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Kelly Services, Inc. (NASDAQ:KELYA)

Q4 2013 Earnings Call

January 30, 2014 9:00 am ET

Executives

Carl T. Camden – President, Chief Executive Officer & Director

Patricia A. Little – Chief Financial Officer & Executive Vice President

Analyst

John Healy – Northcoast Research

Analyst for Tobey Summer – SunTrust Robinson Humphrey

Welcome to Kelly Services’ fourth quarter earnings conference call. All parties will be on listen only until the question and answer portion of the presentation. Today’s call is being recorded at the request of Kelly Services. If anyone has any objection you may disconnect at this time. I would now like to turn the meeting over to your host Mr. Carl Camden, President and Chief Executive Officer.

Carl T. Camden

Welcome to Kelly Services’ 2013 Q4 and year end 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 this call. Please refer to our SEC filings for a description of the risk factors that could influence the company’s actual performance.

Turning now to Kelly’s fourth quarter and full year results, I’m pleased to report that our performance in the final quarter of 2013 exceeded our expectations. Revenue was $1.4 billion, up 1% year-over-year for the fourth quarter but down 1% for the full year. For the full year Kelly’s revenue was $5.4 billion compared to $5.5 million in 2012. Our gross profit rates for the fourth quarter was 16.7% up from 16.4% delivered last quarter and this also represents a 50 basis point improvement over the 16.2% achieved during the same period last year.

Expenses on an adjusted basis were up 6.5% year-over-year in the fourth quarter due to planned investments, and up 1% for the full year. We achieved an adjusted operating profit of roughly $10 million in the fourth quarter compared to $14 million for the same period last year and down from $21 million in the third quarter. Adjusted operating earnings totaled $57 million for the full year compared to $75 million in 2012.

Kelly’s adjusted fourth quarter earnings from continuing operations were $0.45 per share compared to adjusted earnings of $0.33 per share for the same period last year. For the full year, our adjusted earnings totaled $1.62 per share compared to $1.34 in 2012. Patricia will cover our quarterly and full year performance in more detail a bit later.

Overall, we’re pleased with our performance during the quarter and now let’s take a closer look at our Q4 performance in each of our business segments beginning with the Americas. We continued to experience softness in revenue demand in the Americas as temporary job growth is lagging in the market segments we service. Combined staffing revenue for the region was down just under 4% year-over-year for the fourth quarter consistent with the 4% decline we reported in the third quarter.

Americas’ commercial revenue was down 3% year-over-year for the fourth quarter. This is a slight improvement compared with the 4% decrease we reported in Q3. Light industrial revenue was down 3% from a year ago. This drop was primarily the result of exiting two sizeable accounts in the US. Adjusting for those accounts our light industrial revenue grew 3% year-over-year during the quarter.

Office clerical was down 10% for the quarter consistent with the 10% year-over-year reduction we reported in Q3. However, we continue to see outsized growth from our new customer wins and our Kelly educational staffing unit which reported revenue growth of more than 47% year-over-year in the quarter. This compares to growth of 35% in Q3.

Americas’ PT revenue was down 5% from the prior year consistent with the 5% decline we reported in the previous quarter. However, more than half that decline was due to the exiting of a customer and the strongest performers during the quarter within PT were our science and engineering businesses.

We had strong growth in our fees during the fourth quarter. As fee revenue grew nearly 19% year-over-year. This is up substantially from the 4% year-over-year growth we reported in Q3 and the 4% decrease we reported in the second quarter. Our PT fees were the primary driver of this improvement, up 29% compared to 17% growth last quarter and we also showed marked improvement in commercial fees which grew 10% year-over-year compared to a 7% reduction in Q3.

Americas’ gross profit rate was up 80 basis points from the previous year. This improvement was driven by fee growth in customer mix as well as lower payroll taxes and employee benefit costs. Expenses were up 8% year-over-year in the Americas. During the quarter we began to accelerate our investments in centralized operations to support our large customers and an upgrade in our technology infrastructure. These investments are designed to position Kelly to capitalize on the growth opportunities available in the PT specialties and vertical markets we serve. Americas achieved earnings of $26 million for the fourth quarter and while this is a decrease from the previous year, our performance was solid and in line with our expectations.

Let’s turn now to our operations outside the Americas beginning with EMEA. Revenue in EMEA was up more than 9% in the fourth quarter compared to last year. On a constant currency basis revenue was up by almost 7% with 8% revenue growth in our professional and technical businesses on a year-over-year basis. For the remainder of my EMEA discussion all revenue results will be discussed in constant currency.

Sales increases in EMEA are being driven by double digit increases in large international and national accounts as we accelerate our focus on targeted vertical markets. In these vertical markets life sciences continues to lead our growth for the entire region. We achieved growth of 11% in Western Europe, primarily due to our solid performance of our operations in Portugal and Switzerland. Our UK operations are also showing signs of year-over-year improvement with a 6% increase for the quarter while sales in Eastern Europe will relatively flat.

During the quarter fee revenue was flat year-over-year, a sequential improvement compared to the 7% decline in the third quarter. We’ve seen growth across our commercial segment while PT fee growth remains challenging. EMEA’s GP rate for the fourth quarter was 16.2% compared to 16.7% for the same period last year, a 50 basis point decline. The overall GP decline is attributable to margin erosion due to customer mix partially offset by the benefit of the CICE tax credit in France.

Adjusted expenses decreased by nearly 1% year-over-year. This is primarily due to ongoing reductions in headquarter costs as well as efficiency improvements in our operations through branch consolidation and large account delivery model optimization. Netting that all out, EMEA reported an adjusted profit of more than $3 million for the fourth quarter in line with our expectations and an increase of roughly $3 million compared to the same period last year. We expect that conditions across Europe will continue to improve slowly but will remain challenging for the staffing industry for the foreseeable future especially with regard to fee income.

Now let’s turn to APAC. As a reminder, we’re 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 deconsolidating. Combined revenue for the APAC region increased by nearly 8% in constant currency year-over-year. This was driven by improved staffing volumes in Singapore and New Zealand. [Inaudible] improved by nearly 10% in constant currency in the quarter compared to the prior year. Our gross profit rate for the region was 16.5%, up 60 basis points compared to the same period last year.

This improvement was primarily due to an adjustment in workers’ compensation in Australia. Expenses for the APAC region were up roughly 5% in constant currency for the quarter. That was primarily driven by the addition of recruiters in Singapore as well as increased incentive compensation costs. We concluded the quarter by achieving earnings operations of $1.3 million in APAC, an improvement of $1.2 million year-over-year.

Now let’s turn to our results for OCG, an important driver of our talent supply chain management strategy. OCG revenue was up 24% in the fourth quarter compared to last year and included double digit growth in solutions across all talent categories: business process outsourcing BPO; contingent work force outsourcing CWO; and full time talent acquisition recruitment process outsourcing RPO.

Revenue in our BPO practice hit nearly $50 million and was up 26% year-over-year. This was largely attributed to growth in the stem solutions as well as increased demand in our Kelly Connect, our outsource contact center solution. CWO revenue for the quarter increased 24% over last year and RPO revenue grew 34% year-over-year as a result of new customer wins and renewed full time hiring. Overall, OCG’s gross profit rate was 24.5% compared to 25.6% a year ago. The year-over-year decline was primarily due to business and customer mix.

Expenses were up 8% year-over-year, the result of servicing cost associated with the expansion of customer programs and new customer program implementations. We continue to see momentum in our OCG business with several new program wins in the second half of 2013 including our most recent win with Exxon Mobile. OCG had an operating profit of $6.6 million for the fourth quarter, $3.4 million higher than the same period last year. The progress we’re making in this segment is a key element in our overall strategy and we’re pleased to make the necessary investments to support the growth we’re experiencing.

Now I’ll turn the call over to Patricia who will cover our quarterly results for the entire company.

Patricia A. Little

Revenue totaled $1.4 billion, up 1% compared to the fourth quarter last year and up 3% sequentially. We have changed the way we report fee based income. Previously, we included OCG fees in the number reported. However, the growth in OCG has begun to mask the trend in staffing placement fees so starting this quarter we are no longer including OCG fees but will simply breakout staffing placement fee revenue. For the fourth quarter we’ve also adjusted the fee percentage change for the deconsolidation of our former operations in North Asia.

So worldwide adjusted staffing placement fees were up 6% year-over-year and down 4% sequentially. Our gross profit rate was 16.7%, up 50 basis points compared to the fourth quarter last year, in part due to an 80 basis point improvement in the Americas. As Carl noted, the Americas improvement was due to fee growth in customer mix as well as lower payroll taxes and employee benefit cost. On a sequential basis, our gross profit rate was up 30 basis points also due to improvements in the Americas.

During the fourth quarter we recorded restructuring charges of $300,000 primarily related to our previously announce plans in Europe. At this point we have completed our restructuring in Europe. The fourth quarter of 2012 included $1.3 million of restructuring charges and $3.1 million of impairment charges. Excluding restructuring expenses were up 7% year-over-year and 11% sequentially. The increase in both periods is due to a number of factors including higher costs due to additional headcount related to investments in OCG and centralized operations, merit increases, incentive based compensation, and an adjustment to our disability reserves.

Adjusted earnings from operations were $9.9 million compared to 2012 adjusted earnings of $14.2 million. Income tax for the fourth quarter was a benefit of $8.2 million compared to a benefit of $800,000 in 2012. US work opportunity credits provided a significant reduction to income tax expense and delivered $4.2 million of benefit in the fourth quarter 2013 compared to $1.3 million in the fourth quarter of 2012 when the credits were not generally available for new hires.

2013 also benefitted from strong returns on tax free investments in company owned life insurance policies that are used to fund those qualified retirement plans an and adjustment to deferred tax balances related to a Mexican law change. 2012 included the release of reserves related to audit closures. Our adjusted diluted earnings per share from continuing operations from the fourth quarter totaled $0.45 per share compared to $0.33 in 2012.

Looking ahead to 2014, for the full year we expect revenue to be up 5-7%. We expect the gross profit rate to be relatively flat and we expect SG&A to be up 7% to 9%. At this level of revenue growth we would normally expect SG&A to grow in the 4% to 6% range however, there are three factors impacting our expected expense growth: regulatory pressure including the impact of the implementation of The Affordable Care Act; investments to reorganize our PT staffing business; and investments to continue to build our solutions capability in OCG.

We expect that revenue will lag these investments and that our full year earnings will be down compared to 2013. Carl will elaborate on the operational investments in his concluding remarks. Over the last several years we have managed our expenses very closely. While the investments we are making are very important to the long term growth of Kelly, you can be assured that we will continue to focus on expense management in all areas.

Our 2014 annual income tax rate is expected to be in the mid 20% range including work opportunity credits. As you are probably aware, work opportunity credits expired at the end of 2013 which puts us in the same situation we were in two years ago. At this point we don’t know if or when they will be renewed. If work opportunity credits are not renewed, our tax rate is expected to be 25 percentage points higher. This also assumes that we don’t receive any benefit on our tax free investments and company owned life insurance policies.

For the first quarter, we expect revenue to be flat to up 2% on a year-over-year basis. Keep in mind that seasonally the first quarter is always the weakest for our industry. We expect our gross profit rate to go down slightly due to customer mix in EMEA and business mix in our OCG segment and we expect expenses to be up 3-5% on a year-over-year basis. As a result, we are projecting only a small contribution from our OCG segment and breakeven to a small loss for the company in the first quarter.

Turning to the balance sheet, I’ll make a few comments. Cash totaled $126 million, up significantly from $76 million at year end 2012. A portion of the increase, about $20 million was due to payments we received very late in our physical 2013. Most of which were paid to suppliers in the first few days of fiscal 2014. Accounts receivable totaled $1 billion an increased $9 million compared to year end 2012.

For the quarter, our global DSO was 52 days, down one day compared to last year. Accounts payable and accrued payroll and related taxes totaled $637 million, up $77 million compared to year end 2012. As I just mentioned, about $20 million of this was related to payments we received late in the year paid out early in 2014.

At the end of the fourth quarter debt stood at $28 million, down $36 million from year end 2012. Debt to total capital was 3% down from 8% at yearend 2012. We refinanced both our revolving credit facility and our securitization facility in December to extend maturities and lower pricing. We increased the revolving credit facility from $150 million to $200 million and retained a securitization size at $150 million. In our cash flow we generated $115 million of net cash from operating activities, up from $61 million last year. Again, about $20 million was related to payments which crossed over year end and which will also impact our 2014 cash flow.

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

Carl T. Camden

Looking back on 2013 despite the improvements in the US economy, it’s clear the job creation did not accelerate as expected. In fact, it’s important to remember that we’re still behind the prerecession employment peak. Though job creation remains uncertain, it’s clear that Kelly’s strategy is positioning us for growth. Our fourth quarter and full year results confirm that we’re moving in the right direction. Our OCG segment continues to exceed expectations, consistently delivering strong revenue fee and earnings results, winning profitable new business, and expanding current relationships within our large accounts.

Our innovative talent supply chain management approach is gaining recognition and bringing in high margin business for Kelly while creating opportunities for significant growth well into the future. Our commercial business continues to be a market leader and deliver solid profitability. When it comes to professional and technical staffing frankly, we didn’t begin to make the level of investments in 2013 that were necessary to position Kelly for growth and our full year PT results reflect this delayed investment.

In 2014 management and the board have committed to making a departure from the previous scope and speed of investment in our business. We will make targeted investments this year to adjust our operating models and intensify our focus on driving aggressive growth in higher margin specialties. As Patricia mentioned, we expect our SG&A to increase approximately 7-9% over 2013 levels as we continue to support OCG growth, accelerate our centralization efforts and as we ramp up our ability to recruit specialized talent and win profitable new PT business.

Patricia commented on the expected impact of these investments on our 2014 earnings so let me provide you some additional color around the specific initiatives we are taking. We will continue to make the necessary investments to support the increase in demand for our solutions within OCG and add additional capabilities particularly in supply chain analytics. In the US, we’re introducing a centralized approach to PT recruiting for our local markets. This centralized approach will create strong communities of specialty recruiters, and a clear process for attracting, motivating, and retaining top PT talent.

These recruiting centers will be nationally focused and will support teams alongside branch based and virtual recruiters for Kelly’s IT, engineer, science and finance specialties. As our recruiting centers focus on growing our PT talent pipelines, we will also aggressively grow our PT sales pipelines in 2014 by adding local business development resources on the ground to win new business.

As we execute these growth strategies we will also continue to invest in driving efficiencies throughout our organization. We will continue to rapidly build out our centralized service delivery model for large accounts and create operational efficiencies that remove administrative burdens from client facing teams. These investments and efficiencies, specialty recruiting and sales, and our ongoing investments in OCG will result in lower year-over-year earnings particularly early in 2014.

We expect to begin to see the results of these investments through accelerating growth in sales and profits beginning late in the year and continuing on into 2015. We believe these are the right investments in our strategy to enable Kelly’s long term growth. Looking ahead, we expect steady improvement in the US economy and we believe that companies will be more confident about making stronger investments in people and capital as the outlook continues to strengthen.

Let me conclude by thanking all of the Kelly employees whose passion and commitment contributed to our success in 2013 and have laid the foundation for great things to come in the years ahead. Patricia and I will now be happy to answer your questions. The call can now be opened.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Healy – Northcoast Research.

John Healy – Northcoast Research

I wanted to hear a little bit more about the centralized PT effort. Could you give us a little more flavor for the size and maybe the number of locations you’re planning on opening, when those doors might be opened, how you plan on staffing it, and just a little bit more operational flavor for it?

Carl T. Camden

We’re still in the process of putting together the exact sizing information. But again, if you look at centralized recruiting hubs that have been successful for us in the commercial space, we’re looking for that same type of effort in the PT space on the joining together of our virtual recruiters with our field based recruiters into virtual hubs as well as actual hubs on the ground. I’m not certain yet exactly how many branches are going to end up being affected. This is all in the process of being sorted out and delivered now.

John Healy – Northcoast Research

Do you know how many hubs that you’ll actually establish for the centralized effort?

Carl T. Camden

Four.

John Healy – Northcoast Research

Kind of along the same lines, it seems like the investments that you’re making, your taking that leap, and I would expect though that with that going on as well as some of the momentum you’ve had on the OCG and some of the investments you’ve made there I was kind of surprised that you view gross margins to be kind of flat for 2014. Is there a level of caution in there or is there something kind of in the background? Competition kind of heating up on the more traditional staffing business? I was hoping to understand a little bit more why gross margins wouldn’t show some progress in ’14 relative to ’13?

Carl T. Camden

I’d say a couple of issues are unfolding. One, you’ve seen us talk about mix as we’ve been playing out which is large customers have been more responsive to what we’ve been offering and to the centralized services and as we mixed out saw a couple of segments where we had lower GDP reported as a result of that change in customer mix and I think that’s one big factor. Also, on certainty around how much fee, what’s going to be the mix between firm placement and temp placement, perm fees [inaudible], nice pops here and there in margins for us. Will that continue into next year? Will company often, as they do, retreat back a bit after they’ve had a first perm hiring to bring in more temporary employees? We’re not certain.

Patricia A. Little

I’ll also remind you something you and I have talked about before which is within OCG the different segments of the business have very different margins and so you can see that this particular quarter for example, as our PPO and BPO business increased they have wages in the denominator of that equation. So we like all that business, it’s just the accounting treatment is so very different between the segments it tends to influence our results. Actually OCG continues to be a bigger part of the equation.

John Healy – Northcoast Research

Then I just wanted to make sure I heard you right Patricia, you said that the tax rate, assuming [inaudible] isn’t brought back in, is 25 percentage points higher than that mid 20s goal for the year so that would cut it close to 50%? I always thought it was a bit closer to 40%, I was just trying to understand that.

Patricia A. Little

Structurally given our tax profile internationally, yeah it could be that high. Ever year we’ve done a little bit better than I always expect so I’m not a good tax predictor, I’ll certainly give you that. You’ve also seen our results overly influenced – I wouldn’t say overly influenced but highly influenced the last couple of years, as have most companies by high stock market gains in our company owned life insurance policies and of course I just couldn’t begin to tell you where that might go this year. So that’s part of what would drive a higher rate.

Operator

Your next question comes from Analyst for Tobey Summer – SunTrust Robinson Humphrey.

Analyst for Tobey Summer – SunTrust Robinson Humphrey

I’d like to dig into the OCG growth a little bit. Can you give us maybe even a ranking of where that growth is coming from in terms of either new work, market share gains, or increased use of the work at existing customers?

Carl T. Camden

It’s pretty balanced. I would say, if you were running a 50/50 model you’d be pretty close to what the actual numbers would be. We have a lot of programs that take anywhere often from a year to two years to implement and so you have a constant strain from your accounts of additional implementations. Then we’ve talked about significant new wins in the second half of this year that we think will continue the fee growth next year. So, at the moment I’m happy with the balanced approach, it’s growing the accounts we have which is always a really nice thing to see as well as an adoption of the talent supply chain model by new customers.

Analyst for Tobey Summer – SunTrust Robinson Humphrey

In terms of the additional investments in PT, the pace of that has seen a little bit of a change here or it seems to be changing, what are you seeing out there that gives you the confidence to increase that pace of investment relative to the commercial side?

Carl T. Camden

I think this is probably the first earnings call you would have heard us use the word so we have some confidence in a sustained growth in employment inside the United States. So we’ve got more confidence that we’re going to see not necessarily rock and roll employment growth but a nice steady growth and that has been overweighed in a lot of skill sets that fall within our technical professional space and as we talk with customers we expect an increase in demand for engineering, IT, science professionals so everything from general economic trends to specific customer conversations.

Analyst for Tobey Summer – SunTrust Robinson Humphrey

Then outside the US especially, in EMEA, can you talk about what you’re seeing in commercial versus PT there?

Carl T. Camden

I would never use, and I always remind every one of this, Kelly as an indicator of what is taking place in Europe. We have specialty businesses, we’re not sized in a lot of the countries. For us, we’re placing a particular emphasis on professional and technical as we are everywhere but that will be the results indicative of Kelly’s success or non-success of what we do not necessarily general growth in the market.

Operator

(Operator Instructions) Mr. Camden there are no additional questions coming in.

Carl T. Camden

Thank you all for joining our call. I look forward to further conversations.

Operator

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

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