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Sterling Check Corp. (NASDAQ:STER) Q1 2023 Earnings Call Transcript

Sterling Check Corp. (NASDAQ:STER) Q1 2023 Earnings Call Transcript May 13, 2023

Operator: Thank you for attending today’s Sterling First Quarter 2023 Earnings Call. My name is Megan and I’ll be your moderator for today’s call. [Operator Instructions] I would now like to pass the conference over to Judah Sokel, Head of Treasury and Investor Relations. Judah, please go ahead.

Judah Sokel: Thank you, operator. Welcome to Sterling’s first quarter 2023 earnings call. Joining me today are Josh Peirez, Chief Executive Officer of Sterling; and Peter Walker, Chief Financial Officer of Sterling. The slides we will reference during this presentation can be accessed on Sterling’s Investor Relations website under News and Events. The slides have been posted to our website and a replay will be made available on the website. After prepared remarks we will open this call for questions. Before we discuss our results. I encourage all listeners to review the legal notice on Slide 2, which explains the risks of forward-looking statements and the use of non-GAAP financial measures. Additionally, please refer to our most recent Form 10-K filed with the Securities and Exchange Commission for a discussion of risk factors that could cause actual results to differ materially from these forward-looking statements.

Our slide presentation and discussions on this call will include certain non-GAAP financial measures for such measures, reconciliations to the most directly comparable GAAP measures are in the appendix to the presentation and in our earnings release issued this morning. I’ll now turn the call over to Josh Peirez.

Joshua Peirez: Thank you. Judah. Good morning and thank you for joining us. Sterling’s first quarter of 2023 was a successful period of execution, and I am very proud of the accomplishments and results the team delivered, the year is unfolding as we expected, and as a result we are reiterating our 2023 guidance. Slide 4 shows highlights of the quarter. First and foremost, this was a quarter where we took steps towards achieving our long-term strategy and ambitious 2023 goals. Our financial results were encouraging, our revenues were slightly favorable to our prior expectations even against the uncertain macro environment and our progress in executing our cost-savings programs in the first quarter helped us to deliver on adjusted EBITDA, adjusted net income and free cash flow that we’re solidly above our expectations.

These positive results and out performance were driven by the Sterling team’s continuous hard work to enhance our value proposition, customer service and technology through an unyielding commitment to innovation and operational excellence. In the first quarter, we made great strides on several key initiatives that we set at the beginning of the year and which I will further explore in the following slides, identity verification, cost optimization and M&A. Turning now to Slide 5, which summarizes our long-term strategy and 2023 goals. On our fourth quarter earnings call, we mentioned a strategic refresh we completed in 2022, which set the foundation for our company’s long-term aspirations. We aspire to be the world’s most trusted background and identity services company, differentiated by our deep market expertise, unrivaled client service, best in class data and seamless workflows.

To achieve these goals, we have several specific growth strategies, including development of innovative new products to upsell, geographic expansion and M&A. The strategic framework directly fueled our focus areas for 2023 with concrete near-term goals that we believe will drive our company closer to that long-term vision. Specifically, we are focused this year on doubling down on the organic revenue drivers we can control, scaling our identity verification business, optimizing our cost profile and M&A. In the first quarter, we saw positive results on each of these four areas. Starting with organic revenue growth on Slide 6, in the first quarter, we continued to execute on the organic revenue drivers in our control. We won new logos in all our geographic regions, increased our clients spend, and maintained strong gross client retention rates.

To do this, we enhanced our core offerings with continued investment into exceptional client service and cloud-based technology capability. When combined with our innovative culture, those characteristics enabled us to perform slightly ahead of the expectations we provided in March. In the first quarter growth from new clients remained solid at 5%. This was slightly better than our expectations, albeit a bit lower than our long-term target and the levels we have previously delivered. As discussed on our fourth quarter call, we saw some signed new client implementations push till later in the first quarter and to the second quarter. As those implementations come online, we expect our new client growth to return to the long-term target of 7% to 8% over the course of 2023.

We continue to see our new business pipeline remains robust and supportive of our long-term targets. In the first quarter of 2023, we delivered growth from upsell and cross-sell in line with our long-term target an accomplishment we are very proud of, given the uncertain macro environment. Our innovative culture combined with the past work we did to complete Project Ignite continues to drive the release of new products and new functionality at a swift pace. During the first quarter we saw traction in our newer solutions such as identity verification, clinical concierge services, and post-hire services like monitoring and I-9. We also increased our automation, powering faster time to hire and delivering high accuracy at low hiring cost. Last quarter, we shared our milestone achievements in the improvement of U.S. criminal fulfillment turnaround time, and now we can say the same about motor vehicle records and civil searches, with the recent release of improved automation capabilities.

Moreover, we made progress on fulfillment automation outside of the U.S. where background screening and digital integrations into courthouse data are less mature. Moving to the right half of the slide, we made great progress during the first quarter and identity verification. We believe our investments into identity create true market differentiation, which significantly amplify our addressable market and our right to win, and we are pleased to see positive outcomes of our identity verification investments paying off. Identity adoption has been consistently growing at a robust pace since we first released our exclusive ID.me identity verification workflow to the market in early 2022. In the first quarter of 2023, our global suite of identity solutions are continued strong growth on both a quarter-over-quarter and year-over-year basis.

While we are seeing traction with all types of clients, enterprise clients are leading the adoption of identity, and in the first quarter, we added identity verification to several large client programs. Regardless of size, all clients who adopt identity can benefit from stronger screening programs and an increase in criminal records identified. Candidates are no longer able to submit inaccurate information, either intentionally or accidentally into the background screening process. We have also been pleased that the U.S. Candidate experience is fast and efficient and takes just 30 seconds to 90 seconds to complete. Finally, we continue to invest in fortifying our competitive advantages within identity. In partnership with ID.me, our exclusive ID verification partner in the U.S., We have built an in-person verification pathway, enabling individuals to verify their identity at a physical location.

We were pleased to recently announce a major milestone by achieving IAL2 certification. This certification recognizes our pathway as conforming to the federal digital identity guidelines set by the National Institute of Standards and Technology and opens the path for other government agencies to utilize our verification services. Those conversations have already begun and we are excited about the large growth potential that can arise from this milestone. Turning now to cost optimization on Slide 7. We’ve shared in recent earnings calls that we launched a series of initiatives aimed at building a more scalable and profitable company. We expect these initiatives to drive long-term meaningful cost savings and efficiency gains and we are targeting $25 million of run rate savings including $10 million of in-year savings during 2023.

We have a history of driving productivity and cost savings through financial discipline and by leveraging technology. For example, our proprietary and cloud-based technology platform is supported by our powerful artificial-intelligence driven fulfillment platform leveraging more than 3300 automation integrations including APIs and RPA bots. In 2023, we aim to continue our rich history and achieve our cost savings targets through a three-pillar approach. First, through Project Nucleus we aim to reduce labor and data costs in our cost of goods sold through re-engineering fulfillment processes and increased automation. Second, we are reducing our facilities costs by leaning even more into our virtual first approach and reducing our real estate and facilities footprint.

This strategy has served us well. Since its adoption in 2020 with the closure of multiple offices around the world, and we are now closing additional offices. Third, we’re enhancing functional alignment by streamlining our organization to align with the go-to-market structure we established in 2022, and initiative we believe will result in meaningful OpEx savings. Q1 was a strong first step in executing against our goals. In particular, we made progress towards closing 8 offices and facilities globally streamlining our functional teams and we made strong early steps towards process re-engineering and automation of our fulfillment engine. Our progress in the quarter gives us increased confidence in our goal of margin expansion during 2023 and beyond.

The final 2023 goal, I will discuss is M&A, shown here on Slide 8. As a result of the large and fragmented addressable markets, which we serve and the cash flow we generate, we have a great opportunity to increase our scale through both organic and inorganic growth. As we shared on our March earnings call, during the first quarter, we executed on two acquisitions, Socrates and A-Check. Our January acquisition of Socrates achieves our goal of using M&A to expand geographically into attractive new regions. Outside the U.S., We are already a leader in several key regions, and with our new found presence in Latin America, we can now serve the rapidly growing hiring needs of multinational and local clients in another region. Our other acquisition was of A-Check, a highly complementary deal, which builds on our successful M&A strategy of growing market share in the U.S. through accretive tuck-in deals.

The Company possesses a high quality enterprise-focused client base diversified across attractive verticals including health care, industrials and tech media. As with EBI, we expect this deal to yield significant synergies from platform migration, SG&A rationalization and upsell of Sterling products. In the early months of integrating both deals, we are pleased with the revenue trends inclusive of a healthy new business pipeline. We are also pleased early on by the deal integration with the expertise and skills we built from the EBI ideal and other initiatives, yielding clear dividends. An acquirers ability to integrate cultures, operations and performance goals effectively and efficiently is a key determining factor of a deal success and we are laser focused on executing this important goal during 2023.

We plan to complete the integration of Socrates by the end of 2023 and for A-Check by the second quarter of 2024, with the expectation to realize increasing synergy gains throughout that period. Thus far during the first quarter of 2023, the team’s execution has been highly encouraging. I’ll conclude with Slide 9. The market for background screening and identity verification services is attractive with a large and growing total addressable market driven by multiple secular tailwinds. These include remote work, millennial churn and continued growth of the contingent and Gig Economy. Overseas the opportunity for geographic expansion is particularly attractive with background screening adoption still nascent. We’re excited about the growth of the global market and believe that our strong competitive advantages, innovation-led culture and financial discipline will enable us to execute on our 2023 goals and take another step forward towards achieving our long-term strategy.

We look forward to continuing to update you on our progress as the year unfolds. With that I will hand it over to Peter Walker, our CFO, to take you through our financial results. Peter?

Peter Walker: Thank you, Josh. And good morning everyone. Turning now to an overview of our financial performance starting with revenues on Slide 11, During the first quarter of 2023, we reported revenue of approximately $179 million, a 7% decline compared to the first quarter of 2022 on both a reported and organic constant currency basis. The quarter included a 150 bps contribution from M&A, partially offset by 100 bps drag due to foreign currency translation. These results were slightly favorable to the expectations we provided on our March earnings call as our team is executing on our 2023 goals. We continue to see success in the areas of our business most within our control, including growth from new clients and cross-sell, upsell alongside strong revenue retention rates.

We are focused most on these areas and we feel that our momentum in winning market share and expanding wallet share with clients can help offset the unpredictability of base growth over time. Following 9 consecutive quarters of new client growth at or above our 7% to 8% long-term target this quarter’s new client growth was 5%. This result was slightly above our expectation. As we discussed in March, this was caused by some signed new business implementations pushed out to late Q1 and Q2, 2023. With those implementations now ramping as planned and our new business pipeline remaining robust, we expect our new client growth to return to 7% to 8% over the course of the year. In the first quarter, our revenue from existing clients was down approximately 30% year-over-year.

Within those existing client declines we saw upsell cross-sell and gross retention performing within our long target ranges, which were outweighed by expected base business declines. As we mentioned in March, our clients base hiring volumes have been down year-over-year primarily due to macroeconomic uncertainty. It’s worth noting, the current industry hiring volumes remain strong relative to history and are down year-over-year, only when measured against 2022 record levels, including our robust 38% revenue growth in the first quarter of 2022. Looking further back our revenues have grown at a 15% CAGR over the past three years, demonstrating the strong secular growth we’ve been able to deliver through this past cycle. These base business trends tempered our positive results in other revenue drivers including upsell cross-sell where we’ve seen robust traction in our newer, fast-growing areas such as identity verification.

As Josh described, client adoption has been very strong for services we provide to our exclusive identity partnerships. As we’ve discussed we view identity verification as a significant opportunity to expand our addressable market and revenue growth along with accretive margins. It’s exciting to see our investment coming to fruition. Now looking at revenues by region, our U.S. business was down 6% year-over-year in the first quarter. Within the U.S., We have a diversified and attractive vertical mix, which has been instrumental in supporting our compelling revenue growth in recent years. In the first quarter, our U.S. performance was led by our healthcare and industrial verticals, which continued to grow year-over-year. We saw softness in some other verticals including Tech Media and Finbiz.

Turning to international revenue in our international business was down 10% in the quarter. Similar to the U.S., base volume declines offset good trends in the revenue drivers we can control. International revenues were led by the EMEA region, which saw good growth in our core screening markets tempered by softer gig vertical trends. We are seeing increased opportunities in digital identity and right to work fueled by our newest partnership with Yodi as well as new client wins in the U.K. and EU. In the first quarter, we delivered 1.5% of inorganic revenue growth from Socrates and A-Check, the two acquisitions we closed in January and March of this year. In these first months we’ve been pleased with both companies’ performances with results matching or exceeding our initial expectations.

As Josh described, the integration work is well underway to deliver on the upside potential from these deals, including the attractive geographic expansion capabilities presented by Socrates and a robust synergy potential at A-Check. Turning to Slide 12, our first quarter adjusted EBITDA was $46 million, a 4% year-over-year decline compared to last year, primarily due to the base revenue decline. Despite the softer top line trends, we are pleased to expand our adjusted EBITDA margins this quarter by 60 basis points to 25.4%. This exceeded our prior expectations and was driven by early progress on our cost savings initiatives and financial discipline. As we introduced last quarter, and Josh described in greater detail today, we have several cost initiatives underway, which are aimed at driving meaningful cost savings and efficiency gains.

These programs will be executed over 2023 and 2024. When complete, we are targeting a run rate cost savings of $25 million and expect to see in-year savings of $10 million during 2023. We plan for these initiatives to drive permanent reductions in our cost profile and position the company to scale efficiently and profitably over the long term. So far we are quite pleased with the progress and we’ll keep laser focused on execution going forward. In the first quarter of 2023, we had adjusted net income of $23 million or $0.24 per diluted share, representing year-over-year decline in adjusted EPS of 4%. This year-over-year decline was similar to the decline in adjusted EBITDA with a lower tax rate partially offset by higher interest expense. Turning to Slide 13, free cash flow in the first quarter was $7 million, a substantial increase from the prior year period.

Q1 free cash flow is our seasonal low point and the results in 1Q 2023 exceeded our expectations. The drivers of the quarter’s improvement included increased collections, lower cash tax payments and a decrease in purchases of property, plant and equipment. We remain very focused on free cash flow and are forecasting full year free cash flow conversion of adjusted EBITDA in our target range of 40% to 50% Our net leverage at quarter end was 2.3 times net debt to adjusted EBITDA at the lower end of our 2x to 3x net leverage target. In the quarter, we spent approximately $49 million of net cash on our two acquisitions and $8 million on share repurchases. Despite these outlays, our net leverage remains at an attractive level and is poised to continue declining, absent any future M&A or buybacks.

We ended the quarter with total debt of $504 million, cash and cash equivalents of $51 million and $193 million available under our credit facility, providing us with ample capacity to execute our growth strategy of reinvesting in organic revenue growth and pursuing M&A. During the quarter, we also enhanced our capital structure through the implementation of an interest rate hedging program, which fixes approximately 60% of our floating rate debt. Our capital allocation priorities remain investing in organic revenue growth, pursuing M&A and maintaining a healthy balance sheet. This includes opportunistic share buybacks under our previously announced share repurchase program. These priorities hold true in a lower growth environment as we see macro uncertainty as opportune times to build the foundation for future success.

As we discussed last quarter, our rising cash position allowed us to use cash on hand for our two M&A deals in the quarter. Following these two deals, we remain well positioned to continue pursuing M&A to supplement our organic revenue growth and make further compelling investments. That said, we are focused in the near term on the integration of these two assets and executing our core strategy. On Slide 14, we reaffirm our guidance for 2023, which is unchanged since we provided it in March. For 2023, we expect to generate revenues of $760 million to $800 million, representing year-over-year growth of minus 1 to positive 4%, adjusted EBITDA of $198 million to $218 million, representing year-over-year growth of 0% to 10% and adjusted net income of $106 million to $121 million, representing year-over-year growth of 0% to 14%.

Our guidance includes full-year organic constant currency revenue growth of minus 3 to positive 1%. As we discussed earlier. We continue to see solid growth in items within our control, including new client wins and upsell cross-sell, these are being offset by base revenue declines. We are not assuming a material change in the macro environment over the course of the year. If there is a material shift for better or worse, we would reflect those changes and updates to our guidance. We continue to expect year-over-year declines during the first half of the year based on what we’ve seen so far in April and part of May, Q2 will likely see year-over-year revenue declines comparable to Q1. We are seeing positive signs in multiple parts of our business and are encouraged by the new clients and upsell cross-sell trends.

At the same time we are cycling over our strongest quarter of 2022, and in our company’s history, both in terms of revenue dollars and growth rate when measured on a multi-year basis. This tougher comp will temper 2Q’s year-over-year growth. As we move into the second half of this year we expect to show year-over-year growth due to several key items. First, new client on-boarding throughout the year, second ramping client hiring plans, third upsell and cross-sell based on our pipeline, and fourth easing year-over-year comps, especially in Q4. From the combination of our two M&A deals, we expect 2.5 points to 3 points of inorganic revenue growth in 2023. We are now assuming no impact from foreign currency, slightly less favorable than our previous assumption.

Turning to profitability, our 2023 guidance includes adjusted EBITDA growth of 0% to 10%, the midpoint of this range implies a full-year adjusted EBITDA margin of 26.7%, reflecting a notable margin expansion of over 100 basis points versus 2022, muted by approximately 30 basis points drag from our two M&A deals. We expect margin expansion for the full year, even in the absence of robust organic revenue growth due to the cost measures we’ve put in place as well as the variability of our cost structure. The first quarter’s margins were stronger than we previously expected due to some early success against our cost savings targets as well as strong financial discipline. These results give us increased confidence in our ability to hit our targets of cost savings and margin expansion.

To give you some more color on our thoughts by quarter we expect 2Q adjusted EBITDA margins to be in line with first quarter. As Josh mentioned, we are doubling down on our virtual-first strategy by closing additional facilities. In the second quarter, we expect these closures to result in impairment charges and accelerated rent expense of $8 million to $10 million, which will be added back for the purposes of adjusted EBITDA. We expect margins over the back half of 2023 to improve from the first half and for the year-over-year margin expansion to increase as our revenue trends improved the benefits of our cost actions ramp and year-over-year comps ease. Finally, turning to our adjusted net income growth guidance of 0% to 14%, We will benefit this year from reduced D&A, which should drive growth to the bottom line in excess of our adjusted EBITDA growth.

We remain encouraged by the leverage in our financial model driving adjusted EBITDA growth during 2023 ahead of our revenue growth and driving adjusted net income growth ahead of adjusted EBITDA growth. to further help with your modeling we’ve included a page in the appendix with our updated assumptions for 2023 and a detailed breakdown of our revenue guidance. In closing, we are reaffirming our long-term targets on Slide 15. Over the long term, we are targeting 9% to 11% organic revenue growth levels with margin expanding towards 29% to 32% plus and adjusted net income growth of 15% to 20% per year. Even in the absence of robust revenue growth this year, we expect 2023 to be a healthy step towards achieving our profitability targets. That concludes our prepared remarks.

At this time, operator please open up the line for questions.

Q&A Session

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Operator: [Operator Instructions] Our first question comes from the line of George Tong with Goldman Sachs. Your line is now open.

Operator: Thank you. Our next question comes from the line of Andrew Nicholas with William Blair. Your line is now open.

Operator: Thank you. Our next question comes from the line of Toni Kaplan with Morgan Stanley. Your line is now open.

Operator: Thank you. Our next question comes from the line of Andrew Steinerman with JPMorgan. Your line is now open.

Operator: Thank you. Our next question comes from the line of Kyle Peterson with Needham. Your line is now open.

Operator: Thank you. Our next question comes from the line of Scott Wurtzel with Wolfe Research. Your line is now open.

Operator: Thank you. Our next question comes from the line of Mark Marcon with Baird. Your line is now open.

Operator: Thank you. Our next question comes from the line of Jason Celino with KeyBanc Capital Markets. Your line is now open.

Operator: Thank you. Our next question comes from the line of Shlomo Rosenbaum with Stifel. Your line is now open.

Operator: Thank you. There are no additional questions waiting at this time. So that will now conclude the Sterling first quarter 2023 earnings call. Thank you for your participation. I hope you have a wonderful rest of your day.

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