Mastech Digital, Inc. (MHH) Q1 2015 Earnings Report, Transcript and Summary

Greetings and welcome to the Mastech Holdings, Inc., First Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jennifer Ford Lacey, Manager of Legal Affairs for Mastech Holdings, Inc. Thank you, Ms. Ford Lacey, you may begin.

Thank you, operator, and welcome to Mastech's first quarter 2015 conference call. If you have not yet received a copy of our earnings announcement, it can be obtained from our Web site at www.mastech.com. With me on the call today are Kevin Horner, Mastech's Chief Executive Officer; and Jack Cronin, our Chief Financial Officer. I would like to remind everyone that statements made during this call that are not historical facts are forward-looking statements. These forward-looking statements include our financial growth and liquidity projections as well as statements about our plans, strategies, intentions and beliefs concerning our business, cash flows, costs and the markets in which we operate. Without limiting the foregoing, the words believe, anticipate, plans, expects and similar expressions are intended to identify certain forward-looking statements. These statements are based on information currently available to us and we assume no obligation to update these statements as circumstances change. There are risks and uncertainties that could cause actual events to differ materially from these forward-looking statements, including those listed in the company's 2014 Annual Report on Form 10-K, filed with the Securities and Exchange Commission and available on their Web site at www.sec.gov. As a reminder, we will not be providing guidance during this call nor will we provide guidance in any subsequent one-on-one meetings or calls. I will now turn the call over to Jack for a review of our first quarter 2015 results.

Thanks, Jen, and good morning everyone. Revenues for the first quarter of 2015 totaled $27.1 million, which were 6% below the first quarter 2014 revenues. The revenue decline largely reflected at a high level of assignment in December 2014, which impacted a number of consultants-on-billing that we entered the New Year with. Our average bill rate for the first quarter of 2015 of $74.46 was approximately 1% higher when compared to the corresponding quarter of 2014. Activity levels were solid for most of the quarter after a slow start in early January. Given a tightening supply of IT professionals, our assignment win rate was a little late in Q1 2015 compared to historical averages. Gross profits for the first quarter of 2015 totaled $4.7 million or 17.3% of revenues compared to $5.2 million or 18.2% of revenues during the same period last year. Our gross profit dollar decline was due to less consultants-on-billing in the 2015 quarter compared to the first quarter of 2014 as well as a lower overall gross margin percentage. Our first quarter 2015 gross margin percentage was impacted by higher bench cost related to the start-up of our technology practice and higher benefit cost related to the Affordable Care Act. On new assignments, we have adjusted our pricing to recover these higher benefit cost, however, we haven't been a successful in getting bill rate increases on existing assignments that's the reason for the negative impact on margins in the short-term. SG&A expenses were $4.1 million in the first quarter of 2015 when adjusting for severance cost of $305,000 incurred due to a change in sales leadership. Adjusted SG&A expenses represented 15% of total revenues in the first quarter of 2015 compared to 13.4% of revenues in the corresponding quarter of 2014. This increase in SG&A expense reflect additions to our offshore recruitment staff and investment in our sales organization to support our technology practice. Net income for the first quarter of 2015 was $195,000 or $0.04 per diluted share compared to $869,000 or $0.20 per diluted share in the first quarter of 2014. It should be noted that the previously mentioned severance charge negatively impacted diluted earnings per share by $0.05. Addressing our financial position at March 31, 2015, we had cash balances on hand of approximately $2.9 million, no outstanding borrowings and over $16.4 million of borrowing capacity under our existing credit facility. We currently have a commitment from PNC Bank to increase our existing $20 million credit facility to $26 million in support of our recently announced plans to acquire Hudson Global U.S. IT staffing business. I will now turn the call over to Kevin for his comments.

Thanks, Jack, and good morning all. First I would like to comment on our first quarter performance then I will give you some of my thoughts on our recently announced agreement to acquire the U.S. IT staffing business with Hudson Global. With respect to first quarter, we made changes to our sales organization in early March. In connection with these changes, I assume the role of Chief Revenue Officer in addition to my CEO responsibilities. While we certainly have much work to do, I'm feeling very good about what we have accomplished in just a few months and how the organization is responding to the change. As we clearly stated in our Q4 earnings call, year-over-year comparables would be unfavorable for the first half of 2015. I do want to point out that our [CMB] [ph] head count was essentially unchanged in Q1 and more importantly currently positive in the last half of the quarter. The supply side of our business continues to be our largest challenge as IT talents become more and more scarce in relation to demand. Simply to put, recruiting capacity and capability both need increase and our sales organization needs to be in its absolute best given the available talent in the market. For the low cost recruitment engine, I believe these market dynamics will actually put us in a better competitive position as compared to many of our peers. Gross margins were disappointing in Q1 and were impacted by two cost items, which should not have the same negative impact in future periods that they have in Q1. Namely, higher bench costs from our start-up technology practice and the cost of compliance with the Affordable Care Act. Moving forward, bench cost in our technology practice will be significantly lower than in Q1 than higher health care cost of [HCA] [ph] will largely be reported by higher bill dates on new assignments. Additionally, it should be noted that as you all know Q1 gross margins are historically lower than subsequent quarterly gross margins due to the impact of higher payroll practice in Q1. As Jack mentioned, operating expense in the first quarter 2015 was impacted negatively by $305,000 in severance expense as well the cost having additional recruitment capacity and additional sales capacity in both our new business development space and in our technology practice area. We still view the sales related cost we have added for the business plus investments in growth. We are expecting to make those investments payoff in Q2 and Q3 of this year. In summary, while certainly not pleased with Q1 year-over-year declines, I have seen many of the cost elements that negatively impacted the first quarter 2015 result is transitory and I'm looking forward to meaning improvements in operating profits in coming quarters. Lastly, you are seeing meaningful consultants-on-billing growth in the latter half of Q1 and now into Q2. So I'm encouraged as we walk into Q2. Now, I would like to offer some comments on the Hudson announcement that was made yesterday. As we announced yesterday, we have signed a definitive asset purchase agreement to acquire the U.S. IT Staffing business of Hudson Global. The transaction is subject to customary closing conditions and expected to close in the second quarter of 2015. In my view, this is a perfect acquisition for Mastech. As I mentioned many times, acquisitions have a significant component of our growth strategy and while Jack and I look at many target companies over the last year, I believe it's far and away this acquisition is the most compelling that we have seen for Mastech. I see attributes of the two organizations complementing each other strengths and mitigating each others weaknesses. Without diving too deep given the public nature of both of our businesses and the acquisition is not closed strategically, I see the following advantages for our company. First and foremost is the fusion of capable talent. I have been impressed with the leadership that we will be inheriting as well as the talent of both those sales and the recruiting organization in Hudson IT. As we look for the right talent over the last two years – excuse me, as we look for the right acquisition over the last two years talents, the lack of it was the factor that usually made us walk away. Number two, Hudson have the strong stable of retail clients, which complements our business model. As you all know, our current business model is more aligned with the wholesale channel. I have seen a needed opportunity to leverage our offshore sourcing capabilities to enhance client service within Hudson. Hudson has a domestic recruiting focus and again, a great complement to our offshore recruiting model in an area that we wanted to grow strategically during 2015 to better serve the direct client market. Number four, as we alluded in our press release, [there have been] [ph] synergies to cost savings transaction, this is a synergy to grow transactions. Not only do we plan on keeping all the Hudson sales and recruiting staffing intact, we also want to legalize the benefit of our business model and our SGA model to enhance services to their clients. From a financial perspective, we believe the acquisition will a) be immediately accretive to earnings, b) increase our revenues by close to 30% and c) impact gross margin percentage favorably. So we will immediately add to our portfolio a high concentration of retail revenues and a robust current placement business. In summary, I couldn't be more excited about this opportunity and look forward to announcing our closing later in the quarter. At this time, I would like to open it up for questions.

Thank you. At this time, we will conduct a question-and-answer session. [Operator Instructions] Our first question comes from David Polonitza with AB Value Management. Please proceed with your question.

Hey, guys, good morning. Just wonder if you can just explain a little bit why Mastech was looking at acquisition candidates, what is the benefit of improving or increasing your footprint now in the retail space and how you will be able to leverage your existing infrastructure to improve this acquisition?

Sure, Dave. Let me take a shot at that and Jack, if you have anything to add please do. Number one, obviously, we are trying to be a bit careful because the acquisition didn't close. And – but let me offer what I can right now Dave. We talked in the past about a growth strategy for Mastech that includes basically four prongs or four quadrants of activity. The first quadrant is growing with our existing client base and driving both the 1.5x market. But, the second quadrant is adding new larger scale customers that are VMS, MSP style customers that stick in our high volume, low cost speed recruiting model. The third quadrant of growth was really all about growing in-depth in the technology practice and growing from a retail client base as you will all know, our wholesale – excuse me, our business is 75% wholesale and 25% retail today. And our long-term vision is to drive that to a balance – it looks pretty much 50/50. We don't expect to get there overnight much more of a 3 to 5 year approach. But, we see high value in having a retail client base as well as having a wholesale client base. And the couple of obvious reasons, right, and if you look at any of our publicly traded peer group, who have a much higher retail base than we do, you can see gross margin impacts of that retail base, or interesting and we like those. And we believe that first and foremost, we can bring a retail client base into our business and then using our low cost SG&A model service that through our offshore sourcing business and our offshore sourcing group, so we can actually make that onshore recruiting organization a bit stronger and a bit broader by supporting it with a sourcing organization that's working while, our folks in the U.S. are sleeping. So – but Hudson recruiters will then wake up in the morning with sourced candidate that they can create relationships with and so on and so forth. So we believe that retail client base have a huge – is a huge component of our long-term strategy to grow the company significantly. Our fourth quadrant was really to acquire the fill-in gap one of those first three quadrants and that's where the Hudson acquisition fit in our overall growth strategy. It is a play to actually add retail client base; add strong talent; and add a couple of customer facing markets that we frankly don't have today. The business that we are acquiring has offices in Boston, Chicago, Orlando and Tampa, the only office overlap that we have with them is in Chicago and our presence in Chicago is fairly small in comparison. So I really like the fact that there is virtually no end-client overlap and there is no physical overlap between the two businesses. So Dave, I think all of those segments are rationale to how the acquisition fits into our strategy and why we would look for – look at the business like Hudson IT extremely favorably.

Thanks. Just a kind of one more question kind of related to that. Our – would you guys be looking at further acquisition candidates once the integration of this potential acquisition has been completed, and also what's your plan to really drive organic growth of the existing business, obviously, the first quarter there was a lot of areas that you worked on. But, overall, how do you see your company – your legacy business and now this new business achieving that growth rate that you are hoping to achieve with respect to industry?

Yes. I will answer that several ways and I may have to be a little bit cryptic here just because the deal isn't closed. So in our legacy business in the Mastech [proper] [ph] business, we have as I think, you will all know from our last call, we made a – we now make two really significant leadership changes in the organization. First, we moved Sameer Srivastava, who was running our alliance channel out of India, moved him into a role where he is now the Managing Director in India and he is running all the recruiting. So first and foremost, Sameer's role inside of our company since the beginning of January has been to bring a disciplined focus to the way we on-board, train and develop our recruiting organization. And Sameer and his team have worked on that pretty hard over the last 90 to 100 days. As you guessed, those kinds of things – those kinds of changes aren't simple to make. I think I quoted the numbers for the group of four, so let me do that again. We have a – we built a recruiting efficiency in that to put several variables around the recruiting process into consideration and created kind of a batting average, if you will say. And in 2012 that batting average for our team was about 25%, right – 250 batting average. Over the last two years, we have driven significant amount of change to the recruiting organization and move that batting average to about 500, okay. What we determined in the fourth quarter of 2014 is that, if you wanted to have batting average to look more like 750 and we had to make a step change in the way we manage the organization and with the quality of the people who are managing the organization and with onsite, onshore leadership there in India. It was that organization had historically been managed out of COO channel from 9000 miles away. And we loved that. That's part of what we want. So we made that first major change, any changes it was possible because we took people and took process that was being the folks executing it and looked at it, said I'm being way more successful today than I was a year-and-a-half ago. And he decided that the time to make that step change is when you actually being successful not when you are – not when the sky is falling. So we made that change. Taken a little bit of time, but we are now seeing a much better quality of candidate in our proposals and we are working on getting our throughput, our time to respond back up to where we needed to be in the market. So stayed along – so long and shorter that this first side of that answer around growing organically with our current business is actually getting the changes implemented that's merely driving in the recruitment organization like any other major change in the business, I'm expecting that we will – we are beginning to see the results in Q2 and [indiscernible] support for the change will probably show up in the Q2 early Q3 based on the large scale change management and we are in the middle of it. So that's number one. Number two, as mentioned in – couple of times now, we continued to invest on the sales side, so not – that we brought in about 7 or 8 new sales folks over the last 120 days, 140 days and those – and each of those is beginning to find a feet and beginning to actually close the business. And so yes, I'm pretty excited from that perspective for the – we have legacy business that is now fully to grow both its – from a new business development standpoint and from a tech factor area can't talk much about that. But, you got – the folks off the bench as Jack mentioned that hurt our gross margins in the first quarter but folks are on project and we changed our model a little bit in that – we are going to do a little bit plus bench moving forward for Q2 and Q3 and probably in the Q4 than we have up until now and use the market a little bit more to make that sales force practice and I'm convinced that would be fine. And then lastly, you talked about what – how you think about organic growth with the newly acquired business? We have several thoughts; we just want to be careful. We have several thoughts about our business is a complementary. And when we close this one, I will be more than happy to talk a little more depth about some of what we see. As already said immediately, I think we can help the existing Hudson recruiters on the day of close with our sourcing organization that caters offshore that we can immediately begin to add potential candidate volume for those folks that – so they can go out and create relationships with candidate in the market that they may not have been exposed before. And then the second thing, that we will examine with the Hudson sales team and the Hudson leadership team as they come over into Mastech is -- we will take a look at each and everyone of the existing Hudson customers and we will assess if there is an opportunity to take a potentially dormant Hudson customer that actually runs a big chunk of the business through MSP or VMS, and work that directly through the Mastech model. So there is an opportunity of sales synergy that we can bring. We are way early in the process and I don't want to confuse anyone or scare anyone, right, that we are going to change the counseling because that's not the plan. But, the plan is for, Hudson to roll into Mastech as a stock contained business. There are no changes that are happening from the sale and recruiting perspective. We brought all of the sales team. We got all of the recruiting team and really will plug-in our finance and HR, legal and IT back office functionality into the sales and recruiting folks in Hudson. I expect that to be a bit of synergy there that given our SG&A model versus most of our peers but nothing on the side in recruiting side. We bought the business for the sales people and we bought the business for the recruiters. We bought the business for those folks.

Great. Thank you.

[Operator Instructions] There are no further questions in queue at this time. I would like to turn the call back over to management for closing comments.

Thanks operator and thanks to all for participating today. Please join our call in late July as we talk about second quarter, look forward to that with you all and watch for the close announcement as we have noted in our press release, we expect the transaction to close some time in the second quarter. So yes, I'm very, very excited for the business as we move forward into the second half of 2015. Thank you very much.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. And have a great day.