NCC Group plc (NCC) Earnings Call Transcript & Summary

Ladies and gentlemen, welcome to the NCC Group FY '20 results Q&A session for analysts. My name is Ruby, and I will be your moderator for today's call. [Operator Instructions] I will now hand over to your host, Adam Palser, CEO, to begin. Adam, please go ahead.

Lovely. Thank you, Ruby, and good morning to everybody. Thank you for joining us today, and I look forward to taking some of your questions in just a few moments' time. Now I'm here with Tim, Tim Kowalski, the CFO. And what I thought I would do is just take a few minutes to just reprise some of the headlines of the results. I'm sure most of you will have had an opportunity to read the RNS. The presentation should be available for you to watch and has been for the last hour on our website. But if I draw out some of the main highlights. Now I think the first thing to say is that I feel that we are absolutely blessed to be working in the cyber resilience market as opposed to many of the other markets at the moment, given the uncertainty that we're all sort of facing. Underneath the cyber markets, the 4 secular drivers, which is the increase in the connected environment, society's dependence on that connected environment, the rise of more and more bad actors and the relentless growth of legislation, are driving that sort of relentless growth of the cyber resilience market. So despite this short-term impact from the pandemic, and goodness knows how long it's going to last, the one thing we do know is that cyber resilience will be ever more important. And I'm very, very pleased to give you the results that we've been able to present today, which have demonstrated that in this market, despite the challenges that we're all facing, NCC has demonstrated itself to be growing and to be resilient. Now you will see the thumbprint of COVID on our results. You will see that we've had an estimated GBP 15 million impact on sales orders converting. But to stand before you with a company that has grown during these difficult times, that has delivered a very strong free cash flow of just short of GBP 30 million, I think it's about GBP 29 million free cash flow, to have brought down our net debt to just over GBP 4 million, admittedly with the help of around GBP 4 million to GBP 5 million of government deferrals, I think, is tremendous. Back in February, when we stood up our COVID management task force and back in March when we withdrew our guidance, we weren't quite sure how the next few months were going to pan out. But we went in with a very explicit objective, 2, in fact: Number one was to come out with a strong balance sheet. We didn't want to come back out of whatever crisis we were facing on the back foot. We wanted to come out on the front foot with a strong balance sheet and with the firepower to take advantage of opportunities as and when they appear. And the second thing is having spent so much effort creating a pool of high talent in cyber. And as we all know, those skills are scarce and hard to come by. Having seen our retention rates go up over the last couple of years, what we really didn't want to do was spoil that. And so we made some very deliberate, conscious decisions to hold on to our capability and our capacity. So even though we felt the impact from COVID, we did not furlough any colleagues, we did not make any redundancies because of COVID-19. And so today, the results, you've had a chance to look at. Our revenue is up. Our profits are down significantly because of those -- well, the profits are down slightly, but the significant part of that cause is our decision to hold on to our capability and capacity. However, yes, I really want you to take away from our results today that we have not been defined by COVID. We're still operating in a good market. Our destination, our ambition remains current. We have that strategy, and we are executing it relentlessly. So you will also see that we have done more research. Our average order value has increased. We are delighted by the growth of our Managed Detection and Response business line in Assurance, which underpins our business with more and more recurring revenues. And that is a trend that we are very focused on continuing over the next years to come. Our Escrow business, which has declined over the last few years, was flat half 2-to-half 2, which is a good result and something we're very, very pleased at. As you know, returning Escrow to sustainable growth is one of our key objectives. And I'm delighted to see the progress that we've made on that. Looking forward, we're taking this time. We don't know how long uncertainty will plague our client base, how long people will feel financial and logistical pressures. But what we are absolutely determined to do is come out of this in better shape than we went in. So we will come out of this with a strong balance sheet. We are continuing to invest selectively to broaden our proposition so that we can better serve customers wherever they are across the world. And then just one final word on outlook. I'm very pleased to say that in the first 3 months of the year, we feel slightly on the front foot compared to what was a very weak comparative period last year. Our Q1 is running a little ahead, although we are flagging that, that is because of some rather lumpy and excellent M&A support work that came in towards the end of last financial year, which has spilled over into Q1. The run rate, underneath. We are seeing clients lessen their procurement cycles. We are seeing them become a little bit more predictable. And straightforwardly, how we do this full year will depend on how quickly and when our clients' buying cycles normalize. So look, I think that's a quick counter over the main features that you will have heard me speak of in the presentation. And I'll be delighted to take any questions that you might have.

[Operator Instructions] We have a question from Tintin Stormont of Numis Securities.

One question on Escrow and one question on the Assurance side of the business. On the Escrow side, could you just talk a little bit more about the pipeline and what you're seeing there, maybe differentiating between the EaaS offering and the sort of kind of the more standard one, what you're seeing in terms of that? And in terms of kind of going forward, sort of how nervous are you in terms of volumes there if volumes of kind of new license sales towards the back end of the year start to come down, if there are pressures on CapEx budget? Just trying to get a sense of kind of the buildup of the pipeline there. And secondly, on the Assurance side, if it's possible to perhaps describe some of the kind of the trends, to some extent, month-on-month, as you went through the period. You rightly pointed out that Q1 last year was obviously a weak period, followed by a really good bounce in Q2. In terms of kind of the orders and the pipeline that you're seeing there, does it feel like a better environment going into that Q2 versus, say, kind of the last few months? Just trying to get a sense of if you're seeing that. I take it that, obviously, we don't have the visibility in terms of corporate budget as sort of kind of the year goes on. But in terms of what you could see at the moment, is that sort of kind of improvement kind of happening?

Yes, absolutely. No problem. Tintin, thanks for joining. So look, I'll have a pop at those. And Tim, if you have anything to add on top, then please do [ just shout ]. So let's take those in turn. First of all, if we look at Escrow, if we look at our pipeline, we are seeing nothing untoward at the moment. I think it's fair to say, Tintin, that we were hoping to have tilted back to a bit of growth in H2 last year. So delivering a flat H2 is probably the minimum expectation, but we were impacted by, for example, not being able to get into clients' offices and do some verification work, in particular some Secure Discovery work in the States, which held us down a little bit. But at the moment, there's nothing untoward in our pipeline. We are naturally cautious, like everybody is, as people go through their budgets line by line, looking for every cost saving they can possibly find. The sort of work we're doing, I'm sure it's the sort of work that other people are doing as well. So that's all fine. But with our EaaS, I mean I think we had -- I think it was GBP 1.2 million of orders last financial year. So it's a number that we're thrilled with. But in the context of the available market, it's just not a very big number. So even though there, I'm sure, will be greater nervousness about license sales over the next 6 to 9 months, I think our scope for market penetration is just so significant that it shouldn't hold us back from continual growth in Escrow. What we're really looking at is just procurement cycles and speed of people making decisions, which seems to be just a little bit slower. But so far, as I think I've highlighted in the presentation, Escrow is flat year-on-year. So again, we're looking forward into the midst that there's nothing that causes us undue concern at this point. Now Assurance, coming to that question, trying to give you a flavor of the month-on-month piece. It's -- let me see if I can do this. I mean, first of all, we definitely saw a wave of impact from coronavirus across the world. So it hit our smaller Asia Pac operations first. And then it washed across Europe, and I think North America was last in and indeed is last -- it was last out. As we roll through this year, Q1 has, I suppose, exceeded our expectations is the simplest way of putting it. Visibility hasn't been good for some time now. But we have had a fabulous team of people, both at the management level, both at the sales level, both at -- in our delivery teams who are actively supporting our sales colleagues, trying to get scoping done quickly and come up with the best possible solution, getting things converted. So it's been an absolutely heroic team effort. And that, as I think it was inelegantly described by one of my colleagues, knife fight in a phone box has kept us moving forward in a way that we're pleased with, boosted by the exceptional M&A work that we talked about. Now last year, at the half year point, Tintin, you'll remember I stood up and said Q1 was really, really weak, but we had just this fantastic bow wave of orders that we could see running in the door. So we had great confidence over Q2, and Q2 indeed turned out to be absolutely wonderful. We're not quite in that place. We've had a Q1 that's put us on the front foot, which is good news. We don't have that bow wave of orders coming through, which guarantees of Q2. So what we're doing is we're moving forward into the fog, trusting ourselves to be able to execute in the way that we have so far. But there's more uncertainty than we have at this -- in the same month last year.

Our next question is from Sanjay Jha of Panmure.

Can you hear me?

Sanjay, yes, we can.

Excellent. I just wanted to follow up on the Escrow. Can you explain to me what happens if companies, let's say, got a business or they're in financial pressures, what happens to your contract on the Escrow? I just wanted to understand the dynamics and if you could explain me -- explain it to me.

Yes, certainly. I mean, hopefully, I'm asking -- answering rather the correct question. And if I'm not, come back and tell me. So the Escrow contracts that we write, they are -- specifically release the source code to the person who has bought it under certain conditions. And one of those conditions is typically that the vendor goes bankrupt. So when that falls into financial difficulty, we would release the source code to the licensor, whether that's a bank or a transport company or whatever else. Does that answer your question? Or have I missed the answer to it?

Okay. So basically, there is no recourse to you -- there's no kind of liability to NCC or there's nothing to be done. I'm just trying to say, is there kind of a follow-up business for you? Or is that the end of it, you just release source codes?

So on the whole. We release source codes, but there has been some very good examples of that where large multinationals have bought software from much, much smaller businesses, and they have gone out of business. And of course, they then face the challenge of standing up and continuing their operations. Of course, getting hold of the source code is an important part in that overall answer, but it's not the whole answer. So we do have some lovely case studies of where we secured 6-figure sums helping people to stand up continuing operations. So yes, those follow-on opportunities do exist, but I wouldn't highlight it as part of our core business.

Okay. Can I just keep on Escrow, if I may? I know you've had sort of increased the bonus structures or incentive structure for your staff, depending on contract and verification. How has that panned out? Is that sort of -- have you seen more effort to bring -- sort of get the verification work? I know it's been difficult under COVID-19.

Yes. I mean, I think it's difficult to point to a cause and effect. And I will also credit the management team in Escrow, which has been significantly strengthened over the last 12 months. We're pulling a whole raft of levers to take our proposition to market more effectively. So I think they've had days which have been purely focused on cloud sales, for example. But on the whole, we have a team now which is selling a blend of our on-prem solutions and selling our cloud solutions. It sells a blend of contracts. It sells a blend of verification. And you're absolutely right. I think about 12 months ago, we did change and tweak our commission structures, just to make everybody realize how important it was for us to continue to secure that solid base of contracts. But yes, we also recognize that every verification sale we make is about 10x the revenue of the contract. So I think if my memory serves me correct, Sanjay, I think we sort of tweaked and refined that through the year. And I couldn't honestly tell you exactly where that stands today. But what I can tell you is that the -- everybody in Escrow, from the top management down, is absolutely focused on maintaining that contract base.

Then Adam, if I could just add. In verifications, that's the element that is more discretionary. So we expect it to be impacted more by COVID. And as you can see in America, it was. But overall, verifications grew by 1.7% year-on-year. So we're pleasantly surprised by that.

Our next question is from Ken Rumph of Jefferies.

Three questions, if I could. One is you mentioned that there was some one-off or lumpy, I don't know if one-off is the right word, sort of contracts benefiting the first quarter. Can you sort of quantify that? Is there a sense of the sort of underlying trend in the first quarter? Secondly, just on cash. You mentioned, obviously, that the deferral of the tax that the government introduced sort of saved you some money. Basically, just what kind of unusual items or reversal should we expect in the current year? Is the working capital situation normal? Is there anything other than tax we should think about? And finally, just perhaps given the weakness of the dollar generally, a comment on kind of FX exposures sort of as a guideline, depending how things pan out for the rest of the year.

Thanks, Ken. Lovely. Well, Tim, if I can just say a little bit about the first one and then hand it to you, if I may, for a far more educated answer than I could possibly give. So I think it's always tricky, Ken, when pointing at lumpy or sort of irregular work because I think exceptions happen every year, if that makes sense. It flows upwards and downwards. But the key message that we wanted to get across is to say, we've had a good first 3 months. We're sort of on the front foot, rather on the back foot, which is great. And I hope that kind of confidence comes through in our trading statements. But it's absolutely essential that I point out that the trading has been boosted and that the underlying run rate is running below the level we saw of the pandemic. So stripping it out precisely, I think, is tough. Tim may have some better granularity on that. But I wanted to get across the qualitative piece, in particular. But Tim, if you got anything on that and then the others, that will be very helpful.

Yes. I think we're estimating the one-off impact of this bluebird of M&A, and don't get us wrong, Ken, we do always have bluebirds coming in, is up to a couple of million pounds in the first quarter. So that's that, but these bluebirds can come in lots of [ ways ]. In terms of your cash related question, the deferral -- the cash with government schemes, and I'm going to split it because it is really important. We have a GBP 4.6 million government tax deferral, which is split by GBP 3.4 million of indirect taxes, so that's, if you like, above the line and FX cash conversion, and then we have GBP 1.2 million of direct taxes or corporation tax equivalents across the world, that gets you back [indiscernible] on the tax line. So that's why we've made the distinction that, that reduces net debt. All of that -- all of those taxes are now being paid back. And so I don't perceive there to be any problem in terms of going forward or unusual working capital movements other than the fact that we're in COVID-19. And generally, as you'll appreciate, cash is king and people are conserving it. But we are -- the message to our credit control team is we shout the loudest as soon as we get paid, hopefully, one of them or some of the first, as you can see in our cash performance. In terms of tax, tax rate is at 23.5%. We think that effective rate is about right because we've got the blend of the U.S. tax rates, which are higher federal and state versus the U.K. So unless either of those -- they are the 3 main tax movers. And unless one of those move, it'll -- it should be around the same. We have an offset to R&D tax credit, but that's a lot lower this year, and we have made a provision there. In terms of the dollar weakness, we don't tend to have a FX exposure because we are self-hedging, if you like, because roughly our U.S. and U.K. operations are roughly the same size. So in fact, what happens is, it tends to net off and not give us a big exposure. Obviously, it moves one way or the other. You see it on the constant currency issue, but it doesn't really affect us materially because of that self-hedging naturally within the company.

So you mean that there's no sort of transaction effect. It's purely translation, whatever the value of the dollar turnover is.

Yes.

Okay. So [ if I can ] just follow up. You've flagged that you're going to stop reporting adjusted numbers. And indeed, we have no more exceptionals or ISIs in the current year for the first time in a long time. So pulling on the hair shirt there, Tim, do you want to comment a little bit about why you're choosing to do that? I think probably, plenty of people would still look at things like amortization of acquired intangibles and share-based payments as a little bit different and not cash items and so on.

Okay. So overall, what we're trying to do is, obviously, clean up our accounts to make them what I would call more normalized in best practice. And if you look at the best companies across the world, they tend to have nothing below the line. So that's the overarching objective, is to become a normal, good best practice company. The FRC also would like companies to clean up their act and have nothing below the line. So it's good practice in terms of the best practice from the institutions as well. If you look at the ISIs, we're not saying we can never have any ISIs again. We're just saying this year, we don't have any. And the last time we looked, we think it's at least 10 years since that's occurred. If we -- if there was some huge event that happened in the future, there could be an ISI again. So we're never saying never. But what we're saying is that this year, we have had none, and we do try our best not to have any, unless it's an exceptional circumstance [ as truly ]. In terms of adjusting items, it's just along those lines. We want to really adjust and put those things above the line again and just say, look, the EBIT is the EBIT, and there's nothing else to move around. We will still clearly identify those elements of share-based payments and amortization of acquired intangibles. So if people wish to make the adjustments, they can do.

Our next question is from George O'Connor of Stifel.

I appreciate your comments on there's more uncertainty in terms of year-on-year. My interest is really around the sequential progress and specifically, how it relates to your comments on procurement. So firstly, how has phasing played out? Has it sort of improved through the period, deteriorated, no change? In terms of procurement, is it a matter of more hurdles being put through the procurement process? Or are you seeing moratoriums? And then I appreciate it's a little bit of navel-gazing at this juncture. But is there any issue at all around a bigger-than-expected budget flush period this year, simply as customers defer procurement until calendar year-end?

Thank you, George. So let me see if I can say some words about phasing to start with. First of all, we've seen phasing vary according to our geographic regions. So I think as I said before, we saw APAC hit first, then Europe, then America and then kind of -- they kind of came out or improved also in that area. So we saw proposal volumes, which is one indicator that we track of demand, obviously, fall quite substantially in end of March, April time in the U.K. We saw them recover a little bit coming back into May time and recover a bit further into June. But we haven't seen them spring all the way back up to the kind of levels they were at before. The U.S., we saw proposal levels lagged that a little. But again, we saw them depressed quite significantly in the final month of April and then into May. And they have recovered again, but not to the same level as we would have seen pre-pandemic. So I suppose that's what we're trying to get across. Procurement, it's absolutely fair to say -- as you asked the question, the answer that springs to mind most readily is that more people tend to be involved in each procurement process, which means that there just tend to be more people that have to say yes, more gates to go through and, therefore, an inevitable lengthening. We do mention in the RNS that some of our clients in the leisure and entertainment sectors have almost explicitly pushed stuff back about 12 months because they just have far more urgent things to focus on. So in those sectors, we are seeing -- if I understand the term correctly, perhaps that little bit of budget flush where people are pushing everything they can out. But that's not true of every sector. And I would point to some of the tech sectors and some of the banks as not behaving in that way as far as we can see.

Our next question is from Julian Yates of Investec.