Exponent, Inc. Q3 2008 Earnings Call Transcript

| About: Exponent, Inc. (EXPO)

Exponent, Inc. (NASDAQ:EXPO)

Q3 2008 Earnings Call

October 15, 2008 4:30 pm ET

Executives

Brinlea Johnson – Director, Blueshirt Group

Michael R. Gaulke - Chairman and Chief Executive Officer

Richard Schlenker, Jr. – Chief Financial Officer and Secretary

Analysts

Tobey Sumner – SunTrust Robinson Humphrey

Joe Alkire – William Blair & Company

Joseph Foresi – Janey Montgomery Scott, LLC

[Brian Horrey – Arelian Partners]

Operator

Welcome to the Exponent third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Brinlea Johnson of the Blueshirt Group.

Brinlea Johnson

Please note that this call is being is simultaneously webcast on the Investor Relations section of the company’s corporate website at www.Exponent.com/Investors. This conference call is the property of Exponent and any taping or other reproduction is expressively prohibited without Exponent’s prior written consent.

Joining me on the call today are Mike Gaulke, Chairman and CEO, and Rich Schlenker, CFO of Exponent. Before we start I would like to remind you that the following discussion contains forward-looking statements including statements about Exponent’s market opportunities and future financial results that involve risks and uncertainties and that Exponent’s actual results may vary materially from those discussed here.

Additional information concerning factors that could cause actual results to differ from forward-looking statements can be found in Exponent’s periodic filings with the SEC including those factors discussed under the caption Factors Affecting Operating Results and Market Price of Stock in Exponent’s Form 10-Q for the quarter September 26th, 2008.

The forward-looking statements and risks stated in this conference call are based on current expectations as of today and Exponent assumes no obligation to update or revise them whether as a result of new developments or otherwise. And now I’d like to turn the call over to Mike Gaulke, Chairman and CEO of Exponent.

Michael R. Gaulke

We’re pleased to report another good quarter of financial performance. For the quarter total revenues increased 20% over the same period last year and income grew 18% and earnings per share improved to $0.38. During the third quarter we saw strong performances from our electrical, thermal sciences, technology development, human factors, mechanics and materials and environmental practices in addition to our health group.

Project activity in the quarter included the electrical practice assisting a major computer manufacturer with an intellectual property matter. Our mechanics and materials and biomechanics practices worked together to help a pharmaceutical company with a potential recall of a drug delivery system. The role of our engineering practices assisted a major utility with an audit of maintenance procedures used in its gas distribution stations.

In our environmental practice we continued our work related to the Exxon-Valdes oil spill in Alaska and our health sciences group assisted a number of multinational clients with the new chemical registration and regulatory compliance requirements mandated under the EUs REACH program. During the quarter we continued the delivery of rapid development integrated surveillance systems to the US Army.

Additionally we received a new $9.3 million indefinite delivery, indefinite quantity contract for culvert denial systems which are designed to prevent insurgence from placing IADs in drainage culverts which run under roads in Iraq. The initial order under this contract is for $2.3 million of which we expect to realize approximately $750,000 of net revenue in the fourth quarter.

During the quarter we continued to hire in key areas in order to capitalize on market opportunities. FTEs increased more than 7% year-over-year. In summary we posted another strong quarter and believe we are well positioned for the future. Historically our business has not been materially impacted by major economic downturns and to date we have not seen any significant on our firm’s performance as a result of the current challenges some of our clients face.

However that doesn’t mean that we aren’t mindful of today’s overall economic environment and will continue to focus on delivering value to our clients. I will now turn the call over to Rich for a detailed discussion of our financial results.

Richard Schlenker, Jr.

As Mike discussed we were pleased with our third quarter results posting double digit revenue growth, improved utilization, higher operating margins and strong cash flow. For the third quarter of 2008 total revenues increased 20% to $58.7 million, revenue before reimbursements or net revenues as I will refer to them from here on increased 15% over the prior year to $51.8 million.

Net income for the third quarter of 2008 increased 18% to $5.9 million or $0.38 per diluted share as compared to $5 million or $0.31 per diluted share for the same period in 2007. For the third quarter of 2008 EBITDAS increased 21% to $12.4 million as compared to $10.3 million in the prior year. Our average full time equivalent employees in the third quarter were 629 an increase of 7.4% versus the third quarter of last year.

For the fourth quarter we anticipate a 3% to 4% sequential growth in FTEs as a result of a number of new hires starting in late September and early October and a good pipeline of exceptional candidates. Utilization for the third quarter improved to 68.6% from 67% in the same period of 2007. In the fourth quarter we expect utilization to be in the low 60s which is seasonally our slowest as a result of holidays and we also anticipate it will be impacted by an additional 14th week which includes New Years and the integration of our new staff.

Turning back to the third quarter defense technology developments net revenues from product sales were $2.1 million which contributed to our strong performance. For the fourth quarter we anticipate product sales of $1.3 million and as a reminder in the fourth quarter of 2007 we had significant product sales for which we realized $3.3 million in net revenues. We are pleased with the operating leverage we were able to achieve during the quarter.

Operating margins for the third quarter improved to 18.7% of net revenues from 16.6% last year. In the third quarter of 2008 our margins benefited from overall improvement in the operating model. Operating margins also benefited from a $520,000 swing in deferred compensation expense which was offset by a $520,000 loss taken against miscellaneous income.

For the quarter compensation expense increased 13.1% year over to year to $33.1 million or 64% of net revenues versus 65.2% in the same period last year. This included the growth in FTEs, the impact of annual raises and the bonus accrual. As a component of compensation stock-based compensation expense for the third quarter was $1.7 million up from $1.4 million reported last year. We reiterate our expectations that stock-based compensation will be between $7.5 million and $8 million for 2008.

Other operating expenses increased 2.5% to $5.6 million or 10.9% of net revenues as compared to 12.2% in the same period last year. As a component of other operating expenses depreciation and amortization in the third quarter was $1.1 million. G&A expense for the third quarter increased 23.9% to $3.3 million or 6.5% of net revenues as compared to 6% in the same period of 2007. This increase is a result of an unusually low expense level in the third quarter of last year.

Reimbursable expenses for the third quarter increased to $7 million as compared to $4 million last year. Reimbursable expenses were up significantly this quarter with a substantial increase in revenue from our defense technology development practice. Our tax rate for the third quarter of 2008 was 40.8% as compared to 39.3% in the same quarter of 2007. For the full year we expect our tax rate to be 40.1%.

Turning to our balance sheet we closed the quarter with cash and short term investments of $52.1 million after repurchasing $12.2 million worth of common stock during the quarter. At the close of the third quarter we still had $23 million authorized for future repurchases. Over the first nine months of the year we generated $15.7 million in cash from operations and used $28.2 million for repurchase activities. The fourth quarter is usually our strongest from a cash flow standpoint. Capital expenditures for the third quarter were $1.6 million and DSOs were 99 days.

In summary we are pleased to report strong financial results for the third quarter. Although the fourth of quarter of 2007 is a difficult comparison because of the exceptional product sales we had last year we are optimistic about delivering full year results of low double digit revenue growth and approximately 50 basis point improvement in operating margin. We are well on our way with year-to-date results of 14% growth in revenues, 20% growth in net income and 23% growth in earnings per share. We look forward to reporting to you again in January.

Now I will turn the call back to Mike for concluding remarks.

Michael R. Gaulke

As we enter the fourth quarter we remain optimistic about the future strength of our business. Looking forward we will continue to pursue new opportunities in our strategic growth areas including health science consulting, product design consulting and energy consulting, remain well positioned to capture future growth opportunities and follow on contracts in defense technology development, focus on solid revenue growth and profitability and finally generate additional cash from operations, maintain a strong balance sheet and continue to buy back stock through our share repurchase program to enhance shareholder value. We look forward to reporting more success to you in coming quarters.

Now I will turn the call over to our Operator for your questions.

Question-And-Answer Session

Operator

We’ll now begin the question-and-answer session. (Operator Instructions) Our first question comes from Tobey Sumner – SunTrust Robinson Humphrey.

Tobey Sumner – SunTrust Robinson Humphrey

I had a question for you about FTEs, it sounds like you’ve got a decent amount of potential hires in the pipeline and recent hires that will roll into the business for the fourth quarter result with 3% to 4% sequential growth. Is the hiring environment improving for you or has that always been your plan to see this ramp in the fourth quarter?

Michael R. Gaulke

That’s multiple questions there, Tobey. Let me just comment on the environment overall, the hiring environment for us is one that is good at this point. It is slightly less competitive than it has been over the last few years, but the major difference in terms of our success this year in terms of recruiting has been the focus that we have put on it.

We’ve invested additional internal resources in terms of full time recruiters on staff. We have overhauled our college recruiting program and have a lot of focus on finding the bright new talent coming out of PhD programs in some of the leading institutions in the country and that’s reflected in the results that we’re reporting today.

So it is a program that we pay a lot of attention to. With respect to the fourth quarter there typically is not an abnormal group of hires that come in in our fourth quarter. They’re generally spread out over the year, so that’s perhaps just a slight anomaly going into our fourth quarter here.

Tobey Sumner – SunTrust Robinson Humphrey

Then I had a question about your product sales and the culvert denial system. How would you expect that to ramp over the following quarters? I guess you have a slightly larger than $2 million contract to start off with, about a third of that hitting the fourth quarter. Could you give us a little bit more color there?

Richard Schlenker, Jr.

At this point in time the client has not set a schedule for that implementation. What they’ve tried to do is give themselves the flexibility here into the future. What they want to do is get this first order out there into the field, get them implemented and let the demand from theater drive the schedule that they want to come forward with.

If it falls in line with what we saw on other programs, both our IDIQ on robots and [Artist] Systems tends to be that we get these out there, we’ve had success where the clients like the product and the [inaudible] orders have followed in suit in the following couple of quarters. I would view that the rest of this would be spread out, if they order it all even, over the next following three quarters.

Tobey Sumner – SunTrust Robinson Humphrey

Rich, is this product sale in addition to other product sales or this what you would expect in total product sales in the fourth quarter?

Richard Schlenker, Jr.

In fourth quarter I would view that this will contribute probably about 60% of the product sales. We expect to have about $1.3 million in net revenues from it. This will produce about maybe $750,000 of that. The others will be made up of some remaining Artist Systems, some camera systems that we’ve been working on called drop cams. Those are what are making up the remainder of the mix.

Tobey Sumner – SunTrust Robinson Humphrey

I’ll ask one other question about the hiring patterns and I’ll get back in the queue. You did highlight in your closing remarks continued emphasis on health product design and energy. Is it a fair assumption that your hiring in the third and fourth quarter are reflective of those strategies?

Michael R. Gaulke

In general, yes. We’re certainly making hires in those areas, Tobey, but it’s not exclusively in those areas. We have experienced growth in all of our practices this year and look to next year as well. We have hiring plans across the board.

Operator

Our next question comes from Joe Alkire – William Blair & Company.

Joe Alkire – William Blair & Company

First question relates to the technology development business. You mentioned $2.1 million of product sales in this segment during the third quarter. What were the consulting fees?

Richard Schlenker, Jr.

There were around $2.1 million of additional consulting net revenues out of that practice so that we had a total of $4.18 million in total tech dev net revenues.

Joe Alkire – William Blair & Company

Next question, regarding clients in the automotive industry, can you remind what percentage of your revenue is generated from that sector and whether you’ve seen demand weaken from those clients over the past few months?

Richard Schlenker, Jr.

Our exposure to the overall transportation industry as a whole tends to run in the middle teens as a total of our revenues. That revenue is made up of a broad set of work that we do for that industry. It includes everything from litigation work around products liability both for our vehicle practice, biomechanics practice and statistical sciences. It includes litigation matters related to friction products, asbestos litigation as it’s referred. We also do environmental work in that area. So it’s very broad based across many of our practices for which we do that work.

As far as to date, on a year-to-date basis I would say that we have not seen a decline in our revenues from that industry and we had a number of active engagements with them in the third quarter. It is fair to say that especially from the Big Three over the last several years they have been very cost conscious and really focused on only spending where they have to.

What impact additional cuts end up coming down the line, we’re just going to have to see. I think at this point in time we are only doing work for them where they absolutely need it. When they’re in a litigation matter or they’ve got an issue going with a potential product recall and they need some engineering or scientific help from an outside expert, they bring us in. We are not doing a lot of development work for them on their new products.

Joe Alkire – William Blair & Company

Similarly in the environment how has demand generally held up as it relates to product design work outside of that sector?

Michael R. Gaulke

Outside of the vehicle arena, actually our product design consulting has been an area of growth for us. We have not experienced an impact yet as a result of the overall general economic conditions and in fact in a few cases it has been just the opposite. We have one major client that about six months ago in a biotechnology area had a hiring freeze that has increased our work flow as a result of that hiring freeze internally as more of their work has been outsourced. It’s in fact created an opportunity for us to be doing more work in this product design area.

Operator

Our next question comes from Joseph Foresi – Janey Montgomery Scott, LLC.

Joseph Foresi – Janey Montgomery Scott, LLC

Just to take sort of a different approach to any exposure you may have to what’s going on in the economy, are there any engagements that you currently look at that you may think might provide some exposure? Would it be fair to say the automobile industry would be one that would be an area of concern if there was, even though you’re not seeing anything right now?

Michael R. Gaulke

Let’s go back and look at our business overall to try to dissect that question. Overall about 65% of our revenues come out of providing expert witness work in support of products liability where we serve as the experts. That business it’s hard to identify that there are economic impacts that would cause it to be significantly altered, at least we haven’t seen it in the past.

The remaining parts of our business, about 10% in the government arena and the largest part of that being defense and that really goes to on its own economic cycle and very much disassociated with general economic conditions. So the remainder that being 25% of our business is this more proactive product design consulting. That is a larger piece of our business and we’ve historically gone through economic ups and downs with before and we don’t have as much experience as we do in the base business, if you will, as to what it’s sensitivity may be to changes in the environment.

To date all I can tell you is that we have not seen a downturn in that business and as I just gave you an anecdotal story of how it, in one significant case, has led to increased business for us. Our business in consumer electronics in particular has continued to be good as we’ve worked on problems associated with new products and portable power systems with the ion batteries, that business is up very strong for us this year versus a year ago.

We’ll obviously be a lot smarter, Joseph, six months to a year from now in terms of looking back and answering your question, but based on what we’ve experienced to date and what we see, right at the moment we don’t see a major impact there.

Joseph Foresi – Janey Montgomery Scott, LLC

Real quickly without belaboring it, as far as discretionary work that you have coming in excluding of course the government which tends to be a bit lumpy, any discretionary projects that are particularly large that might be coming to an end or may need some re-upping at some point?

Richard Schlenker, Jr.

We don’t have one significant project that is on the discretionary side. I have heard nothing really of clients asking for us to stop work temporarily while they reevaluate their spending on any of these. We tend to be getting hired by clients even on the proactive side where they’ve got let’s say high exposure, they need something today.

They’re coming to us because they have an FDA filing and they need to get an [EPPE] study. They’re coming to us because they have got a product on the line and they’ve got a niche issue with their consumer electronics and they need it solved today. They need to complete their regulatory filing in Europe or on their chemicals.

The clock is ticking related to those things. They don’t typically tend to be that discretionary unless they can find the internal resources to help them solve the problem. That would be our primary competitor in the long term there.

Joseph Foresi – Janey Montgomery Scott, LLC

On the utilization side, obviously it comes down to the fourth quarter. If you could just give us a little color on what you think the impact will be and how maybe we should look at the operating margin side.

Richard Schlenker, Jr.

I view that utilization as I spoke about earlier will be around 60% for the fourth quarter. I think that that is unusually impacted by the fact that it’s a 53-week year for us which puts an extra week into the fourth quarter. You would normally think about that as an up, but for us the way all the holidays lay out, we end bringing the New Year’s Day into that week which creates other vacations around it. So we anticipate that that week we will get maybe two productive days out of it and other days will be used for holiday and vacation.

That is having a couple of percentage point impact on the utilization. In addition to that we tend to find that it trends down by probably a good four or five percentage points just related to moving into the fourth quarter and we are integrating a pretty strong growth here in FTEs. I think those people will come in and get reasonably productive but they’re not going to be above average in their productivity during that period of time.

It will have some draw down on it. Overall last year the fourth quarter on a net revenue basis evaluating operating income margins we benefited a little over 400 basis points from the product sales that we had in that quarter. An apples-to-apples comparison of the two quarters from a year ago is really just not fair.

That’s why we are anticipating that with the operating margins probably being about 400 basis points less this year in the fourth quarter that will result in overall margins being up approximately 50 basis points for the full year.

Joseph Foresi – Janey Montgomery Scott, LLC

Lastly, if I could just sneak one more in, maybe you could give us, I know it’s still early but maybe you can give us just some idea of where you see the products business heading into next year? I know you’ve given some rough color on the quarters, but do you see anything in particular heading into next year?

Richard Schlenker, Jr.

From a product side, I think we continue to not have a lot of visibility into that area. We’ve talked before that we view product sales maybe on an ongoing basis $500,000, maybe in some quarters upward to $1 million in net revenues from product sales. For us product sales are really a result of our consulting business in the sense that it turns into a product for which the client wants a small lot production.

It really depends on what type of consulting projects and issues we’re solving for the Army at this point in time. We do have a number of consulting projects that could result in us doing further product sales as we go into ’09 but they just as easily might end up resulting in our recommendation being that they’re better off going out to a third party for mass production.

We still remain conservative as far as where product sales can be in the future because that’s not really the core of our business and it’s just not, at this point, something that we can predict.

Operator

Our next question comes from Brian Horrey – Arelian Partners.

Brian Horrey – Arelian Partners

I had a bit of a bigger picture question. I’m wondering if you can talk about the extent to which regulation drives demand for your business?

Michael R. Gaulke

Let me say that it certainly does. I can’t quantify to what degree it does. If you just reflect upon the nature of what we do for clients here, certainly a portion of the products liability work is a result of laws on the books relative to performance of products. In the case of the health side of our business, the work that we’re doing right now in Europe in support of clients who are having to comply with these new EU regulations relative to REACH, that’s all in that sense of regulation driven.

In the environmental side of our business, again very much the work that we do is generally all around compliance with environmental laws that are on the books that have been passed and from that standpoint is regulatory driven in the sense of what is at the root of ultimate leading to business. It’s an important driver for us.

Brian Horrey – Arelian Partners

If we think about the business environment for you all next year, if we believe the polls it looks like we’re going to have a Democratic Administration and a more Democratic Congress. Do you think that’s a bullish set of circumstances from a regulatory standpoint and potentially a driver of demand for your business?

Michael R. Gaulke

I can only tell you that we’ve been through several changes of Administrations, from one party to the other over our history and I think it’s hard to point to where a change in Administration has had a strong driver one way or the other on our business. Even though if we went to a change in Administration here that might be more proactive in environmental legislation, greenhouse gases, carbon emissions and the like, that potentially be good for business because that will be new regulations, if you will. But I don’t see the converse where a change in Administration would in any sense cause a lessening of activity for us in 2009 or going forward.

Operator

We do have a follow up question from Tobey Sumner – SunTrust Robinson Humphrey.

Tobey Sumner – SunTrust Robinson Humphrey

Are you seeing any changes in customer behavior in terms of vendor consolidation or an increasing desire on your customer’s part to find solution providers that can provide one-stop shopping as your multi-disciplinary platform could provide?

Michael R. Gaulke

To give you a succinct answer, no. I don’t think there’s a discernible trend there. Where we are best positioned in the marketplace is in the area of more complex problems where the ability to bring together multi-disciplines needed for the solutions is more unique to our firm. That has always been a competitive advantage that we’ve enjoyed in the marketplace and there continue to be, I guess fortunately for us, complex problems out there.

But I wouldn’t necessarily describe it that there is a move on the part of our clients to necessarily look for vendors that can provide only turnkey solutions.

Operator

This concludes the Exponent third quarter 2008 earnings conference call.

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