Kforce Inc. (KFRC) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Kforce Inc. First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce our host for today, Mr. Michael Blackman, Chief Corporate Development Officer. Sir, please go ahead.

Great. Thank you. Good afternoon, and welcome to the Kforce First Quarter Earnings Call. Before we get started, I would like to remind you that this call may contain certain statements that are forward looking. These statements are based upon current assumptions or expectations that are subject to risks and uncertainties. Actual results may differ materially from the factors listed in Kforce public filings and other reports and filings with the Securities and Exchange Commission. We cannot undertake any duty to update any forward-looking statements. I would now like to turn this call over to David Dunkel, Chairman and Chief Executive Officer. Dave?

Thank you, Michael. You can find additional information about Kforce on our 10-Q, 10-K and 8-K filings with the SEC. We also provide substantial disclosure in our release to assist in better understanding our performance and to improve the quality of this call. The firm's results in the first quarter did not meet our expectations, and we're not satisfied with our performance of $265.6 million in revenues, and earnings per share of $0.09. Our Technology and Government businesses performed near anticipated levels, though our top line results were slightly below our expectations. The shortfalls focused primarily in our FA and HIM businesses. The steps we took at the end of 2012 and continued in this past quarter are taking hold, and we began to see the fruit of those efforts with sequential revenue growth as we moved into April. We are making progress toward our goal of accelerating revenue growth in the second half of this year. Joe will provide additional perspective later in this call. Demand remains very strong for Technology and strong for F&A and health care. Our Government unit performed very well against the backdrop of sequestration and budget cuts. Throughout the quarter, our many client meetings continue to affirm our belief in the structural shifts taking place in the employment marketplace. We believe that economic uncertainty and the increasing cost of employment due to regulatory changes such as health care reform are increasing demand for contingent labor. The temporary staffing penetration rate has improved from 1.34% at the beginning of this economic cycle to 1.94% at the end of March and will likely achieve historic highs in the U.S. during this economic expansion. The challenges to revenue growth continue to be on the supply side where candidates remain in extremely short supply and typically have multiple opportunities from which to choose. In this regard, we're expending significant effort to educate our clients in this war for talent, with the intent of accelerating hiring decisions on resources that have been identified. We're also seeing a sustained high level of conversions as clients are recognizing their need to compete for core talent. We've taken steps to improve our competitive positioning in this environment through changes in staffing levels and processes for both our delivery and sales teams. In terms of the industries, where our services are in greatest demand, technology, telecom, health care and retail clients are providing the best current opportunities. Our Government business is doing a nice job replacing revenues lost from sequestration with new contract wins, and it's grown its business year-over-year. Within our Technology business, we also provide subcontract business to some of the larger government contractors, as well as some state and local governments, which had a negative impact on Q1 revenues. We have continued to add associates in both the field and NRC to better position the firm to achieve and sustain double-digit year-over-year revenue growth by the end of 2013. These new associates are distributed in both client and candidate roles. As our new associates ramp and revenues grow, we also anticipate improvements in operating margins due to the leverage existing in our infrastructure. We remain confident in our direction and believe there are significant opportunities for the firm as we operate against the backdrop, Kforce only having a 3% market share and a growing domestic staffing market and no direct exposure to Europe. I'm confident that we have the right operating model and talent to capitalize on this positive staffing environment and drive continued revenue growth and operating leverage. I'll now turn the call over to Joe Liberatore, President, who will provide operating insights. Dave Kelly, Chief Financial Officer, will then provide additional insights on operating trends and expectations. Joe?

Thank you, Dave, and thanks to all of you for your interest in Kforce. During the first quarter of this new era for Kforce, we will remain externally focused on better meeting the needs of our customers. During Q1, I personally had the opportunity of meeting with over 41 clients as I visited 9 markets, which contribute 1/4 of our revenues. These conversations continue to reinforce our belief that the opportunity exists for us to significantly grow revenue within our existing clients. We're streamlining and leveraging our processes and tools to simplify how we do business with our clients and consultants, and we will leverage real-time data to hold our associates accountable to higher levels of performance and superior customer service. Our flexible staffing business, which is comprised approximately 2/3 Technology staffing, declined slightly in the quarter on a sequential basis, primarily as a result of typical year-end project ends and slower-than-expected rebuild in our FA and HIM businesses. Our permanent placement business increased both sequentially and year-over-year, driven by strong search, sequential growth, which we believe is a sign of continued strength in the Tech market. To break things down further, Tech Flex, our largest business unit, representing 61% of total firm revenues. On a billing day basis, Q1 revenues decreased 1.9% sequentially but increased 3.2% year-over-year. Overall, our key performance indicators for Technology remain at healthy levels. Job orders, external submittals, and send-outs remained at high levels, and candidate supply remains tight, particularly for skill sets in high demand such as Java and .NET developers, business analysts and project managers. We continue to improve in prioritizing the highest-quality job orders, and our fill ratios for these orders are at an all-time high level, though we believe additional opportunities remain for improvement. Inter-quarter trends for Tech Flex revenues showed a decline in January and increases in February and March. Our national footprint and diversified service offerings also allows us to service clients in the industries with greatest demand for Technology professionals. These industries performed the best in Q1 were health care, comprising approximately 18% of Tech revenues, telecom and retail. Health care Tech is growing 15% year-over-year. Demand for Technology services and health care is expected to remain strong for the foreseeable future as hospitals and health care organizations implement systems to leverage EMR and the adoption of ICD-10 in October 2014. Late Q1 and early Q2 activity in Tech Flex is trending nicely as we expect Q2 2013 revenues to be up and year-over-year growth rates to improve from Q1 2013 levels. Revenue for our Finance and Accounting Flex business represents 19% of total revenues. On a billing day basis, Q1 revenues decreased 5.4% sequentially and 7.3% year-over-year. These declines were primarily due to significant project ends that were not offset by anticipated new project wins in Q1. Revenues declined in January and increased in February and March. We expect Q2 2013 revenues to be up for FA Flex from Q1 2013 levels, though we are currently not expecting any significant new project awards until late Q2 or Q3. Revenue declines for the quarter for our Tech and FA businesses were driven by our small and medium-sized client base and some select strategic accounts. Our Strategic Accounts portfolio increased slightly as a percentage of total revenues in the quarter. In the aggregate, the firm provides consultants to approximately 3,000 clients at any time with one -- with no one client constituting more than 3% of total revenues. HIM revenue decreased 5.4% on a billing day basis sequentially and 2.6% year-over-year. HIM revenues suffered from a lower hospital census than expected and a greater number of cancellations from clients prioritizing spend on ICD-10 and EMR implementations than expected. In addition, we believe this business is experiencing some temporary adverse impacts from the realignment we implemented last year. We expect this business to continue to stabilize in Q2 and be flat to slightly up. Revenues for our Government Solutions decreased 7.2% sequentially but increased 0.8% year-over-year on a billing day basis. The sequential decline was almost solely attributable to the expected declines in our Government product sales due to typical seasonal buying patterns. The Government services revenue was essentially flat sequentially despite the impacts of sequestration. Our Government unit has done a nice job in shifting their business to areas less impacted by Government cutbacks, and early indications are that we are having some success. We expect less than 10% of revenues to be impacted by sequestration and continue to strive to outrun these impacts with new project wins. There remains continued uncertainty around funding levels of various federal government programs, and the environment for our government services remains difficult. We anticipate Q2 revenues to remain stable. Perm revenues from direct placement and conversions, which constitute 4.3% of total revenues, increased 4.1% sequentially and 4.9% year-over-year. The war for talent continues to create an environment of strong demand for highly skilled candidates, and the pace of conversion has remained elevated for the past 4 quarters. Q2 has historically improved as the quarter progresses. Perm revenues are difficult to predict, but we expect an increase relative to Q1. During Q1, we continued to invest in revenue responsible headcount in both client and candidate focused positions, although at a rate much lower than that of Q4 2012. Headcount inclusive of the NRC and Strategic Accounts increased 3.3% sequentially and 24.3% year-over-year. The demand for our services remains strong. Our most experienced performers are close to capacity, and we have seen contributions from our 2- to 4-year tenured performers increased nearly 27% year-over-year, and a 1- to 2-year population responsible for an additional 19% over the same period. Continuing improvement in performance from these tenure groups and the ramping of newly hired associates should positively impact revenue trends as we move further into the year. However, it typically takes 9 months for new associates to ramp, and as a result, we expect increased compensation costs relative to gross profit generated from this population in Q2. We plan to continue to make measured investments in our sales associate headcount in geographies and industries that we believe represent the greatest opportunity in order to support double-digit revenue growth levels as we near the end of 2013. We had solid performance in the first quarter. However, our team is capable of more. I am confident we've built a strong foundation for future success. We will remain heavily focused on our clients' needs, and we'll leverage our platform of tenured field teams, the National Recruiting Center and our Strategic Accounts model to adapt to changing market dynamics and client and industry trends. We believe that the current environment remains very attractive for professional staffing. We will remain focused on driving profitable revenue growth by meeting our clients' needs and gaining market share. We will do this by maintaining our focus, executing with simplicity and holding ourselves accountable for delivering great results. I will now turn the call over to Dave Kelly, Kforce's Chief Financial Officer, who will provide additional insights on operating trends and expectations. Dave?

Thank you, Joe. Total revenues for the quarter were $265.6 million, which represented a billing day decline of 3.1% sequentially and an increase of 0.5% year-over-year. Quarterly revenues for Flex were $254.1 million, which represented a billing day decline of 3.4% sequentially and a 0.3% year-over-year increase. Search revenues of $11.6 million increased by 4.1% sequentially and 4.9% year-over-year. Revenues were lower than expectations in our Flex businesses as trends flattened in the middle of the quarter after a promising start. However, trends began to improve in March as the volume of weekly starts began to accelerate. Flex revenue trends for the beginning of April are up from March levels as we're beginning to see consistent weekly headcount increases in both Tech and F&A. For the first 3 weeks of April, Tech Flex is up 3.7% year-over-year, Finance and Accounting Flex is down 5% year-over-year, and HIM is down 10.1% year-over-year. Search revenues are up 5% year-over-year for the first 4 weeks of Q2. It is difficult to assess potential full quarter results with this limited data, though recent activity has improved from Q1. First quarter net income and earnings per share was $3.1 million and $0.09, respectively, which was within expectations despite weaker Flex revenues, primarily as a result of a strong search quarter. Net income and EPS decreased from $8.6 million or $0.24 per share, excluding the goodwill impairment charge in Q4, primarily as a result of the increased cost of recent additions to revenue responsible headcounts and increased statutory costs in Q1. Relative to Q4 2012, EPS was impacted by $0.10 as a result of increased statutory costs and $0.04 from investments in revenue responsible headcount. These costs were essentially as expected. Our overall gross profit percentage of 31.4% decreased 140 basis points sequentially and increased 130 basis points year-over-year. Our Flex gross profit percentage of 28.3% in Q1 decreased 160 basis points sequentially and increased 120 basis points year-over-year. The sequential impact of payroll taxes on margins in Q1 was 140 basis points, and overall spreads were slightly down. The following is a breakdown of the year-over-year and sequential bill pay spread changes by business unit. From a year-over-year perspective, Tech Flex spreads improved 100 basis points, and F&A Flex spreads improved 40 basis points, while HIM spreads were down 290 basis points, driven by a combination of business mix and increased compensation costs for our consultants, which we expect to continue for the foreseeable future. Sequentially, FA spreads increased 40 basis points, while Tech Flex spreads were down 20 basis points, and HIM spreads were down 210 basis points. Flex margins in the second quarter will benefit from a decrease in payroll taxes as many consultants will have hit their FUTA/SUTA resets in the first quarter. We continue to see good demand and an improving bill pay spread on our new starts in both Tech and FA and anticipate bill pay spreads to be flat to slightly improving from current levels in Q2. Q1 SG&A levels of 28.5% increased 160 basis points from Q4 2012, largely as the result of an 80-basis-point increase in payroll taxes and an 80-basis-point increase in revenue responsible costs from additions we made in Q4 and contingent investments in Q1. While we expect the impact of payroll taxes on both cost of sales and SG&A to alleviate in Q2 as is customary, the costs being incurred related to our revenue responsible investments will continue to impact bottom line results in the second quarter. We have a mature infrastructure and continue to maintain a disciplined approach to expense management, which should generate operating leverage as revenue growth accelerates in the second half of 2013. Assuming a similar mix of revenues and stable gross margins, we expect operating margins approaching 6% in the second half of the year as year-over-year revenue growth rates exceed 10% and to improve into 2014 as revenues increase. We continue to assess the impact of health care reform and how best to comply. Based upon continuing interaction with our customers, we continue to believe that this will benefit temporary staffing over the long term. As we work through our options, we believe the law should have less impact on Kforce than many other companies because of our ability to obtain insurance coverage or self-insure in addition to the level of benefits we already offer, particularly to our Tech Flex consultants. We currently offer benefit plans that will likely exceed the minimum requirements to approximately 2/3 of our employees, of which slightly over half enroll on our plans. Under the new law, the requirement for offering benefits to a larger population will likely increase, so there will be an impact. We believe we will be able to pass these incremental costs through, which will be most significant in our FA business through to our clients over time. A positive implication of this law is the potential for increased demand from companies looking to better manage their employee health care costs, which is particularly relevant in project-related disciplines such as Technology. We believe Kforce is in a strong position to provide solutions to our clients to minimize the effect of the new rules. As we look at our balance sheet and cash flows, our accounts receivable portfolio continues to perform well. Write-offs and the percentage of receivables aged over 60 days remain at very low levels. Capital expenditures for Q1 were $2.6 million, and we expect full year capital expenditures to be between $8 million and $9 million. EBITDA for Q1 of $7.9 million decreased $8.2 million sequentially and increased $9.7 million year-over-year. Our projected annual EBITDA exceeds $60 million. The firm had $39.5 million in bank debt at quarter end compared to $21 million in debt at the end of Q4 2012 and no debt at the end of Q1 2012. This increase was primarily the result of the timing of certain annual payments and the repurchase of approximately 410,000 shares of stock for $5.9 million. Currently, $83.9 million is available under our Board authorization for future stock repurchases. As cash flows improve, we typically reduce debt levels, but we will continue to evaluate the opportunity to return earnings to our shareholders through share repurchases or dividends as cash flows and market conditions warrant. With respect to guidance, the second quarter 2013 has 64 billing days compared to 63 billing days in the first quarter. We expect Q2 revenue may be in the $277 million to $281 million range. Earnings per share in the second quarter relative to the first quarter will be impacted by the decrease in payroll taxes but will still be impacted by our investments in revenue responsible headcounts. We expect the decrease in payroll taxes and cost of sales and SG&A to positively impact EPS by approximately $0.08 relative to the first quarter. Earnings per share may be $0.19 to $0.21 in Q2. Our effective tax rate in Q2 is expected to be 40.8%. We anticipate weighted average diluted shares outstanding to be approximately 34.3 million shares for Q2. This guidance does not consider the effect, if any, of charges related to the impairment of intangible assets, costs related to the settlement of any pending legal matters, the impact on revenues of any disruption in government funding or the firm's response to regulatory, legal or tax law changes. We've made progress in the first quarter towards our goal of accelerating revenue growth in the back half of the year, but there remains much work to do. We expect to continue making selective human capital investments to drive top line growth as we continue to see positive indicators for the demand in our business. We remain confident in our strategy and long-term prospects. We expect to capitalize on the operating platform we've built to grow revenue and generate operating leverage. Karen, we'd now like to turn the call open for questions.

[Operator Instructions] Our first question comes from the line of Mark Marcon of Robert W. Baird. Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division: I was wondering if you could talk a little bit more about what you're seeing on the F&A side. I know that's only 19% of your business, but the trends have been fairly steady there on a quarterly basis and not necessarily the direction you want to see. So what's your sense in terms of what's going on there? And how difficult would it be to take some of the resources that are dedicated to that space and reallocate them to the IT space where you do have strong demand?

Mark, this is Joe. I would say from an FA standpoint, there's the core FA business, which is the bread and butter. That business has been pretty consistent, probably a little bit lighter in Q1 than typically what we see. We typically see a little bit of seasonality in Q1. But I think that's been broad based in terms of, I think, some of our other competitors that's seen something similar. We also benefit in that business by project-oriented business, so we had a couple of larger projects on the back end of last year that wound down late in Q4. So we had a hole that we were -- we were starting out at a much lower basis in terms of our billable headcount coming into Q1. And typically, we see some projects coming online in Q1. In fact, we had some that were on the radar, and they've just been pushed out into late Q2 or into Q3. So I don't think anything is really materially changed about that business, but having sat in the CFO seat, and I always kind of viewed that everything that happens here inside Kforce is kind of a microcosm of what we also see taking place in our clients. As I've been out on these market visits and meeting with these key leaders within really some of our largest clients, the financial pressure that's on organizations in terms of cost containment is -- it's really -- it's epic. It's at an all-time high, and we're consistently hearing that. So when I translate that to F&A, I know what I see here at Kforce is our FA group just because they're the finance group, they do much more out of hide [ph] than what we see in certain other areas. So that might be something that's a little bit more broad-based impacting that there's work in the FA people a little bit harder. As I said, we saw our job order flow actually picked up 16.6% over Q4 levels in Q1, but we have this pause, and we saw this really in our FA business and in our Tech business. We had this pause mid-quarter, which ironically was right around the sequestration hype when everything was happening, kind of in that mid-February to late February time period. And we -- so I think broad based, we've seen a little bit more ripple into the commercial space, as well as just the government space in terms of that pause of people really not knowing what that was going to mean and what the resolution was going to be. Now in terms of redeployment of resources, we do that all the time actually within our NRC resources. Those are redeployable, and we point those where highest demand is. But in terms of field level personnel, they're are very different businesses, and so we do, from time to time, have people transition from FA into Tech. But it is a very different business model. FA is much more kinetic, so there's only a certain percentage of population that really can make those types of transitions. Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division: I appreciate the color there. And then you did say April was still down on the F&A side by around 5%. Is that not correct in terms of what Dave just said?

Yes, Mark. Mark, yes, Mark. Mark, this is Dave, yes. We made a comment on a year-over-year basis that F&A is down 5%, but the commentary that we made was that no, we're seeing headcount growth and upward trend in F&A on a sequential basis. Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division: Sure, sure, okay. And then on HIM, what are you seeing there in terms of -- clearly, a little bit lower than what you were expecting. What's your sense from your clients in terms of when that will stabilize and rebound?

Yes. I mean, Q1 is always a little bit more difficult in the HIM business. But there's kind of a -- there's a tail of a number of things that were happening. We did see census down. So there is a byproduct impact to -- because our HIM business is predominantly coders, coding of medical records. So if medical procedures are down, the need for coders is going to go down. So census was down, but I don't really believe that's the only driver of the revenue dynamics within HIM. One of the other things that we saw in HIM that we haven't really seen in the past is we saw customers that had approved hires to start and then came back and basically canceled those starts. And we saw that much more pervasive across many customers than we've experienced in the past, and what the customers were telling us is they were reallocating costs into other areas because what's happening in the hospitals right now, and you see this through more M&A activity within the hospitals, is the hospitals are coming to the realization, because of the Affordable Care Act, what's going to happen is the percentage of people that they're going to have to be taking care of, they're going to be more at the Medicare or Medicaid rates, which were a lower-margin business for them, is much higher. So they're going through major cost realignment within the hospital systems, which is part of what's driving the M&A, because you have smaller hospitals joining together, so they can get some leverage. So that played into that business as well, and then really, the third piece or the third leg that's impacted us is we went through a realignment of that business last year, just because of a lot of the statutory and compliance dynamics within that business, that we've had to apply resources because of HIPAA, high tech and various other things that have come down on that business. And we had to address some of those costs, and some of those costs, caused us to have some turnover because of realignments. So we're confident we did the right things for the long term of the business, but we're seeing a little bit of that impact. Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division: I appreciate the color. I mean, based on what you just said with regards to the HIM, with the exception of the third element that you mentioned, it doesn't sound like the other 2 are going to changing anytime soon, particularly the impact with regards to Medicare and Medicaid impacting the hospitals and the merger wave over there.

Yes. Well, you see another dynamic happening there. So as we look out to the second half of the year, I'd say we're little bit more optimistic on that business because what we're starting to hear from a number of customers, they're actually starting to put orders in now for coders that have ICD-10 experience because what their plan is, is to run parallel with ICD-10 and ICD-9 as that comes about for the October 2014 implementation. So actually, I think that, that provides us a little bit of opportunity because we, in theory, could be placing both ICD-9 coders and ICD-10 coders within those hospitals. So I would say no. As we start to look out to the second half of the year, we're a little bit more optimistic in terms of the business opportunities. We are projecting that business to be more than likely flat to slightly up in Q2. Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division: Great. And then with regards to IT bill rates, what's the progress in terms of convincing your clients to increase the bill rates in order to alleviate some of the demand pressures?

Yes. Mark, this is Dave. So as we talked about Q1, and we've done a good increasing spread, it's come from a combination of our ability in the longer term to increase bill rates and keep a lid to the extent possible on pay rates. I think we talked last quarter about the fact that pay rates are going up. Bill rates are going up a little bit better. As we kind of look in Q1, pretty similar story, I would tell you. In the aggregate, bill rates, there's still good demand out there. And there are opportunities, especially as we look most recently to the lot of the new starts that we've had over the course of the last few weeks. We're seeing some improving bill rates. For the quarter, in the aggregate, bill rates were pretty flat as were pay rates as well. So I think the signs are still good for that business. The bill rate opportunities that we're seeing, not as huge, though, impact in Q1.

And our next question comes from the line of Kevin McVeigh from Macquarie.

I wondered if you could give us a sense of -- it sounds like there were some inability to fill demand. What the incremental revenue opportunity that was associated with that? And then ultimately, as you're hiring in front of revenue, is it at a rate you would have thought historically? Or are you seeing some leverage from the NRC? And those hires, are they more on the IT side? Or is it different areas? So it seems like a little later in the cycle to be scaling up the revenue stream at this point from a hiring perspective. Any thoughts on that would be helpful.

Yes. Kevin, well, yes, I've now met with 66 customers in the last 5 months. And most of those have been predominantly on the Tech Flex side of the house, and the demand is extremely strong. And the optimism on what's on these plates, on people's plates, in terms of what they have to get done is very high. So about 73% of the hiring that we've done over the course of the last 2 quarters has been within Tech Flex. And the bulk of that hiring has been basically field-based or people within the NRC that we're basically building up and then deploying to the field. So that's really where we've been doing our activities. So no, I mean, short of us seeing a truncation of this cycle like what we saw back in 2008 driven by some event, we're hearing the demands there from our clients. So we're very optimistic about, as the year progresses, short of something of that nature taking place.

Got it. And then as you think about -- and this is maybe hard to quantify but the inability to fill some of that Tech demand, do you have any sense of what type of revenue opportunity that was?

No. I mean, I've been doing this for 25 years. And I grew up on the Tech side of the business. And so inability to fill requirements is not an excuse, and you can't really quantify it. The business is there. And I mean, now we are focused heavily in terms of how we're addressing, building pipelines, where we know demand's going to be, and placing those demands on all of our recruiters as well as on our NRC resources. So we're doing everything that we know how to do in terms of better building our inventory, so that we can better satisfy that need. But I will tell you, at the end of the day, this business is no different than any other business that's sales-driven. And control is the number one driver to sales success. So what we're really focused is working with our clients on how do we streamline the hiring process so that we can become more efficient and, in reality, so that our customers can get the candidates that they desire. Because what's happening is their processes are too slow. When they come back around and they want to hire the candidate, the candidate's no longer available. I mean the shelf life of high-quality candidates nowadays is 24 to 48 hours, so people are moving. They're going through all the exercise, and they're not getting the outcome. And so that's within our control to work with our clients and have our clients understand what's in it for them relative to getting after those types of activities.

Got it. And then just, any thoughts on where penetration peaks in terms of -- I know that's hard. Is it kind of a 2,2 [ph], a 2,4 [ph], depending upon the life [ph] of the cycle? Any -- just any thoughts, Joe or anyone else?

Kevin, this is Dave. I think the -- we talked last fall, when we were going through our planning, we've been -- we were being measured in what we were expecting for growth. And we all had an eye on the "cycle." But as we know, this is not a cycle anything like anything we've ever seen before. So when it became clear that we're going to have 4 more years of the current president, we're going to operate in a highly regulated environment, that the ACA was going to stand. All of those things told us that the environment that we've been operating in became a little bit clearer. Our clients made it very clear that they wanted to shift the employment risk. So it was at that point that we made the decision to make some changes in our model and to invest in certain areas. Now with that being said, where do we think the penetration rate goes? I believe, at least, from what I've heard from the clients, that as long as there isn't another event, an economic event, something that -- or a geopolitical event, we're going to see this thing push through the prior peaks and continue. So what we're positioning for isn't just tomorrow. We're actually positioning for the back end of this year and into 2014 and '15. So that as they move through our tenure pools, we're actually be able to accelerate and sustain the revenue growth and the operating leverage. So we did it with an eye towards the future while, at the same time, trying to make sure that we're meeting expectations now. If you look at where we are, I think some of the things that hit in the first quarter, certainly, the sequestration was an issue to us, it affected us in ways that, frankly, we didn't expect or see -- the ripple effect to commercial clients that were doing business with other government clients, subcontractors and even state and local business. So we've made adjustments, and as Joe said, there are no excuses.

And our next question comes from the line of Paul Ginocchio from Deutsche Bank.

Just I guess 2 questions, one on the financial services end market for IT, it sounds like large clients outperform small-, medium-sized clients, if I heard that correctly. How did financial services do in their marketing? And can you remind us the size of that? And then just second, thanks for the color on the $0.04 impact from the hiring of new sales and recruiters. Can you talk about, either in an absolute number or percentage, how many additional sales people you hired in the first quarter and then relative -- how much did that grow the business? If you said it, I apologize. But what was the growth there?

Yes. So from a financial services, actually, in Tech Flex, financial services makes up 16% of our Tech Flex business. That number remained constant quarter-over-quarter, so we really didn't see much movement in one direction or the other. What we did see, however, is we saw job order flow increasing as the quarter went on, which gives us some optimism there. And we are hearing some positive things from our financial services customers. In fact, there is just some press that just came out and I forget, I can't quote where it came from. But worldwide, the demand in terms of the impact of what's happening from a regulation standpoint in the banking industry, I mean there's a shortage of individuals because of the regulations that are being pushed out upon them, which all have ripple effects into technology. So that's kind of where we are from an FA standpoint. In terms of the hiring and the impact, I guess the way that I could break that out for you at this point in time is about 2/3 of our total field-based sales population has 2 or less years of experience currently, and they're contributing only 1/3 of our gross profit. So that just kind of gives you some impact. And typically, with the new hires as well, we talk about their 9-month -- to kind of really covering their cost, it takes about 9 months for them to get their GD [ph] up to a level where they are kind of breaking even on their costs. That -- there's really that kind of -- that has a multiple effect as they move on through the different periods, meaning through 0 to 3 months, 6 to 9 months and so on and so forth. I mean, for example, their performance from 3 months to 6 months jumps about 140% and then from 6 months to 9 months, jumps another 140%, so it compounds pretty quickly. Realize the bulk of the hiring that we've done, most of those people are kind of in the 3-month window or just coming out of the 3-month window, so they're not contributing virtually anything to performance at this point in time.

Paul, adding a couple of things, just to give you some perspective of hiring and what it means to Q2. And I think Joe said in his remarks -- we obviously, in Q4, added quite a few folks. The hiring that was done in Q1 certainly was at a more measured rate, although we did net up. And so we commented of the impact on Q1 EPS was about $0.04. When you think about the 9-month ramp that Joe talked about for those associates that we hired at the end of the year and then some of these net adds that we made in Q1, that type of impact, when we think about costs, is expected to continue into Q2. So just to kind of give you some perspective on that front.

And our next question comes with the line of Tobey Sommer from SunTrust.

I wanted to ask a follow-up question to a recent one. You mentioned that new hires are kind of driving down the tenure of the field personnel, et cetera. Can you give us sort of -- kind of a sense for how that's different in history? Because I know that recruiter -- that's a position that has a decent amount of natural turnover and, therefore, kind of not as much tenure as some other slots. So any kind of reference for how today's scenario is different than sort of a normal operating state?

Yes, Tobey, I'd say for Kforce specifically, and I'm not going to talk about anybody else's business, because I don't know their business. We've actually seen an improvement in terms of our retention rate of this population of new hires that we've brought in. Now we've changed a number of things in our model to facilitate that. But at this point in time, I mean, we're running about an 82% retention rate on the people we've brought in, which normally, at this point in time, we would probably be closer to about 60% on those individuals. So I think the things that we're doing are working. And in terms of history of what it's doing -- the biggest difference is the weighting of the population, which means we still are at an all-time high in terms of number of performers that are with the firm, that have greater than 4 years of experience. And they contribute a little bit short of 50% of the total gross profit. So they're highly profitable for us, so we're holding on to that population. That population turnover still remains in the low-single digits. The key is for us to continue to move people through the gate, through those -- through that 1-year gate and then through the 1- to 2-year gate and into the 2- to 4-year gate and then into the 4-plus-year gate. And we've implemented a number of programs that should facilitate our ability to do that. But it all comes down to making people successful. I mean, success breeds retention, which breeds success. So they kind of feed off of each other.

And from a broad perspective, looking at the performance in the quarter, if you -- how would you break it down, market-related impacts versus execution and internal performance?

Market-related, I would say, 2 things. Market-related, there's no question that the sequestration dynamic, it impacted us greater than just within our KGS business. In fact, I'm very proud of what our KGS team did. So basically, they offset the full impact of sequestration in their business in terms of new business wins and redeployment of individuals, which really exceeded our expectations from that standpoint. But what I'm -- we also have -- we have -- we do business, kind of the sub-business within the federal business as many of our competitors do, which really isn't racked up in our KGS business. And so that business was down 12.5% sequentially. So we were able to outrun that, and that's embedded in our Tech Flex numbers. So again, I think the overall business, I think we're executing, I think we always have room to improve our execution. I mean, we have an opportunity to fill a higher percentage of orders. We have an opportunity to increase the quality of our orders, which will facilitate that through working with our clients, on gaining more controllable orders that if we don't have to fight the clock on the shelf life of candidates. So I think the team -- because as like I said, I've been out there. I mean, I've been in 16 markets now, 66 clients, I've spent time with our field offices. And when I go on to these visits, it's not like I'm going by myself. I mean I'm going with our people, so I have an opportunity to be out there with our reps and hear how they're presenting and hear first hand from the client. And I think our team is executing. I mean I'm very proud of the leadership team that we have in place. We really went after a lot of things, starting probably around October of last year. And the team's really ratcheting things up. People are rallying around it. And I've never seen the enthusiasm and the level of execution that's taking place inside Kforce right now. And my -- probably going back in the old days when we were very small, and Dave Dunkel could keep his foot on everybody's head. And it's not just one person, it's the team. Everybody's onboard. Everybody's out to win. Our teams want to become dominant in their marketplace as we take customer share. And so I'm proud of where they are from execution, but we're not going to stop. There's still opportunity to improve.

My last question is, assuming the market is there and demand is there to grow with all these new hires, what kind of incremental margin should we model now that you've kind of taken in so much revenue-generating capacity at this point?

Yes. Yes, Tobey, this is Dave. So I'd made a comment that our expectations and our model suggests that from where we are today and what we talked about our expectations in Q2, that we expected as we got to the back half of the year, to approach operating margins in the 6% range. So that kind of suggests some significant leverage in the business. As a matter fact, just on the back of the envelope modeling, it suggests that as we reach these double-digit growth rates for the back half of the year, that the incremental revenue that we generate, about 30% of that would drop to the operating profit line. So it kind of gives you some perspective of the leverage in the business, with the accelerated growth rate and what type of operating margins. And as we think about moving forward, where our operating margin opportunities exist, we think, as we continue to grow revenues and get somewhere between that $1.5 billion to $2 billion in revenue, that we'll be looking at double-digit operating margin. So certainly, we believe there's significant opportunity in the business to expand profitability.

If I may ask one last question, assuming that 10% kind of double-digit operating margin is achievable, does -- what kind of perm assumption would a company that -- just trying to get a sense for how much would be Flex versus perm. Because that's [indiscernible]

Yes, I -- yes, Tobey, I would tell you that the way that we're thinking about this is relatively consistent to what we're looking at today, that perm-Flex mix could be pretty close to where we are today. The operating margin is going to come from a combination of operating leverage in SG&A. There may be some margin opportunity. But the outlook right now for gross margins is just flat to slight improvement. And so we're not planning for a significant expansion in those things to meet those operating margin targets.

[Operator Instructions] Our next question comes from the line of Randy Reece from Avondale Partners.

I was wondering if you could distinguish for me what your comparisons in the first quarter look like in terms of order flow, just the number of orders you are trying to fill on a year-over-year basis versus the fill rates. I'm trying to understand what you're saying about those 2 factors.

Sure. It's a great question, Randy. So in Tech Flex, actually, our order flow was up about 23.2% sequentially. And in FA Flex, our order flow was up 16.6% sequentially. Our fill rate was down in both of those. And again, it was down because we have this pause in the mid-quarter, and we've seen fill rate accelerate back to the prior levels as we moved onto the very back end of Q1 and as we move into Q2.

And in terms of the new people that you have added over the past few quarters, I'd like to get a better idea of how much you are adding people to bring in orders versus people to execute orders to work on improving the fill rate side of it?

Yes. I'd say it's been pretty balanced, maybe a little bit of a slightly more weighting on the candidate side just because of supply-demand dynamics. And again, most of the people, any of that weighting that goes to the NRC is predominantly on the candidate side. So it's pretty balanced in terms of the people that we've been bringing in, but we had demand needs on both of those fronts. Now I will say the bulk of the hiring we've been doing is in markets where we're having success, which is also a contributing factor of, I believe, why we're seeing these people were retaining a little bit higher ratio than historically when we just do broad-based hiring, as well as we're seeing them ramp a little bit more effectively. Because when you put people into successful teams, their probability of success increases.

I can understand not having a verdict on the performance of a lot of people that have recently come into the organization. But at the same time, this quarter was disappointing to you and yet, you still have confidence in a significant improvement as the year goes on. What are the KPIs that are going to improve? What are your assumptions resting on? Is it just catching back up to the market? Or is there some other factor that I'm missing?

I mean, tenure is one factor. Because I'll tell you, every month that these people have more reps at what they're doing and with the accountability to move their skill sets along and work with them from a training and development standpoint, every month makes a difference with these new hires as they move from month 1 to month 2 and month 3 to 4 and so on and so forth. So that's a big factor. But really -- so I'd say, the new hires play a part as we get into the back half of the year. But the other big piece of the equation is we have -- I know our team can do better in terms of fill ratios, in terms of -- the great thing is, is the job flows up. But we got to get our fill ratios up. Like I said, we've seen starts kind of really spike here the last several weeks, so fill ratio is moving. But we need to stay after that and keep moving that up and driving the accountability in and around that. But this is all about execution. We have a very seasoned team. They know what they're doing. They know what needs to be done. We've simplified the messaging. We've simplified what we're focused on. We're not focused on a lot of ancillary stuff. I mean we're focused on things that are meaningful to the client and meaningful to the candidate and the consultant. And that's where we're exerting our energy. So I'm highly -- I have a high degree of confidence in the team and a high degree of optimism that, short of things that are out of our control, the external market, geopolitical events, things that truncate this cycle, that you're going to see our team perform.

And our next question comes from the line of John Healy from Northcoast Research.

I wanted to ask a follow-up question on a previous question. When you talk about fill rates and order flow, I was wondering if you can maybe try to directionally describe to us maybe what the delta was between this quarter and maybe what you'd seen over the -- maybe the last -- maybe 4 to 6 quarters?

Yes, hold on because I didn't have that right in front me. Let me see if I can give you a sense, because I don't want to misquote a number I'm going to give you, because we typically haven't talked about fill ratio or percentages. Yes. I hesitate to throw it out there, just because I don't have it at my fingertips.

Okay. Would that be maybe something we can follow up with on?

Probably -- well, here, I actually I have a -- so I'll give you an example. So we saw about a 13.5% decrease in our FA Flex starts in Q1. And so our fill ratio did decrease by probably almost equivalent to that, so pretty close to that. So fill ratio moved almost proportional to what we saw from the starts standpoint, to give you a sense. So roughly about 13% decrease. Okay. And from a Tech standpoint, we saw about a little less than a 3% decrease in fill ratio. So obviously, Tech -- in our Tech performance, you can see the delta between Tech and FA performance. So Tech wasn't really material, but still it was down. And there's a lead lag on that, because fill ratio is not over until it's over. But again, that's where we saw the biggest delta from an FA standpoint.

Okay, great. All right. That is very helpful. And I wanted to ask about the bill pay rate spread in the HIM business. I might have missed it, but can you give us a little bit of color on why maybe the sequential step-back there?

Sure. So this is Dave, John. I have alluded to, in my remarks, about some changes that we made in the first quarter to compensation for HIM consultants. This is certainly an area where there's high demand for these folks. Joe alluded to the impending changes as a result of ICD-10, so we made some changes to the compensation structure to that team in Q1 in the interest of increasing retention and attraction of those folks. And so looking at that sequentially, that was a big contributor to that 210-basis-point spread decline that I'd mentioned. So as we think about this on a go-forward basis, the program that we expect to continue on in that group, so I think when you kind of normalize margins in that business, you're looking at it being -- I think, historically, been in the 35% range. You're probably looking at 33%, 34%, prospectively, on kind of a normalized basis.

Okay, helpful. And then on -- I wanted to ask on the ICD-10. I know there's been some starts and stops with implementation of that over the last few years. How far along do you think your customers are in terms of adoption? And kind of what inning are we in, in terms of the opportunity for the company?

Yes. What I'll tell you, as a whole, I don't -- health care providers, in general, are not ready for health care reform initiatives. And that's inclusive of ICD-10. It's HIPAA, HITECH, ERM, the meaningful use. So I think, in general, if I were to say to the marketplace, the marketplace is behind the curve. We have seen here in Q1, we've seen an uptick in terms of people getting, going on the assessment piece. And in fact, one of the other dynamics we saw here in Q1 as we've seen people basically going through kind of, almost like an accelerated process in and around assessments and going right into remediation, realizing how far they are behind the curve. So they are really applying more what I would consider kind of an agile type of approach to it versus traditional development waterfall approach, which is they're just getting started and addressing it, because they know that they're just going to ripple from one system to the next. So we see a lot of opportunity on that front. I mean the Tech Healthcare, and as I mentioned in my comments, I mean it's one of our areas that's highest on a year-over-year basis as well as sequential, we continue to see that opportunity on that front.

And that concludes our question-and-answer session for today. I'd like to return the call back to David Dunkel, Chairman and CEO, for any concluding remarks.

All right. We appreciate your interest and support for Kforce. And again, I'd like to say thanks to each and every member of our field and corporate teams and also to our consultants and our clients for allowing us to [indiscernible]. Thank you very much.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a good day.