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Exponent (NASDAQ:EXPO)

Q2 2013 Earnings Call

July 23, 2013 4:30 pm ET

Executives

Erica Abrams - Co-Founder and Managing Director

Paul R. Johnston - Chief Executive Officer, President and Director

Richard L. Schlenker - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

Analysts

Timothy McHugh - William Blair & Company L.L.C., Research Division

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

David Gold - Sidoti & Company, LLC

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Exponent's Second Quarter Fiscal 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, July 23, 2013.

I would now like to turn the conference over to Erica Abrams with The Blueshirt Group. Please go ahead.

Erica Abrams

Thank you. Good afternoon, ladies and gentlemen, and thank you for joining us on today's conference call to discuss Exponent's second quarter 2013 results. Please note that this call is being 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 expressly prohibited without Exponent's prior written consent.

Joining me on the call are Paul Johnston, President and Chief Executive Officer; and Rich Schlenker, Executive Vice President and Chief Financial Officer 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 June quarter of 2013.

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 would like to turn the call over to Paul Johnston, President and Chief Executive Officer of Exponent. Paul, please go ahead.

Paul R. Johnston

Thank you for joining us today for our discussion of Exponent's second quarter of fiscal year 2013 results. We are pleased to report revenue, utilization and EBITDA performance that were better than expected.

Net revenues increased 5% to $71.9 million. Total revenues were $75.5 million. Net income in the second quarter was $10.8 million or $0.77 per diluted share. Our EBITDA was $19.5 million.

During the quarter, we had notable performances in our mechanical, electrical, thermal sciences, human factors and chemical regulation and food safety practices, as well as our infrastructure group.

Our revenues before reimbursements during the second quarter of 2013 included $1.75 million related to services performed for a foreign client in prior periods, which was recognized upon receipt of payment.

As we discussed with you last quarter, we are experiencing the anticipated step-down in major assignments and we are feeling the impact of the sequestration and the planned reduction of forces in Afghanistan in our technology development business.

More than offsetting these headwinds, we continued to see a steady flow of reactive engagements to investigate accidents, product recalls and health and environmental exposure. Additionally, we are seeing growth in our more proactive services, including product design consulting, regulatory consulting and risk management.

Now Rich will provide a more detailed review of our second quarter financial performance.

Richard L. Schlenker

Thanks, Paul. We are pleased to have delivered another solid quarter. Revenues before reimbursements or net revenues, as I will refer to them from here on, were $71.9 million, up 5% from $68.3 million in the same period of 2012. Total revenues for the quarter were $75.5 million as compared to $74.5 million 1 year ago.

Net income for the second quarter was $10.8 million or $0.77 per share as compared to $10.3 million or $0.72 per share reported 1 year ago.

EBITDA for the second quarter was $19.5 million, an increase of 6% over $18.2 million 1 year ago. EBITDA margin on a percentage of net revenue basis was 27.1%.

Our diluted share count decreased to 14 million from 14.3 million in the same period last year as a result of our ongoing repurchase program.

In the second quarter, we recognized revenue -- I mean, we recognized $1.75 million in revenue related to a contract in our health and environmental segment for work performed primarily in the fourth quarter of 2012 and some in the first quarter of 2013. Due to concerns about collectibility, we waited to recognize revenue until we received the cash, which occurred during the second quarter. This incremental revenue contributed $1.75 million to revenues before reimbursements, $1.2 million to EBITDA, $700,000 to net income, $0.05 to EPS and 2 percentage points to utilization.

In our defense technology development business, net revenues were $3.1 million. We had no revenues from product sales in the quarter. As Paul discussed, we are continuing to feel the impact of defense budget cuts and the plan to reduce forces in Afghanistan. At this time, we do not expect any additional product sales, and as such, the comparison to the fourth quarter of 2012 will be difficult as we had $2 million of net revenues from product sales in that quarter, which also contributed significantly to margins.

Utilization in the second quarter was 75% or 73% after adjusting for the environmental project as compared to 76% in the second quarter of 2012. We expect full-year utilization to be approximately 70%, which reflects the step-down in some major assignments and seasonality during the third and fourth quarters when we have more vacations and holidays taken.

For the second quarter, billable hours were $280,000. Full-time equivalent employees were 714, which is an increase of 4% from the same period last year. We have continued to add some great talent in several of our fast-growing practices and now expect FTEs to grow 1% sequentially in the third and fourth quarters. We also realized a 2% billing rate increase year-over-year.

For the second quarter, compensation expense after adjusting for gains and losses in deferred compensation increased 4%, which is in line with our headcount growth. Included in total compensation expense is a gain in deferred compensation of $168,000. As a reminder, gains and losses in deferred compensation are offset in miscellaneous income and have no impact on the bottom line.

Stock compensation expense in the second quarter was $3 million, and we expect stock compensation for the full-year to be approximately $13 million.

Other operating expenses in the second quarter increased to $6.2 million as compared to $6 million in the same period last year. Depreciation was $1.2 million and is included in other operating expenses. We expect other operating expenses to be in the range of $6.4 million to $6.6 million in each of the third and fourth quarters.

G&A expenses in the quarter were $3.7 million as compared to $3.1 million in the same quarter 1 year ago. G&A expenses are up as we are spending more on recruiting, marketing, professional development and professional services. For the remainder of the year, we expect G&A expenses to be in the range of $3.8 million to $4.4 million per quarter.

Interest income for the quarter was $36,000. Our income tax rate in the quarter was 40.6%, up from 40.1% in the same period last year. We expect 40.8% for the full-year.

Operating cash flow for the quarter was $21.6 million. Our cash and short-term investment balance was $123 million at quarter-end.

Year-to-date, stock repurchases are $17.1 million or 328,000 shares. We still have $38.8 million authorized and available for repurchase under our current repurchase program. We also distributed $4 million to shareholders through the dividends during the first half of the year and today announced our third dividend to be distributed in September.

Capital expenditures in the quarter were $1.7 million. DSOs were 95 days.

Considering our better-than-expected performance year-to-date, we now expect growth in revenues before reimbursements for the full-year to be in the low single digits. We are also improving our 2013 outlook on EBITDA margin by 75 basis points, which means we now expect the EBITDA margin to be down by 150 to 200 basis points as compared to 2012. This guidance reflects the offsetting effects of reduced revenues from a few major assignments and a decline in defense work, with increased revenues from growth of the remaining business.

With that, I will turn the call back over to Paul for closing remarks.

Paul R. Johnston

Thank you, Rich. In summary, we are pleased with the level of activity in our underlying business in the first half of the year. While last year presents some difficult comparisons for the back half of the year, we are encouraged by the fact that we are continuing to get retained to investigate the most significant engineering and scientific issues in the news. We remain focused on building our capabilities to assist our clients with their most challenging technology, health and environmental issues.

Our top financial priorities will be generating substantial cash flow from operations, maintaining a strong balance sheet and enhancing shareholder value through stock repurchases and dividends.

I'll now turn the call over to the operator for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Tim McHugh with William Blair & Company.

Timothy McHugh - William Blair & Company L.L.C., Research Division

First, I guess, I just wanted to ask, just to get the context right, are you still seeing an expected fall-off in the large cases, or have you seen any longer tail to them head all -- continue here into Q2?

Paul R. Johnston

So, Tim, I think the way I would describe that is, at the beginning of the year, we said we expected them to drop off, and we are seeing that happening. Some step-down in the first quarter, some more step-down. We expect to sort of continue to see that this year. So I think that's sort of in keeping with the -- with kind of our viewpoint on those matters. I think that the -- we sort of expect these to sort of step down from these, what we've always described as sort of unusually large assignments for our firm back into what might be considered to be sort of normal large assignments, but not unusually major assignments, just sort of typical large projects. And we expect that to sort of continue sort of through next year, as far as we can see. So we do think these kinds of matters have long tails, and we continue to see that.

Timothy McHugh - William Blair & Company L.L.C., Research Division

I guess, but as we think about the impact for this year, have you seen the bulk of the -- now that we're kind of halfway through the year, did you see the step-down at this point in the year, or is it a gradual thing that we'll continue to see the impact, I guess, more so?

Paul R. Johnston

I mean, we have -- we definitely saw a step-down in the first quarter and we're continuing to see a step-down, and we expect that to -- step-down to continue through the year. But we expect at the end of the year and through next year we will continue to have these as what we would call large cases, but not the typical sort of -- or not the unusual major assignments.

Timothy McHugh - William Blair & Company L.L.C., Research Division

So it's a trend line down, not a step-function, is kind of what you were saying?

Paul R. Johnston

Yes, I think that's -- I mean, there has been a step-down, but I think it's sort of consistent with what we had expected for the year.

Timothy McHugh - William Blair & Company L.L.C., Research Division

And the strength you've seen in the other parts of the business, is it the more traditional smaller cases? Or have you seen anything that's starting to work its way up in terms of more larger cases that you're winning?

Paul R. Johnston

So what I would describe there is, we have seen some -- a mixture of small cases, medium cases and I would even say quite large cases by our normal standard, but not anything that would be described as the sort of more major assignments. We've talked in the past about sort of major assignments maybe being sort of 4%, 5% of revenue each, the major assignments, and whereas sort of large projects for us might be 2% or 3% in a quarter. And I think the work that's coming on varies from large cases to medium and small cases, but there isn't anything of the scope and size that the major assignments were.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Okay, but do you have...

Paul R. Johnston

But that's what we expected.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Do you have more large cases, I guess, based on that definition, I guess, than you typically would have? Or is it reverting back to the historical mix between?

Paul R. Johnston

I'd say we're reverting back to the historical mix.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Okay. And then just on the utilization comment, Rich, for the 70% for the year, does that exclude the impact of this catch-up in Q2? Because if not, I guess it feels a little hard to see you guys getting down to 70% for the year.

Richard L. Schlenker

Yes, so look, I think what -- we were, on a run rate basis, about 3 percentage points below where we were last year in the second quarter, so the 73% versus 76%. We view that in the third and fourth quarters, we'll probably have utilization that's somewhere in the 4 to 5 percentage points below where we were last year, so putting us probably in, let's call it, high 60%, 69%, 70% for the -- 68% to 70% sort of range for the third quarter and then in the mid-60s for the fourth quarter, which would be still a trend line that would put us in the sort of 70-ish range, maybe between 70% and 71%. But that's where that would come out to be.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Okay. And why would it be a bigger impact, I guess, just a slightly bigger impact than the second half of the year? What's the...

Richard L. Schlenker

Because, as Paul described, we're continuing to see a step-down in the major assignments, as well as defense work. We expect that those will be less than they were in the second quarter when we look out to the third and the fourth quarters. So that it's just and others as they continue to gradually step down a little bit.

Operator

Our next question is from the line of Joseph Foresi with Janney Montgomery Scott.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

My first question here is just on the product sales. What can we expect from that over the long term? I know that the short-term is going to be challenged because of sequestration. And then can you talk about how you've repositioned, if you have, the resources in that particular offering?

Paul R. Johnston

Yes. So first of all -- I mean, I think for the long-term with regard to product sales, our view here is -- we're a consulting company, we're not a products company. We ended up, as a result of the work we were doing in the defense area of our business, where we had sort of some particular opportunities to make some product sales that we capitalized on, but we've never felt that was sort of part of our core business. It just was an opportunity we weren't going to throw away. So is it possible that we could get product sales in the future? It's possible, but we think sort of less likely. I mean, we're in a situation where those were developed out of ideas that came out of the rapid equipment force. As we see the wind-down going in Afghanistan, along with the tightness on the defense budget, it's not clear to us that we'll get those opportunities again. So, as Rich has indicated, we certainly don't expect anything to happen in the balance of this year, but it's not -- we're not necessarily -- we're not giving a guidance for next year yet, but we're not necessarily expecting product sales to come back. So that would be kind of the first thing I would say. The second question, which had to do with how we're utilizing those resources, our defense technology development practice is one that has consistently used a lot of the other practices in the company to leverage the kind of work that they were doing, particularly in the electrical practice, for example, but also in our vehicle practice. So it's a practice that has -- when it's been operating at the higher levels, has utilized resources across the company in many different offices and a number of different practices. And so I think what's -- the first thing that sort of happens when that sort of business scales back is that the outreach into other practices is much smaller and your other practices have other work. For example, in electrical area, that's -- with the consumer electronics work and so forth, that's growing very nicely, so it kind of gets absorbed in that way.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Okay. So how would you view sort of your long-term targets as far as utilization and EBITDA margins, given the fact that this potential area that you've capitalized on in the products side won't be a part of that? I mean, should we expect that to be a slower ramp as you try and kind of increase utilization rates as we get to a more normalized level next year?

Richard L. Schlenker

Look, I think that this year's revenues will only end up having $200,000 of product sales into it. So basically, we're going to end up with the year in 2013 that won't have product sales built into the margins that are there. I think that if the year -- as we've spoken about before, we think that long-term, this firm can run up, move its utilization on a long-term basis, up towards the mid-70s. We think that will be a gradual growth from this year being approximately 70%. And then improving thereon out, we clearly have our larger practices where there's critical mass performing above that level. We think as we build out critical mass in other practices and offices, we will likewise continue to get improved utilization going on. That, along with the fact that over the years, we have continued to demonstrate that we can get leverage out of building up critical mass in our offices by leveraging our operating cost and by being a small public company, we believe there's continued leverage to be gained out of that. I think all of that will result in Exponent being able to improve, on average, its margins about 30 to 50 basis points a year over the next, call it, 3 to 5 years as we continue to gradually get leverage out of the business. And I think that's something we've been able to do for many years. There is clearly a step-back here. But, clearly, a lot of that has come from the fact that we're going to end up with about $3 million less in product sales this year. And clearly, a step-down in the utilization that I think will be a good platform for us to build off of, hopefully, going forward.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Great. And then just the last one for me. I think you talked a little bit about there being some potential large deals or large deals coming back. Maybe you could give us some color in what area those deals are taking place in? If you could just give us your view on sort of the proactive versus the reactive demand environment, that would be helpful as well.

Richard L. Schlenker

So, Joe, just to be clarified, you're talking about project work coming in?

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Yes. And I think, Paul, just in one of his prior answers to one of the questions, he talked about there being some large deals in the pipeline as it reverts back to kind of normalized progression.

Richard L. Schlenker

Yes. Yes, I think the emphasis there was actually that I think we're seeing a regular flow of projects of small, medium and large. There isn't a differentiated backdrop -- backlog from -- or pipeline than we've seen in sort of the prior years. We continue to get involved or called upon by clients to address some of these large engineering or scientific incidents on a reactive basis that occur. Those are the types of things that end up hitting the news, where there's an accident or a failure in a product or process that's occurred and there needs to be an investigation, as well as potentially future litigation and such going on. We continue to see a steady flow of that, and I think we believe that we're continuing to get contacted by clients who really want our help in these areas and want that. So I think that it doesn't matter if they're in the oil and gas area and there's an explosion or an event or they apply to medical devices or consumer electronics. We've, I think, continued to see that our brand, as the old Failure Analysis Associates that's morphed and grown into Exponent, has continued to play well and have us get those calls in the marketplace. We're continuing to see, again, a buildup of proactive business going on. The work continues to be a lot of focus around the biomedical area, as well as the consumer electronics area. We're seeing that our reputation is building in, in those marketplaces and we're getting called upon by more firms more often in those areas. Additionally, in the proactive area, we continue to see a growth in our consulting to clients as they're working through a regulatory process with their product. That could be with the Consumer Product Safety Commission, it could be with the FDA, it can be with a number of agencies, but that work has continued to grow as well. So those are some examples of what's happening. I don't think there is a sort of difference in the level of backlog or pipeline that we have. As you know, those are short-lived for us. Cases come in, they settle, they get resolved, some of them go on for years. It's hard to predict.

Operator

Our next question is from the line of Tobey Sommer with SunTrust.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Many of my questions have been answered, but you've discussed some additional marketing in investments in what seemed like kind of sales generation. Could you describe those and the extent to which it's just an increase in ongoing efforts or there's some sort of new investment?

Richard L. Schlenker

Yes. So again, I had mentioned that we -- G&A was up slightly because -- or up a little bit because of both emphasis on recruiting, professional development, professional services, as well as marketing. The marketing part, I think, is probably a little bit more the same. Clearly, as we expand into new industries and as we're doing more proactive consulting, we're finding that we need to be out at conferences, trade shows, events such as that where clients that are more on the product design, regulatory consulting, risk management side are there. So we are seeing that we need to put more effort into that, get more exposure and build our brand on the proactive consulting side.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

And then, I just wanted to ask a question about software in the expertise that you have in the consulting base now as more and more of your customers in industry verticals have that embedded, the extent to which that may be one of the areas of focus for you to add headcount.

Paul R. Johnston

Yes, that is an area of focus for us to add headcount. We have been doing that. I think that we have a concerted effort here to make sure that we can, on the reactive side, cover all of the kinds of things that can lead to sort of the failures of products not performing. And, obviously, those can be sort of overall design-type things, they can be material-type things, they can be mechanical, they can be electrical, but they can also be software, and that's an increasingly important part of our analysis for a number of different areas. There are also -- when you look at the intellectual property, the sort of the patent litigation area, there's a demand for some services in that area as well. So we are very focused on trying to build up that area. We're building it up organically. So it is brick by brick, person by person. And so, that will take some time to make a meaningful impact on the firm as a whole. But we feel pretty good about the -- some of the recent hires that we've had in that area.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

And then my last question is, are you seeing any new competitors emerge, any boutiques that are starting to assemble more of a critical mass? Or is it still the same disparate set of competitors by scientific and engineering specialty, as well as geography?

Paul R. Johnston

I think it's really a bit more of the same. We've got competitors in every practice that we're in. They're mostly smaller firms. There are some areas where there are large firms that a small portion of it competes with us. For example, in the environmental area, construction consulting area would be examples of that, some in the infrastructure. And so, there are those ones. In terms of sort of our level and our tier, we -- I think we continue to be absolutely the -- sort of the major player.

Operator

[Operator Instructions] Our next question is from the line of David Gold with Sidoti.

David Gold - Sidoti & Company, LLC

I was just hoping for a little bit more color on -- and then you spoke a little bit to Tim on the step-down. But just a little bit more color on where we are today versus the expectation at the beginning of the year. So it sounds like you've seen some of the step-down, but -- I mean, it makes sense that it's been a little bit less stable than you thought it would be -- or less quick than you thought it would be 6 months ago. So, a, curious if I'm correct on that. And then, two, given any changes, how does your thinking change on sort of the step-down over the next, let's say, 12 months?

Richard L. Schlenker

I think another way to look at it -- I mean, first of all, I think you're correct. The step-down was maybe a little slower than we had thought, and I think part of that was since we'd previously described that sort of January was slow and so forth. But I think part of the challenge in trying to sort of be precise about answering the question is that these -- the major assignments we have, there's parts of the work that are what I would call clearly related to the original events or alleged events, and -- that we were investigating at a very strong level. But I think over time, part of what happens is that you end up doing more work for those clients. And those clients -- you find other opportunities with those clients that are maybe not directly but still somewhat related to the original event. And over time, you may continue to do quite a bit of work for that client that is sort of pretty loosely related to the original assignments that you got. So in all of these cases, what we're dealing with is, I would describe it as pretty major organizations, very large corporations that have a lot of different issues. And so, as a result of that, it's sort of difficult to pin exactly what's related to what. We just think we're kind of on track to have these major assignments sort of fall into the category of typical large projects by next year.

David Gold - Sidoti & Company, LLC

Got you, got you. So I guess, it's presumably to say -- I mean, I think when we spoke about it 6 months ago, the thinking was that they could maybe half over 2013, but we'd still be up and running next year. So presumably, the thinking is still that they'd be sizable next year, it's just a question of how big sizable is, or maybe it's a little bigger than maybe you thought before?

Paul R. Johnston

Yes, I think they're going to be sizable next year. It's just a matter of whether I would put them in the classification of a sort of a large project as opposed to what we've used as a term of major assignment.

Richard L. Schlenker

Yes, I mean, I think that when we get -- where we're headed is where we thought we would be at the end of the year. There was a little bit of slowness in January. We saw some strength in February and March. We probably saw them step down to a level we expected them to be at during the second quarter, and it will continue to -- a little bit of step-down the next few quarters, and we'll sort of move on.

David Gold - Sidoti & Company, LLC

Got you. So if all of that works out, I guess, then by the end of the year, you think -- still think it would be at maybe -- if we were talking 13%, 14% of revenue last year, you think for this year, they're at a run rate of, say, 7% towards the end of the year?

Paul R. Johnston

I mean, I'm not sure I want to put a -- try to put a specific number on it. But certainly, if you were thinking that cases -- that projects that were in the 2%, 3% of revenue, what we would call typical large projects and you had 3 of those, yes, you're probably in the right ballpark.

Operator

And at this time, there are no further questions in queue. Ladies and gentlemen, that does conclude our conference for today. If you would like to listen to a replay of today's conference, please dial (303) 590-3030 or (800) 406-7325 and enter the access code 4626926. We'd like to thank you for your participation, and you may now disconnect.

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