Kforce Inc. (KFRC) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2017 Kforce Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call will be recorded. I would now like to introduce your host for today’s conference, Mr. Michael Blackman, Chief Corporate Development Officer. You may begin.

Good afternoon and welcome to the Kforce Q2 call. The prepared remarks of this call are available on the Investor Relations page of Kforce, Inc., website in the Download Library under Shareholder Tools. 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 and expectations and are subject to risks and uncertainties. Actual results may vary materially from the factors listed in Kforce’s 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 the call over to David Dunkel, Chairman and Chief Executive Officer. Dave?

Thank you, Michael. You can find additional information about Kforce in our 10-K, 10-Q and 8-K filings with the SEC. We also provide substantial disclosure in our earnings release to assist in better understanding our performance and to improve the quality of this call. In addition, we have published our prepared remarks within the Investor Relations portion of our website, as Michael indicated. We are now nine years into a cycle, where flexible staffing revenues have continued to capture an increasing proportion of the total workforce as the temp penetration rate recently hit an all-time high at 2.07%. The specialty staffing market growth rate continues to significantly outpace total flexible staffing growth. Domestic IT staffing specifically has grown from $15.8 billion in 2009 to an estimated $30 billion at the end of 2017. This does not include technology services and solutions. We’ve taken significant steps to position our firm to take advantage of the long-term growth prospects of this vibrant market. Though second quarter revenues of $340.3 million and earnings per share of $0.44 fell short of our expectations, the underlying improvements we have made in our business model provide an excellent foundation for growth. Over the last 18 months, we’ve been executing a strategic plan to refine our operating structure, rebalance our revenue-generating talent, and make prudent and necessary investments to improve our sales efforts and enable our associates with new technology, including a new CRM system. These efforts are not yet complete. And with regard to our sales transformation investments, the anticipated return on investment is taking longer than we had originally anticipated. However, the improvements we are beginning to see in activity levels and the quality of client conversations provide confidence that those returns are forthcoming. Joe will comment further later in the call on these sales transformation investments. From a gross margin perspective, we have reinforced to our associates the value of the services we provide our clients, and as a result have stabilized flex margins through improved pricing in Q2 relative to the first quarter. We are also pleased with the ongoing progress we have made to improve our operating leverage. Earnings per share increased $0.03 on a year-over-year basis. One of the drivers to this increase is an improvement in the productivity within our revenue-generating talent. Productivity remains significantly below peak levels, which we believe we should be able to return to as a result of our investments, and we have ample capacity to meaningfully grow our firm at current talent levels. The strength in the demand environment has not changed. We believe the secular drivers of demand remain intact as companies increasingly look to technology to provide internal operating efficiencies, enhance competitive position and enable sustained market relevance in today’s rapidly evolving marketplace. Also, competitive pressures and the need to innovate continues to intensify and technology investments in areas such as big data, artificial intelligence and machine learning remain a critical component. The areas of highest demand include mobility, cloud computing, cyber security, e-commerce, machine learning, and digital marketing. The shorter-term project nature of technology requires specific skill sets, which are increasingly driving companies to a greater use of flexible resources. Though already strong, an improvement in economic conditions could accelerate demand for flexible resources as technology investments typically increase in more robust periods of growth. Recent job growth statistics provide additional confidence in sustained economic growth and a positive environment for flexible staffing. The second quarter brought very little clarity on key political policy initiatives, including corporate tax reform, immigration reform, healthcare reform, and financial de-regulation. While there is still great uncertainty as to the details and impact of any potential reform, we believe the balance of any changes should be a net positive for our industry. We remain confident that our ongoing investments will enhance our business model and improve our growth prospects. The fundamental necessity of technological investment in every business, in every geography and in every industry, along with the project nature of these investments will continue to drive demand for flexible resources. We still have much work to do, but remain confident in our long-term success and the operating objectives we have established. I will now turn the call over to Joe Liberatore, President, who will provide further details on our Q2 operating results. Dave Kelly, Chief Financial Officer, will then add further color on our Q2 operating trends and financial results as well as provide guidance on Q3. Joe?

Thank you, Dave, and thanks to all of you for your interest in Kforce. Our top line results for the quarter reflect growth on a sequential and year-over-year basis of 1.9% and 1.6%, respectively, but fell short of our expectations. Tech Flex, our largest segment, which accounts for roughly 65% of total revenues, increased 2.7% sequentially and 1.5% year-over-year. The momentum in new starts activity that we generated in the first quarter and carried through April plateaued in May and June. We also experienced slightly higher than anticipated assignment ends and higher conversions during the quarter. Critical to the long-term success of our Tech Flex business is the ability to deliver at scale to larger consumers of flexible technology talent, and further deepening our expertise within growing industry verticals to allow us to expand the breadth of our service offerings to these larger, sophisticated buyers. Larger customers continue to concentrate spend with firms, such as Kforce, that can meet their needs nationally as well as ensure compliance with internal and external policies and regulations. We are one of the few providers that can meet these client needs on a national basis. We continue to focus efforts to optimize driving efficiency in sales, delivery and our back office within this segment. Our mature platform within Centralized Delivery remains a significant element in our efforts to reduce overall servicing cost, while allowing us to maintain bottom line contribution within this important segment within our overall portfolio. Our 25 largest Tech Flex customers comprise nearly 50% of Tech Flex revenues. Our largest customer represents 8% and our top five represent 23%. We believe we are well-positioned to gain further client share in this portfolio, while further diversifying within other significant consumers of flexible resources where we already have relationships. We are also investing to differentiate ourselves from the competition and deepen and expand our service offerings to the more sophisticated buyers, where we have strong relationships and a platform for growth. During the quarter, we experienced year-over-year growth in six out of 10 of our industry verticals. Communication, manufacturing, retail and energy were particular strengths year-over-year. For the third quarter, we expect Tech Flex revenues to improve sequentially and year-over-year growth to accelerate slightly from Q2 levels on a billing day basis. Our FA Flex business, which represents 24% of our total revenues, increased 4.3% year-over-year. From an industry perspective, eight out of our top 10 verticals experienced year-over-year growth, including financial services, business services, retail and energy. We experienced sequential declines in the second quarter, as expected, following a slowdown in activities associated with bulk staffing engagements late in the first quarter. We expect year-over-year growth rates to improve from Q2 and to be in the mid-single digits on a billing day basis. Revenues for Kforce Government Solutions decreased 4% sequentially and 6.4% year-over-year. KGS was negatively impacted in the quarter by delays in the commencement of services work and delays in the delivery of product within our highly profitable product-based business, as a result of the timing of funding associated with recent contract awards by the Federal Government. Our team is executing well against the backdrop of a challenging procurement environment. Much like the commercial space, Technology and Finance & Accounting resources are in short supply. We expect revenues for KGS to increase sequentially and be stable on a year-over-year billing day basis. Direct Hire revenues from placements and conversions improved 20% sequentially and 2% year over year and is currently 4.1% of total revenues, which is flat compared to a year-ago period. We believe this growth speaks to our clients’ confidence in both the economy and their future growth prospects. Our Direct Hire capabilities remain an important element of our strategy and our objective is to meet the talent needs of our clients through whatever means they prefer, leveraging our 50-plus years of experience servicing clients. The second quarter of the year is our typical peak Direct Hire quarter historically, so we expect some seasonal sequential decline. Year-over-year Direct Hire revenues are expected to improve slightly. As Dave mentioned earlier, we are focused on making investments that provide our revenue-generating talent with the necessary training, methodologies and digitally enabled tools to engage in more strategic conversations and allow us to elevate the value we are bringing to our clients and consultants. We rolled out our new customer relationship management system to a number of offices throughout the second quarter and expect to complete the deployment in the third quarter. We believe these investments, among others, will generate a significant return by improving how we consistently engage with and deliver services to our clients, candidates and enhance the effectiveness and efficiency by which we conduct business. We are beginning to see positive momentum in front-end indicators, such as quality of proposals, case studies, client visits along with year-over-year and sequential productivity improvements. Our revenue-generating talent was down 8.5% in the second quarter on a year-over-year basis, which principally relates to the intentional reduction in our delivery talent to ensure optimal ratios exist to maximize productivity. We believe capacity exists within our revenue-generating talent to accelerate revenue growth rates. We expect associate headcount levels to be stable for the remainder of the year with second quarter levels and resume modest investments after further adoption of our new sales methodology and our customer relationship management systems positioning us for improvement in productivity. Our success is tied to our ability to consistently improve associate productivity by ensuring they are engaging with the right customers, leveraging the investments we have made in our new sales methodology, as well as the technology-related investments we are making, inclusive of our new CRM. We are confident in our ability to realize the benefits of these investments. 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 revenue for the quarter of $340.3 million represents growth of 1.6% on a year-over-year basis. All of our staffing businesses grew year-over-year and our government business declined slightly. Earnings per share of $0.44 in the quarter improved $0.03, or 7.3% over the second quarter over a year ago, reflecting continued progress towards our long-term – longer-term profitability objectives. Our gross profit percentage in the quarter of 30.5% increased 140 basis points sequentially, which slightly exceeded expectations, due to a greater mix of Direct Hire revenue than anticipated. The 120 basis point year-over-year decline is the result of a decline in Flex gross profit margins. Our Flex gross profit percentage of 27.6% in the second quarter improved 100 basis points sequentially. On a sequential basis, we’ve seen improving spreads between bill and pay rates on new assignments primarily in our Tech Flex business, while FA Flex spreads have been stable. We have reinforced our internal messaging to ensure that, during pricing discussions, our associates appropriately consider the value of services that we provide to our clients. The recent improvements have allowed overall spreads to remain essentially stable, as the higher spreads this quarter are helping offset some of the lower spread business booked previously. As anticipated, we also experienced a 100 basis point sequential improvement from the reduction in seasonal payroll taxes. Year-over-year, bill/pay spreads are down and we expect pay rates will continue to rise as tight labor supply in our candidate population persists. We will work to pass through these increases in the form of bill rate increases. However, if the current economic landscape continues, where our customers still lack pricing power, spreads may continue to be under pressure. As we look into Q3, early quarter data suggests that Tech Flex and FA Flex spreads may be stable sequentially. We continue to make progress in improving our operating leverage. SG&A as a percentage of revenue in Q2 2017 of 24.2% was down 130 basis points year-over-year. This leverage is primarily a result of the realization of the benefits from the realignment activities completed over the last 18 months, improved productivity within our revenue-generating talent, and greater expense control in other areas of spend. We will continue to make additional investments in enabling technologies to further increase our efficiency in delivering service to our clients and candidates. Q2 2017 operating margins were 5.7% compared to 5.5% in Q2 2016. The SG&A reductions and operating margin improvements we have seen are anticipated to continue as we grow and associate productivity continues to improve. During the quarter, we announced the completion of a new $300 million cash flow-based revolving credit facility, which replaced our previous $170 million asset-based revolving credit facility and provides significantly flexibility and support for our future growth. With respect to our balance sheet and cash flows, operating cash flows in the second quarter were $16.1 million, an increase from $12.6 million in the year-ago period. Long-term debt at the end of the quarter was $127.4 million, a decrease of $8.3 million from Q1 2017 and reflects leverage of 1.6 times trailing 12 months EBITDA. Capital expenditures for the quarter were approximately $2.1 million. We returned approximately $3 million in dividends to our shareholders in the second quarter. We did not repurchase any stock during the quarter. Since the beginning of 2015, we have spent approximately $80.7 million on stock repurchases and returned $31.1 million through dividend payments over the same period. In total, cash returned to shareholders has exceeded operating cash flows over that period. We will continue to appropriately balance the utilization of available capital between investing in the long-term growth of our business through technology investments and potential tuck-in acquisitions, reducing debt levels and returning capital to our shareholders. With respect to guidance, the third quarter of 2017 has 63 billing days, which is one day less than both Q2 2017 and Q3 of 2016. As a reference point, we generate approximately $5.3 million in revenue per each billing day. We expect Q3 revenues to be in the range of $338 million to $343 million, and for earnings per share to be between $0.44 and $0.47. Gross margins are expected to be between 30.5% and 30.7%, while flex margins are expected to be between 27.8% and 28%. SG&A as a percentage of revenue is expected to be between 24.1% and 24.3%. Operating margins are expected to be between 5.7% and 6%. This guidance assumes an effective tax rate of 38.3%. Weighted average diluted shares outstanding are expected to be approximately $25.5 million for Q3. This guidance does not consider the effect, if any, of charges related to the impairment of intangible assets, any one-time costs, costs related to any pending tax or legal matters, the impact on revenues of any disruption in government funding, or the firm’s response towards regulatory, legal or tax law changes. Our activity levels and feedback from our revenue-generating talent suggest strength in demand for Technology andFinance & Accounting services. This provides us confidence in our ability to reaccelerate revenue growth, even though it is taking longer than we had originally anticipated. We remain on track to achieve operating margins of 6.3% at $1.4 billion in annualized revenue and 7.5% at $1.6 billion in annualized revenue and remain confident in our long-term success. Catherine, we’d like to turn the call over now for questions.

Thank you. [Operator Instructions] And our first question comes from Tim McHugh with William Blair & Company. Your line is open.

Thank you. First, just on the competitive environment, and I think there’s a fair amount of mention of that in the opening remarks. So is that getting more challenging, or is it changing in anyways versus what you would have said six months ago?

Yes, I mean, I wouldn’t say, it’s changed materially over the last six months. I’d say probably the biggest dynamic within the competitive environment would really be two things if you look at the two major populations that we compete with, which are the smaller more localized operators and then the larger more at scale national operators. We’re seeing more aggressive on pricing to go after large bulk-type arrangements. So – and we’re seeing that mostly from the large providers that can provide at scale. And then what we’re also seeing is at this point in the cycle being about nine years into the cycle, there’s more mom and pops out there, which is typical for the later part of the cycle. And they typically are willing to sacrifice a little bit more margin to capture business realizing that many of those owners are leaving for a lifestyle. So an incremental dollar, they’ll do it at a much lower margin, which puts a lot of pressure on our people to be stringent in terms of our pricing.

Okay. And I guess, when you – there’s a number of facets to kind of the efforts to accelerate growth here. And you talked about, you’re still confident in those playing through, I guess, but it’s just taking a little longer. Is there – can you dissect a little bit more, I guess, just – or maybe summarize for us a little more. I guess, what pieces feel like it’s taking longer to really change behavior, and I guess, then why you’re confident those will eventually translate for you?

Yes, I’d say, the taking longer is we were probably a little bit too optimistic as we rolled out our sales methodology transformation on the back-end of last year. I realize by the time we rolled that out and then took all of our leaders through certification to be equipped to train and as well as stay on top of and monitor that business, which we really didn’t complete until the end of Q1. So it’s really – it comes down to execution and the basic fundamentals of blocking and tackling on top of. And again, I don’t say these things to make excuses, but it is just the reality. We went through a major organizational shift last year as we’ve communicated on these calls. We went through one organizational realignment around the March timeframe in 2016, and then we realigned a lot of our regions to gain a lot of efficiency and span of control in the September type timeframe. So, we’re still settling in from that. So we’re confident that we have the right people in the seats and the strength of our team and it’s about execution.

Okay, great. And then just one, numbers one, how many billing days in the fourth quarter of this year, if you have that?

Yes, sure, Tim. So there are 61 billing days in the fourth quarter of this year.

Okay.

So that compares – there were 61 last, year 61 this year.

Okay, thanks.

Thank you. And our next question comes from Tobey Sommer with SunTrust. Your line is open.

Hi, this is Kwan Kim on for Tobey. Is the new CRM system dampening sales productivity at all as your teams migrate to it and or trained? Thank you.

Yes, we’re on the front-end, so we’ve rolled out a number of our offices in Q2 and we’re really ramping that rollout up at this point in time from our experiences with the offices that we initially rolled out. We wouldn’t tie anything back to any dampening of productivity because of the rollout and implementation of those tools.

Got it. And on the shrinking bill/pay spread, what needs to happen to reverse the spread compression?

Yes. So, as I mentioned in my prepared remarks, actually, and it’s been seen most significantly in our Tech Flex business recently. During the quarter, actually, we saw a stabilization, actually a slight improvement in the spread between bill and pay rates. We had spent sometime last quarter talking about the fact that in this environment a lot of what we had seen, we think were – it was our own doing. So we spent quite a bit of time this quarter and continue to make sure that we’re reinforcing to our associates that we’re providing valuable service and to be appropriately compensated for that makes sense from our clients. And as a result, we’re driving the stabilization as we look forward and you think about the guidance that we show in the third quarter, we expect continued stabilization actually mild improvement there. So we think we actually have turned the tide, it is a tough environment, but we think we’re doing the right things to stabilize and improve those spreads.

Got it. Thank you very much.

Thank you.[Operator Instructions]. And our next question comes from Kevin McVeigh with Deutsche Bank. Your line is open.

Great, thank you. Hey, I wondered, can you give us just some commentary on how trends are at the larger clients versus smaller clients in terms of hiring outlook and that factored into some of the delayed revenue?

Yes, Kevin, this is Joe.

Hi, Joe.

I’d say, we haven’t seen anything materially changed in the marketplace in terms of demand. The demand has been robust. All of our front-end performance indicators remain very strong. So I don’t – we don’t really partition and see any difference between what the large customers where we do business versus the large consumers where we’re not quite as mature within those relationships. I mean, we’re seeing broad-based demand across the spectrum.

Got it. And then just any thoughts, I mean, it seems like perm has definitely been pretty strong relative to temp. Do you expect that to kind of revert back to normal, or is that just supply demand imbalance?

Yes, I’d say, our Tech Direct hires has remained pretty consistent. The strong performance we had in Q2 was through our Finance & Accounting, Direct Hire. And that that’s just was some pent-up demand. So I mean, it still seems to be robust. We see clients continuing to try and bring people on from a permanent standpoint, which, as I had mentioned in my opening remarks, we did see a little bit of an uptick in terms of conversion, which we look at those as positive indicators in terms of where clients view we are in a cycle and the amount of work that they have to get done, as well as and I’ve said this before. There’s nothing that we look at, it’s a greater compliment to a job well done on our behalf. And when our client has one of our flexible employees and desires to convert them, because that’s a win-win for us on both ends. So it causes them short-term pain, but we’re in it for the long haul and those individuals become hiring managers over time and they remember the people who help them find the right opportunities.

No, understood. And then just I wanted to make sure I understood. You had an 8% reduction in your revenue-generating talent, is that right? And did that span Tech Flex all verticals, or was that focused one place more than the other, or was it primarily the NRC, or it was that at branch level?

Yes, it was – it really – it’s spans across the spectrum. It’s much more heavily weighted on the delivery side, because when we had gone through our realignment, one of the things when we started looking at ratios, we had overstaffed on the delivery side. So ultimately, we weren’t providing those people an environment where they could become successful. So that was really the rebalancing of that, and the numbers that I had shared were on a year-over-year basis. And as I mentioned, our objective here forward is to hold stable through the remainder of the year, because we believe we have ample capacity to not impair near-term or longer-term growth.

Got it. Okay. And then just one last one, if I could. Any reason why you didn’t buy any stock in the quarter?

Hey, Kevin, this is Dave Kelly.

Hey, Dave.

So, I think, a couple of things. One, part of it, there was a disruption for us, because we put a new credit facility in place. The other is, we’re balancing debt levels and cash flow and, as you recall, the first quarter was a little bit worse than we had anticipated. So nothing in particular other than as we balanced our decisions. We thought that was the right way to go.

Okay. Thank you.

Thank you. And I’m showing no further questions. At this time, I’d like to turn the call back to Mr. David Dunkel, Chairman and CEO for any closing remarks.

All right. Well, thank you very much. We appreciate it and thank you for your interest and support of Kforce. And once again, I want to thank each and every member of our field and corporate teams, and our consultants and our clients, for allowing us the privilege of serving you. Thank you very much. We look forward to speaking with you again at the end of Q3.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone have a great day.