential. The increase in the proportion of our business coming from integrated payments gives us confidence in achieving long-term margin improvement. We believe our focus on organic growth, long-term margin improvement, and strategic acquisitions positions us well for success. Clay, could you give us a financial overview?

Clay Whitson -- Chief Financial Officer

Sure. The following pertains to the second quarter of fiscal '19, which is the three-month period ended March 31st, 2019. Net revenues increased 16% to $31.5 million for Q2 '19 from $27.1 million for Q2 '18, driven by internal growth and acquisitions. Excluding acquisitions and the purchase portfolios, net revenues increased 6.4% organically. Acquisitions contributed an increased of $3.6 million in net revenues for Q2 '19. Net revenues from purchase portfolios declined to $1.5 million for Q2 '19 from $2.3 million for Q2 '18, a 33% decline.

Adjusted EBITDA grew 13% to $8.7 million for Q2 '19 from $7.7 million for Q2 '18. 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 earnout estimates, equity-based compensation, acquisition-related expenses, state and local taxes not included in income taxes, and deferred revenue writedowns associated with acquisitions of software companies.

Adjusted EBITDA as a percentage of net revenues remained 28% for Q2 '19 despite a 47% increase in corporate expenses. The increase in corporate expenses was principally associated with public company costs, but also expanded costs for a sales conference and president's club. As a reminder, we have expected a onetime step-up in corporate expenses for fiscal '19, with inflationary-level growth in future years.

Pro forma diluted earnings per share was $0.20 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 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. In proprietary software and payments, net revenues grew 86% to $7.7 million for Q2 '19 from $4.1 million for Q2 '18. Revenues from software licensing in Louisiana were realized a little sooner than planned. These revenues helped the top-line growth rate, but did not impact internal growth because they came from a recent acquisition.

Adjusted EBITDA continued to grow and improve in margin. Adjusted EBITDA increased 98% to $3.6 million for Q2 '19 from $1.8 million for Q2 '18. The segment benefited both from continued expansion in our flagship education vertical and healthy contributions from our acquisitions in our public sector vertical. The adjusted EBITDA margin for proprietary software and payments improved to 46% for Q2 '19 from 43% for Q2 '18, with education margins driving the increase. Despite our success in education, we expect our public sector vertical to surpass education as the largest contributor in this segment in coming quarters.

Net revenues for merchant services increased 4% to $23.8 million for Q2 '19 from $22.9 million for Q2 '18. Adjusted EBITDA for merchant services increased 2% to $7.8 million for Q2 '19 from $7.7 million from Q2 '18. Excluding the purchase portfolios, net revenues in merchant services increased 8%.

Outlook: We affirm guidance for fiscal year '19, which was issued last month on April 8th in connection with the Net Data acquisition, as follows: Net revenues, $127-133 million, adjusted EBITDA, $36.5-39.5 million, and pro forma adjusted diluted EPS, $0.85-0.90. This guidance marked the third time the company has raised guidance for fiscal '19. We will include expectations for the education acquisition we announced today as part of our fiscal 2020 guidance, but for the remaining months of fiscal '19 ending September 30th, it will not move the needle.

Like our other education companies, we expect the acquisition to lose money during June and July when school is out. These losses should largely offset profits we expect for the months of May, August, and September. Over the course of the year, we expect the acquisition to conform to a purchase multiple of less than 10 times EBITDA.

A new credit facility: Greg referenced our strong acquisition pipeline. In order to take advantage of our opportunities, last week, we expanded our credit facility from $150 million to $300 million. The structure is 100% revolver so that we can borrow for an acquisition, pay down borrowings with free cash flow, rinse, and repeat. We will benefit from a lower interest rate spread of approximately half of a percentage point. The agreement contains a maximum leverage covenant of 3.75 times EBITDA, with a stepdown to 3.5 times in two and a half years. For further details on the credit facility, please see the agreement filed along with the press release yesterday afternoon.

Bank of America is again the lead arranger, and Fifth Third is joint bookrunner. Wells Fargo remains a joint lead arranger, while newcomers KeyBanc, Citizens, and PNC joined as joint lead arrangers. Other banks that are new to the syndicate include Bank of Montreal, HSBC, and First Financial Bank in Cincinnati. These banks all play important roles in our industry and have the capacity to help us grow for the foreseeable future.

Our current leverage ratio, giving effect to the two acquisitions that have been completed after quarter end, is approximately 2.75 times. We currently have approximately $113 million borrowed. Over time, we expect to convert roughly two thirds of EBITDA into free cash flow, which can either be used for more acquisitions or debt repayment. I'll now turn the call over to Rick for an update on M&A activity.

Rick Stanford -- President

Thank you, Clay. Good morning, everyone. In our February 13 earnings release, we indicated that we had entered into three term sheets for potential acquisitions -- two within our public sector vertical and one technology acquisition that would fold into public sector as well. We are pleased that all three of these deals closed. The first two we announced on March 4th and the third we announced on April 8th. While we're excited about each of these deals, we're particularly excited about our acquisition of Net Data in Texas. This 35-year-old company offers a robust software platform for courts and municipalities that has widespread adoption throughout the state. It is led by an experienced management team and has a strong group of talented employees that have hit the ground running in the weeks following the closing. We look forward to good things from this business.

As Greg mentioned, we're very excited to have recently closed another acquisition within the education vertical. This acquisition augments our existing business within this important vertical. It expands our footprint in various states where we currently operate, but also creates a new foothold in many states where we do not reside today. We feel this acquisition will give us room to run in those new states in the future from a sales perspective. We continue to work hard on integrating all of our prior acquisitions. Business integrations can be challenging, but we are encouraged at the early results of these efforts, and we are convinced that maintaining consistency in the leadership positions of each acquired business helps us streamline these integration efforts.

We work hard to find acquisition partners that have leadership groups who buy into the vision that Greg has laid out for us. This helps us both win deals and also make sure the deals are successful post-close. As we have said before, fit is extremely important to us. We look forward to sharing more information on M&A activity as it becomes available. As you know, we stay very busy on the acquisition front, and we continue to see opportunities in the market. This concludes my comments. Ranjita, at this point, we'll open the call to Q&A, please.

Questions and Answers:

Operator

Thank you, sir. If participants would like to ask a question, please signal by pressing *1 on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again, please press *1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We will now take our first question from George Mihalos from Cowen.

George Mihalos -- Cowen and Company -- Managing Director

Nice to see the acceleration in the growth. Before getting into the quarter, just maybe Greg and Rick -- at a high level, now that you've got access to the $300 million, should we assume that you are potentially looking at larger acquisitions than what you have in the past? And then, Clay, to the extent you can ballpark for us -- I know it's not going to matter for '19, but any sort of financial metrics around the education acquisition revenue EBITDA contribution on an annualized basis? I would love to hear that.

Rick Stanford -- President

Good morning, George. Thanks for the question. I think we'll continue to stay between $2-7 million in EBITDA. We're not looking for a deal that would be transformational at this point> We're looking for a perfect fit in smaller-type companies that we can grow.

Gregory Daily -- Chief Executive Officer and Chairman

George, I think we've mentioned we think the education acquisition should roughly break even over the next few months. For a full year, we would anticipate... We paid $10 million up front, so, staying within the 10 times multiple, we'd expect at least $1 million of EBITDA and maybe five times that for a revenue number -- a gross revenue number.

George Mihalos -- Cowen and Company -- Managing Director

Okay, that's very helpful. Understood. And then, just looking at the performance in the quarter, the merchant services line ex the purchase portfolios -- that accelerated. Can you speak a little bit to what you saw there? I know that there's a hardware business there as well. How did that perform in the quarter relative to your expectations?

Clay Whitson -- Chief Financial Officer

Hardware had a better quarter. I think we were $100,000.00 ahead this quarter versus the same quarter last year in gross profit. Fairway performed better. It was down 9-10% last quarter on a quarter-over-quarter basis, same quarter the previous year. Second quarter this year, it was down 5% versus second quarter last year, so, about half of the impact from Fairway.

George Mihalos -- Cowen and Company -- Managing Director

Okay. And then, Greg, anything you can speak to as to your traction on the ISV front and partnerships that you're able to forge there?

Gregory Daily -- Chief Executive Officer and Chairman

Yeah, George. We mentioned that we had found seven ISVs on the last call. That brought our total enterprisewide to 34. Two of those seven have completed their integrations, and both have begun to board merchants with us. So, total 34, 29 are active today, with five that are currently integrating to our platform.

George Mihalos -- Cowen and Company -- Managing Director

Okay. Last question for me -- Clay, I think you mentioned there were some items that elevated the corporate expense in 2Q. Should we expect that to come down modestly 2Q to 3Q?

Clay Whitson -- Chief Financial Officer

No, that's more infrastructure spending than we signaled at the IPO, that our first year -- our fiscal '19 -- would have higher corporate expenses, a onetime step-up, and then, in future years, fiscal 2020 and beyond, we would expect inflationary growth. But, it's just a little more HR, a little more legal, a little more accounting, that sort of thing.

George Mihalos -- Cowen and Company -- Managing Director

Okay. So, this is a good run rate to think of for the rest of the year.

Clay Whitson -- Chief Financial Officer

Yeah. I think we'll have modest growth over time.

George Mihalos -- Cowen and Company -- Managing Director

Great. Thanks, guys.

Gregory Daily -- Chief Executive Officer and Chairman

Thank you, George.

Operator

We'll take the next question from John Davis from Raymond James. Please go ahead.

John Davis -- Raymond James -- Analyst

Hey, good morning, guys. I just wanted to follow up a little bit on George's question around organic growth and the Fairway acquisition specifically. Clay, what drove the modest improved performance? Any update on -- I think you guys bought a gateway and were integrating that into the Fairway business. How has that gone so far? Is that what's driving the improvement in results there?

Clay Whitson -- Chief Financial Officer

I think we've lapped some of the attrition we noted on the last call, and over time, the comparisons ease from the prior quarters. The new business... I don't know if you want to comment on that at all, Rick, but they are bidding on a lot of new business now. I do know we've won a large -- or, for us, a large equipment order, which is an encouraging sign. But, it's not so much new business now as the comparison easing up from the prior quarters.

John Davis -- Raymond James -- Analyst

Okay. So, along those lines, we could expect organic growth to continue to step up, all else equal, given you've lapped the tougher compares at Fairway?

Clay Whitson -- Chief Financial Officer

At Fairway, I believe so.

John Davis -- Raymond James -- Analyst

Okay. And then, Rick, I just wanted to touch on the education acquisition. I appreciate Clay's detail on revenue and EBITDA, but I was more interested in what it adds to the software offerings as something you can roll out nationwide. It seems like this may be a little bit more of a platform acquisition than a tuck-in, so any comments there would be helpful.

Rick Stanford -- President

Sure. I would compare this to a platform deal. Similar products to PaySchools, lunch program being the biggest. I think what attracted us to this particular organization was -- we had talked about in the roadshow that this was one of the verticals that we'd have to acquire a way into other states. It's very difficult to get in there when we don't have a footprint today, and this brings us into multiple states that we're not in today. So, comparatively, we're very excited about this software and the modules it has to offer, and we think we'll do well growing this organization. Greg?

Gregory Daily -- Chief Executive Officer and Chairman

I'll jump in. Good morning, John. So, I was with this team yesterday. They're amazing -- 15 employees, 15-year-old business, which is a young business for us nowadays -- and they're excited. They needed just a little bit of our resources to go to the next level. We've known them very well for four years. We've followed them; they've followed us. We have meetings going starting Monday with how we work together. But, education is something that we know very well. It's our first software company that we got involved with five years ago. It's a payfac, it's on WorldPay, so it should be a natural company that helps us drive organic growth a year from now when it anniversaries. I was very impressed with how excited the team is -- younger, couldn't be prouder about this one. It's a little bit smaller than some of them that we do, but it's one that has probably more opportunities going forward than we're accustomed to.

John Davis -- Raymond James -- Analyst

Okay, great. Thanks. And, last one for me -- Clay, operating cash flow took up quite a bit. This quarter, I think it was up 60% year over year. EBITDA was up 13% by my math. So, anything to call out there from an operating cash flow standpoint?

Clay Whitson -- Chief Financial Officer

The only thing I can think of -- our software revenues fall straight to the bottom line, so when we have a quarter where software revenues are higher than planned, it drops straight down. Scott, would you have any further color on that? Okay. We'll look at it, JD, and see if anything else comes to mind.

John Davis -- Raymond James -- Analyst

Okay. All right. Thanks, guys.

Gregory Daily -- Chief Executive Officer and Chairman

Thank you, John.

Operator

If you find that your question has been answered, you may remove yourself from the queue by pressing *2. We will take the next question from Josh Beck from KeyBanc.

Josh Beck -- KeyBanc Capital Markets -- Director

Thanks for taking the question. I was just wondering if you could maybe help us get a sense of where the public sector and education sector are in terms of contribution to the business. It sounds like there could be a potential overlap there where one's going to pass the other. So, I'm just trying to get our arms around how big of a contributor they are to the business.

Clay Whitson -- Chief Financial Officer

About a year ago, education might have been 80% of that segment, and today, it's a little bit over half. Now, we've just purchased a business in education, and also one in government, but I think government's going to be the lion's share from here on out.

Josh Beck -- KeyBanc Capital Markets -- Director

Okay. And, Greg, it sounded like you were pretty excited about what you could do with this most recent acquisition. Should we be thinking about it as you're expanding the footprint into new states and you see yourself as gaining share within that state, and that's where some of the synergy comes from? I would like to understand that comment a bit better.

Gregory Daily -- Chief Executive Officer and Chairman

Yeah. It's a great piece of software, it's a great platform that needed -- that just needs maybe a half a developer, another person in marketing, another person in sales, attending more conferences, just more block and tackling. So, they have a nice presence in the West Coast and in Florida, and those are areas that we're not involved with at all, but I think we'll be able to give you even more clarity next quarter after we have all met together and compared notes. But, my sales team has told me -- PaySchools -- that they need references to be able to effectively open up a new state, and now they have them.

Josh Beck -- KeyBanc Capital Markets -- Director

Okay, that's very helpful. And, when we think about some of the other verticals that we haven't touched on quite as much -- B2B, healthcare, property management -- anything notable to call out about either the trends that you're seeing within the business, or maybe opportunities down the road within some of those verticals?

Gregory Daily -- Chief Executive Officer and Chairman

So, we're actively looking for -- I think as we broadcast regularly -- in healthcare and nonprofit, a platform. We have looked at a few more this past quarter. We haven't been able to close a deal. They're performing well. The whole team is. There's probably 10 or 12 of our key platform companies that drive our revenue. They're all doing very well. B2B is always at the top of the leaderboard when it comes to growth. The hospitality vertical is doing very well. The public sector flurry -- Rick's been in the zone -- has just kept us crazy busy of getting into these other verticals, but we're still interested, we're still engaged, but because of public sector being five out of the last six deals, we only have so much -- we can only do so many, and so, we're comfortable doing four or five a year. This has been an unusual year of doing seven, but we're still involved in the other verticals.

Clay Whitson -- Chief Financial Officer

Well, property management grows at 50% a year. It's just so small. That's the reason we never talk about it, but it is gaining a little bit of traction.

Josh Beck -- KeyBanc Capital Markets -- Director

Okay, very helpful. Thanks, guys.

Gregory Daily -- Chief Executive Officer and Chairman

Thanks.

Operator

To participants, once again, if you'd like to ask a question, please press *1 on your telephone keypad. We will take our next question from Peter Heckmann. Please go ahead.

Peter Heckmann -- D.A. Davidson & Company -- Analyst

Good morning, gentlemen. Nice results. In terms of the public sector, there are some interesting capabilities there. My impression is that the marketplace there is still very fragmented, especially at the Tier 3 and Tier 4 municipalities. What areas do you think you're going to focus on initially for court payments, traffic violations, things like licensing and permitting? Are there specific areas where you feel like you have proprietary capabilities that really stand out and can drive organic growth?

Rick Stanford -- President

Pete, I would say the areas you mentioned are a focus. We are taking the opportunity to bring all of our public sector leaders in for what I call a summit in a couple of weeks, and the specific design of that meeting is to look at cross-pollinating products among those different entities. So, I think that's a big step in the right direction. It is continuing to be fragmented. I don't know that I would say that anything's necessarily proprietary because there's others out there that may offer the product, but I would tell you that the ones we've picked and done a deal with do it very well compared to their competitors. In some ways, I would say the guys that we're buying do it a lot better than the bigger guys that we pass on because they're close to the customer, they're high-touch. We're very high on public sector, and I think you'll see some more deals, and you'll like what you see.

Peter Heckmann -- D.A. Davidson & Company -- Analyst

That's great. From a sales perspective, is there a little bit of synergy between K-12 schools and small municipalities, or at least governing school districts? Would that be a little bit of the same type of sales process?

Gregory Daily -- Chief Executive Officer and Chairman

There's not that much overlap. We have done a couple of public sector acquisitions, and they had maybe 10% of their business in education, and so -- but, it's not doing lunch money or activities, it's something else that they're doing for the local K-12 school. From a sales perspective, public sector gets us into states that we haven't been in educationally, so I wouldn't call it overlap, it's just more opportunities.

Peter Heckmann -- D.A. Davidson & Company -- Analyst

Got it. Okay, thank you. And then, Clay, just one more. Could you help us -- with the acquisition that you did outside the public sector last quarter with the wireless providers, can you talk about incising that a little bit in terms of their relative size to what you think the market is there?

Clay Whitson -- Chief Financial Officer

Oh, they're mainly in the Midwest. I'd probably say they're less than 5% of the market.

Gregory Daily -- Chief Executive Officer and Chairman

Maybe more. There's only 4,000 of them, and we have 400.

Clay Whitson -- Chief Financial Officer

They're very small.

Gregory Daily -- Chief Executive Officer and Chairman

We'd like to think that all of our companies and verticals and acquisitions could grow at 10% or more.

Peter Heckmann -- D.A. Davidson & Company -- Analyst

Okay, that's helpful. Thank you.

Operator

That concludes today's question and answer session. At this time, I will turn the conference back to you for any additional or closing remarks.

Gregory Daily -- Chief Executive Officer and Chairman

Again, everyone, thank you for joining us on our second quarter of fiscal year '19. We look forward to further updates as Rick continues to do more deals and give you updates on a quarterly basis. So, thank you again.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect your lines.

Duration: 35 minutes

Call participants:

Scott Meriwether -- Senior Vice President, Finance

Gregory Daily -- Chief Executive Officer and Chairman

Clay Whitson -- Chief Financial Officer

Rick Stanford -- President

George Mihalos -- Cowen and Company -- Managing Director

John Davis -- Raymond James -- Analyst

Josh Beck -- KeyBanc Capital Markets -- Director

Peter Heckmann -- D.A. Davidson & Company -- Analyst

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