Kforce Inc. (KFRC) Q3 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Third Quarter 2018 Kforce Incorporated 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 call is being recorded. I would now like to introduce your host for today's conference, Michael Blackman, Chief Corporate Development Officer. Sir, 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 the 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. In addition, we have published our prepared remarks within the Investor Relations portion of our Web site. I will provide some high-level opening remarks on our third quarter results and the 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, CFO, who will add further color on third quarter results and provide guidance on Q4. Third quarter revenues of $355.5 million grew 4.2% year-over-year. Growth in our largest business, Tech Flex, continues at above-market levels and grew at 10.3%. Overall, revenues, however, fell short of our expectations due primarily to weaker than expected results in our FA Flex and KGS services businesses. We continue to evolve our FA Flex model, as we did with Tech, which Joe will comment on further later in this call. Recent significant KGS awards should accelerate growth beginning in Q1 of '19. Despite the lower than expected revenues, the Firm continues to generate operating earnings consistent with our previously stated expectations and generate strong cash flows. Despite the recent volatility in the market, economic data and client activity suggests that growth in the U.S. economy is strong and business spending is robust and accelerating. The digital transformation of every industry is forcing every organization to increase and sustain their technology investment as competition and the speed of change intensifies. 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 firmly 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. These rapidly changing technologies are also impacting staffing as new tools become available and non-traditional competitors enter the industry. At Kforce, our strategy is to embrace technologies that will enable our associates to focus on serving our customers with trusted relationships. We believe that technology will facilitate enhanced productivity and improved customer service in the sophisticated complex world of professional and technical staffing. We have already deployed many new tools that are contributing to the improved productivity we are experiencing. 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. It is people serving people. While there remains work to do to reaccelerate growth in FA Flex, we are well positioned, with over 70% of our revenues in Tech Flex and with the recent significant awards at KGS. I will now turn the call over to Joe Liberatore, President to provide further details. Joe?

Thank you, Dave, and thank you to all of you for your interest in Kforce. The third quarter saw a continuation of strength in our largest business, Tech Flex, which saw an improvement to 10.3% growth on a year-over-year basis. The investments we have made and continue to make in technology and training and the continued refinement of our sales and delivery model have driven above-market revenue growth rates in this business. We continue to refine the alignment of our sales and delivery talent within 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 these more sophisticated and substantial consumers of the services we provide are facing and to craft solutions. From an industry standpoint, we experienced broad-based growth in 7 of our top 10 industries, including Technology, Financial Services, Professional Services and Retail. As we look forward to the fourth quarter, weaker than anticipated start activity and higher conversions during the third quarter will have an impact on near term growth rates. We expect Tech Flex revenues to be relatively flat sequentially, and for year-over-year growth rates to be in the mid to high single-digit range on a billing day basis. Our FA Flex business, which represents roughly 20% of overall revenues, declined 11.8% year-over-year. We have experienced softness in this business as we place greater emphasis on higher bill rate opportunities as we position the business within the skill sets less susceptible to being disrupted long term by technology advancements. Bill rates within FA Flex have increased 6.4% on a year-over-year basis, which reflects our pursuit of a more balanced mix of higher skilled roles in FA as larger projects end. We are positioning this business for future growth against a solid demand environment. We expect fourth quarter revenues to be up sequentially on a billing day basis in the low to mid-single digit range as we take advantage of seasonal fluctuations in this business and the ramp of a large project. We expect the year-over-year percentage decline to approximate third quarter levels. KGS services revenues declined 0.6% year-over-year. KGS’ management team has done a solid job building a strong qualified pipeline of new business pursuits. During the quarter, KGS was awarded business having an aggregate contract value of $32.5 million that is expected to be recognized over a period of 5 years. Additionally, late last week, KGS received another sizable award of approximately $150 million, the largest in its history, which is also expected to be recognized over a period of 5 years. Revenues from these new business opportunities were expected to positively impact the third and fourth quarters, however, the awards were delayed, but are expected to accelerate growth in 2019. In the third quarter we also experienced attrition in assignments on existing low margin contracts that, by design, were not backfilled. The combination of award delays and selective attrition resulted in KGS services revenues falling short of our expectations in the third quarter. KGS product revenues, which are inherently more volatile than its services business, accelerated 95.9% year-over-year. For the fourth quarter, we expect KGS product revenues to be flat with Q3 levels and for total KGS revenues to be up sequentially and flat to slightly down on a year-over-year billing day basis. Direct Hire revenues, which represent roughly 3% of overall revenues, declined 13.7% 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. This is particularly true in Tech, where hiring managers are increasingly looking for a model that allows them to add flexible consultants that they ultimately convert to full time employees, which may be contributing to both our declines in Tech direct hire and supporting the strong demand for Tech Flex. We have been selective in our investments in this line of business to meet this evolving model. We expect a typical seasonal decrease in the fourth quarter, and year-over-year to be down in the high single to low double digits. Over the long-term, we have built our model with the belief that direct hire will continue to decline as a percentage of our entire business. Our technology and process investments have led to improved productivity of our revenue-generating talent. We have made slight additions to our associate population in the quarter, though we expect headcount levels to remain relatively constant near term. As we refine our model, we continue to identify opportunities for improving productivity, and therefore have not made material additions to associate headcount beyond those areas where productivity levels warrant additions as we believe significant capacity exists to continue to grow revenue at our 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. I appreciate our team’s efforts as we continue to move our Firm forward. 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. Revenues of $355.5 million in the quarter grew 4.2% year-over-year and earnings per share of $0.64 improved 60% year-over-year on a GAAP basis and 42% on a adjusted basis. For comparison purposes, we have provided a reconciliation between GAAP and non-GAAP results for the third quarter of 2017, in our press release. Our gross profit percentage in the quarter of 29.4% declined 120 basis points year-over-year, primarily related to a decline in the mix of Direct Hire and a 110 basis point year-over-year decline in our Flex gross profit percentage to 26.7%. Staffing bill/pay spreads have held up well, though increased healthcare costs and competitive pricing pressures in our KGS services business have driven down Flex margins overall. Tech Flex margins of 26.5% declined 50 basis points year-over-year and FA Flex margins of 29.0% were flat on a year-over-year basis. Contributing to the decline in Tech were elevated healthcare costs in the quarter. And additionally, after experiencing slight spread improvement throughout the year due to success in our account diversification efforts, we saw a slight compression in spread this quarter. This was driven due to higher revenue growth in several of our largest accounts, which have a slightly lower margin profile, as well as an acceleration in pay rates overall. Pay rates in Tech have increased 5.1% year-over-year, which is a bit faster than the 4.6% increase we have seen in bill rates. Both pay and bill rate increases have accelerated slightly from Q2 levels. Looking forward to the fourth quarter, we may see further compression in spreads as a result of the continued strong growth in the large accounts I mentioned. In Q4, overall spreads will also be negatively impacted by seasonal paid time off. SG&A expenses as a percent of revenue declined 160 basis points year-over-year to 22.4% in the third quarter of 2018, which is a historic low for our Firm. We continue to make significant progress in generating SG&A leverage by improving the productivity of our associates and exercising solid control over discretionary expenses. These actions have allowed us to increase our investments in technology while also improving operating margins. Looking forward to Q4, we expect SG&A dollar expense to be flat sequentially and continue to be down on a year-over-year basis. SG&A expenses in Q4 contemplate continued increased investments in technology, with a focus on improving the candidate and consultant experience and further expanding our business intelligence capabilities. Third quarter 2018 operating margins of 6.4% improved 40 basis points year-over-year and is where we would expect at these revenue levels. During this economic cycle, our gross margin percentage has declined by 230 basis points. Despite this compression, operating margins have improved by 450 basis points. 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 third quarter was 25.2%. As it relates to our effective income tax rate in Q4, we expect this will track close to levels seen in the first half of 2018, excluding the impact of any excess tax benefits that may be recorded and any impact from the anticipated changes in tax regulations related to the deductibility of executive compensation. With respect to our balance sheet and cash flows, operating cash flows in the third quarter of $26.4 million were very strong. Capital expenditures in the third quarter were $900,000. We decreased outstanding borrowings under our credit facility by $21.3 million in the quarter. Long-term debt under our credit facility at the end of September was $79.3 million and less than 0.9 times trailing twelve-months EBITDA. Our healthy cash flows, strong balance sheet and $300 million Credit Facility collectively provide significant flexibility if we were to identify strategic or tuck-in acquisitions or partnerships. Additionally, our Board of Directors recently approved an increase to our share buyback authorization to $100 million which, along with the 50% increase in our dividend last quarter, allows us to continue returning cash to our shareholders and maintaining flexibility to take action if there are dislocations between our stock price and performance. Based upon our current stock price, our dividend yield of 2% represents significant value for our shareholders. Looking forward, there are 62 billing days in Q4, which is one day less than Q3 2018 and one day more than Q4 2017. Revenue per billing day in the third quarter of 2018 was $5.6 million. With respect to guidance, we expect Q4 revenues to be in the range of $349 million to $354 million and for earnings per share to be between $0.56 and $0.58. Gross margins are expected to be between 28.8% and 29.0%, while Flex margins are expected to be between 26.4% and 26.6%. SG&A as a percentage of revenue is expected to be between 22.6% and 22.8% and operating margins should be between 5.6% and 5.8%. Guidance assumes an effective tax rate of 25.5%. Weighted average diluted shares outstanding are expected to be approximately 25.2 million for Q4. 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 towards regulatory, legal or future tax law changes. We are pleased with the above-market performance in our Tech Flex business and are optimistic about our KGS services business as a result of their recent wins. We believe we are on the right path to addressing the challenges in our FA business. The market for our services remains strong and we remain confident that we have built a solid foundation for sustained revenue growth and continued improvements in profitability which will lead to operating margins of at least 7.5% in a quarter, without seasonality impacts, where revenues reach $400 million. Heather? We would now like to turn the call over for questions.

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

Hi, good morning. It's actually Trevor Romeo in for Tim today. Thanks for taking my call. So first question for Tech Flex, you mentioned you are seeing some weaker than anticipated start activity, could may be just give some detail on what your conversations with clients are like at this point maybe or there any particular reasons that might be driving that?

Yes, Trevor. This is Joe Liberatore. I would say we started to experience that in the second -- the summer months based upon what we had historically seen and that kind of continued through September. Now as we move into the beginning of Q4 here, we have see now start to rebound. So, I don't think it's really any particular, our client driver exactly not market demand driven. I think it was just a soft patch that we -- so we don't really have any concerns on a forward look based on what we are hearing from clients.

Okay. Got it. Thanks. And then, on the new contracts for KGS, how significant is the contribution going to be in 2019. I guess do see the total contract value being recognized sort of evenly over five years, or is there some sort of [indiscernible] involved? And also, could you just about the margin profile in those contracts and whether there might be any start up costs?

Sure, Trevor. This is Dave Kelly. So as you mentioned that $180 million when completely up and running equates to about $45 million a year in incremental revenue for KGS. We had indicated that we will see some benefit there beginning in 2019 and I expect there is going to be some ramp up. But, I would tell you that, I think probably conservatively and of course, there are still some things that are yet to be determined, $30 million plus in additional revenue for 2019 in the aggregate and as I said normalized $45 million and when its fully up and running. Turning to the profitability of that business, no significant start-off cost really as you ask. I would tell you the margin profile of this business is actually incrementally positive toward KGS services margins are today. So not only is an uplift in revenue but actually it's a very attractive piece of business at this point.

And then also doesn't contemplate any additional wins. Still have a strong pipeline. So that's just what we've recently picked up.

Got it. Great. Thank you very much.

Thank you. [Operator Instructions] Your next question comes from Tobey Sommer with Sun Trust. Your line is open.

Thank you. Within the Tech Flex business, could you talk about the large customers maybe give us some context and try to size the exposure there -- is there any particular project that the large customers with a definitive time that maybe ending in the near to mid-term or is this just large customers buying broadly from you in greater quantity? Thanks.

Tobey, I'd say that the large customers continue to drive buying activity mainly we're not seeing the historic CapEx spend. I mean this is transformative as you know it's widely been publicized. I mean every organization is looking at addressing how they best serve the end customer. And the end customer is really driving a lot of the technology especially where we focus, which is a very high percentage of our business probably almost 50% of our business is wrapped up in app dev and project management type resources. So we're seeing that it's broad based. As I mentioned in my opening comments I mean seven of our top 10 verticals demonstrated very strong growth. One of the other things I would say is, I think our team as we've really honed in on the portfolio and targeting those customers that are large consumers where we really don't have as great a footprint on today, but yet we have some longstanding relationship. The teams really done a nice job on repositioning the business and diversifying into those customers is reflected. I think I was looking this last quarter about 28% of our top 25 clients in tech are new to the top 25. So I think that's a clear demonstration that their team has really done a nice job from an execution standpoint on targeting those customers where we see that forward-looking demand just based upon different dynamics going on within different industries.

Tobey, this is Dave Kelly. Let me also give you a little quantitative information as you used the word exposure, want to give some perspective here on the impact on margins. Our spreads year-over-year in Tech Flex even with this change are down less than 20 basis points. So the spread between bill and pay is not a huge impact. And when we look to Q4 maybe a little bit more but we're not talking in terms of the profile of the revenue stream as a whole having a material degradation and margin here. So I know we made a comment about that but it's not a big number.

Okay. Thank you. With respect to the conversion activity that you cited. Is that a broad based or is there a kind of a small subset of customers or in industry vertical that happens to have higher conversions and is driving the change?

I would say when we look at it on a year-over-year basis actually in tech specifically, our conversions were up almost 15%, which I would consider pretty substantial and that's coming off of the elevated levels. We've really seen this evolve through the -- really the majority of the cycle and especially here the last three or four years. So there is no question that the end customers just because of the demand in the marketplace and how difficult it is to find top talent is taken advantage of proven resources on the back end of their contracts and converting them into full time hires, which by the way and I've mentioned this numerous times on prior calls. We love when that happens because I don't think there's a greater compliment to what we do in terms of serving our customers and serving the consultants that we work with them when we make that match. And it's right for both of them because many of those consultants go in and ultimately turn into hiring managers which provides us a great relationship to pivot off of. So I don't I don't foresee as long as the cycle stays intact this dynamic changing which just makes it that much more imperative of why we have to ramp our starts on average to keep up with the attrition. I mean the flip side of that the good news is and we've mentioned this before we continue to see average duration of assignment length expanding which is very favorable. So it's not anything that's of concern to us. But it does put more pressure on really ramping up on the starts within our overall customer portfolio.

Yes. I would add a couple of things that as well. On the higher skill areas where we're competing with some of the more sophisticated consulting and solutions providers they don't offer conversion features for their talented associates consultant. So it's actually a competitive advantage for us in the higher skill areas.

Thank you. You mentioned you have opportunity to increase the productivity of your sales generating staff. Could you give us some color in kind of frame that like how much you think you have because we're seeing good demand on one side. But some headwinds with a slight soft patch and starts and then increased conversion. So just trying to get a sense for how much productivity -- how much growth could be driven by productivity. Thanks.

Yes. When we look at the makeup of our associate population, I mean our four plus year people, which are the most productive in our system, I mean in reality there are two times as productive as people that are two less -- two years or less in experience. We remain at the highest levels in terms of people that are actually in that grouping within our Tech Flex business. Likewise our two to four year population has remained a pretty healthy level, so over 50% of our entire population is made up in two plus year which are our most productive people. So very, very comfortable that we have a lot of capacity, capability with our existing populations. Now that doesn't mean that we're not selectively adding where we have very high productive teams and we're bringing people onto those teams. So we're very comfortable with capacity from that standpoint.

Yes. So I would add. And Joe gives you some of the detail that doesn't even contemplate and we're just beginning as you can appreciate to see some of the benefits of the technology investments that we've made in productivity. So we feel very strongly that the path that we've taken is the right path that we're going to continue to create the opportunity to improve our productivity expectations for our associates. So I think we're we feel very good about where we are today.

With the elevated investment in technology that [indiscernible] selectively deploying that within delivery in particular early on, we expect that there'll be some pretty significant improvements in productivity as we continue to invest in technology. And it really goes beyond just the pure technology investments made, we're doing quite a bit in terms of digital marketing and really looking at how we've become more efficient and effective from the identification of talent in the marketplace. So it goes beyond just pure technology, but it's still what's woven in there is strategies of really how to leverage the evolving landscape that's out there.

Thank you I'll get back in the queue.

Thank you. [Operator Instructions] And we do have a question from the line of Tobey Sommer with Sun Trust. Your line is open.

Okay. Sorry. Just a couple of questions on KGS, if I could. Could you describe of the $180 million you cited of new awards, the proportion that was kind of new versus re-competes you might have had just to get a sense for how much of that we might think about as a driver of growth going forward?

Now, the $180 million that Dave referenced and then that I broke out into a little bit more detail was, there is no re-compete in that. That's all new business awards. And in fact, in that $180 million, I mean that's really wrapped up in two major wins. There's also some smaller wins that will also bleed in same thing over a five year period. But two very significant wins. And these are one was a prime win, which was a little bit short of $30 million. And then, $150 million win that we referenced that it's actually a teaming. So that is our work share on a much larger contract. So these aren't just hunting licenses. I mean these are actually awards for to fill those positions. Those are guaranteed teaming percentages.

And as we think about basis, I think in 2019, we can visit a very low re-compete in 2019 as well. As we feel very good about the foundation of the business in KGS.

Does this represent further penetration of your primary customers or diversification on these two larger awards?

It's a great question. One of the things with a new leader we had brought in a little while back. One of our main focuses as we move through 2018 and look forward is further diversifying our footprint within KGS. And so it's really a mix of two. One of the awards actually is off of an existing contract vehicle that provides us access into an area where we were not doing business. And then, it is clearly the diversification efforts that they put forward in terms of going after new business is really starting to take hold.

Great. And then, my last question just -- in your prepared remarks talking about F&A, you talked about focusing on skills that are less vulnerable to being displaced by technology. What sort of occupations do you see is patent risk to being displaced by technology and maybe conversely give us if you could a couple of examples of skill sets that you're targeting that are less vulnerable?

Yes. I guess I'll start with the back end of that. When you look at the skill sets that are less vulnerable they are ones when you just think of -- just think of anything from an artificial intelligence, machine learning standpoint where access to lots of data can become more efficient in one's role. So it's kind of as you work up the food chain in terms of skill level or and/or interaction with other individuals. So that the roles that we see being automated more over time and there's a lot that's been published on this, if you look. I mean actually, I believe there you can see skill set breakdown of probability of disintermediation of those skills. So it's really the lower end skills, when you think that they're more routine in tasks because those are the things that we're going to see more automated through RPA or through box or various other aspects. So it's pretty simplistic when you think of the lower level skill levels. So we're just moving up that food chain to those roles that are less possibility of really being automated and we see opportunity there.

Could understand low level being more at risk, but could you cite some examples of positions that are being automated?

Well, I wouldn't say anything per se today is being automated away, but for example when we look what was happening with overall rev cycle business, you're seeing a lot happening within that space in terms of automation coming into play to drive efficiency in those areas. And also if you go into low level more clerical counting type roles, there is a higher probability of those being more automated. And then, when you get in even some of the financial analysis aspects you're seeing a lot of technology being applied on those fronts. I mean I'd be more than happy offline to send you kind of a breakdown of the various skill levels not something that we're saying. I mean this is widely published in the marketplace.

Thank you very much.

Sure.

Thank you. And I am showing no further questions at this time. I'd like to turn the call back over to David Duncan, Chief Executive Officer for closing remarks.

Well, thank you for your interest and support of Kforce results, we're experiencing as a result of a lot of hard work and tough decisions by our team and I'm grateful for their tenacity. But we have much more to do. I would like to say thank you to each and every member of our field and corporate teams and our consultants, our clients for allowing us the privilege of serving you. Thank you very much.

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