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Kelly Services, Inc. (NASDAQ:KELYA)

Q2 2013 Earnings Call

August 7, 2013, 9:00 AM ET

Executives

Carl Camden - President and Chief Executive Officer

Patricia Little - Executive Vice President and Chief Financial Officer

Analysts

Tobey Sommer - SunTrust

Ty Govatos - TG Research

Josh Vogel - Sidoti & Company

Operator

Ladies and gentlemen, good morning and welcome to Kelly Services second quarter earnings conference call. (Operator Instructions) I would now like to turn the meeting over to your host, Mr. Carl Camden, President and CEO. Sir, you may begin.

Carl Camden

Good morning, everyone. Welcome to Kelly Services 2013 Q2 conference call. And with me on the call today is Patricia Little, our CFO.

Let me remind you that any comments made during this call, including the Q&A, may include forward-looking statements about our expectations for future performance. Actual results could differ materially from those suggested by our comments and we have no obligation to update the statements made on the call. Please refer to our SEC filings for a description of the risk factors that could influence the company's actual future performance.

Turning now to Kelly's second quarter results. I'm pleased to report that our performance was in line with our expectations in this persistently sluggish economic environment. Revenue was flat year-over-year, excluding restructuring and impairment charges, we held our expenses flat amidst making targeted investments in our long-term growth, and we achieved in adjusted operating profit of $19 million.

Our gross profit rate for the quarter was 16.1%, down from the 16.3% reported in the second quarter of 2012. Kelly's adjusted second quarter earnings from continuing operations were $0.33 per share compared to adjusted earnings of $0.34 per share for the same period last year.

Now, let's take a closer look at our second quarter performance in each of our business segments beginning with the Americas. We continue to experience soft revenue demand in the Americas, as customers remain cautious about the economic environment. Combined staffing revenue for the region was down roughly 2% year-over-year for the second quarter, a slight improvement from the 3% year-over-year decline in the first quarter.

Americas commercial revenue was down 3% year-over-year for the second quarter. This compares to the 5% decrease we reported in Q1. Light industrial was once again flat compared to the same period last year, while office clerical was down 8%. And we're continuing to see gains in Kelly Educational staffing, where new customer wins help drive revenue growth of 15% year-over-year in the quarter.

Americas PT revenue was down 1% from the prior year compared to the flat growth we reported in the previous quarter. We continue to see some softness in the higher (NYSE:NPT) market, stemming from many of our customers delaying new project implementations.

With (NPT) we saw revenue declines in our science, IT and finance businesses, somewhat offset by strong growth in engineering and healthcare. We also saw a softening in demand in fees, combined temp to perm, direct placement and other fees saw a 4% revenue decline during the quarter, down from the 13% year-over-year increase we reported in the first quarter.

Americas gross profit rate was once again 10 basis points higher than the same period last year. Expenses in the Americas were up 5% year-over-year. This increase was expected as we continue to make planned investments on professional and technical and centralized operation staff to support our large customers and in our technology infrastructure.

As we stated last quarter, these targeted investments will continue throughout 2013, and that there may be a drag on the region's earnings in the short term, we fully expect these investments to deliver a positive long-term impact. All told, Americas achieved earnings were $32 million for the second quarter, while this is a decrease from the previous year. Our performance was solid and in line with our expectations, given both our investment strategy and the lower volume that we're experiencing.

Let's now turn to our operations outside the Americas, beginning with EMEA. Revenue in EMEA was up 3% in the second quarter compared to last year on both reported and constant currency basis, a nice improvement over the 4% year-over-year decline we saw in the first quarter. For the remainder of my EMEA discussion all revenue results will be discussed in constant currency.

Economic and business conditions continue to be difficult across EMEA with the exception of Eastern Europe. For Kelly specifically, revenue in Easter Europe was up 16% year-over-year, due primarily to the strong performance of Russia and Hungary. The performance of our operations in Switzerland and Portugal fueled growth of 2% in Western Europe year-over-year, while the Nordics experienced a decline of 6%.

During the quarter we also saw a decrease in our fees across this region. Fee revenue for the second quarter was down 15% year-over-year. The decrease can be seen across both our commercial and PT segments.

EMEA's GP rate for the quarter was 16.9% compared to 17.6% for the same period last year. The benefit of the CICE tax credit in France was worth about 50 basis points. You may recall, the intent of the CICE is to improve business competitiveness by reducing the cost of labor. Aside from this particular benefit, the overall GP decline in EMEA is attributable to continued margin erosion in the commercial segment due to customer mix as well as the decline in perm fees.

Our corporate accounts have increased 9% in revenue over last year with the decrease in temp GP of 60 basis points. Similarly revenue from our retail customers is improving slightly, but also at a lower temp GP rate.

Adjusted expenses decreased by 5% year-over-year. This reduction was primarily due to staff reductions and commercial branch consolidations, bringing expenses more in line with the level of activity.

Netting everything out, EMEA reported a profit of $4.4 million for the second quarter, an increase of $1.2 million compared to the same period last year, excluding restructuring. We're pleased with our ability to remain profitable in such a difficult market and we expect conditions across Europe to remain challenging for the staffing industry for the foreseeable future.

Next, we turn to APAC. As we reported on our last quarterly call, we are no longer consolidating our former subsidiaries in China, South Korea and Hong Kong. As such, year-over-year percentage changes are adjusted to exclude the impact of deconsolidated. Combined revenue for the APAC region increased by 4% in constant currency year-over-year. This is primarily driven by improved staffing volumes in Australia and Singapore.

For the remainder of my APAC discussion, all revenue results will be discussed in constant currency. These remain flat to prior year due to soft demand across the region. Our gross profit rate for the region was 16.6%, down 20 basis points compared to last year, but up 30 basis points compared to the prior quarter and this was primarily due to changes in business mix in Australia and New Zealand.

Expenses were down 9% in constant currency for the quarter. This was primarily driven by a combined 17% reduction in headcount in Australia and New Zealand as we consolidated our operations there. We also realized the 23% reductions in all other headquarter expenses across the region during the quarter, and we continue to keep a careful eye on expenses in the APAC region. We concluded the quarter by improving reported earnings in APAC by $2 million year-over-year.

Now, we'll turn to our results for OCG, an important segment that continues to be a driver of our growth. OCG revenue was up 20% in the second quarter compared to last year. Growth within OCG continues to be driven by two core elements of our talent supply chain management strategy, business process outsourcing and contingent workforce outsourcing.

Revenue in our business process outsourcing practice at $40 million and was up 32% year-over-year. This was primarily due to an increase in our traditional BPO solutions within the Americas as well as increased demand in our KellyConnect contact center solution. Total OCG fee revenue was $16 million for the quarter and was up 25% year-over-year in our contingent workforce outsourcing practice. We're pleased that we continue to experience double-digit growth in both our BPO and CWO practices year-over-year.

Overall OCG's gross profit rate was 23.3% compared to 25.9% a year ago. This decline was primarily due to the cost of services incurred to ramp up a large program ahead of the revenue stream as well as business and customer mix.

Expenses with our restructuring and impairment cost were up roughly $3 million or 12% year-over-year. This increase is the result of servicing cost associated with the expansion of customer programs and new customer program implementations. But all in all, we are realizing significant operating leverage.

At the time of our first quarter earnings call, we anticipated a small loss in OCG for the second quarter. That said we're pleased that excluding restructuring and impairment cost, OCG was breakeven for the quarter compared to the same period a year ago.

During the second quarter we made the strategic decision to exit the executive search business in Germany. In connection, with this decision, we recognized $1.7 million of asset impairment and $800,000 of restructuring cost. We continue to be pleased with the strategic progress we're making for this important segment.

And now, I'll turn the call over to Patricia, who will cover our quarterly results for the entire company.

Patricia Little

Thank you, Carl. Revenue totaled $1.4 billion, flat compared to the second quarter last year and up 4% sequentially. Worldwide, our fees were down 2% year-over-year and up 4% sequentially.

Our gross profit rate was 16.1%, down 20 basis points compared to the second quarter of last year. On a sequential basis, our gross profit rate was down 40 basis points, primarily due to the OCG cost of services in advance of revenue.

During the second quarter we recorded restructuring charges of $810,000 and impairment charges of $1.7 million as a result of our decision to exit our executive placement business in Germany. Excluding restructuring and impairment charges, expenses were flat year-over-year.

As I noted last quarter, we recorded a $3 million charge in the first quarter due to an unclaimed property settlement. Absence this charge, expenses were down 2% sequentially and as a result of our continued efforts in controlling expenses, we were able to offset the investments we have been making in PT, centralization and technology. Excluding the restructuring and impairment charges, earnings from operations were $18.9 million compared to 2012 adjusted earnings of $21.6 million.

Income tax expense for the second quarter was $4.8 million compared to an expense of $8.3 million in 2012. Our tax rate was 32% for the quarter, 28% excluding restructuring and impairment charges, which were not cash deductible. That compares to a rate of 39% last year, when work opportunity credits were not available for most new hires.

Diluted earnings per share from continuing operations, excluding restructuring and impairment charges for the second quarter of 2013, totaled $0.33 per share compared to $0.34 in 2012. Looking ahead to the third quarter of 2013, we expect revenue to be flat-to-up 2% on a year-over-year basis, flat sequentially.

We expect continued pressure on the gross profit rate holding us flat on a sequential basis, down 70 basis points year-over-year. We expect SG&A to be up 1% to 3% both year-over-year and sequentially. We will continue to invest in our PT and OCG businesses as well as front office systems and expansion of our large customer service delivery model.

Our 2013 annual income tax rate will be around 10%, including the retroactive work opportunity credits we've recorded in the first quarter. Our tax rate is highly dependent on the mix of our business, especially the amount of U.S. lid business, which drives work opportunity credits, the geographic mix of business, earnings or losses from our deferred compensation plans and tax planning.

Turning to the balance sheet, I'll make a few comments. Cash totaled $70 million, down from $76 million at yearend 2012. Accounts receivable totaled $1 billion and increased $25 million compared to yearend 2012. For the quarter, our global DSO was 54 days, up one day compared to last year. Accounts payable and accrued payroll and related taxes totaled $567 million, up slightly compared to yearend 2012.

At the end of the second quarter, debt stood at $83 million, up $19 million from yearend. Debt-to-total capital was 10%, up from 8% at yearend. In our cash flow, we use $40 million of net cash for operating activities compared to generating $6 million last year. The change primarily reflects higher additional working capital requirements. Even with the weak revenue situation, we had a strong operational performance this quarter.

And I'll turn it back over to Carl for his concluding thoughts.

Carl Camden

Thank you, Patricia. Our second quarter results demonstrate Kelly's ongoing progress in three strategic areas that we believe are key to our long-term success. Our OCG segment continues to deliver strong revenue and fee results and the investment we're making to support key OCG clients will serve to further strengthen our talent supply chain capabilities for years to come, including developing scalable, repeatable delivery methods to drive efficiency across our solutions.

We continue to pursue higher margin professional and technical staffing solutions to meet the growing demand in the higher skilled talent space. And we believe our success from OCG will create a better awareness for Kelly's PT capabilities. And finally, we continue to keep a close eye on expenses, making strategic targeted investments that support our long-term growth, while delivering an operating profit in the face of flat revenue.

This progress confirms that Kelly's strategy is responding the secular trends in the labor force, trends that require holistic higher-end workforce solutions larger companies and highly skilled professional technical talent performance of all sizes. We're also especially pleased with the progress we've seen in our EMEA region this quarter, as they continue successfully to execute, despite the recessionary conditions there.

Still, while we're pleased with Kelly's second quarter results, we know that they reflect in economy that is far short of full recovery. The slow and uneven growth trends we saw in 2012 remain with us. And although, we have experienced modest job growth thus far in 2013, the improvement in temporary employment in the U.S., as reported by the BLS, has primarily been driven by hiring in the construction, retail and hospitality sectors, areas which we're not generally engaged in. As such, staffing revenues remain constrained and there is still significant pressure on margins and direct hire fees.

Looking ahead, we expect the current trends in the U.S. labor market will continue and true signs of momentum will remain elusive. The one year reprieve in the Affordable Care Act employers mandate is unlikely to lessen the anxiety of U.S. companies. Compliance will still be extremely complex and uncertainty over the impact to 2014's individual mandate will continue to dampen hiring.

For our part, Kelly is moving ahead with our work towards ACA compliance. We're confirming with staffing industry groups, working with vendors to develop ACA compliant plans, updating our internal IT systems and developing financial models, communication plans, and support strategies to ensure that we're prepared.

This concludes today's report. Patricia and I will now be happy to answer your questions. Operator, the call can now to be opened.

Question-and-Answer Session

Operator

(Operator Instructions) And now we'll go to Tobey Sommer with SunTrust.

Tobey Sommer - SunTrust

Carl, I had a question for you about the OCG segment and I guess, sort of, the contingent workforce outsourcing element, how do you think about the opportunity for that business and the growth there to help drive growth in the staffing businesses?

Carl Camden

You have a mixed set of customer expectations. We have some CWO practices where there is an expectation that we'll do no staffing. And we have other CWO customers where there is an expectation, we'll take all that we can acquire and do. So it's not an even answer.

In general, owning the customer strategic relationship will generally provide you better opportunities to acquire staffing revenue over the future, but I see the size of those opportunities to be an overstated by some and misunderstood by many. It's more of the relationship, the strategic relationship that you have with the customer that's important, than it is the fact that you have the particular CWO contract. I think in the long run, it's a significant advantage for the firms that have control of the customers' talent supply chain strategy.

Tobey Sommer - SunTrust

Within OCG, how much, sort of, maybe, think of it as, customer spend are you shepherding at this point?

Carl Camden

I'm looking around the table to see if that's the number, let's say, close to $5 billion.

Tobey Sommer - SunTrust

And then asking just one last question on that, then I'll, kind of, get back in the queue soon. The customer that you were, kind of, ramping for in the quarter that suppressed the profitability, we probably see better operating margins within OCG headed into 3Q?

Carl Camden

If not, I would be unhappy.

Patricia Little

Yes. But still the little piece of it is in the third quarter, but overall it will be the big impact that was in the second.

Tobey Sommer - SunTrust

My last question, I'll get back in the queue. Are you involved in executive search in other markets, now that you have exited Germany?

Carl Camden

We have executive search in several markets and particularly in the APAC region.

Operator

And next we'll next go to Ty Govatos with TG Research.

Ty Govatos - TG Research

Couple of questions. I was surprise that the SG&A was down so much sequentially, and Patricia, I tried fast, but my fingers didn't move fast enough. Could you go through some of the guidance numbers again?

Patricia Little

Yes, I will. We basically said that it would be up 1% to 3% for the third quarter, whether you do the math year-over-year or sequentially. That's inclusive of the investments that we continue to make in the areas we're investing in PT, OCG, large customers, centralization and technology.

Ty Govatos - TG Research

And gross profits?

Patricia Little

What we said about gross profits is that they will be pretty flat sequentially.

Ty Govatos - TG Research

You are referring to margins, right?

Patricia Little

I'm sorry, said it again?

Ty Govatos - TG Research

Referring to margins?

Patricia Little

Yes. Gross profit margins.

Ty Govatos - TG Research

And you think the SG&A will be up 1% to 3% sequentially?

Patricia Little

Yes.

Ty Govatos - TG Research

From the second Q?

Patricia Little

Yes. Whether you do the second Q to third quarter, or third quarter to last year, it's somewhere in that range.

Ty Govatos - TG Research

And why the dip because if I remember right, you were looking for flat sequentially Q1 to Q2 and it was down pretty sharply?

Patricia Little

Well, we really focused in the second quarter on expense control. We'll continue to do that. As I look ahead though, some of the things that we were doing in APAC, in particular, and EMEA I don't see necessarily having being able to continue with that pace, for the amount of change.

Operator

And that we do have a follow-up from Tobey Sommer.

Tobey Sommer - SunTrust

Could you walk us through now what your expectations may be, I know, it's a little bit early, but for work opportunity credits for next year. Is there certain legislation that you are already monitoring or do we need to sit tight and wait for something to develop in the legislature?

Carl Camden

My long experience with the U.S. government, the work opportunity credit is always held till the end because it's a negotiating chip that people were able to put on the table to offset something else by saying, look, how good we're being for business or look, how good we're being for employment and the only expectation I have is that nothing will be done until the last minute, because that's been my experience now for, certainly, for like a long time.

Patricia Little

Well, plus with all the discussion about corporate tax reform, I think that that will just lead to even more uncertainty and then therefore lack of actions. So I wouldn't be surprised if it was another cliffhanger or beyond.

Carl Camden

You are as good as we are. What do you expect?

Tobey Sommer - SunTrust

Well, I was hoping for a revelation here?

Patricia Little

Well, you are not getting.

Carl Camden

It's not happening.

Tobey Sommer - SunTrust

Excluding that, if for example, we don't get to a situation where we start out '14 and it's not in place, Patricia, what would be a ballpark tax rate in the absence of Work Opportunity Tax Credits?

Patricia Little

In the absence of having them at all?

Tobey Sommer - SunTrust

Yes, for example, if we started the year and we were just talking about the year without that in place, what would the tax rate look like?

Patricia Little

Upper 30.

Tobey Sommer - SunTrust

And then on DSOs up a day, is that just a customer mix or a particular timing issue. Could you give us a little bit of color as to what drove that and see, if you expect it to revert?

Patricia Little

It's an interesting thing. I'm not sure it will revert, because the biggest change that we're seeing is that our large customers are paying slower, although still within their terms. So what we see them doing is they used to be paying a little bit in advance of their terms and now they are really carefully maximizing that. I'm also surprised by the number of customers, large customers that we have that really play the end of their quarter and seem to slowdown especially at that period of time. So what's going to sit on their balance sheet as cash is not going to sit on our balance sheet as cash.

Tobey Sommer - SunTrust

And then, Carl, the investment that you're making in the branch structure to facilitate more regional and local sales. How do you feel about that at this stage and when would be a, kind of, more reasonable timeframe to be able to judge the outcome of those investments more fully?

Carl Camden

I think Toby, what we're really more focused on is the consolidation of our service delivery especially for the large accounts and to centralized hub. So you hear us talking about centralization, and we and others in the industry are slowly shifting away from, too quickly shifting away from our branch-based model of a lot of that service into a centralized model.

What you have though, are branch is left behind with more capacity than they had before, as that business has moved, as the large accounts business has moved out and that, of course, takes sometime to refill up that capacity with local business. And so it's not so much an investment in branch in a brick-and-mortar structure to drive more local business, as it is a refocusing of the branches on the local business structure. And that takes a while to play out, a year or so. It tends to be our experience.

Tobey Sommer - SunTrust

So would that be a year from now or a lesser time, because you began the initiative a while back?

Carl Camden

Yes. We began the initiative a while back, so it's less than a year for some branches, but it's still new to other branches. So the clock has just started ticking and some work is still to be done on centralizing and pulling some of that business out of the branch network.

Tobey Sommer - SunTrust

And my question, it has to do with Europe and some of the margin pressures there. Would some of those other global players in the midst of branch consolidations and, kind of, reducing their costs structures very significantly, do you see an opportunity for any stability in margins at this point or are we probably still in a compression phase in Europe for the foreseeable future?

Carl Camden

Are you talking gross margins or operating margins?

Tobey Sommer - SunTrust

Gross margins.

Carl Camden

For us, I'm not certain that we're seeing a downward trend in the margins of any particular contract. But we have been talking about a shift in mix, as the larger accounts have become a bigger proportion of our mix. So it's not that contract that used to be 22% and then it got renewed at 20%. That's not really what's taking place.

It's that the larger corporate or global accounts for us are becoming a larger proportion of our business. And then in particular, driving some of the GP rate down would be, the commentary we had about a significant reduction and the placement-oriented type of fees in terms of the conversion of workers or the direct hire of workers in Europe.

Again, Western Europe still, although, maybe stabilize and still on recessionary environment and you don't see a lot of firm hiring in that environment. So I would say the greatest downward pressure for us has been on the fee side and then secondarily on the mix, but not much towards a revision downward of pricing contracts.

Operator

And we do have a question from Josh Vogel with Sidoti & Company.

Josh Vogel - Sidoti & Company

First question, I know you have exited some markets and/or not including some revenue from certain countries in APAC, but it looks like the year-over-year and sequential trends seem a lot weaker in the PT front versus commercial. And I was wondering if you could just talk to the overall demand trends, the nature of the commercial work there and why that business seems to be outperforming relative to PT?

Carl Camden

Again, I'm not certain that it so much an outperforming. And again, like you said, we are washing out the effects of, what we're consolidating and in countries that we've exited. And I would not use Kelly at all as an indicator for what's taking place in big chunks of Asia on the PT or commercial size, given our presence.

Again for us, we are much more responsive to changes in demand from a handful of customers rising or falling than we are to general trends in the region. So I'm pretty hesitant to give you a commentary as to what I think are the macro up or down pressures on PT and commercial.

Patricia Little

And the fact that we're deconsolidating the joint venture does have a lot of impact, because that was primarily PT based. So when you look at the PT numbers in the release, those are not adjusted for that deconsolidation.

Josh Vogel - Sidoti & Company

Now with EMEA, I know France is one of your largest markets there, I know you saw a better result in Q2. And based Q2 and what you're seeing for Q3, do you think that's a beginning of the steady recovery there?

Carl Camden

No. I see nothing and wearing any of the hats that I wear arguing that Europe is now on the edge of a recovery, I would argue that'd be a downward slope in the recession. And I can make a case that things have stabilized at a lower point for both the industry and for what passes for GDP growth there. But I for sure, would not want to be, saying the recovery is coming profit. I am not certain yet what the timing of that is going to be.

Josh Vogel - Sidoti & Company

And lastly with OCG, I know it's breakeven on an adjusted basis. And there is some residual ramp costs and ongoing investments there, but should we expect that unit to be profitable in Q3 or breakeven again or running around breakeven?

Carl Camden

I have a stronger expectation that it would be profitable in Q3.

Operator

Mr. Camden, no additional questions in queue.

Carl Camden

Great. Thank you, all.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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