Kforce Inc. (KFRC) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2018 Kforce earnings conference call. At this time, all participants are in a 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 conference call may be recorded. I would now like to introduce your host for today's conference, Mr. Michael Blackman, Chief Corporate Development Officer. Mr. Blackman, you may begin.

Good morning. 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 this call over to David Dunkel, Chairman and Chief Executive Officer. Dave?

Thank you, Michael. You can find additional information about this quarter's results in our earnings release and our SEC filings. And in addition, we have published our prepared remarks within the Investor Relations portion of our website. I will provide some high-level opening remarks on our second quarter results and operating environment and will then turn it over to Joe Liberatore, President, who will give greater detail into our operating results and trends and then Dave Kelly, our Chief Financial Officer, who will add further color on second quarter results and provide guidance on Q3. We are very pleased with the second quarter results. We have been on a journey over the past two years to enhance and improve our operating model through disciplined process, standardized messaging and through embracing technologies to improve productivity, accelerate revenue and improve operating margins. While we still have a long road ahead of us with significant opportunity to further improve, the investments we have made in our people and technology are having a meaningful impact on our operating metrics and financial results. Q2 revenue and earnings per share were near or at the high end of our expectations, and we reached our first profitability milestone, as operating margins were 6.4%. The most notable driver to our improving revenue trajectory was the growth of our Tech Flex business, which grew 11% year-over-year when adjusted for the divestiture of our Manila business. Our diversification efforts within Tech Flex to better segment our client portfolios and more strategically align our sales and delivery talent within these portfolios are contributing to the acceleration in revenue growth and is also benefiting Flex margins. Cash flow was also particularly strong in Q2, with operating cash flows of $28 million. This strength should continue due to our expectation of continued profitability improvements as we grow. Our internal metrics and conversations with our clients suggest the demand environment continues to be very strong and we believe we are very well positioned to capitalize. Recent economic data suggest that growth in the US economy is strong and business spending is robust, with many leading economists expecting that this will continue. We have seen some increase in spending since the passage of the recent tax reform legislation, but anticipate that this may accelerate going forward as confidence in the economy's growth prospects continue. The strengthening economic environment only adds to the secular drivers of demand for our services. Companies across virtually all industries, and of all sizes are experiencing competitive dynamics requiring technology investments to enhance their customer experiences just to keep pace with the market leaders. These investments are not optional. Rather, they are necessary for survival in this increasingly tech-driven world. Non-traditional competitors are also entering new end markets, thus putting increased pressure on companies to invest in innovation and the evolution of their business models. We believe these secular drivers will transcend traditional cyclical patterns as these business models are transformed. Big data, artificial intelligence and machine learning continue to be in high demand, as well as cloud computing, cybersecurity, mobility and digital marketing. As has been the case for this entire economic cycle, we expect that the need for increasing technology investments across all industries will drive companies to look to large firms such as Kforce to solve their human capital challenges. There are limited providers with the infrastructure to not only provide quality and timely talent, but to also meet increasingly stringent compliance requirements. These represent significant competitive advantages in today's war for talent. Our confidence in the sustained strength of our business is demonstrated by our Board of Directors' approval of a 50% increase in our dividend, effective in the third quarter. As we look to Q3, we expect to further accelerate revenue growth and, consistent with our profitability objectives, continue to improve the operating leverage from our revenue growth. We also are continuing to invest in technology that equips our organization with improved capabilities to deliver exceptional service to our clients, candidates and consultants, while also increasing the productivity of our associates. We are also very proud to have recently launched our Kforce brand refresh. Kforce has always been, and will always be, in the business of personal relationships. That's why when the time came to realign our brand, we started with our own people. Many of the words and sentiments you'll find in our brand update came directly from the employee perspective. Our new tagline – We Love What We Do and We Love Who We Serve – reflects my personal belief that we needed to convey that love and empathy are at the core of what we do. Kforce impacts the livelihoods of our people and those we serve. And it's important to never forget that. This phrase has organically woven itself into Kforce's brand over the last several years and our people have really embraced it, so it's only natural that it has made its way into our official brand update. I'll now turn the call over to Joe Liberatore, President, to provide further details. Joe.

Thank you, Dave. And thanks to all of you for your interest in Kforce. We believe the results for the second quarter of 2018 are reflective of the benefits being realized from the investments we have made and the actions we have taken over the last few years. Most notable is the continued acceleration in our Tech Flex business, which is now roughly 70% of overall revenues. The year-over-year growth rate in this business exceeded our expectations, accelerating to 11.0% year-over-year growth, when adjusted for the divestiture of our Manila business, and 9.8%, as reported, in the second quarter, up from 6.7% reported last quarter. This growth rate is roughly three times the projected industry growth rate. During the quarter, our new assignment starts were strongest in the last month of the quarter and we also benefited during the second quarter from the higher overall average bill rate, and this momentum has continued into the early third quarter. Our average bill rate of $73.60 per hour is up 3.5% year-over-year. This compares to a bill rate of $72 in Q1, which was a 3.1% improvement year-over-year. We have commented on prior calls on our efforts to better segment and diversify our client portfolio, optimizing the alignment of our sales and delivery talent with our client portfolio and tailoring incentives to the growth that we expect to occur. Fortune 1000 companies continue to be the largest consumers of flexible technology talent. Our revenue growth over the last several quarters has been largely a result of our broader diversification efforts beyond our largest clients and deeper into other Fortune 1000 customers where we have established relationships. This focus on significant users of flexible staffing services has better enabled us to understand the technology issues they are facing and to craft solutions. From an industry standpoint, we experienced growth in virtually all of our industries, so growth was very much broad-based. The increasing bill rates that I previously mentioned, coupled with this more broad-based growth, has again allowed us to sequentially increase bill/pay spreads for the fourth time in the past five quarters. Our focus on large users of flexible staffing is well supported by our mature centralized delivery platform, which allows us to deliver consultants at scale across the United States. This capability, combined with the improved execution and focus of our field offices, our enhanced candidate attraction and sourcing capability, leveraging the application of technology, has also allowed us to increase productivity levels again this quarter. While we are certainly pleased with the productivity gains, we believe significant additional capacity exists. We also believe that our continued investments in technology will yield additional efficiencies and productivity. For the third quarter of 2018, we expect Tech Flex revenues to grow sequentially and for year-over-year growth rates to accelerate and again exceed 10%. Our FA Flex business, which represents roughly 20% of overall revenues, declined 9.4% year-over-year. Similar to what we accomplished in our technology business, we are focused on diversification, better aligning our sales and delivery talent with a more strategic client portfolio in mind. In addition, as larger projects end, we are actively pursuing a more balanced mix of higher skilled roles in FA. We are seeing some early positive indicators to this focus in the form of increasing bill rates, which have increased 4.4% year-over-year. However, as we work through this transition, new assignment starts have been lower than anticipated, which is driving the revenue declines. We are positioning this business for future growth against a demand environment that we believe is solid. We expect third quarter revenues to be flat to down slightly sequentially, as activity levels begin to improve in the second half of 2018 and year-over-year declines to approximate second quarter levels. In addition, we expect this business to turn sequentially positive during the fourth quarter of 2018. KGS services revenues grew 18.2% year-over-year as this business continues to benefit from the two strategic prime contracts that were awarded in the third quarter of 2017. We referenced in our last call that we were successful in winning a significant re-compete that represented approximately 18% of our revenue base. However, as is common, the award was being protested. This protest was favorably resolved in the second quarter. We believe there is insignificant recompete risk for the remainder of 2018 and 2019 for KGS. KGS continues to operate in a cost competitive environment and the secured recompete is expected to put pressure on KGS margins going forward. With that said, we are strategically focused on improving the profitability of KGS, especially in certain existing contracts and expect margins in the services business to improve sequentially in Q3. KGS product revenues, which are inherently more volatile than its services business, accelerated 63.2% year-over-year. For the third quarter, we expect KGS total revenues to increase sequentially by high single-digits and for growth to be in double digits on a year-over-year basis, though the rate of growth will decline compared to the second quarter. Direct Hire revenue, which represents roughly 3.5% of overall revenues, declined 9.5% year-over-year. Our Direct Hire business continues to be an important capability in ensuring that we can meet the talent needs of our clients through whatever means they prefer. Given the volatility in this business, sensitivity to cyclical economic cycles and the necessary ramp cycles for talents, we have been selectively investing in this line of business as we have in past economic cycles. We expect a typical seasonal decrease in the third quarter and year-over-year to be down slightly. We continue to make targeted investments in training, technology, business intelligence and other tools that are directed towards improving the experience of our clients and consultants, as well as significantly improving the productivity level of our people. These tools, technologies include our customer relationship management system, a new consultant time and expense management system, talent management system with greater capability for candidate sourcing and matching, among others. We have improved the productivity of our revenue-generating talent by approximately 13.6% year-over-year. As we refine our model, we continue to identify opportunities for improving productivity and, therefore, have not made additions to associate headcount as we believe significant capacity exists to continue to grow revenue at targeted levels. Our success is tied to our ability to consistently improve associate productivity by ensuring they are engaging with the right customers and arming them with the best tools and leadership. Our team has executed well, and I appreciate everyone's efforts as we continue to move our firm forward. I'll now turn the call over to Dave Kelly, Kforce's Chief Financial Officer, to provide additional insight on operating trends and expectations. Dave?

Thank you, Joe. Revenues of $358.6 million in the quarter represent 5.4% year-over-year growth, which accelerated from 3.7% last quarter. Earnings per share of $0.65 improved 48% year-over-year. Our gross profit percentage in the quarter of 30% declined 50 basis points year-over-year, primarily related to a decline in the mix of Direct Hire revenues and a 30 basis point year-over-year decline in our Flex gross profit percentage to 27.1%. The Flex margin decline is due to continuing pricing pressures in our KGS services business. Flex margins in our core commercial staffing businesses continued to improve, however. Tech Flex margins, which are now 27.2%, have increased 30 basis points year-over-year due to an improvement in bill/pay spreads and FA Flex margins of 29.1% have also increased 30 basis points year-over-year. We have now seen a sequential improvement in bill/pay spreads in four of the last five quarters in our staffing businesses, which reflects increasing bill rates due to its strong demand and success in pricing discipline and further penetrating higher margin accounts. As previously shared, the sale of our low bill rate Global operations in the second half of 2017 has also contributed to the improvement in our Tech Flex average bill rate. Overall bill rates, normalized for the Global divesture, have grown approximately 3.5% year-over-year in our Tech Flex business and 4.4% in our FA Flex business. This represents a slight acceleration from the 3.1% and 3.5% bill rate increases last quarter for Tech Flex and FA Flex respectively. Third quarter Flex margins are expected to be relatively stable in our Tech and FA Flex businesses, while Flex margins in our Government service business are expected to improve sequentially. SG&A expenses as a percent of revenue declined 120 basis points year-over-year to 23% in the second quarter, which is a historic low for our firm. We continue to make progress in generating SG&A leverage by significantly improving productivity and controlling expenses. This has allowed us to increase our investments in technology while continuing to improve operating margins. Looking forward to Q3, SG&A dollar expense should be essentially flat sequentially on greater revenues, providing further leverage and improving margins. SG&A expenses in Q3 contemplate continued investments in technology, with a focus on improving the candidate and consultant experience and further expanding our business intelligence capabilities. We are also aggressively pursuing opportunities to partner with leading firms to embrace technology that enhances our customer experience and improves productivity and relationships. Second quarter 2018 operating margins of 6.4% improved 70 basis points year-over-year, exceeding the milestone we set when quarterly revenues were to exceed $350 million. During this economic cycle, we've now improved operating margins by more than 400 basis points despite the divestiture of two non-core businesses that were more profitable than overall firm averages, and the overall compression in our Flex gross profit margins. We are very pleased with the progress we have made and are firmly on track to reach our next milestone of 7.5% operating margins when quarterly revenues exceed $400 million. Our effective tax rate in the second quarter was 25.5%. As it relates to our effective income tax rate for the remainder of the year, we expect this will track close to Q2 levels. With regard to our balance sheet and cash flows, operating cash flows in the second quarter of $28 million were very strong. We used this cash flow to decrease debt by $22.6 million. Long-term debt under our credit facility at the end of June was $100.6 million and approximately one times trailing 12-month EBITDA. Our strong balance sheet and cash flows allow us to continue returning cash to our shareholders, while maintaining the flexibility to take action if there are dislocations between our stock price and performance or if we were to identify strategic or tuck-in acquisitions or partnerships. Capital expenditures in the second quarter were $1.6 million. As Dave mentioned, our Board approved a 50% increase to our quarterly dividend, bringing the payout to $0.18 per share effective with our third quarter dividend. This increase brings the dividend level to approximately 25% of earnings and the dividend yield to approximately 2%. Our strong performance and cash flows make us quite comfortable with a dividend at these levels and the Board will plan to evaluate dividend levels annually. The third quarter of 2018 has 63 billing days, which is one day less than Q2 2018 and the same as Q3 last year. Revenue per billing day in the second quarter of 2018 was $5.6 million. With respect to guidance, we expect Q3 revenues to be in the range of $359 million to $364 million and for earnings per share to be between $0.65 and $0.67. Gross margins are expected to be between 29.7% and 29.9%, while Flex margins are expected to be between 26.9% and 27.1%. SG&A as a percent of revenue is expected to be between 22.7% and 22.9%. Our guidance for the third quarter reflects continued progress towards our next operating margin milestone and operating margins should be between 6.4% and 6.6%. Guidance assumes an effective tax rate of 25.7%. The high end of guidance also contemplates Tech Flex year-over-year growth rates exceeding 10% on an as-reported basis. Weighted average diluted shares outstanding are expected to be approximately 25.4 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 or charges related to any pending tax or legal matters, the impact on revenues of any disruption in government funding or the firm's response to regulatory, legal or future tax law changes. We are very pleased with the continued acceleration in our Tech Flex business and believe we have a solid foundation for sustained revenue growth and continued improvements in profitability. Sequentially, our operating margin is expected to benefit from the leverage gained from revenue growth, stable Flex margins, improved associate productivity and continued SG&A expense discipline. We expect to make continued incremental improvements in meeting our next milestone of 7.5% operating margins in a quarter, without seasonality impacts, where revenues reach $400 million. We continue to believe we are in businesses that will remain in significant demand and are excited about our future prospects. Sherry, we will now open up the call for questions.

Thank you. [Operator Instructions]. Our first question comes from Mark Marcon with R. W. Baird.

All right. Good morning. And congratulations on the good IT results and the result margin improvement. I was wondering if you could talk a little bit more about the capacity that you currently have within the system and how you would expect SG&A would trend as you get towards the $400 million quarterly revenue mark.

Yeah, Mark. It's Joe. I'll handle the first part and Dave Kelly can address the second part of your question. Relative to capacity, we've seen nice productivity improvements. We still have plenty of room to go. We're not near levels that we have seen historically. So, very comfortable. Also, the mix of our population. We've grown our 4-plus-year population almost 50%. As we've discussed on prior calls, we get tremendous leverage out of tenure. So, we're really focused on the quality of the individuals, holding on to those people as they move into that 4-plus category and leveraging the relationships that they've built over their tenure with the firm. So, we're very comfortable with capacity. As well as, I had mentioned, we're doing quite a bit from a strategic standpoint on not just on pure technology, but partnerships and relationships to equip our people. And we believe, through those means, there is ample capacity. And as those things become more embedded into our operating model, we see a big opportunity in the future.

So, Mark, this is Dave Kelly. To put a little bit of color around how we think the income statement looks, as we think about operating margin improvements, at this point, we're looking at a pretty linear progression, I think, from where we are today. As revenues grow, that will incrementally continue to improve operating margins. And the profile of the business, as we expected, is going to – the productivity that Joe had mentioned is really going to drive decreasing SG&A levels. And that's going to be the contributor to the improving operating margins. We're still looking at a scenario where Flex margins are very stable here. And the productivity – the technology and the productivity improvements that we're seeing that are going to drive SG&A levels down and that's how we're going to attain those operating margin targets.

Great. And then, with regards to IT Flex, nice acceleration there. I was wondering if you could talk just a little bit about the breadth that you're seeing in terms of penetrating more clients in a more meaningful way relative to perhaps some of your deeper relationships ramping up their spend. Like, what would you attribute most of the acceleration to?

The acceleration is right where you win. It's relationships where we had a footprint and we're going deeper and wider into those customers and grabbing a higher percentage of the spend within those clients. And I think you really can see it reflected. We're seeing the majority of our growth being driven. We've kind of broken out our portfolio into three groupings, what we call, enterprise. Those are very large existing relationships where we've had very good penetration. And then, on the other side of that spectrum, what we call our market-based accounts. There are still large consumers the we haven't established a significant footprint at this point in time. And then, what sits in between the two of those is what we're following our major portfolio. And those are the accounts that we're growing towards more this enterprise. And significant – the bulk of our growth is coming out of the latter two categories. So, I think that's clear demonstration that the diversification is working. So, the market has been there, and I think it's been the shift in our focus in and around the portfolio, the execution of our field. Kye Mitchell, our regional president, our vertical presence, just did a marvelous job on really gaining traction and driving that focus. And I think we're seeing the results of those efforts.

This is Dave Kelly. I would add on to Joe's comment. That strategy also has an added benefit of bringing stability and improvement on our Flex margins, right? So, that profile, I mentioned that we've improved the spread in bill/pay rates over four of the last five quarters. That is reflective of the growth we've seen in those clients that are those major clients that have a bit better margin profile than the very, very large clients that we have. So, it's got a duplicate benefit there.

To Dave's point, I think when we look at margins within that portfolio, we probably see a 200 basis point delta in those clients that are outside of our enterprises. As we all know, there's an exchange of volume for rate when you become very significant. And so, to Dave's point, that's playing well for us.

That's great. And then, I know IT is the focus. But on accounting, wondering if you can talk about what gives you confidence that we'll see a sequential uptick in the fourth quarter. Are you already starting to see some build up in terms of orders there? Or how should we think about that other than just pure seasonality?

Part of it is seasonality. The other part is, we've been after the FA business for a period of time. So, this is by design. There's been certain, what I would consider, large engagements that were of lower margin profile that we've been walking away from by design, so that we can have our resources focused on, what I would consider, a little bit higher quality of business that has a longer relationship cycle to it that will benefit from in the long term. And I think the numbers work to our favor to a certain extent as well, right, when we start to look at what some of the comps are. So, when you put all of those things together, that's what gives us confidence relative to sequentially turning that positive as we head into Q4 and it gives us some optimism as we start to look out to 2019.

Great. And then, just going back to your earlier comment on the IT side in terms of gaining more business from some of those enterprises that you had some penetration with, but could deepen the relationships. To what extent are you just benefiting from increased IT spending versus really gaining share relative to other providers or how would you characterize that?

I think the IT spend has been there for a period of time. This is execution on our end. And as you well know, because you follow this space closely, clearly, there are certain competitors out there that have demonstrated what it's capable. And now, we're finally moving into those ZIP codes. So, again, I put this back on the team. We step back. We looked at how we need to attack the marketplace differently. We put a plan in place and we're in the process of executing that plan. This goes back to two years ago when we made a rather large investment in our go-to-market strategy, in our sales methodology. And I think we're just starting to see some of the traction and the benefits associated with those things.

That's great. I'll jump back in the queue. Thank you.

Thanks, Mark.

Thank you. [Operator Instructions]. Our next question comes from Tim McHugh with William Blair.

Hi, good morning. This is Trevor Romeo in for Tim. Thanks for taking the call. So, first question, you mentioned that bill rate growth is starting to pick up on the Flex side for both segments. Just wanted to see if you think similar 4% type bill rate increases will be the norm going forward if we continue to see a solid economic backdrop. And do you see any room for that to continuing moving up at this point?

Yeah. Trevor, so bill rate growth in the last couple of quarters was between 3% and 4% in Tech Flex and about 4% in FA Flex. Clearly, the environment that we're seeing here doesn't suggest that that growth rate is going to slow down. And the good news for us, obviously, is we're able to – that is true on the pay rate side. And our ability to maintain spreads is reflected in our ability to increase bill rates. So, I don't know that there is – and something will have to change in the economy for that trajectory to change.

Okay, makes sense. And then, I guess, you talked about improving productivity levels, giving you the ability to, I guess, not add internal headcount, even though with the growth you're expecting. So, my question is, I guess, at what level of growth do you think you would need to start adding headcount a bit more aggressively? And looking out the next several years, do you think you can reach the long-term growth objectives without growing that headcount?

Yeah, we have models. And part of this is, as time plays out, and a lot of these technology investments and other strategic relationships and the overall strategy that we put in place, as that takes hold, personally, I believe that we'll see productivity levels go to places that we haven't seen historically. This November, I celebrate my 30th year in and around the business. So, we have a lot of optimism on that front. That's not to say that we will we will add to headcount when we start to see any compression taking place there to make sure that we're providing ample time to ramp up those people, but I don't think you'll find us jumping on a call and all of a sudden, out of the blue, we've ramped up headcount 10% or something along those lines. So, it will be measured.

Okay, got it. And then, maybe just one more for me. On the Direct Hire side, I know that business is a bit more volatile, but could you maybe just elaborate a bit more on why you're seeing that revenue down around 10% despite the strong economic environment. And do you think a lower mix of Direct Hire revenue going forward would hurt your ability at all to reach the margin targets?

Direct Hire, it's been part of our plan. We made these decisions actually coming out of the dotcom downturn for those that were around back in those days. Our Direct Hire mix was north of 20% of total revenue, almost contributing north of 40% of gross profit. So, we've been on the other side of this equation and watched $40 million a quarter run rate drop to $6 million a quarter in a matter of six quarters and when you look at the infrastructure aspect and tear down that's required there. So, coming out of that downturn, we made a conscious decision to be more measured in terms of the mix of Direct Hire. We are strategically investing in Direct Hire where we have capacity, where we have the right teams, we have the right client makeup. So, we're very comfortable with where our mix is, and that's all been built into our models in terms of profitability. So, that percentage does not need to go up. In fact, I'm here to tell you it could go down and we'd hit the targets that we've established.

Great. Well, thank you very much for the detail.

Thank you.

Ladies and gentlemen, thank you for participating in the question-and-answer portion of today's call. I would now like to turn the call back over to Mr. David Dunkel for any closing remarks.

Great. Well, thank you for your interest and support of Kforce. The results that we've experiencing is the result of a lot of hard work and tough decisions by our team. While we have much more to do, I'd like to say thank you to each and every member of our field and corporate teams and to our consultants and clients for allowing us the privilege of serving you. Thank you very much.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect and have a wonderful day.