i3 Verticals, Inc.

And welcome to the I3 Vertical's first quarter 2024 earnings conference call. Today's call is being recorded, and a replay will be available starting today through February 16th. The number of the replay is 877-344-7529, and the code is 411. Again, for the replay, 877-344-7529 with the code 4184683. The replay may also 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 Jeff Smith, Senior Vice President of Finance. Please go ahead, sir.

Good morning, and welcome to the first quarter 2024 conference call for I3 Verticals. Joining me on this call are Greg Daly, our Chairman and CEO, Clay Whitson, our CFO, Rick Stanford, our President, and Paul Christians, our COO. To the extent any non-GAAP financial measure is discussed in today's call, you will also find a reconciliation to the most directly comparable GAAP financial measure by reviewing yesterday's earnings release. It is the company's intent to provide non-GAAP financial information to enhance understanding of its consolidated GAAP financial information. This non-GAAP financial information should be considered by each individual in addition to, but not instead of, the GAAP financial statements. 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. We are hereby cautioned that these forward-looking statements may be affected by the important factors, among others, set forth in the company's earnings release and in reports that are filed or furnished to the SEC. Consequently, actual operations and results may differ materially from those 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 will now turn the call over to the company's chairman and CEO, Greg Daley.

Thanks, Jeff, and good morning to all of you on the call. We have some big and exciting things to discuss with you this morning, but first, I'd like to highlight the results of our first quarter of fiscal year 24. Revenue and EBITDA were both 7% higher in Q1 over the same quarter last year, and ARR grew at 9%. We're laser-focused on nurturing recurring revenue streams such as SaaS and transaction-based revenue. Sometimes these come at the expense of license revenue, which you will notice is much lower this quarter. I'm sure many of you saw our disclosure yesterday, as we are well along in the process to sell certain assets related to our merchant services business. Rick is going to give you a full rundown of the process, and first I want to make a few points. First, our roots lie deep in merchant services. We started this company and we knew the business well. We understood the power of consistent recurring revenue that could be unlocked when we add value to our customers and take care of them. We have built and acquired best-in-class technologies, attracted amazing customers, and most importantly, assembled an incredible team. I'm extremely proud of the i3 Merchant Services business and what we've accomplished together. Second, our merchant services capabilities have set the stage for us to build something very special in vertical market software. We've always believed in our scale and our expertise in payments gave us an edge. We're not just looking for any buyer of our merchant services business, but a long-term partner who wants to help us continue to unlock payment opportunities within our current software businesses. Third, we like the opportunity of the sale because we believe it is beneficial to our customers, our employees, and our shareholders if we focus. By this narrowing of our focus to our core markets of public sector, healthcare, and education, we will be better poised to capitalize on the expansive opportunities within each. Now I'll turn the call over to Rick, and he'll provide you more details on the ongoing process. And then when he finishes, Clay will discuss our financial performance. And then we'll open up the call for questions.

Thank you, Greg. Good morning, everyone. I'll start by talking briefly about the process mentioned in last night's press release and then cover M&A. As previously announced, the company's board of directors has directed i3 management to explore the sale of certain assets related to our merchant services business. This decision was made after careful consideration by our board with input from management and the company's financial advisor and is consistent with the company's strategic focus on vertical market software. Consistent with the strategy, the board believes that the sale of this discrete portion of our business and no other part of the business or I3 as a whole is in the best interest of the company and its shareholders. Merchant services business includes all payment-related assets not tethered to proprietary vertical market software, including the associated payments technology. This is a leader in the market, and we believe it has tremendous potential with increased attention and resources of external ownership. It is led by highly respected industry veterans with decades of experience, and their sales and technology teams are formidable and top-notch. This business has appropriate leadership, sales, and support to operate on a standalone basis, and we are confident that it will be attractive to many potential buyers. The sale of the merchant services business would generate capital that the company would expect to deploy to pay down debt and can be used with additional strategic application towards M&A in our three target verticals. Our focus will continue to be growing our industry-leading software businesses in public sector, healthcare, and education, which we believe are the optimal platforms to deliver enhanced shareholder value over the long term. Each of these verticals includes a large addressable market, a decentralized competitive landscape, and is underserved by technology. We believe these businesses have significant opportunities for growth. Our board, with the benefit of input from management and our financial advisor, has directed us to initiate this process solely to explore the sale of our merchant services business as a best path to create value for our shareholders. As we explore the potential sale of the merchant services business, we will continue to fully support current payments clients and the payments technology platform. clients should not be affected by this decision and if the sale transaction does occur it would be a seamless transition for them further as part of any transaction we would expect to execute an agreement for ongoing payment partnership with the potential buyer so that we continue to offer this value-added integrated payment service that our customers expect from us after this call I3 does not intend to make any further disclosure concerning these matters unless or until a definitive transaction agreement is reached or until I3 determines that additional disclosure is appropriate and warranted. All inquiries from potential third-party purchasers concerning our merchant services business should be directed to Raymond James and Associates. Regarding M&A, we continue to look at opportunities over the last quarter for potential targets for acquisition. Most of them were in public sector with a few in healthcare and education. Our pipeline continues to be robust with target companies, largely in public sector and healthcare verticals. I'll now turn the call over to Clay and he'll provide more details on first quarter financial performance.

Thanks, Rick. The following pertains to the first quarter of our fiscal year 2024, which is the quarter ended December 31st, 2023. Please refer to the slide presentation titled Supplemental Information on our website for reference with this discussion. Revenues for the first quarter of fiscal 24 increased 7% to $92 million from $86 million for Q1 2023, reflecting organic growth and acquisitions. Organic revenue growth for this quarter was a little above 5%. Revenues from software licenses fell to just 0.7 million for Q1 2024, from 1.2 million for Q1 2023, and an average of 2.7 million per quarter in fiscal 23. As we have communicated in the past, software license sales are the most variable and difficult revenue stream for us to forecast. It can be feast or famine on this line, depending on customer schedules, particularly in the public sector. We have been deliberately replacing one-time software sales with recurring revenues such as SAS and currently expect one-time software sales to be $5 million lower in fiscal 24 compared with fiscal 23. The transition is happening a little faster than expected. SAS grew 13% for Q124 versus Q123. ARR increased 9% to $317 million for Q124, a new record, compared to $290 million for Q123. Over 80% of our revenues in the quarter continued to come from recurring sources. Our revenue yield improved modestly to 148 basis points for the quarter. from 145 basis points for Q1 23. Software and related services represented 47% of total revenues for Q1 with payments 48% and other 5%. Adjusted EBITDA increased 7% to 25.2 million for Q1 24 from 23.6 million for Q1 23. Adjusted EBITDA as a percentage of revenues remained steady at 27.4% for Q1 2024 and 2023. The adjusted EBITDA margins in both the software and services segment and merchant services segment improved, but were offset by an increase in our corporate expenses, principally healthcare insurance costs and duplicative hosting costs. as we transition from our private cloud with Rackspace to AWS and Microsoft Azure. Proforma adjusted diluted earnings per share was 36 cents for Q1 24 compared to 37 cents for Q1 23. Again, please refer to the press release for full description and reconciliation. Segment performance. Revenues in our software and services segment increased 6% to $56.6 million for Q1-24, from $53.2 million for Q1-23, reflecting growth in healthcare and public sector, including education. The Celtic acquisition anniversaried this quarter and declined by $1 million Q1-Q1, reflecting the strike in Manitoba, which we discussed on our Q4 conference call. While the strike has ended, our projects have not yet resumed. Payment revenues represented 25% of the software and services segments' revenues. The segments adjusted EBITDA improved 7% to $20.2 million for Q1 2024 from $18.9 million for Q1 2023. Adjusted EBITDA as a percentage of revenues improved to 35.6% for Q124 from 35.4% for Q123, reflecting cost efficiencies gained from an internal realignment within verticals we discussed on the Q4 call. Revenues for our merchant services segment increased 8% to $35.4 million for Q124, from 32.8 million for Q123, reflecting broad-based growth in our ISO, ISV, B2B, and POS channels. Adjusted EBITDA for our merchant services segment increased 14% to 10.7 million for Q124, from 9.4 million for Q123, outpacing revenues. Our revenue yield moved up a few basis points with continued expense control. The balance sheet. Our balance sheet remains strong and well positioned for 24. During January, we repurchased 90.8 million face value of convertible notes utilizing the revolver for a discounted amount of approximately 86.6 million. There are 26.2 million of notes remaining 19% of the original $138 million issued, which addresses a springing maturity clause in our revolving credit agreement. We currently expect to allow the remaining notes to remain outstanding until maturity. While we saved roughly $4 million from the repurchase, we will have a similar amount of additional interest expense for Fiscal 24 associated with the higher interest rate from the revolver. As of December 31st, borrowings under the revolver net of cash and pro forma for the repurchases in January approximated $348 million. Our total leverage ratio pro forma for the note repurchase was 3.6 times. The current constraint is five times under our $450 million revolving credit. The interest rate for the convertible notes is 1%. while the interest rate for the revolver is currently around 8.5%. We have remained disciplined in our approach to growth and acquisitions. Our estimate for earn-out payments for the remainder of fiscal 2024 is approximately $5 million. In the absence of acquisitions, we currently expect to finish fiscal 24 with a leverage ratio around three times. We want to be clear on our rationale for the proposed merchant services sale. Once a sale is completed, we should have very little, if any, remaining debt. This will free up even more resources to deploy towards the public sector, education, and healthcare verticals. We believe that the remaining public companies should trade at a higher EBITDA multiple as a pure play software and services company. Outlook. Looking forward, our Q1 results gives us confidence in the following guidance for fiscal year 24. It excludes acquisitions that have not yet closed, transaction-related costs, and the potential asset sale discussed on this call. Revenues, 385 to 400 million. Adjusted EBITDA, 109 to 115 million. Depreciation and internally developed software amortization, $11 to $13 million, cash interest expense $26 to $29 million, pro forma adjusted diluted EPS $52 to $64. From a seasonal standpoint, we currently expect the quarters of fiscal year 24 to follow a similar pattern to those of fiscal year 23. Although actual results on the one-time software line can vary significantly, Our current expectations for software license sales are $800,000 for Q2, $1 million for Q3, and $3 million for Q4. We currently expect to resume high single-digit organic revenue growth in fiscal 25. As Manitoba gets back to a normal cadence, our opportunities in the utilities market progresses and the SAS transition becomes less of a short-term drag. This concludes my comments, Marlise. At this time, we will open the call for Q&A, please.

Thank you very much. We will begin the question and answer session. To ask a question, you may press Start then 1 on your touchtone phone. And if you are using a speakerphone, please pick up your handset before pressing the keys. If you need to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from John Davis from Raymond James. John, please go ahead.

Hey, good morning, guys. Maybe first, Clay, just on the lowered revenue outlook, it sounds like it's just $5 million less of license revenue this year. Anything else to call out on the kind of the reduced outlook for the top line?

No, I think you've, that's the correct point. And just to do some math around that, what would have been $5 million of one-time license revenue might turn into $800,000 of SAS revenue because let's assume a three-year contract and maybe it comes in halfway through the year. So it's quite a short-term headwind, although in the long term it's a much better model.

Okay, no, that's helpful. And then as we think about the margin guide, I think it's about, you know, for about 150 basis points of expansion year over year, I think margins were roughly flat in the first quarter. So how should we think about kind of the cadence of the margin expansion throughout the rest of the year and kind of what gives you confidence and what's driving the higher margins in the back three quarters here in 24?

Well, one-time revenues is a big factor when looking at a quarter's margin. It 90% of that, maybe even 95% of that revenue drops to the bottom line. So in a quarter light on one-time revenues, it's remarkable. We could keep the margin as we did flat. The internal realignment is ongoing and continues. And so we'll get the full effect of that as the quarters progress in 24.

Okay, and then the last one for me quickly, just on the EPS guide, it looks like the majority of that is just higher interest expense, you know, eight or nine cents and a few pennies for slightly lower EBITDA. Just curious if that's the right way to think about it or anything else that's going on on the EPS line.

That's correct. It's about four million, more than four million of interest expense for the eight and a half months, you know, from mid-January. We did get a $4 million discount approximately on our bond repurchase, but one hits the balance sheet and the other hits the P&L.

Okay, great. Thanks, guys.

Thanks.

And our next question comes from Peter Hackman from DA Davidson. Peter, please go ahead.

Hey, good morning, everyone.

Good morning.

Good morning. maybe provide a little bit finer detail in terms of the portion of the merchant services business that is being considered for divestiture. If I heard correctly, it's those portions that either are not integrated with software or not integrated with i3's proprietary software. Could you confirm that and then just maybe give a little bit of better idea of what we're talking about in terms of percent of revenue and potentially percent of EBITDA for 2023 or 2024?

Pete, it corresponds pretty closely to the merchant services segment. We don't know exactly what assets will be included depending on a buyer's For example, they might not want the PayFact platform if they already have one, and we'd love to keep the PayFact platform. So there's a little bit of play, but for planning purposes, I would just use the segments, revenues, and EBITDA.

Okay. Okay, great. And then in terms of kind of the determination of whether or not you proceed, certainly valuation is a part of that. How do you think about then kind of that long-term partnership and how that might work in terms of servicing current clients? Is that a significant part of the decision-making process?

Yeah. I mean, our customers still want bundled payments and integrated software. And we intend to continue to provide that. In our software and services segment, 25% of our revenues are payment revenues. We just don't feel like we have to own the payments capability, so we would like to partner with whoever we sell the business to to continue to provide that to our customers.

Got it, got it. And so just for me, I heard this right, but you believe that divestiture could eliminate the majority or all of the company's debt. Divestiture would probably be modestly dilutive or somewhat dilutive to earnings, but eliminating the debt could really provide the company with a lot of flexibility going forward in terms of thinking about alternatives, primarily M&A, right?

Yeah, I mean, number one goal, we want to be a software business. Number two, we fix our balance sheet, to your point, being debt-free, if not close, and then We've been public six years. We have to make a change. And we're very excited about it. This should put us in a good spot over the next three or four years.

Great. Thanks for the additional callers.

And now we will proceed with a question from Matt Van Vliet from BTIG. Matt, you may proceed.

Yeah, thanks for taking the question. I guess when you look at the public sector software market out there, given the backdrop of the quarter's performance, how are you, I guess, assessing the demand environment out there? Which areas or sub-verticals of public sector are still driving the results here? And maybe where are you seeing either elongated sales cycles or just sort of indecisiveness on behalf of customers?

So there's a lot of exciting stuff going on in utilities and education. Healthcare is great. The public sector dealing with counties, municipalities, states, that seems to be a slower process. We've got a huge pipeline. A lot of delays, it seems like things have pushed back. And most of it is at the state or the county level.

I think courts are a big opportunity on top of utilities going forward. Yeah, that could be huge.

Okay. Very helpful. And then maybe just one more on the potential sale of the merchant services. I guess it seems like over the last couple of years, being able to go in with a combination offering of powerful software with embedded payments into it would run a little counter to then being looking to sell off the business. I guess what type of stipulations or contractual obligations might you include in terms of keeping the payment side of the business, if sold to a third party, involved in kind of what you're doing, maybe more importantly on the growth pipeline ahead? And then how does that change your go-to-market strategy if it's not an internally owned merchant services attached to the software?

Okay, great question. I'm glad it's So let's make it clear, we're still in the payments business. We're still selling payments every day through our software in public sector, government, utilities, education, and healthcare. We're selling everything else. So we're keeping payments in our own software within public sector. But if there was business that's not in those verticals, That's what we're selling.

And a good way to think about it is we're going to continue to sell the payments in our primary verticals. Once the sale is complete, then we'll flip it over the fence for onboarding and support thereafter with the buyer.

Okay.

You're right.

Our plan is to go to market, mine software companies, and then You know, the cream on top is being able to sell payments into their installed base and new customers.

Okay. Thank you.

And now we have a question from Charles Maben from Stevens. Charles, please go ahead.

Good morning and thank you for taking my question. I wanted to follow up Pete's earlier question around a potential deal and could appreciate that there's a range of possible outcomes, but curious how we should think about the breakout of corporate across the across the segments.

You know, corporate annual corporate expenses in the low 20 millions we think 20% of that might be reduced with a sale of the merchant services segment, roughly. That's what we've identified so far. That number will likely increase over time as we examine it a little more closely.

Got it, okay. And good to see the strike in Manitoba has been resolved, but curious if you could quantify the impact that's had on financials thus far this year. Speak to your expectations in terms of, like, getting things up and running again there, as well as what that could mean for growth.

Yeah, this is Jeff. So while the strike is over, the project has continued to push out as they've kind of had to ramp back up and get people back to the table, get stakeholders back reengaged. So there's three phases to it. The second phase will go live later this year. It's been ready for the better part of the last year, but the strike delayed all of that. And then the requirements for the third phase will be getting built out later this year. There won't be a lot of revenue from that, though, until the following year, and it'll trail out from there. It's a meaningful amount of revenue that has pushed back out of this year from when we guided back in the fall. Ballpark, nearly $2 million. just from that one deal.

Okay. And if I could speak, if I could sneak in one more, any comments you could make on the vertical or channel exposure within merchant services? I know a chunk of it is restaurant, but any color you could provide based on previous disclosures would be, I think would be helpful.

Well, we have, what we think of as partners, ISOs and ISVs. POS is a good portion of the business. We're a reseller of Aloha and we have our own proprietary POS system. B2B is a good category. But those would be the biggest portions of it.

Got it.

Appreciate all the callers, guys.

Thank you. Thank you.

And our next question comes from Alex Markgraf from KeyBank Capital Markets. Alex, you may proceed.

Thank you, and thanks for taking my questions here. Greg, just wanted to follow up on your earlier comment on kind of the – you know, the go-to-market thought process in the event of the sale of the merchant services business, it sounds like the kind of bottom line is little to no change. I'm just curious, categorically, are there any sort of disenergies associated with that potential sale? I mean, again, it sounds like no, but I just want to maybe put a finer point on that topic of disenergies.

There's not. I mean, obviously, 100% of our focus is being on public sector education and healthcare, you know, I think is a primary goal also. So, you know, better balance sheet, 100% focus on our software businesses. The merchant service, it's been a great business, steady, fantastic team. they've always kind of been separate from our software business.

Okay, that's great. And then just one more quick one on the exploration of the sale. I mean, it sounds like, you know, as you all have shared this morning, just more narrow and focused on, you know, certain aspects of software. I guess, is there any way that the, you know, your MO around M&A might change in the event of a sale? I mean, or is it simply just kind of accelerating and pushing further into the pipeline than you maybe could have with the merchant services business on board?

Yeah, I mean, since going public, all we've done is software businesses. That will continue. Most of them... will be public sector, but we do have some things in our pipeline of education and healthcare. I don't think any change.

No.

Okay. So nothing that, I mean, I guess is not addressable today, having the merchant services business in the model, it's more just, you know, pushing further into that pipeline. Is that a fair characterization? Yeah, that's correct. Right. Okay. Thank you.

Let me remind you that if you still have a question to pose, please press star 1. And we'll proceed with a question from Rufus Hone from BMO Capital Markets. Rufus, please go ahead.

Hey, guys. Good morning. Thanks for the question. Just two quick ones. You mentioned using the proceeds of any sale, mostly going to paying down debt. I don't know if you could give us a sense of the leverage ratio you're potentially going to be targeting as a pure software and services business. And then the second question is really around the size of target acquisitions you're expecting to complete this year. I know in the past you've talked about sort of $1 million to $5 million of EBITDA being your sweet spot. Just seeing if there's any update to that. Thanks.

Well, our leverage will start off at near zero. I think we haven't put a number on it, but I don't think we will run quite as high in the future, and that's a big driver for doing this. As far as acquisition size, I don't think much changes. It's still our sweet spot, 1 to 5 million, but we've done larger deals. We've done 10 million. I really don't think that changes in the future.

Then we have a follow-up question from Peter Hackman from DA Davidson. Peter, you go ahead, please.

Thank you. Thank you. So just to put a little bit of, again, finer point on it, and I know that any sale is going to be contingent on the buyer and what assets they want and don't want. But if we look at fiscal 23 under your kind of alternative revenue breakdown, payments was 45% of revenue in last year and merchant services was 37. So if you consider divesting majority of merchant services, then kind of on a pro forma basis, payments would go from being 45% of the revenue stream to kind of maybe like 15 to 20% with the vast majority of the rest being software, either maintenance or SaaS. Is that the way to think about it?

Well, that's very close, Pete. In the last quarter, payments were 25% of the software and services segment. So that's probably a better number to use.

Okay. Okay, 25. All right. Thanks. All right. And do you have any timeline for this type of transaction? Should we expect to hear something in the next three to four months, or could it take longer?

Hopefully it's sooner.

Great. Okay. We'll look forward to hearing more details.

Thank you. Thanks, Pete.

And we have a question now from James Fossett from Morgan Stanley. James, please go ahead.

Hey, good morning. Thanks a lot. I just wanted to ask, just from a, like you guys, and you've highlighted multiple times is that you've been focused on building out the software. part of your business and that kind of thing. And from a strategic focus, especially the direction you'd like to go, I think that's consistent. I'm just wondering how you're thinking about the proceeds in capital allocation and, you know, if you're able to execute a sale, should we expect that that pace of acquisition and can accelerate, or are you feeling like this is something that makes sense given what you're seeing from a valuation perspective in the market? Just wondering if there's pricing and capital-related considerations in the timing, or is this purely just you've reached the stage of next in strategic focus that now is the right time? Just trying to tease out that nuance.

So I think our timing is good. We do plan to spend around $100 million a year. It feels about right. That's what we're able to digest. We're not going to do stock buybacks. It's going to be our capital is going to be deployed toward M&A in our software verticals.

Got it, got it, got it. All right. That's really helpful. Thank you so much. Good luck. Thanks, James. Thank you.

And this concludes our question and answer session. I would like to turn the conference back over to Greg Daley for some closing remarks.

Well, thanks, guys. This has been a very interesting three or four months to be able to get to this point. We're excited about the next couple of months. And I appreciate everybody's time this morning. Call us if you need us. Thank you.

And the conference has now concluded. Thank you very much for attending today's presentation. You may now disconnect and have a great day.