Edited Transcript of MSI.TO earnings conference call or presentation 11-Mar-20 2:00pm GMT

To date, we have converted over 2.2 million lives to our core well-being platform, up from 1.8 million in the previous quarter, and we anticipate seeing that number continue to grow. Our health and productivity business turned in a strong fourth quarter as our focus on absence management and mental health takes hold in the market.

One of the solutions that we’re most excited about is our internet cognitive behavioral therapy, iCBT, which we name AbilitiCBT, a therapist-assisted internet-based CBT program that can be accessed from any device anytime. We recently sold this solution to an existing large public sector client. We’re also about to launch a pilot project in partnership with CAMH to provide our solution to patients in their mood and anxiety outpatient clinics. It is highly atypical for CAMH to use an outside provider for mental health services. It speaks volumes about the level of confidence they have in our solutions. These wins represent positive steps towards leveraging our strength in this promising high-growth market from mental health care offered on digital platforms.

We’re also starting to see considerable interest in iCBT in the U.S., which tends to be an early adopter market for these kinds of technology-enabled solutions. We’re actively pursuing opportunities to roll out our solution in the U.S. ahead of our original schedule, which bodes well for growth opportunities in other geographic markets outside of Canada.

Our administrative solutions business has been on a growth trend for some time now, thanks to strong organic growth, some significant wins, and our acquisition of Mercer’s large market pension and benefits admin business. In Canada, we won a large onetime implementation of a state-based organization over the next 3 to 5 years. In the U.S., we won a significant admin contract with a large retailer.

And finally, in our retirement solutions business in Canada, we won a contract for core actuarial services with a large public sector client.

As many of you know, last week, on March 2, we announced the sale of our benefits consulting business to Hub International, a diversified global insurance broker. As part of our strategic planning process, we continuously assess our businesses across the enterprise to ensure that they align with our strategy to be the clear market leaders in the businesses in which we operate, to be the leader in total well-being market and to accelerate growth through global expansion and drive world-class delivery through people and technology.

While benefits consulting has been an important business in Canada for Morneau Shepell, with great clients and a talented team, it no longer fits into our road map for the future. Hub International, on the other hand, is committed to the growth of benefits consulting as a core business, which makes them a great partner for this transaction. The transaction will allow us to more effectively leverage distribution partners, such as insurance carriers and brokers for many of our services.

With the closing of this strategic acquisition, we have also entered into partnership with Hub. Hub has selected us as a key partner in delivering internet cognitive behavioral therapy, or iCBT, and other employee well-being services to their clients. The transaction is a win-win situation for all parties. It’s a clear example of a business that has different value in different hands.

Going forward, we’re focused on the businesses where we are or can be the clear market leaders, top 3 in the market where we compete. As part of that approach, we want to invest our capital and grow our business in support of our strategy, which has 3 pillars today: own the total well-being space globally, accelerate growth through geographic expansion and leverage technology to deliver a seamless experience for our clients and their employees.

Over time, we expect our Canadian business to produce growth in the mid-single-digit range, with high single-digit growth in the United States and outside North America.

As we move forward today, we do so with the confidence that Morneau Shepell is well positioned strategically, operationally and financially to deliver profitable growth.

On that note, let me turn it over to Grier to review the financials.

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [3]

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Thanks, Stephen, and good morning. 2019 was a solid year for financial results, and we made progress on taking our global expansion to the next level by executing on the strategy that Stephen talked about.

Let’s turn to the numbers for the year. Revenue grew 23.1% to $888.9 million, with adjusted EBITDA increasing by 33.2% to $182.5 million. Stephen mentioned the main factors in this upswing in our results being the midyear acquisition of Mercer’s stand-alone, large-market administration business in the United States; a full year of LifeWorks revenue; and organic growth across our core lines of business, which came in at 5.7% for the year.

Adjusted EBITDA margins increased to 20.5% from 19.0% in 2018. This increase is primarily due to the impact of adopting IFRS 16 and transformation initiatives, partially offset by Mercer being a lower-margin business.

For the fourth quarter of 2019, the company produced revenue growth of 23.3% versus prior year to $247.5 million. Adjusted EBITDA increased 34.7% to $48.0 million, with adjusted EBITDA margins increasing to 19.4% versus 17.8% in Q4 2018. The factors in the company’s improved quarterly performance include revenue from the Mercer acquisition, organic growth across our core lines of business and the impact of adopting IFRS 16.

The fourth quarter represents a strong finish to the year, and we are pleased with the integration of our acquisitions, and more recently, the transaction announced subsequent to the quarter with Hub.

As Stephen has mentioned, the sale of our benefits consulting business enabled us to divest the business that was less strategic to us, and it provides the company with additional liquidity that will be redeployed as a component of the company’s overall capital allocation strategy. Despite the divested business having higher margins, which will have a small negative impact on our overall margins, we are very happy with the economics of this transaction.

Ultimately, we are generating results that our shareholders expect from us, and these will be critical in funding our growth plans.

Adjusted EBITDA per share for the year was $2.76, a 21.1% increase compared to $2.28 per share in 2018. Profit for the year was $19.0 million compared to $21.8 million last year. The decline is due to higher amortization charges related to acquired intangibles from acquisitions and due to higher finance costs.

Normalized free cash flow for the year increased by $18.4 million to $93.5 million compared to $75.1 million for the same period in 2018, due to higher cash flow from increased adjusted EBITDA.

The company is maintaining its policy of paying a monthly dividend of $0.065 per share. And finally, a few comments about our strategies to maintain our financial strength and flexibility as we go forward.

In Q4 2019, the company increased its existing revolving credit facility by $100 million with the same terms and conditions. Combined with the proceeds from the sale of our benefits consulting business, we have the capacity to execute on our strategy. And finally, in December, the company issued a redemption notice in respect of the outstanding $80.7 million of convertible debentures. Of the principal amount, $79.2 million was converted into 3.2 million common shares at a conversion price of $25.10 each. The remaining $1.5 million was redeemed through a cash payout at face value.

And with that, I’ll turn the call back to Stephen.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [4]

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Thanks, Grier. Before we move to the Q&A, I’d like to address a question that is likely on your minds about our response to COVID-19. We are committed to and prepared to address the evolving risk posed by COVID-19. We’ve activated our comprehensive business continuity pandemic plan and have a very active executive and management groups coordinating our response globally. We have regular communications with employees, updating them as new information is available. We are continually assessing and updating our approach based on the changing environment, including things like travel restrictions for nonessential travel, self quarantines in certain situations, working from home, restrictions on large gatherings of people, et cetera. We are communicating best available information and advice to help protect our employees. We’re also providing support to our clients and their people.

In terms of the impact to the business, based on how things are unfolding at this moment, we anticipate the impact to be fairly neutral. In some areas, we’re seeing an increase in service, like more cases in the absence and disability business, and in others, we’re seeing a slight decrease, like face-to-face training. It is a fluid situation, and will continue to evolve. And as I’ve said, it’s something that we’re very actively monitoring.

I’d like to thank everyone on the call for your time so far today. We’d be pleased to now answer your questions. Maud, will you go ahead and open the line?

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Questions and Answers

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Operator [1]

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(Operator Instructions)

Our first question is from Stephanie Price from CIBC.

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Stephanie Doris Price, CIBC Capital Markets, Research Division – Director of Institutional Equity Research and Software & Business Services Research Analyst [2]

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Maybe just on COVID-19, since you just mentioned it. Can you talk generally about what you’ve seen historically in terms of the EAP well-being utilization in kind of downturns and periods of uncertainty?

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [3]

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Yes, really good question. I’ll put it into two parts, Stephanie. The first would be a recession or a financial downturn, where, when that happened during the financial crisis previously, we saw an uptick in calls coming into our EAP related to stress and anxiety, as you can imagine, and more clients would ask them to go on-site and help them with downsizings and things like that. In our pension administration business, we would have seen more activity relating to — need them to do calculations for people around retirement and things like that.

If I take it more specifically to your question around COVID-19, when we take a look back at SARS or H1N1 or something like that, we did not see a large uptick. We would have seen a small uptick in calls and things like that, but nothing material or substantial.

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Stephanie Doris Price, CIBC Capital Markets, Research Division – Director of Institutional Equity Research and Software & Business Services Research Analyst [4]

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Okay. And then in terms of the Mercer acquisition, looks like revenue was a little bit higher than consensus modeling this quarter. Can you talk a bit about the growth you’re seeing in the business? And whether it was in line with your expectations?

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [5]

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Yes. I’ll start, Stephanie, it’s Stephen, and then turn it over to Grier. I think the first comment I would make is, as we’ve been out talking to our new clients, the ex-Mercer clients, we’ve been really pleased with the interactions, been really pleased with their openness to talk around, how do we do things differently, what other things can we do together, which really opens a lot of doors to continue the partnerships to build.

As you would have noticed, the revenue is higher than what we would have expected. That obviously puts some pressure on margin percentages, not margin dollars obviously. And that really is, I would say, tied into a couple of things. It’s tied into less turnover of those clients that we would have expected, and some onetime work that, I think, came our way as those clients saw a long-term player in the industry rather than necessarily an organization that they weren’t sure if we’re going to be in that business longer term.

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Stephanie Doris Price, CIBC Capital Markets, Research Division – Director of Institutional Equity Research and Software & Business Services Research Analyst [6]

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Okay. And when you think about that onetime work, should we think of that going into the next quarter as well? Or was this pretty much wrapped up in the quarter?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [7]

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One of the things I would add — it’s Grier, Stephanie. I view this as when we looked at what we thought Mercer would be and what it has been, we’re obviously very, very pleased with it, both revenue and EBITDA. When we made the assumptions in our acquisition model, we made some assumptions about the clients that would stay and clients that would maybe not say. And a big part of the outperformance is that we’ve had a really good result in terms of clients that we’ve been able to continue to work with. So I think the reason why I’m saying that, I think, it’s — there are some opportunities to grow this portfolio. I think it’s really that we saw some outperformance at the beginning of it. And so it’s not like we’re going to see this outperformance again and again and again. So I wouldn’t look at it as hyper growth. More as, we’re really pleased, everything is converted a lot better than we thought, we’ve got great value here, but don’t look at it as a huge growth engine.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [8]

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And I do think — just on your question around onetime, Stephanie, I do think that was a little bit of pent-up demand rather than necessarily those growth rates continuing.

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Stephanie Doris Price, CIBC Capital Markets, Research Division – Director of Institutional Equity Research and Software & Business Services Research Analyst [9]

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Okay. And I’ll throw one more in. Just — you mentioned iCBT quite a bit in your prepared remarks, Stephen. I was wondering how you kind of sell that into — is it mainly some of your existing well-being clients? And is that kind of a revenue add to your existing revenue in the well-being space? Or how do we think about that?

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [10]

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Yes. And we really think about it as part of, what I would call, our continuum of care, which moves from the lower end of the continuum, where you’re talking about recognition and having people feel involved in a workplace, up to elder care, child care, up to the other areas that exist from an EAP. Think about anxiety, depression and things like that. And then it really moves into iCBT. So at a very simple level. Rather than going to see a counselor face to face, you’re essentially moving through modules online with a counselor in the background, assisting you as required. And then beyond that, when you do need the face-to-face or you move into being off work, you move into our disability management business. So iCBT was a really nice fit into that overall continuum. We do sell it as an extra product, and we’ve seen good take-up on that.

Again, it’s very small. It is in our health and productivity business. But we do see that as being a growth driver in that business. And that did help contribute to the nice growth that we saw in Q4 in the health and productivity.

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Operator [11]

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A following question is from Jaeme Gloyn from National Bank Financial.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [12]

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First question, just going back to that onetime work component of Mercer, how much would that have contributed in the quarter? I guess what I’m trying to get at is, what would be sort of the run rate revenues? Is it the $36 million that you generated? Or is it something a couple of million dollars lower? Or a little bit more color.

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [13]

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Yes. So let me say it again. So I think the run rate is probably a pretty good one, Jaeme, aside from seasonality and stuff like that. But I think that’s a good run rate. So it wasn’t so much as it was the onetime nature of it. It was that we converted more — had an ongoing relationship with more than we thought. So we don’t look at it as onetime, but it converted. So is that, I guess, an increase onetime over what we thought, but it will continue. So it’s recurring.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [14]

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Okay, that’s great. In terms of the benefits consulting transaction with Hub, it was noted in the statement there would be a small gain. Do you have any additional color you can provide as to the size of that gain in Q1?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [15]

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Yes, for sure. So I look at it — the two different pieces, I look at our cash flow. So one thing, I think it’s important to understand is that there’s no cash tax on this transaction. So the net, we should be able to take $64 million, $65 million kind of zone out of this and redeploy that cash. Obviously, in the interim, we’ll apply it to our credit facility until we find a place for it.

On the accounting side, I’m just — I’m going to give you a number. Obviously, there’s still stuff moving around, but it’s probably in the — it’s in the $30 million to $40 million, I know that’s a wide range, but it’s in the $30 million to $40 million range on gain.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [16]

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Okay. That’s quite substantial. Shifting to free cash flow, normalized free cash flow ticked down year-over-year this quarter, primarily because of what looked like higher CapEx tied to the Mercer transaction. First off, I guess, how much of that $14 million CapEx tied to Mercer is going to repeat in 2020? And then second part would be, can you refresh us on what your CapEx budget and plans are for 2020 and 2021?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [17]

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Yes. So for Mercer, it’s not recurring. So they’re — on the CapEx side of it, I’m not going to get into specific numbers necessarily, but the Mercer is not recurring. It was some onetime capital that we made. If I said it will be kind of 50% zone going forward, that’s probably close.

In terms of CapEx for 2020, it will be somewhat elevated versus kind of where we came in, in 2019. If I said $60 million type zone, that’s probably relatively close, plus or minus, as we have a bunch of kind of onetime initiatives that will be taking place over the next 24 months. So I think the capital will be elevated through that period, and then when it comes through to 2022, that’s where we see the CapEx kind of coming back into a more normalized zone.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [18]

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And Jaeme, it’s Stephen, a little bit of color just on the elevated pieces. Most folks know we’re looking at new office location in Toronto, capital tied to that as we move through. We’re implementing Workday across the enterprise standard integrated systems between finance, HR and time entry and things like that. And in addition, we’ve got some work just to do to beat some client commitments that we’re quite excited about in terms of the LifeWorks platform, and as we’ve talked before, getting pension and benefit data integrated into that platform.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [19]

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Okay. And I just wanted to — I was actually going to follow-up on that, but since you mentioned the pension and benefits component and what you’re working on there, can you give us a little bit of update around how that’s progressing? Any feedback from clients from initial testing? And then maybe a comment around timing.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [20]

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Yes. I think a couple of things. So the first thing, we are working very closely with 1 client who is very determined to lead with us in the marketplace, and we’re co-developing, and it’s going well. The teams are working very hard. I think we’ve got fairly aggressive time lines. But we’re still working towards having this done by the end of Q2, and we’re on track, but they are aggressive time lines.

We have tremendous amount of interest from other clients in that. But we’re really focused on getting it done on the one, first of all, and then everyone else is kind of waiting, and we will move forward and talk to them as we get through the development.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [21]

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Okay, great. And then last thing for me, and then I’ll requeue for some — maybe some quick one I had is around margins. I’m trying to just sort of run some math here and make some adjustments to neutralize for the IFRS 16 impacts and then Mercer. So stop me if I’m going a little bit too off track here. Taking a look at the adjusted EBITDA of $48 million, if I use the $4.7 million payment of lease liabilities as the adjustment for IFRS 16, is that a correct adjustment? And that would lead me to about a 17.5% adjusted EBITDA margin just on the IFRS 16 impact, is that fair?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [22]

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Yes. Not — I got to be honest, I’m not following all your math. What I would say is the IFRS 16 adjustment is order of magnitude, probably 130 basis points or something like this. What I would do is I — when I kind of reset where the margins are, right? So when you look at last quarter, I think, we were 19.6% this quarter, were 19.4% EBITDA margin. What we said on the last call, which we continue to think it is the right zone, is that our overall EBITDA margins for 2019 will be consistent with 2020. So that came in at 20.5%. We’re still thinking the same. So obviously, we have built margin improvement into our forecast for the year, and we’re still confident we’ll achieve that.

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Operator [23]

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(Operator Instructions)

Following question is from Graham Ryding from TD Securities.

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Graham Ryding, TD Securities Equity Research – Research Analyst of Financial Services [24]

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Maybe I could just start on the free cash flow side. I heard your comments on the CapEx. Just working capital or noncash working capital seem to a bit of a drag in 2019. Is there any color there on what specifically is driving that? And is there any expectation that, that will be less of a drag going forward? Just thinking about free cash flow and payout ratio.

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [25]

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Yes, Graham, it’s Grier. So I think if you look at 2019 on a whole — why don’t I just talk about Q4, I think that’s probably more relevant here. So the working capital in Q4, the primary reason why that move was the WIP, and so our WIP is a little bit higher. A big reason for that is we have one specific client where we’re doing a fairly large implementation, and there’s milestones in the contract. So we built up $5 million or $6 million in WIP for this specific client. That project is going on plan. It’s when, will and all that kind of stuff, it’s just — we built up an unusually large amount for this particular client on WIP. I mean, that to me explains most of it. We should see that reverse in Q1.

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Graham Ryding, TD Securities Equity Research – Research Analyst of Financial Services [26]

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Okay. That’s helpful. Your comments around integrating the pension admin into the LifeWorks platform or app. You’re working on 1 client, then you’re looking to roll it out with the rest. Is there any, I guess, the benefit there, I presume from a client’s perspective, is just it’s a better overall product and for you to be better client satisfaction and retention. Is there any economic benefit from actually integrating pension and benefits admin into the LifeWorks platform?

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [27]

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Yes, Graham, it’s Stephen here. The first thing I would say is, I do believe, as you move into a platform world that the winners will be the ones who have people using the platforms on a regular basis. And we think we’ve got a very strong usage on the current platform as we’ve rolled it out. But we think adding pension and benefit data will just drive substantially more.

Second thing I would say is as I met there talking to CEOs, CHROs, what we see quite often is, they’ve got a number of programs in place in the organizations that have no utilization. And it’s really the fact that it’s buried on a website and hard to get to. And if we, again, can have something that employees are going to and using every single day for all of the key information they have, it just becomes way more valuable than trying to find something buried. So we think it’s phenomenal from an end user satisfaction standpoint. We think it’s really good from our client standpoint.

To answer your question on economics. Yes, we have someone who is a current client with pension and benefit, and we’re integrating that data under the LifeWorks platform. There is no direct economic benefit. If we’ve got someone who would like the pension and benefit data put on the system and is not residing on our systems, obviously, there would be a charge to do that, and there would be, obviously, an economic benefit tied to it. But I think the bigger thing is, I think about it, as you think about this platform continuing to expand and us putting more and more product, services and solutions on the platform, we will, over time, add solutions that we can charge an extra $1, $2 per employee or per month. And there will be things that our clients and HR leaders truly value and their employees value. So I think it’s just setting the platform up, getting more utilization, and then that will be the thing that gets used more and more, and we will be able to recognize economic benefit over time.

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Graham Ryding, TD Securities Equity Research – Research Analyst of Financial Services [28]

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Understood. Makes sense. And then just my last question. The — there was an acquisition just earlier this week announced, Aon and Willis Towers Watson. I’m just wondering, from your perspective, any impact on the competitive landscape or read-throughs to your business if that deal does go through and close?

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [29]

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Yes, really good question. Obviously, we have been close to following it, and I think it’s been on and off the room and now for a good year as we think about it. What I would say, first of all, if you think about what that business really is, it’s somewhere between insurance and consulting. So for the most part, we don’t play in the insurance space. And we’ve got a retirement solutions business that we play in consulting, but we’re not in the benefit space anymore, as you know.

So it would be — what they have would tie to a very small part of our business when we think about it, and it is a Canadian-only part.

The one other thing I would say, though, is as you think about less and less players in this space, as RFPs come up in the retirement solutions space, there are less people bidding on it, and that is a business that we like it fits into our total well-being model and everything. So we would expect, over time, probably more opportunity showing up just with less competitors in that space.

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Operator [30]

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A following question is from Jaeme Gloyn from National Bank Financial.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [31]

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Two quick follow-ups. First, just looking at the Note 4 of the financial statements showed a $7.5 million negative adjustment on the goodwill for LifeWorks. Looks like it was netted out by other adjustments, but maybe you can walk me through what drove that?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [32]

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You got me, Jaeme, I don’t — we have to take that off-line.

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Jaeme Gloyn, National Bank Financial, Inc., Research Division – Analyst [33]

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Okay. And then second one, just going back to the margins, I meant to also ask, last quarter, we talked about Mercer being about 100 basis points drag. Given the revenue was much larger this quarter, is that number still appropriate? Or is it something different?

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Grier Barrett Colter, Morneau Shepell Inc. – CFO & Executive VP [34]

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Yes. So on Mercer, it’s certainly north of 100 basis points. It’s probably closer to 120, 130.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [35]

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And Jaeme, just building on what Grier said before, the way I kind of think about it is we’ve got a run rate going right now on margins of somewhere between 19.4% to 19.6% and we’re working fairly hard before the Hub piece gets factored in to add, we would anticipate about 100 basis points as we move into 2020 on that number. Obviously, that’ll be pulled down a little bit with the transaction with Hub just because of Benefits Consulting business had slightly higher margins.

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Operator [36]

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We have no further questions registered at this time. I would now like to turn the meeting back over to Mr. Liptrap.

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Stephen Liptrap, Morneau Shepell Inc. – President, CEO & Director [37]

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Thank you, Maud. I’d like to end by expressing my thanks to everyone on the call. We continue to appreciate your interest in our company, and we look forward to other opportunities in the future, including these calls, to keep you up-to-date on what we’re doing to drive our growth and success of the business. Thank you.

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Operator [38]

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Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.