I3 Verticals, Inc. quarterly report, Q2 FY2020

Full document

Business context and reporting period

i3 Verticals provides payment processing and proprietary software solutions to small and midsize businesses and organizations, including clients in education, public sector, property management, nonprofit and healthcare markets. This Form 10-Q covers the fiscal second quarter and six months ended March 31, 2020; dollar amounts below are in millions unless stated otherwise.

Financial performance and position

  • Revenue: Reported Q2 revenue was $39.2 million, down 54.1% year over year; six-month revenue was $80.3 million, down 52.8%. These headline declines primarily reflect adoption of ASC 606, which changed interchange and network fees from operating expenses to reductions of revenue. On a presentation basis excluding that change, revenue was $102.4 million for Q2 (+19.9%) and $212.6 million for six months (+24.9%). The filing says the accounting change did not affect operating income.
  • Profit: Q2 operating income was $2.0 million versus an operating loss of $0.2 million a year earlier. Consolidated net income was $1.9 million versus a loss of $1.2 million; net income attributable to i3 Verticals was $0.7 million versus a loss of $1.1 million. For six months, operating income was $6.1 million and consolidated net income was $3.9 million; income attributable to i3 Verticals was $0.6 million versus a loss of $0.9 million.
  • Processing margin: Management’s segment measure was $32.4 million in Q2 versus $24.3 million, and $65.9 million for six months versus $47.3 million. The measure is revenue less interchange and network fees and other costs of services, with residual expense adjustments as described in the filing.
  • Costs and interest: Q2 SG&A rose 45.2% to $20.8 million, primarily from higher employment costs, acquisitions and stock compensation. Q2 depreciation and amortization rose 16.4% to $4.5 million. Net interest expense rose 89.1% to $2.2 million. A $2.7 million reduction in the deferred-tax-asset valuation allowance contributed to the Q2 tax benefit.
  • Cash flow: Six-month operating cash flow was $8.8 million, down from $11.4 million. Investing cash use was $3.9 million versus $44.9 million, largely reflecting the absence of acquisitions compared with $41.2 million of acquisition spending in the prior period. Financing used $5.0 million versus $34.3 million provided in the prior period. Cash, cash equivalents and restricted cash totaled $3.2 million at March 31, including $1.6 million of unrestricted cash.
  • Debt and liquidity: Long-term debt, net of issuance costs, was $123.2 million, compared with $139.3 million at September 30, 2019. This included $19.0 million drawn on the revolver and $109.9 million carrying value for the 1.0% exchangeable notes. The company reported $256.0 million of revolver availability, subject to covenants, and was in compliance. Covenant ratios were 6.11x interest coverage, 3.41x total leverage and 0.38x senior secured leverage. Current liabilities exceeded current assets by approximately $11.2 million.

Material changes versus the prior comparable period

  • ASC 606 adoption effective October 1, 2019 reduced reported revenue and operating expenses by the same pass-through interchange and network fees; prior-period financial statements were not restated. Investors should use the filing’s comparable revenue presentations when assessing growth.
  • Payment volume increased 21.6% to $3.6 billion in Q2 and 26.0% to $7.4 billion for six months. Acquisitions completed in fiscal 2019 contributed to reported growth; no business acquisitions were completed in the first six months of fiscal 2020.
  • Integrated payments increased to 55% of Q2 payment volume from 49%. Monthly net volume attrition was approximately 2%–2.5% in March, which management attributed to COVID-19; the six-month monthly average remained below 1%.
  • In February, the company issued $138.0 million of 1.0% exchangeable senior notes due 2025. Proceeds were used substantially to repay revolver borrowings and fund note hedges. The notes have an initial exchange price of about $40.87 per share; associated warrants have an initial exercise price of $62.88.

Outlook, risks and unusual items

  • COVID-19: Management reported significant business disruption and lower payment volumes and revenue in affected verticals, particularly following closures of schools and local government facilities. March payment volume was down 1%–2% year over year. The company said the impact was expected to materially adversely affect its third quarter and fiscal 2020, but its duration and financial effect could not be reliably estimated.
  • Cost actions and spending: On April 3, 2020, the company announced furloughs and workforce reductions affecting approximately 12% of employees. It deferred certain anticipated acquisitions and is reassessing capital expenditures and acquisition plans. It expected immaterial charges related to the workforce actions.
  • Liquidity outlook: Management expected operating cash flow, cash and available revolver capacity to fund operations, planned capital expenditures and debt service for at least 12 months. This outlook is subject to COVID-related deterioration, covenant compliance and access to financing.
  • Debt and dilution risks: Revolver rates are variable and debt is secured by substantially all company assets. The notes may require cash settlement on exchanges or upon a fundamental change; the company cautioned that it might not have sufficient funds or financing for such payments. Exchangeability is conditional before August 2024. The note accounting also increases non-cash interest expense.
  • Other obligations and estimates: The company recorded $25.8 million of Tax Receivable Agreement obligations, generally reflecting 85% of certain realized or deemed tax benefits. Contingent consideration was $11.8 million. A potential business buyout arrangement with a third-party sales organization is capped at $29.0 million, with up to $9.0 million of additional performance-based consideration; the amount was not estimable. COVID-19 could affect estimates and potentially trigger impairment testing of goodwill and intangible assets.
  • No formal numerical revenue or earnings guidance was provided. Management stated it had no off-balance-sheet financing arrangements and believed ordinary-course legal proceedings would not have a material impact.

Important facts for investors to verify

  1. Reconcile reported revenue with the ASC 606 presentation change and evaluate growth using the filing’s comparable, pre-adoption presentation.
  2. Track subsequent payment volumes, attrition and performance in education and public-sector markets as COVID-19 effects evolve.
  3. Monitor operating cash flow, revolver availability and covenant headroom against the company’s liquidity outlook.
  4. Review exchangeable-note exchange and cash-settlement provisions, potential dilution, variable-rate exposure and debt maturities.
  5. Assess the deferred-tax valuation allowance benefit, Tax Receivable Agreement payments, contingent consideration and possible goodwill or intangible-asset impairment.