i3 Verticals, Inc. (IIIV) Q3 2019 Earnings Call Transcript
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i3 Verticals, Inc. (NASDAQ: IIIV)
Q3 2019 Earnings Call
Aug. 9, 2019, 8:00 a.m. ET
Contents:
Prepared Remarks
Questions and Answers
Call Participants
Prepared Remarks:
Operator
Good day, everyone, and welcome to the i3 Verticals Third Quarter 2019 Earnings Conference Call. Today's call is being recorded, and a replay will be available starting today through August 16th. The number for the replay is 719-457-0820 and the code is 6839934. The replay may be accessed for 30 days 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.
Scott Meriwether -- Senior Vice President of Finance
Good morning, and welcome to the third 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 a 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 SEC. And consequently, actual results and operations 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 the performance of our third fiscal quarter of 2019. We closed four acquisitions, expanded our credit facility, and closed on a secondary offering during the quarter. It was important for me to complete the secondary offering in order to increase our public float and our daily trading volume. I am proud of our team, and we're excited about how these Q3 accomplishments will enhance our future performance.
We had a strong quarter. Net revenues increased to $36 million from $28.8 million in Q3 of '18, fueled by an over-performance in our Public Sector vertical. Pro forma adjusted EBITDA increased to $9.7 million in Q3 '19 from $7.9 million in Q3 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 payment and software solutions to SMBs and organizations in strategic markets. We will continue to focus on verticals that are strategic to us and make selective acquisitions in these verticals.
Our acquisition strategy remains the same. We have plenty of debt capacity to support that strategy. During the last year, we've made several acquisitions focused on the Public Sector market. We're pleased with their performance. We believe our software product enhancements for the Public Sector market will continue to be an area that will drive growth for i3. Rick will provide further details on the Public Sector vertical later.
We're also encouraged by our recent product enhancements in the Education vertical. We're excited about the activity in this vertical ramping back up as schools currently are starting back-to-school across the country.
Integrated payments and proprietary software-enabled payments remain our focus. 51% of our payment volume was integrated during Q3, up from 43% during Q3 of the fiscal year 2018. 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 acquisition positions us well for success.
Clay, would you give us the financial overview?
Clay Whitson -- Chief Financial Officer
Sure. Thanks, Greg. The following pertains to the third quarter of fiscal '19, which is the three-month period ended June 30, 2019. We had a great quarter. Net revenues increased 25% to $36 million for Q3 2019 from $28.8 million for Q3 2018, principally driven by $8.5 million from acquisitions, which outperformed during the quarter. Two of our software companies completed projects ahead of plan, which added over $500,000 of net revenues to the quarter. We were not expecting these net revenues until Q4 ending in September.
Excluding acquisitions and the Purchased Portfolios, which declined $700,000, net revenues declined 2% due to a $1.5 million decline in our integrated POS business. Excluding our integrated POS business, internal growth was 5%. Q3 2018 happened to be our largest net revenue quarter for our IPOS business, leading to a tough comparison with Q3 2019. As we have discussed, both the market and our primary supplier are transitioning to a SaaS offering, which will be a short-term headwind as revenues that were formerly large upfront sales get spread over three years. We're not sure of the pace of transition but believe we have $6 million to $7 million of net revenues currently included in consensus estimates for 2020 that could be pushed to 2021 and 2022. We expect to obtain more clarity over the next few months, and we'll bake our expectation into our formal guidance for 2020 when we report Q4. In the long run, this should prove to be a better IPOS model despite the short-term challenges and give us greater visibility into revenues and profits from this market.
EBITDA grew 22% to $9.7 million for Q3 2019 from $7.9 million for Q3 2018. 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: operating-related expenses, changes in earn-out estimates, equity-based compensation, acquisition-related expenses, state and local taxes not included in income taxes, and deferred revenue writedowns associated with the acquisitions of software companies.
Adjusted EBITDA as a percentage of net revenues was 27% for Q3 2019 despite a 44% increase in corporate expenses. The increase in corporate expenses were principally associated with public company costs. As a reminder, we have expected a one-time step-up in corporate expenses for fiscal '19 with inflationary-level growth in future fiscal years. Excluding corporate expenses, the EBITDA margin improved 30 basis points. Including corporate expenses, the EBITDA margin has improved modestly for the nine months.
Pro forma adjusted 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 181% to $10.5 million for Q3 '19 from $3.7 million for Q3 '18. Revenues from software licensing in Louisiana and Texas 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 recent acquisitions.
Adjusted EBITDA increased 141% to $3.5 million from $1.5 million, principally reflecting recent acquisitions in our Public Sector vertical. Q3 is always a weak quarter for Education because K-12 public schools generally close in mid-May and open again in mid-August. EBITDA as a percentage of net revenues declined to 34% for Q3 2019 from 39% for Q3 2018 due to mix and seasonality factors.
Public Sector now represents the majority of net revenues and over 150 employees. These companies, almost all acquired post-IPO, generally are strongest during our fiscal first half, our December and March quarters. During the second half, we have all of the costs with less revenues. For the nine months, the margin has improved 50 basis points.
Net revenues for Merchant Services excluding the Purchased Portfolios increased 5% to $24.1 million for Q3 '19 from $23.0 million for Q3 '18. This increase reflected growth in our direct sales channel including B2B and our ISV and ISO channels. The Purchased Portfolios declined 33% to $1.4 million, in line with expectations. Adjusted EBITDA for Merchant Services increased 6% to $8.8 million for Q3 '19 from $8.3 million for Q3 '18. The EBITDA margin improved to 34% for Q3 '19 from 33% for Q3 '18, showing operating leverage from revenue growth.
Outlook. We reiterate guidance for fiscal '19, which was issued on June 3 in connection with the Pace acquisition as follows: adjusted net revenues, $132 million to $138 million; adjusted EBITDA, $37 million to $40 million; and pro forma adjusted diluted EPS, $0.80 to $0.85. As of June 30, we've had $162 million available under our revolving credit. Our leverage ratio as defined in our credit agreement was 3.28 times while our current constraint is 4.0 times. Our interest rate is currently a little north of 5%. Over time, we expect to convert roughly two-thirds of our 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. Before I talk about our M&A outlook, I wanted to take a few moments to specifically highlight one of our recent acquisitions and to discuss some of our strategic integration efforts within our verticals.
As you know, we've been extremely busy on the acquisition front since our IPO, closing nine deals during that time period. While we didn't set out to close that many deals, we remain opportunistic, and we're pleased to have been in a position to acquire these businesses. Each of them offers unique benefits to the i3 organization, specifically groups of very talented people and rich technology, and we're excited to watch them execute on our joint growth strategy. I might also add we doubled our state footprint in Education and tripled our state presence in the Public Sector during this time period. All acquired teams this past year have hit the ground running, and we couldn't be more pleased with what we're seeing.
On June 3 of this year, we announced the closing of the Pace acquisition. Pace provides fully integrated payment and transaction solutions within the Public Sector and Education verticals. Pace operates in the independent software vendor or ISV channel and has a deep pipeline of potential ISV partners. Over the past two months, we've worked on expanding our capabilities in the ISV market. The Pace team is proving already to be very powerful. In fact, we've recently combined our ISV teams to better serve incoming integration requests from potential partners and to provide additional resources used in harvesting efforts within existing integrated ISV partner programs. With the acquisition of Pace, our total ISVs are now 50, with three currently in integration.
We continue to work on integrating all of our prior acquisitions, and we are encouraged with the early results of these efforts. This past month, we began a vertical visioning process with an initial focus on our Public Sector vertical. This visioning process includes management representatives from businesses within a given vertical and concentrates on eliminating duplicative software code and products, defining resource allocation and design and implementation areas, putting together a compelling product suite to be offered by multiple entities within a vertical, aligning business strategies among leadership groups and sales teams across multiple states and companies, and further defining our technology road map enterprisewide. We believe this process will further enable us to be able to become more efficient and streamlined in each vertical and ultimately offer better products and services to the market.
Regarding our M&A outlook, we continually investigate possible acquisition partners to identify companies that fit our playbook. We believe that we will remain successful in executing our M&A strategy. In particular, we recently executed a nonbinding term sheet with a business that offers utility billing software capabilities for gas, water and electric and so on. This product will fit nicely into our Public Sector product suite and seems to generate substantial customer interest.
We are currently performing diligence and hope to share that this deal has closed in the near future. Again, we expect that we will be active in the Public Sector, Education and, hopefully, healthcare verticals in the near future. We still believe we can generate four to five new closed deals per year, and we look forward to sharing more information on acquisition activity as it becomes available.
This concludes my comments. Cam, at this point, we'll open the call for Q&A, please.
Questions and Answers:
Operator
Thank you. If you'd like to ask a question today, please press *1 on your touchtone telephone. 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, it is *1 to ask a question. We'll pause for just a moment to give everyone an opportunity to signal.
Our first question comes from George Mihalos from Cowen and Company.
George Mihalos -- Cowen and Company -- Managing Director
Hey. Good morning, guys. Thanks for taking my question. I wanted to start off with the Merchant Services business. The payment volume there really spiked. I think it was up by 13%, much stronger than what we were looking for. Now the revenue yield declined sequentially and year over year. I was just wondering if you can kind of call out what happened there from a mix perspective to cause those to happen?
Clay Whitson -- Chief Financial Officer
Well, all of our channels, it wasn't just one thing, were up. Our direct sales, mainly B2B, was up. Our ISV channel was up, and our ISO channel was up. As far as the lower revenue yield, the IPOS business has an inordinate effect on that because you have revenues without volume. And as it falls, that lowers the yield. A secondary reason would be the Purchased Portfolios generally have a higher yield because it's more fees as opposed to discount rate driving it. As that falls, that pressures the yield.
George Mihalos -- Cowen and Company -- Managing Director
Okay. And then just as it relates to the hardware business, I think, Clay, you talked about potentially $6 million or $7 million getting pushed out as the model transitions to SaaS. Two questions on that. One, when do you think you'll have insight into that? I would assume it's going to affect calendar 2020, so starting next year. And are you guys considering partnerships with other IPOS providers?
Clay Whitson -- Chief Financial Officer
Well, we hope to have clarity by the time we report our fourth quarter, and then we'll bake it into our 2020 numbers. The $6 million to $7 million of revenues is the total amount we consider at risk for 2020, with about a third of that being the EBITDA risk. We are considering other providers, but as yet, we haven't made any decisions regarding that.
George Mihalos -- Cowen and Company -- Managing Director
Okay. Thanks, guys.
Operator
Our next question is from John Davis from Raymond James.
John Davis -- Raymond James -- Analyst
Hey. Good morning, guys.
Gregory Daily -- Chief Executive Officer and Chairman
Hey, John.
John Davis -- Raymond James -- Analyst
Clay, I just wanted to hit on organic growth for a second here. I think even excluding IPOS, we did see a modest deceleration from 6.4% to 5%. Any commentary on where that is or what's driving that at all?
Clay Whitson -- Chief Financial Officer
Well, do you mean the IPOS in particular?
John Davis -- Raymond James -- Analyst
No, I'd say excluding that, I think organic growth, you said, was 5%. Last quarter, I think it was a little bit higher. So just seeing if there's anything to call out or there's a little bit of mix and there's nothing specific that's standing out there. I mean it's not a huge difference, but it did decelerate modestly.
Clay Whitson -- Chief Financial Officer
Yes. Well, it was 6.4% last quarter, and that did include IPOS, for what it's worth. But when we get into 1 percentage point, it's a variety of factors that varies quarter to quarter.
John Davis -- Raymond James -- Analyst
Okay. Well, I guess, more importantly, maybe give us an idea. I think now you're about to start lapping some of the acquisitions that you did post-IPO, and I assume that those businesses are, as a whole, kind of growing faster than the core organic base so that would have a positive tailwind as these go into the numbers. Can you give us an idea or at least directionally what the combined businesses you've acquired are growing? And is that, in fact, above kind of your internal growth rate now?
Clay Whitson -- Chief Financial Officer
Yes. On average, the acquired businesses post IPO are growing low double-digit. You might use 10% as a number for modeling. And as those blend in, they'll help our organic growth. Our first acquisition was September 1 of last year. You'll see full lapping of that quarter in the December quarter. And then more will layer on each quarter thereafter.
John Davis -- Raymond James -- Analyst
Okay. That's helpful. And then just one more on the IPOS business. I think you said that's, to follow up on George's question, $6 million to $7 million impact next year. But can you just remind us of the size of that business in totality? Because I know, obviously, that's not the entire business. Is it still roughly $10 million? Or just ballpark that for us.
Clay Whitson -- Chief Financial Officer
Well, Q3 last year, total revenues from IPOS was $7 million. Q3 this year, it was $5.5 million, so we lost $1.5 million. So, if you think about it as a $20 million business, about half of that is hardware and software, which we would consider at risk in the SaaS model. There are a lot of service and maintenance contracts, professional services for installation and training. That we don't anticipate being pressured by a transition to SaaS. So, of the $10 million of hardware and software, if two-thirds of that got pushed out, that's where we come up with the $6 million to $7 million.
John Davis -- Raymond James -- Analyst
Okay. That's clear. Thanks. And then maybe, Rick, just talk about Pace for a second. I think you gave some good commentary there. It feels like there's been a little bit of a tone change with some of these acquisitions now being more synergistic, if you will, being able to cross-sell different products instead of maybe just different regions. Any update there? Anything that surprised you? It feels to me like things are going a little bit better than maybe you expected before you closed the deal. So, just any kind of color commentary there would be helpful on Pace.
Rick Stanford -- President
Yes. I think what surprised us was I pretty much keep these acquisitions under wraps until they're completed, but we had time for our entire team to see the products, both views, and insights, and meet the team at Pace, and they're ecstatic. The reception has been different than what we've seen before. I think the integration process with Pace is pretty much on schedule. The conversions have slowed a little bit because we're not dependent just on internal resources. We have to rely on our processors somewhat. The conversions of our ISV team is going to be just fabulous for us going forward. The teams have meshed really well, and they're both excited about the additional resources. So, I think we are, through this visioning process, going to start streamlining processes. I think that will be good for the organization and our customers going forward.
John Davis -- Raymond James -- Analyst
Okay. All right. Thanks, guys.
Gregory Daily -- Chief Executive Officer and Chairman
Thanks, John.
Operator
Josh Beck from KeyBanc has our next question.
Josh Beck -- KeyBanc Capital Markets -- Director
Thanks for the time, everybody. I wanted to ask about the Public Sector. It seems like that's an area where you have some product enhancements going on. So maybe just could you provide a little bit more color there? And as that business certainly grows, are you finding more cross-sell opportunities?
Gregory Daily -- Chief Executive Officer and Chairman
Yes. Josh, that's a great question. Pre IPO, we were mainly in traffic citations, fines, bail bonds, that sort of thing, but post IPO, our acquisitions have brought together case management, property assessor information, imaging and record management, tax collection, jury selection and so on. So, as we continue to do acquisitions, we pick up additional products that we need in our Public Sector suite.
I think I've said this before, no software is ever perfect, so we continue to add features and benefits along the way. And obviously, it goes without saying that as we do more acquisitions, there's going to be overlap in code, and we'll try to deprecate and select one code going forward. And that's part of the process that we're going through today. The Public Sector is and will continue to be a big part of our life going forward.
Josh Beck -- KeyBanc Capital Markets -- Director
Great. And on this transition to SaaS, I mean, should we be thinking about this purely as an accounting change? Or are there secondary benefits, whether it's improved revenue visibility or perhaps more seamless implementation that could be secondary benefits?
Clay Whitson -- Chief Financial Officer
Well, I do think there are secondary benefits, and that's why the SaaS model is succeeding in the marketplace today. You mentioned visibility. It does make for very visible three-year revenue as opposed to lumpy upfront sales. From a business perspective, it's more of an ERP for these businesses, and that is very sticky because you're helping them run their business.
Josh Beck -- KeyBanc Capital Markets -- Director
Okay, OK. That's helpful. And then maybe just if you could talk a little bit about the net debt levels and kind of where you see that your target or comfort range moving forward?
Clay Whitson -- Chief Financial Officer
Well, our business has always supported leverage well, and I'm talking over a 20-, 30-year period. We still have $162 million available under our revolving credit, and that's governed by leverage, as you know. We're currently able to go up to 4.0 times for the next almost year, and we would be comfortable using all of that. With each new acquisition, we pro forma into EBITDA from that acquisition, so it helps with the leverage ratio calculation.
Josh Beck -- KeyBanc Capital Markets -- Director
Okay. That makes sense. Thanks, everybody.
Operator
Once again, it's *1 to ask a question.
Our next question is from Alexis Huseby from DA Davidson.
Alexis Huseby -- DA Davidson & Co. -- Analyst
This is Alexis actually on for Peter Heckmann at DA Davidson. So just starting off, could you update us on the timing of integration of the NET Data and Pace deals? Should the majority of the integration of the businesses be done by early fall, including moving Pace to a new merchant processor, and consolidating offices?
Rick Stanford -- President
Yes, Alexis. As I said, Pace is pretty much on schedule. The conversion activity slowed a bit because we're relying on outside resources, but I would think that that might not push more than a couple of months. As far as NET Data, we're well on schedule with integration efforts with them. I don't see any issues there either.
Alexis Huseby -- DA Davidson & Co. -- Analyst
Great. Thanks. And then I didn't see it in the press release, but what was the revenue contribution of the Purchased Portfolios in the quarter?
Clay Whitson -- Chief Financial Officer
$1.4 million.
Alexis Huseby -- DA Davidson & Co. -- Analyst
Okay. And then just a quick modeling, what's a good number to use for fully diluted shares for the fourth quarter?
Clay Whitson -- Chief Financial Officer
Hold on just a second. 28.5 to 29, I would use.
Alexis Huseby -- DA Davidson & Co. -- Analyst
Okay. Thank you, gentlemen.
Clay Whitson -- Chief Financial Officer
Thank you.
Operator
And once again, it's *1 to ask a question. And it appears there are no further questions today. Gentlemen, I'll turn the conference back to you for any additional or closing remarks.
Gregory Daily -- Chief Executive Officer and Chairman
Thank you. Again, thanks for joining us this morning. I'm very excited about the team and what we've been able to accomplish. We're still just a seven-year-old business, and the pieces have come together very, very nicely especially since the IPO. Given the pipeline, we're excited about our future calls with you.
So, I hope everybody has a nice day. Thank you again for joining us.
Operator
And that does conclude our conference today. Thank you for your participation. You may now disconnect.
Duration: 31 minutes
Call participants:
Scott Meriwether -- Senior Vice President of 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
Alexis Huseby -- DA Davidson & Co. -- Analyst
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