Kforce Inc. (KFRC) Q1 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Kforce Q1 2019 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Chief Corporate Development Officer, Mr. Michael Blackman. You make 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 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 published our prepared remarks within the Investor Relations portion of our website. We've provided an additional table on our press release to reconcile our GAAP results with adjusted results, which is provided to give you greater clarity into the underlying trends in the business. As previously announced, we successfully closed on the divestiture of KGS, our prime federal government contracting business, on April 1 and are making good progress pursuing strategic alternatives for our TraumaFX business. Finalizing the sale of KGS is the culmination of a journey we began years ago to concentrate our business in the areas within commercial staffing that are focused on the most critical talent needs in our information- and technology-driven society. We've executed this plan in a patient and disciplined manner, allowing us to maximize our return on these assets and unlock the capital of our Firm and the focus of our team. As we look to the future, we are excited to have completed this important strategic shift and are even more excited about our future prospects. Kforce is now exclusively U.S. focused and nearly 80% of our revenues are derived from technology. As the technology talent market is evolved, every industry and organization is confronted with the imperative to invest and rapidly adapt to changing business models and new competitors. Our focused domestic technical and professional staffing platform provides an excellent foundation to meet our clients' needs for flexible talent and will continue to be the driver to our near-term growth. However, these same clients are looking to firms, such as Kforce, to assume a greater role in more complex engagements that require managed services and solutions. Our clients have increasingly expressed their desire to engage with us to serve as a viable alternative or complement to the larger-scale integrators. This leverages our delivery capabilities to identify qualified highly skilled talent quickly at attractive rates and also manage the stringent and complex compliance requirements. We believe that significant opportunity exists to invest and expand our capabilities in this space to not only serve existing clients but enhance our ability to grow our client portfolio. This will allow us to expand our reach and capture a sizeable share of not only the $30-plus billion domestic markets for technology staffing but also a portion of the $100-plus billion for IT solutions. We've been working on and will continue to evolve this strategy and consider investments that will help better shape the future of our firm and lead to enhanced prospects for long-term success. I can envision 20% of our technology revenues being derived from this segment in 5 years. The pace of technological change, in particular, suggests that regardless of the economic backdrop, companies will need to continue to access technology resources, which should sustain demand for our services in all economic climates. In anticipation of and subsequent to the close of the KGS divestiture, we have aggressively been repurchasing our stock. At these levels, we believe the repurchase of our stock with the sale proceeds best serves our shareholders, and we expect to continue our repurchase activities until the cash proceeds from the sale are exhausted. We are able to comfortably undertake these actions without reducing our flexibility to make other strategic investments due to our very strong operating cash flows. First quarter revenues and earnings per share from continuing operations were within the range of our expectations. We continue to make meaningful progress in improving our profitability level as the firm grows, while also investing in technology to better enable our associates and improve service capabilities to our clients, consultants and candidates. Given the acute labor shortages, our technology investments have been and continue to be focused in areas, including candidate sourcing and attraction, advanced screening and matching algorithms, engagement and retention platforms. The demand environment continues to be very constructive, and our outlook for the remainder of 2019 is positive. 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. At Kforce, our strategy is to embrace technologies that will enable our associates to focus on serving our customers with trusted relationships. We believe the technology will facilitate enhanced productivity and improved customer service in the sophisticated and complex world of professional and technical staffing I'll now turn the call over to Joe Liberatore, President, who will give greater detail into our operating results and trends, and then Dave Kelly, Chief Financial Officer, will provide further details on impacts of the KGS transaction, share repurchase activities, as well as add further color on the first quarter results and provide guidance on Q2. Joe?

Thank you, Dave and thanks to all of you for your interest in Kforce. Overall revenues from continuing operations in the first quarter met our expectations. We were pleased with the 9.8% year-over-year billing day growth in our largest business, Tech Flex, which now represents approximately 77% of overall revenues. We believe the growth we're experiencing in Tech Flex, which continues to significantly exceed published market growth averages, is reflective of a continued strong demand environment as well as the success from our efforts to optimize the alignment of our sales and delivery talent within our client portfolios. As we indicated on the call last month regarding the sale KGS, our starts activity in the quarter was trending slightly below expectations due to the lingering effects of the shutdown in combination with weather impacts experienced in Q1. Activity has begun to normalize across the business, though government clearances still are taking longer than usual, which affects our staffing efforts within government integrators. However, lower attrition rates of our consultants has slightly lengthened assignments and allowed us to achieve billable headcount levels at quarter end consistent with our expectations. We believe these lower attrition rates and the continuation of bill rate increases at rate higher than inflation are indications of our clients' desire to retain highly skilled and scarce talent as well as the evolution of technology initiatives towards an agile continuous improvement environment. We continue to make the necessary adjustments to the alignment of our sales and delivery talent within our client portfolios, which is contributing to above-market revenue growth rates and associate productivity. 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 diversification efforts beyond our largest clients and deeper into other Fortune 1000 customers, where we have established relationships. We've been very successful in growing these accounts, which remain among our 25 largest relationships through a deep understanding of their needs and our ability to craft solutions through both traditional staff augmentation, and also by providing a greater level of managed services and solutions offerings. While we have seen this growth, no single client constitutes more than 5.5% of Tech Flex revenues. We've experienced growth across virtually every industry vertical in which we do business. Top growth industries for us were financial services, business and professional services as well as new growth in health services. We expect continued above-market growth in our Tech Flex business in the second quarter. Year-over-year growth rates should remain in high single digits despite more difficult year-over-year comps. Our FA Flex business, which represents roughly 20% of overall revenues, declined 11.7% year-over-year. We continue to make progress, repositioning this business in more highly skilled positions that are less susceptible to being disrupted by technology advancements. We are beginning to see progress as average bill rates within FA Flex have increased 7.5% on a year-over-year basis. The market for our FA business continues to be strong, and we believe our efforts in this area should lead to improving performance as we enter the second half of the year. While the realization of results from this strategic shift have taken longer than anticipated, our internal trends suggest that our FA Flex business may turn slightly positive sequentially in the second quarter, and year-over-year declines will recede to high single digits. Direct Hire revenues, which represent roughly 3% of overall revenues, increased 4.8% year-over-year. The market for permanent talent, particularly in Tech, continues to be quite strong and our Direct Hire business continues to be an important capability in ensuring that we can meet talent needs of our clients through whatever means they prefer. We continue to be selective in our investments in this line of business. We expect a seasonal sequential increase in the second quarter and for growth rates in this business to be stable year-over-year. Over the long term, we have built our model with the belief that Direct Hire will continue to decline as a percentage of overall revenues due to the growth expectations in our other lines of business. With respect to our revenue-generating talent, we continue to make significant technology and process investments in order to improve associate productivity, which has now improved greater than 10% each of the past 3 years. Improving productivity has also had a positive impact on associate retention, which should continue to drive additional productivity improvements. We have not made material additions to associate head count beyond those areas where productivity levels warrant additions as we believe significant capacity exists to continue to grow revenue at our targeted levels. Our simplified business model has us well positioned for the long-term growth. I appreciate our teams' efforts in driving the firm forward. I'll now turn the call over to Dave Kelly, Kforce's Chief Financial Officer, to provide additional insights on operating trends and expectations. Dave?

Thanks, Joe. The results of KGS and our TraumaFX business have been reflected as discontinued operations and as assets held for sale in our first quarter 2019 consolidated financial statements. The total gain on the sale of KGS is approximately $72 million. The income tax benefit of $18.5 million or $0.74 per share was required to be recognized in the first quarter. Given the April 1 closing of the transaction, the remaining portion of the gain $53.5 million will be recognized in the second quarter. Net cash proceeds from the sale will be approximately $93 million. Revenue from continuing operations of $326.7 million in the quarter grew 4.6% year-over-year on a billing day basis. GAAP earnings per share from continuing operations of $0.32 were negatively impacted by $0.06 from severance and other costs, recognized as a result of actions to simplify the support structure of our business in anticipation of the KGS divestiture. Excluding these costs, earnings per share were $0.38, which improved nearly 19% on year-over-year basis. Our gross profit of 28.5% declined 70 basis points year-over-year primarily as a result of the decline in our Flex gross profit percentage. Tech Flex margins of 25.3% declined 80 basis points year-over-year. As noted last quarter, we've experienced spread compression in Tech Flex as a result of the mix of growth in some of our larger clients, which have a slightly lower margin profile. As we look to the future, we expect to continue to be more -- to more deeply penetrate our existing clients. This may create slight margin pressure as our pricing strategies structures typically include tiered discounts for greater volume at our largest clients. However, our continued efforts in overall portfolio management should mitigate much of this impact. As importantly, greater scale at individual clients allows our associates and support infrastructure to be more efficient and drive profitability from these clients that is accretive to our operating margin targets even at slightly lower growth margins. SG&A expenses adjusted for the $2 million of severance and other costs resulting from the divestiture of KGS, declined as a percentage of revenue by 100 basis points year-over-year. We continue to make progress in generating SG&A leverage as revenues expand. This leverage has been achieved, while also significantly increasing our technology investments. We are also aggressively pursuing opportunities to partner with leading technology firms to embrace applications that enhance our customer experience and further improve productivity and strengthen client and consultant relationships. Our first quarter operating margin, excluding severance and other costs, was 4.2%, which has improved 40 basis points year-over-year and met our expectations. During this economic cycle, our gross margin percentage has declined by approximately 200 basis points. Despite this compression, operating margins have improved by more than 400 basis points. Our effective tax rate in the first quarter from continuing operations was 26.1%. Operating cash flows in the first quarter, which is typically our lowest quarter of the year, were $11.8 million. Based upon current trends operating cash flows in 2019 could reach approximately $85 million, excluding any proceeds from the sale of our KGS and TraumaFX businesses. We repurchased 430,000 shares of stock at a total cost of $14.6 million during the quarter and have continued to be active in repurchasing our shares subsequent to the end of the quarter. We expect to continue these activities until the net proceeds from the divestiture of KGS have been exhausted. As of yesterday, the remaining net proceeds yet to be deployed were $78 million. Long-term debt under our credit facility was $82.5 million as of March 31. We expect to maintain debt levels for the remainder of 2019 at $65 million, which is a notional amount of our attractive interest rate hedge. Depending upon the extent of our operating cash flows and pace of stock repurchases, we expect to be in a net cash position for the remainder of 2019. Our healthy cash flows, minimal CapEx requirements, low debt levels and $300 million credit facility collectively provide us maximum flexibility to execute quickly on strategic or tuck-in acquisitions or other ventures and strategic partnerships even while aggressively repurchasing stock. I wanted to provide you a sense of how our weighted average shares outstanding could trend for the remainder of 2019, given current repurchase trends. Based upon Q1 activity, we forecast being able to deploy between $20 million and $25 million in cash per quarter. This would result in weighted average diluted shares outstanding of approximately $24.5 million in Q2, $23.9 million in Q3 and $23.3 million in Q4. Actual results, of course, could vary significantly depending upon stock price and volume. Our billing days are 64 days in the second quarter, which is equal to the second quarter of 2018. With respect to guidance for continuing operations, we expect Q2 revenues to be in the range of $338 million to $343 million and for earnings per share to be between $0.64 and $0.66. Gross margins are expected to be between 29.7% and 29.9%, while Flex margins are expected to be between 27% and 27.2%. This includes an expected sequential improvement from seasonal payroll taxes of 100 basis points. SG&A as a percentage of revenue is expected to be between 22.8% and 23%, and operating margin should be between 6.3% and 6.5%. Guidance assumes an effective tax rate of 26%. Weighted average diluted shares outstanding, as I mentioned, are expected to be approximately $24.5 million in Q2. This guidance does not consider the effect, if any, of charges related to any onetime costs, costs or charges related to any pending tax or legal matters, the impact on revenues of any disruption in government funding or the firms response towards regulatory, legal or future tax law changes. We are pleased with continued above-market performance in our Tech Flex business and are focused on repositioning our FA Flex business as we previously discussed. Subsequent to the sale of KGS, we now expect operating margins to be 6.5% or better in a quarter without seasonality effects where revenues are $350 million, which could occur as early as the third quarter. We expect profitability levels to continue to improve to 7.7% in a $400 million quarter. This is a 20 basis point improvement from the 6.3% and 7.5% at the same revenue levels in models provided prior to the divestiture of KGS. Costs related to seasonality impact our first and fourth quarters each year by approximately 180 basis points and 40 basis points, respectively. We continue to be excited about our prospects in the market for our services, which remain quite strong and remain -- and we remain confident that we built a solid foundation for sustained revenue growth and continued improvements in profitability. Demetrius, we'll now open the call up for questions.

[Operator Instructions]. And our first question comes from Tobey Sommer with SunTrust.

We talked about your goals for expanding more fully into, sort of, managed services and a 20% target in 5 years. What kind of percentage do you have now? And could you get to that 20% organically or you need to add some capabilities through acquisition in order to be able to get that started?

Yes. Tobey, this is Joe Liberatore. Yes, currently, we're below 5%. We do believe we can get there organically. However, that is probably the key area where we've been exploring strategic alternatives. So we'll continue to explore. And if we find the right opportunity, we're very confident with where we are from the balance sheet standpoint that we could support doing something. But we do not believe that, that's going to be required for us to obtain that 20%-plus.

Okay. And then with respect to your margin goals, in what quarter within the year would you referenced as one without the seasonalities that you could, kind of, hit your bogey.

Yes. Tobey, this is Dave Kelly. So Qs 2 and 3, I would categorize as clean quarters. So I tried to give you some color. Obviously, we got payroll taxes that impact Q1 significantly as well as billing days, and then we got a slight impact on Q4, obviously. So Qs 2 and 3 are the clean quarters to think about.

That makes sense. When we think about deepening your relationship with your largest customers, how do we try to get a handle on, the trend for margin from here because as you noted, despite a slight headwind over multiple years, the operating margin expansion has, by far, out script that? But how do we think about the trends in gross margin contractions, kind of, annually?

Yes. So Tobey, Dave Kelly, again. So if you look at the last year, as you saw, we've seen slight compression in Tech Flex, but it's been very minor. A couple of things driving that: obviously, our large clients, as we give them discounts for a lot greater volume, have an impact on that; but the portfolio management activities that we've undertaken really helped us here; and our focus continues to be on driving business with clients beyond those couple of largest. So I would expect if there was a bias probably slightly down, but it's a very minor down bias. And I'd reiterate the comment that I made in terms of what this does for productivity of the firm as well, it's actually not a negative. It's quite frankly accretive for the bottom line for us to grow these larger clients on a bottom line basis.

And then could you talk about the drivers of the elongation of assignment durations and maybe give us a couple of reference points for what a duration might have been historically versus where it is now and where it's trending?

Yes. I'd say, historically, if we go back to prior cycles, I mean, our average duration was probably in the 5- to 6-month type of window for Tech Flex. We've seen that continue to expand throughout this cycle. It's probably pushing closer to 8 months at this point in time. So we didn't have anything materially that changed this particular quarter. I mean, this has been ongoing throughout the entire cycle. We just had a little bit of room that we gained this quarter that allowed us to meet those headcount targets at the end of the quarter.

Yes. I would add to that and just, kind of, again, reiterate Dave's point, I think that it's helping drive this duration of assignment, but the work we're doing, the managed services space, even at higher bill rates, helps us in match those. That continues to grow for us. It's going to help us with these longer assignment lengths as well. So I think it's part of how the business has evolved.

[Operator Instructions]. And our next question comes from Tim McHugh with William Blair.

This is actually Trevor Romeo in for Tim. Thank you for taking our call. So you mentioned that internal associate productivity has been up more than 10% in each of the past three years. I just wanted to ask what sort of specific efforts are you undertaking to continue improving that productivity in the future? And do you think it can continue to increase at similar rates going forward?

Yes. I'd say, while the efforts are all in and around alignment, I mean, it started with really getting after alignment of our portfolio and getting people focused and more narrowed. And when you couple that with the things that we're doing from just the overall enhancements to different methodologies on how we go to market, how we're training, how we're onboarding, how we're ramping, and then you apply the things that we're on the early stages from a technology enhancement standpoint, I think all those things come into play on the productivity front. So as the technology continues to gain more traction, we're very confident that we have adequate capacity to continue to grow the business.

Okay. Great. And then just a follow-up on the longer assignments for Tech Flex. Are you still seeing good growth in the number of assignments as well or is most of the growth coming from the lengthening of the assignments now?

The majority of the growth actually came from headcount additions, and then you're seeing some of that growth is coming from bill-rate expansion as well as the extended assignments.

Got it. And then maybe just one more for me on the turnaround for FA Flex. So it's encouraging to see the bill rates up nicely, but I guess what does that imply about the number of assignments there given the decline in revenue? And then any sense of maybe the timing on when you think it might return to year-over-year growth in that segment.

Yes. Well, that's really the comments that I made in my opening statements, which was really if things were to continue to progress, we could turn positive year-over-year in the second half of the year. Some things have to go our way for that to take place. But your earlier part of your question, yes. It's simple math, obviously. If the revenue's declining and the bill rate's going up, I mean, our actual headcount is down greater than the deterioration we've seen in year-over-year revenue growth. However, as I also mentioned, we are seeing internal trends currently that could lead to a slight sequential positive, what I think which were the indications that we're, kind of, getting to a bottom in terms of stabilizing that business.

Yes. I would add a point somewhat related to this. As Joe mentioned, the bill rate increasing the quality of this business, I talked a little bit about what we thought margins we're going to do. So we think that this is really actually helpful to Flex margins as well. So even as you look into the second quarter and beyond, the quality of business, the higher bill rates have been associated with slightly higher margins, too. So again, the quality of the business has helped as well.

[Operator Instructions]. And we have a follow-up question from Tobey Sommer with SunTrust.

I wanted to ask a strategic question. Over the course of this cycle and you've just simplified the business and streamlined it, learn it, aiming more squarely at the professional staffing area, particularly, concentrating yourself in Tech Flex, with the current portfolio, is that process, kind of winding down? Or is there more refinements within your portfolio going forward?

Tobey, this is Dave. This process really began back in '13 with Bill Sanders' retirement, and Joe moving into the President's role as we relooked at the whole business long term, strategically. And concluded that the businesses that we were in were not the businesses that we're going to afford us the greatest growth and opportunities for the longer term, most specifically looking at technology, which was significantly larger than any of those businesses. So just a quick walk in the past. We exited Clinical in '12. We exited HIM in '14. We eliminated Global. Of course, we just divested of KGS Services, and Trauma is in process. So all of those steps were taken to allow us to narrow our focus. So if you look at us now, it's entirely domestic U.S. 80% roughly of technology. So we've really concluded the process of narrowing our focus. We believe that you have to have adequate scale in order to be able to support these businesses. So our conclusion in exiting some of the other businesses were related specifically to our ability to invest in them and scale them as well as the opportunities. Looking back, I think we made the right call focusing on technology. So now as we look ahead, we see even greater opportunities in technology. We did, at the time, indicate that we've seen that the focus now has moved to customer-focused applications, digital marketing, those kinds of things that we believe are sustainable for long term as technology has really moved now to the forefront in terms of business model transformation, disruptors. So there's still a lot of work to be done. And frankly, for just about every firm today, it's not optional. So when we look at the opportunities and in conversations with our clients, they're asking us to take on greater responsibility. So all of this really has been the foundation of a long-term strategy. In terms of divestitures, yes, we're done. In terms of potential strategic acquisitions, still being very disciplined and patient about it, but if you see us do something, it would be a tuck-in or it would be something along the lines of a solutions type business that we've indicated that our clients are asking us to take on. We're already in process on that, have been for a while. So strategically, we're actually really excited about where we're positioned because one of the leverage-able platforms that we have is our delivery platform and our ability to bring teams together in working on some of these major enterprise clients where we have long-trusted relationships. So I know it's a long answer, but we're really in a great spot with the U.S.-domestic exposure. With 3.2% GDP growth here, all of the attention is really focused now on domestic markets, and we're -- with our narrowed focus and concentration here, we're really in a great position.

Thank you, ladies and gentlemen. This now concludes our Q&A portion of today's conference. I would now like to turn the call back over to David Dunkel, Chairman and CEO, for any closing remarks.

All right. Well, thank you, very much for all of you and your interest and support of Kforce. While we always have much more to do, I would like to say thank you to each and every member of our field and corporate teams and to our consultants and our clients for allowing us the privilege of serving you. Once again, thank you very much.