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Heidrick & Struggles International, Inc (NASDAQ:HSII)

Q3 2010 Earnings Call

November 02, 2010 10:00 a.m. ET

Executives

Julie Creed - VI, IR

Kevin Kelly - CEO

Scott Krenz - EVP & CFO

Analysts

Tim McHugh

Kelly Flynn

Tobey Sommer

Mark Marcon

Operator

Good day, ladies and gentlemen, and welcome to the Heidrick & Struggles' Third Quarter 2010 Conference Call. (Operator Instructions). I would now like to introduce your host for today's conference Ms. Julie Creed. Ms. Creed you may begin.

Julie Creed

Good morning, everyone, and thanks for participating in our third quarter conference call. Participating with me on the call today are Kevin Kelly, Chief Executive Officer; and, Scott Krenz, our Chief Financial Officer. As a reminder, we'll be referring to supporting slides that are available on our website at www.heidrick.com, and we encourage you to follow along or print them.

As always we advise you that this call may not be reproduced or retransmitted without our consent. Also, we will be making forward-looking statements on today's call and ask that you please refer to the Safe Harbor language contained in our news release and on Slide one of our presentation.

And now I'll turn it over to you, Kevin. Please start on slide two

Kevin Kelly

Thanks Julie. Good morning and thank you for joining today's call. Before we get into the normal review of the numbers that we are doing in these calls, I would like to give you what I think are some of the headlines. First of all, it was a strong quarter, a revenue of a 126 million exceeds our expectations and encouragingly October showed strong conformation trends.

The operating margin of 3.5% was acceptable and we have not shown these for competitive reasons which I will talk about in a second to increase our variable competition by 5 million in the quarter, operating margin also exceeds our guidance.

The second headline is a very strong performance of a very specific business where we are market leader. For the first quarter ever, Asia Pacific revenue exceeded that of Europe which leads to me to my third headline, Europe did not perform well. Revenue was down 12% quarter-over-quarter and the quarterly operating loss in this region was 1.4 million.

A large part of the relating to my fourth and final headline, turnover and consulting ranked higher than even sort of liked and it's no secret in the industry that certain of our competitors have targeted us.

We have gone a great lengths to prior tearing away tactics have included offering large signed bonus, multi-year guarantees, too many cases leaderships roles were offered. But I believe that we have to come with a strong more cohesive group consultants in our client service and our results to date have clearly demonstrated the incredible strong batch we have at Heidrick & Struggles. We've been both proactive and responsive about retention having deal with the issue in a multitude of ways.

The first and most obvious is looking at the competitiveness of our pay. We firmly believe that we are one of the most competitive consultation packages in the industry and benchmarking in our system towards that. Where we feel we are not being competitive, we've taken action and that is why added this variable component to our consultants compensation this quarter in addition to our normal bonus accrual.

We invested heavily in improving our communications with the consultants and better connecting them to our leadership advisory strategy. The first global consultants meeting in three years in our customer education programs with Harvard and Duke fall under this category as well.

We have also brought together several groups of consultants under them umbrella program we call Aspire to assure that our culture and our organization support our strategy to provide a working environment to this strategy or work force.

We have also been very active in the recruiting front and numerically we will more or less offset our losses this year. And we continue to pursue our strategy at hiring mostly experienced search consultants from boutiques.

All of our data supports this strategies being superior to hiring some other top tier firms where there is a significant upfront investment combined with a fall off in production resulting from a range in the environment so then produces a positive ROI.

However it's not just a number's game. We believe the quality of the hire supports Heidrick at the top of the executive search industry and our strategy to become a leadership advisor. We're being equally aggressive in addressing the challenges we face in Europe for operations in Europe suffered disproportionately from the consultant turnover and that has obviously been quite disruptive to the business. So as one would expect with our new recruits on the European region but there is almost always a 12 to 18 month period for new hires to hit their stride.

This is the time necessary for even an experienced service consultant to adapt to a new -- to adapt to new people, a new environment and a new way of doing things. The other major issue we faced in Europe is just more difficult to address individual performance issues. This is a result of a relatively inflexible and relatively inflexible work roles in many of the locations which we operate. For addressing this issue by focusing our leaders on the underperformers; the idea is to improve their performance through training, maturing and coaching. And we've already begun to see positive results from this effort.

Finally, we are evaluating the leadership to assure we have the right leaders in place to maximize performance in this region. And now I'll hand it over to Julie to go through some of the numbers.

Julie Creed

Thanks Kevin. Starting on slide three, net revenue in the quarter came in slightly ahead of our expectations at $126.1 million, up 21.8% compared to the last year's third quarter and the same as the second quarter. The America's and Asia Pacific had great quarters. From a practice perspective the education and social enterprise practice was up 42% year-over-year. Financial services increased 38%, global technology and services was up 22% and the industrial projects grew 21%.

As you saw on our release, net revenue from leadership consulting services increased 33% year-over-year and 20% sequentially representing 7.8% of total net revenue in the quarter. These results continue to validate our strategy to become a leadership advisory firm.

Slide four is a view of our monthly confirmation. Our signed contracts, our executive search and leadership consulting projects. Monthly confirmations in 2010 continue to track ahead of 2009 levels; up 19% year-to-date compared to 2009 and have been ahead of our forecast this year. As Kevin mentioned, October was a good month and we're very close to surpassing 2008 levels, something we've been looking forward to for a long time.

Slide five is a look at quarterly confirmation trends, specific to executive search. Third quarter search confirmations were 3% higher than last year's third quarter but were 6% lower than the second quarter. If you turn to slide six, we entered the quarter with 343 consultants, down 22 compared to September 30, 2009 and 5 sequentially compared to June 30.

During the third quarter 21 consultants left the firm but 21 consultants joined the firm. 17 of these 21 hires are experienced in search or leadership consulting and four were new to search. We have also hired eight consultants who started in October or haven't even started yet.

Looking at slide seven, productivity, which we define as annualized net revenue divided by the average number of consultants during the quarter improved to $1.5 million in the third quarter, compared to $1.1 million in last year's third quarter and $1.4 million in the second quarter.

In fact the America's and the Asia Pacific regions both achieved record levels of productivity in the quarter. Given the number of new hires we made year-to-date we're extremely pleased with these gains and yes we believe there are still room for us to improve these numbers.

On slide eight, the average revenue per search improved again. For the 12 month ended September 30, the average revenue per search was a $16,500 an improvement compared to 2Q and it was a $12,300.

Turning slide nine and ten, salaries and employee benefit expenses increased by 20.1 million or 29.5% year-over-year. This increase mostly reflects higher performance related bearable compensation which increased 17.9 million compared to last years third quarter.

The majority of these increases were result of higher bonus accruals related to high net revenue and the mix of consultants were generating that revenue but as Kevin referred to earlier that increase also reflects approximately 5 million in the quarter related to a variable component that we added to the consultants compensation in order to be more competitive in the market.

The full year impact of this compensation component is approximately 8 million, so in the fourth quarter they were extensively about 2 million.

Fixed compensation which includes fix salary and employee benefits as well as stock-based compensation expense increased 2.3 million year-over-year. And increase in the cash component of 5 million relates to our restoration of the 5% salary reduction that was in place for 2009, a 6% increase world wide head count and incentive awards issued in the second quarter.

This increase was especially offset by a year-over-year decline in stock based compensation of 2.7 million reflecting an increase in RSU forfeit shares specific to the third quarter and a reduction in RSUs granted in 2009 and 2010 compared to prior years when a portion of consultant's bonus paid in the form of RSUs.

Now turning to slide 11, general and administrative expenses increased 3.9 million or 13.6% from last years third quarter. A number of expenses that we anticipated was to drop off in the third quarter digits. For example there was a 1.3 million in professional service fees related to Project Velocity which is the process improvement project we have talked about for the last 15 months or so that was essentially completed in the third quarter.

And premise related cost and depreciation declined 1.9 million year-over-year as a result of favorable lease renewals or lease terminations. However, there were other expenses in the third quarter such as viable training and development initiatives that we reinstated.

Another year-over-year increase related to the uncapitalized cost related to Project Latitude which is our new search engine. Latitude will be able to the competitive advantage and significant productive entailment. It's a relationship manager and information research and a very much improved search to all in one very efficient application.

We'll let talk more about our expected cost savings going forward. Moving to slide 12, I'll explain the restructuring charges. Of the $920,000 reported we recorded restructuring charges of about 600,000 in the quarter related to the restructuring of our global IT services delivery model.

In September, we began outsourcing the IT infrastructure in order to further reduce our overall cost and improved operational efficiency. The other 300,000 of this charge represent additional charges related to our estimated remaining lease obligation on two previously restructured properties.

Turning to slide 13 and 14, operating income in the quarter was 3.2 million and the operating margin was 3.5%. Excluding restructuring charges the operating margin went up again 4.2%.

Now if you look at the income statement for the nine month period or slide 15, there were a number of unusual items that I thought to review again quickly.

The common first quarter that we recorded other chargers of $4.2 million. $3.2 million of the other charges related to our settlement of lease obligations for our former London office location which was vacated in early 2010 and the other million was due to unfavorable judgment in a lawsuit filed by a former European employee, who left the firm in '06.

Moving down restructuring and impairment charges of $1.6 million for the first nine months reflect the $920,000 I discussed earlier plus about $700,000 of restructuring charges taken in Q2 that related to sub tenant who defaulted on a sub lease and a previously restructured property.

Then moving down to other operating income of $1.1 million recorded in the second quarter, this reflects a fair value assessment of the potential future earn out payments under the purchase agreement for an acquisition we made in 2009 in Eastern Europe. The assessment indicated that there would not be any future earn out payments and this resulted in a $1.1 million adjustment. So if we were to exclude these unusual items, our year-to-date operating income would have been $13 million for the first nine months and the operating margin would have been 3.5%.

And now I'll turn the call over to you Scott.

Scott Krenz

Thank you Julie. In looking at the third quarter numbers where I think there was probably three things that stand out. Salaries and benefits grew faster than revenue. G&A was up $3.9 million compared to third quarter 2009. In the third quarter effective tax rate is unusually high.

Tackling these order, Kevin already mentioned that in order to maintain our competitiveness in the market we booked an additional $5 million in consultants variable compensation expense in the third quarter. Absent this, salaries and benefits would have grown in line with revenue growth. It is worth noting that on a year-over-year basis, we are still seeing the impact of the restoration of the 5% 2009 salary reductions and the 401-K match which was eliminated in 2009.

The G&A increase is more difficult to explain because it is not just one thing and there are a number of items moving in both directions. First the products reductions from project Velocity and real estate are there. 1.3 million quarter-over-quarter improvement from Velocity and $1.9 million quarter-over-quarter improvement from reduced real estate expense.

Kevin already mentioned the large investment we made in our training and development programs at Harvard, Duke and also the Project Aspire. Taken together, these amounted to approximately $2.5 million of year-over-year increase in expense.

Project Latitude, the new search system accounted for $1.5 million of additional spend in the quarter. This system will begin to roll out in the first quarter of 2011. Unusual legal fees and tax planning activities together accounted for another $1 million in spend in the quarter. Finally bad debt expense was up $400,000. These are the larger numbers which account for the increase.

As for the tax rate, early in the third quarter we engaged an outside advisor to do a thorough assessment of the tax function and processes. In the course of their review, they raised a question about the mechanics of calculating the quarterly effective tax rate.

Although we have been using the same methodology since 2005, we concluded they were right. So in the third quarter we changed this calculation and recorded a cumulative adjustment for the impact of the entire nine months of 2010 where about $2 million in taxes in the quarter. Ironically this change will result in an offsetting decrease in the fourth quarter tax rate. Our full year effective tax rate is unchanged. We still estimate the full year effective tax rate to be between 48% and 55%.

As we discussed last quarter, they are relatively high rate is very much influenced by the un-benefited losses in several foreign jurisdictions mostly in Europe by the non-deductibility of some of the costs associated with vacating our Former London Office.

Our long term goal still remains in effective tax rate of approximately 40%, now if you took out the changing methodology in the third quarter. The effective tax would have been approximately 40%, and the impact of EPS is significant without the changing methodology and the taxes the EPS would have been $0.18 rather than the $0.07 that we have recorded.

Cash provided by operating activities in the third quarter was $31.4 million compared to 12.1 million in the third quarter of 2009 and 23.7 million in the second quarter. We ended the quarter with a 122.8 million in cash and cash equivalents up from 92.6 million at the end of June and 75.3 million at the end of last year's third quarter.

Accrued bonuses at the end of the third quarter were 86 million, majority of which we expect to pay in March 2011. We expect positive operating cash flow in the fourth quarter and are projecting 2010 free cash flow between 17 and 23 million.

Free cash flow was net of accrued bonuses and capital expenditures. As I mentioned previously, capital expenditures this year have been unusually high $23 million to $25 million because of the fit outs of the new offices. Going forward we expect capital expenditures to return to their historical levels of 2% to 3% of revenue.

We ended the quarter with a $121 million in accounts receivable. This is high for us representing a DSO of 77 days. Bringing this down will be a focus in the fourth quarter. I will remind everyone we pay bonuses to our consultants on collected not invoice revenue. So there is every incentive to get the cash in, we have analyzed this carefully and then concluded that this does not represent a bad debt issue.

People have been a bit distracted by the changes we have made through our internal processes. We completed the conversion to a single global financial system in September. So, things are starting to get back to normal.

Looking forward, we believe our fourth quarter revenue will be between a 120 and a 128 million. You can see on slide 20, their monthly confirmations have continued to be strong through October.

Given third quarter results and our expectations for the fourth quarter, we are increasing the forecast of 2010 net revenue to 486 to $494 million. We expect the fourth quarter to again be lead by Asia Pacific and the Americas geographically and by leadership consulting and the industrial practices globally.

Trying to slide 22, we are estimating a fourth quarter operating margin of 8% to 11%. Obviously weather we hit the high or low end will largely be determined by whether we hit the high or low end of the expected fourth quarter revenue.

We are maintaining our full year operating margin guidance of 3% to 5%. There are a number of factors that are going to contribute to a fourth quarter margin that is significantly higher than the third quarter margin. We have talked about this a couple of times.

The third quarter was impacted by $5 million in additional variable compensation added to be more competitive in the marketplace. For this compensation component, the impact to fourth quarter will be about $2 million, a $3 billion improvement quarter-over-quarter.

Third quarter included about $1 million in severance that we don't expect to repeat and we have a normal seasonal decline in payroll expenses of about $500,000. We will realize additional benefit from the completion of project Velocity with approximately $1 million of savings in the fourth quarter compared to the third quarter. We have fewer training and development programs scheduled for the fourth quarter. This will yield at least $400,000 of bottom line benefit.

Finally as we collect receivables in the run up to year end we would expect lower accounts receivable balances to help us reduce the impact of bad debt. One other note on real estate. Our year-to-date savings on real estate cost and depreciation is $3.3 million, compared to the same period of 2009 and we expect that number to continue to improve.

And with that I'll throw it back to you Kevin.

Kevin Kelly

Thanks Scott. I'd like to spend a few minutes addressing one of the industry practice groups that's extremely important to all of us; financial services. 34% of our revenue in the third quarter and 33% for the first nine months. We made an excellent recovery from 2009 and for the first nine months it grew 61% compared to the same period of 2009.

Heidrick & Struggles is known for its expertise in this sector and we're clearly the market leader. We have lots of clients who rely on the strength of our global network. Some of you voiced concerns about a potential fall off and recruiting in the sector over the next coming quarters but due to regulatory controls related to risk management, capital adequacy, compensation in the financial services sector -- our clients are going through some similar transformations but this doesn't mean that they will not be recruiting. That means that our clients will have different needs in recruiting in different areas. We are very well positioned to benefit either because of our strength in geographies like a specific Russia or Latin America and because of our product specialization in these areas that are very interesting to banks as their adjust their business models.

The examples include helping an Indian bank go global, a regional bank in Asia go global, a European bank go super regional and a mid market U.S. bank go global as well. We're also doing work with standalone advisory investment banking routines and with hedge funds that -- more so than we have done in some time.

And the positions range from senior management of these entities to bankers, sales people and traders across products and geographies. I would also like to remind you that this is consulting more than just a flat quarter compared to the third quarter in financial services just because inherently there is seasonality. Our clients tend not to hire as many people in the fourth quarter because that would dilute the bonus pool year end and they'd get little return on their investments.

I'd like to end this call as I did in July with Heidrick & Struggles commitment to the core values that make our brand phenomenon with the class including client service, people, integrity, team work and respect.

And I also like to thank our employees listening to the call for their commitment and hard work. I would like to thank our investors and our analyst for the continued support and at this point we will be happy to take any questions you might have. Thank you very much.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Tim McHugh. Your line is open.

Tim McHugh

Yes can you give us a little more color on the additional bonus expense and the quarter was just be clear with, was that a one time kind of retention type of payment. Was it some type of employment agreement or was this a structural increase and the overall compensation level you are going to pay going forward to consultants.

Scott Krenz

Probably it's more of the latter; I mean we have been monitoring the market. We have been monitoring what's been happening with our employee base and receiving a lot of feedback on that and it was clear that in a certain area we were just not being competitive but we decided that we would fund that and it is within the context of the plan that exists but it will be an ongoing expense. It is not a one time thing.

Tim McHugh

Okay so they are going from 5 million in Q3 down to 2 million. Was the 5 million just catching up for the first part of the year?

Scott Krenz

Its $8 million for the year that we added and we got, we sort of caught up through the first three quarters. So, 5 million through the first three quarters and then, the remainder in the fourth quarter and we would expect similar amounts going forward.

Tim McHugh

You said that was in particular sector or certain area, can you elaborate on what area that is?

Kevin Kelly

It was consultants compensation, it is related to our revenue producing consultants but it was across the board there.

Tim McHugh

Okay and then as you said you felt you were below market, is the change designed to bring you in-line with the market at a premium to try and recruit people or where you?

Kevin Kelly

It's defining market and our industry is very difficult given that several of our competitors in fact most of our competitors are private and are probably as guarded about compensation as we are in disclosing it to the marketplace.

We felt in fact that we were competitive, we felt in fact that we have one of the best compensation packages in the entire industry but given some of the recent feedback we have been getting it was clear that people were focusing on certain aspect of it here and that we needed to address that going forward. So, I am not sure and I don't think anybody can tell you whether or not this puts us in a premium or flow. I think in general though we are pretty comfortable that we were and we remain competitive here. But we just wanted to take an issue off the table and not talk anymore with our consultants since we did that.

Tim McHugh

Okay and then one last one would be the SG&A expenses. I think we talked before you thought given the -- you thought expenses would fall off quite a bit in the second half of the year and then we'd be at a much lower rate probably in 2011 than 2010. Without giving specific guidance can you update us on kind of your thoughts on that given the -- basically are the up ticks in training and development type of costs going to offset the savings kind of permanently going forward such that we should expect SG&A to be more flat than necessarily down going forward or would you expect SG&A to trend down from where we saw kind of first half year and then in Q3 as well.

Scott Krenz

I still stand by the statements we've made previously. We are bringing G&A down and we're doing that over a period of time. The work we're doing, which has been completed now in Velocity, the work we're doing in real estate, all which are contributing to that, I think also contributing to it which is a side benefit of Velocity is much more insight into our business and much more timely reporting which is allowing us to really stay on top of the expenses on a going forward basis.

This has been a strange year, 2010 that is in that we've introduced a lot of change here. We've changed the way people do a lot of their day-to-day activities, things like invoicing, things, management reporting and stuff and that was part of Velocity. We've introduced some changes in the compensation system which I think were designed to tie people much more to the firm as opposed to the individual. We've changed offices. We've put new technology in front of people.

We've been rolling out a series of things in IT and making changes there and what you're seeing is that sort of period of high change is a lot of effort has been put into training, into development, into connecting people with our strategy and that's been seen in G&A and that sort of general category is what has kept it from declining the way we would have thought. That's not an ongoing thing. We return in 2011 I hope to a much more normal sort of environment where these changes are behind us and people are used to it and we get into sort of a normal rhythm of things and I'd expect to see the declines than well; we're beginning to see them in the fourth quarter and that to carry through into next year.

Tim McHugh

Okay, thank you.

Operator

And our next question comes from Kelly Flynn. Your line is open

Kelly Flynn

Thanks. First couple of questions are actually kind of a follow-up to the last one. Just on the G&A, sequentially in Q4, you've laid out all those items that are going to be different in Q4 versus Q3 that would explain the higher margin. I just want to be clear. Which of those show up in G&A, severance or?

Scott Krenz

Gosh, let me go back to the list here.

Kelly Flynn

I think you got your $5 million in comp which is obviously…

Scott Krenz

Well comp will not. The severance -- it depends on where it had but I think largely not. Most of the severance was in comp. Payroll expenses will be in comp. Now the Velocity stuff is going to show up in G&A. the training and development will show up in G&A. Real estate shows up in G&A. So those are the big ones that fall into the G&A line.

Kelly Flynn

Okay, so actually I wanted to go back to the Velocity stuff, you said basically you have 1.3 in savings in Velocity.

Kevin Kelly

1.3 in Q3 and then additional 1 million in Q4.

Kelly Flynn

Okay so it will be an incremental 1 million in Q4?

Kevin Kelly

Yes.

Kelly Flynn

And then that 1.9 that you mentioned was that real estate?

Kevin Kelly

Yes real estate and again that's Q3 and then that will continue on into Q4 and probably increase a bit because we continue to streamline our footprint, reduce our real estate footprint.

Kelly Flynn

Okay, so, I mean is it a 1 million or 2 lower the G&A you think in the fourth quarter?

Scott Krenz

I really haven't looked at that but yeah I mean 1.5, it's probably more like 2 million or maybe a little higher than 2.

Kelly Flynn

Okay great and then also a follow-up question just on the variable comp, first of all could you just talk a little bit just qualitatively about how this works, what are you doing there? They have performed well? They are getting more, I mean is it across the board, I know you have competitors.

Kevin Kelly

Yeah I hate to be mysterious about this I really do apologize to everybody. We try to be a little circumspecular our comp plans simply because everybody is doing us what we do to them which is when you hire you personally talk to them, we also try and figure out what other players are paying and how because that really the only sort of intelligence you have out there because people mostly tend to be private. This particular issue really relates more to clarity than anything else. One of the things that we have promised our consulting population is that we would provide them as much clarity in what they are going to be paid as we can.

And this particular issue was an issue of, it was a discretionary issue and we decided the interest of clarity, we just wanted to take it off the table and fund it and make it clear to people that this amount was there and it's not something they certainly have to wait until year end and guess whether it was going to be there or not be there and so it was a matter just making things a little clearer to our consulting population and giving them a little more certainty around what they are looking at.

Now in general, the comp plan for consultants and now I am talking about consultants because it is very different for support people here but for consultants is based largely on their production and the amount of money that they bring in the door.

Although there is a fairly large component of it which is related to a complete assessment of broadly speaking, firm behaviors, mentoring, team building, development of business that sort of thing.

But by and large it still relates back to their personal production, modified by as I said the behaviors we've talked about and modified by performance at the end of the day. So, it's relatively straight-forward. This one piece was just an added distraction because it was a piece where decision would be made typically at the end of the year. People were asking questions about it, we went back and said given everything else here and the way the plan is structured didn't make any sense to have those questions still out there. So, we just funded it and said it's done, take that off the table we are not going to talk about that anymore.

Kelly Flynn

Okay and then related to the same topic variable comp I think you said and answering the last question that you thought it was going to be similar levels in fiscal '11. Does that mean, similar levels meaning $8 million?

Scott Krenz

For this particular piece yes, although it will flex a little bit depending upon just the number of consultants who were there but largely speaking it will be the same level going forward because this piece was a discretionary piece and really wasn't necessarily as closely tied to production as the rest of it and we just wanted -- as I said in the interest of providing more certainty and more clarity to our consultant population we just wanted to take the issue off the table. At the end of the year we probably would have the decision to fund it anyhow. We just decided to take it off the table in the third quarter and get the noise out of the system.

Kelly Flynn

Okay, and do you think you will get leverage on the salary and benefit side in fiscal '11.

Scott Krenz

Leverage, yeah we should because it relates back to productivity and we've done really well in 2010 and in consultant productivity. We've reached levels which are pretty much consistent with 2008. Our goals are higher than that. This is something Kevin has mentioned repeatedly and it's very -- and the reason he mentions it repeatedly is its very important to Kevin and it's a key driver here that we continue to improve our productivity. So our plans going forward are to continue to drive that number up. We've already publicly said that we're aiming for a number that up around $2 million. Ultimately we're at about $1.5 million right now and we'd expect to find some station in between next year in that continued improvement which is a long winded way of saying that yes, we expect some leverage on that compensational item.

Kelly Flynn

But I mean, conceptually if the economy gets better, wouldn't it seem like you competitors are getting more of -- they're recruiting new people and paying them more. Why wouldn't you continue to have to increase your comp as a percentage?

Scott Krenz

Well there's two sides to this. There is our side and it's something which we haven't enjoyed, that's for certain. But I think we have discovered two things. One that we have an incredibly strong bench and probably do -- in my opinion I think our opinion the best job in the industry of developing people internally. We will continue to focus on doing that.

The other side of this is that the people going away, this is an economic decision and in many cases we've looked at it and decided this just doesn't make sense economically. Well unless the people recruiting on the other side have sort of unlimited pocket books, eventually they reach a point where it begins to impact them as well. So you have to look at the balance on this and this looks sort of in my -- and again it is my opinion but it looks to me like sort of a one time run on the bank here and the other side is going to run out of steam here if its not already running out of steam because its just very costly to do this. Kevin mentioned earlier in his remarks that we focus our hiring activity on boutiques and on consulting companies and on the industry and although we've done a couple of hires from the tier one firms we tend to shy away from it. They are a very expensive proposition.

They require multi year guarantees, huge upfront signing bonuses. There is a lot of risk you take onboard when you do that and we have consciously and I think very -- with a lot of focus this year have not followed that path. What's happening to us where people are hiring Tier 1 people from us and they are seeing and we are watching them go with large multi-year guarantees with large sign on bonuses with all of the things which we are trying to avoid because we know from our experience that has a large impact on your bottom-line eventually and it really is other impacts it destabilizes the rest of your consulting population. Why is Joe getting a guarantee I am not, it causes a lot of disruption internally and so eventually it's not a one way street and eventually it's got to reach a balance here and I think that balance is going to come fairly quickly.

Kelly Flynn

Okay just one last quick question, what is the bottom line on what tax rate we should be using in the fourth quarter? I mean there probably isn't one but I mean is it?

Scott Krenz

It's probably a fourth quarter run similar third quarter; it's probably going to be around 20%. If we normalize this quarter it would have been about 40%, people are pointing at numbers I am trying to do math in my head and they are doing very scientific about this which is I think they are frustrated with me. But yeah it looks like the fourth quarter forecast is somewhere around just south of 40%.

Kelly Flynn

So the 48 to 55 you are saying for the full year? Does that assume higher tax rate in the third quarter?

Scott Krenz

Yes it does.

Kelly Flynn

Okay. Thank you.

Operator

Your next question comes from Tobey Sommer. Your line is open.

Tobey Sommer

Thanks, a quick follow-up on the tax rate, so the tax rate guidance assumes a GAAP tax rate in the preceding, in the previous three quarters or does it assume some sort of pro-forma rate?

Scott Krenz

No it's GAAP, it's just reported.

Tobey Sommer

Question for you broadly speaking, we have had some shifts in communications earlier questionnaires have gone through this. Can you update us on your view for margin potential in an expansionary economic period for the firm?

Scott Krenz

We have talked about this before and I think we generally stick to the same thought process and that is as we start moving into the mid-500s roughly speaking in revenue that we start getting into the double digit range and I have said that in previous calls and I think the numbers are still the same that we would start targeting moving into the double digits sort of operating income margin as we move into the other $550 million types of revenue.

Tobey Sommer

Is there anyway you can be more specific a double digital range of ten percentage point range there.

Scott Krenz

Well I think one could guess that the lower end of double digits, we used that 500s and then ramping up from there. We will be much more specific due year end. We are in the midst right now of completing our annual operating plan for 2011 and that's why we haven't mentioned anything about 2011 right now. But when we come forward and talk about 2011 I think we will be much more specific about margins and what we think going forward but to clarify my comments when I said getting double digits I certainly meant getting to that 10% - 11% range of the middle 500s.

Tobey Sommer

Okay and then I am curious about Europe where the margins are a little over right now and that's influencing also I guess the tax rate. These hires that you have on boarded in the recent quarter then October appear to be skewed a little bit to address some of that European attrition. Is there an expectation that margins will improve headed out of this year into next year would that influence the tax rate for next year? Thanks.

Scott Krenz

Yes and yes. We definitely expect margins in Europe to improve as both the -- just the general business atmosphere there improves but also as we address some of the -- the hiring and departures over there. The issue and we've mentioned this before; in the United States its one huge market. Its 50% of our business and if somebody leaves in San Francisco or Dallas or something it's easy to cover out of New York or Chicago. That's not the case in Europe. If somebody leaves in one of the smaller countries, it will be difficult for somebody say out of London to cover -- France to cover because language and culture and stuff. So it's a more difficult sort of mosaic to manage and we've been filling in those gaps. The hiring has been designed to sort of fill in those gaps and get the thing back on track and if those smaller countries that we've lost then have drawn off the losses which have caused the tax issue. So we should address both of those issues going forward next year and should see margins recover in Europe as well as they'll have a -- an impact on the tax rate as well as we move towards our target of 49.

In addition to that we're understanding or have been undertaking for the last several months here a series of sort of tax planning activities which are also -- expect to be put in place over the next two or three years which are aimed to getting us to roughly that 40% range.

Tobey Sommer

Okay, thank you. That's helpful. Is there incremental carry over of cost savings for Velocity in 2010?

Scott Krenz

Oh yes. That's an ongoing thing. We have split some targets out there. Largely speaking from Velocity a couple of associated projects were on the IT and like -- we have stated before that we expect to get about $10 million out of that which is an ongoing annuity and we're still hanging in there with that.

We're making a lot of improvements around the company in terms of all the sort of G&A and overhead processes and then we're still on track roughly $10 million of -- on going improvements in real estate as well. Those have both been very successful projects and I'll point out that it's not just a cost reduction exercise. I can -- with a fair amount of pride say that the team here over the last few years has done an extraordinary job and we'll probably have better insights into our business, provide better reporting to people, provide more timely reporting and better mechanisms to manage the business than we've ever had in the past and a lot of that is to do with Velocity and the changes we've made there. So we're not just getting savings in that specific G&A area but I also think its allowing us to do a lot of things. And as an example we're talking about productivity. It gives us much more insight into that issue of productivity, the levers you need to pull and how we're going to improve it going forward. So we are in a much better position just as a management team but we're also going to have ongoing savings and those are annuities. Those will go on forever and we will continue to look for improvements impacting all those areas.

Tobey Sommer

Okay last question for, is there any incremental expense kind of reinstatements similar to where we came at or something like or is that behind us in 2010. I am just trying to get a sense for what identifiable operating margin kind of improvement we could get with additional revenue in 2011 as a result of maybe not having more of these reinstated.

Kevin Kelly

No we should find, we have had tough year-over-year comparisons this year in areas like fixed compensation and compensation in general because of the reinstatement of those items. Going into 2011 we do not have similar issues which comeback. To my knowledge there is no major changes planned to the benefits structure or the comp structure. So, the year-over-year comparison should be much more understandable between 2010 and 2011 and really we are talking now by something which I think tracks more directly with revenue growth.

Tobey Sommer

Thank you very much.

Operator

And our next question comes from Mark Marcon. Your line is open.

Mark Marcon

Good morning, I wanted to stay a little bit on Tobey's line of questioning, first of all with regard to Europe how should we think about that for next year. I mean what, how long will it take to get that to normal margins?

Kevin Kelly

Mark its Kevin; it will start with new recruits. We invested in -- seen a lot of white space in areas over the course for the last six to nine months as we evaluated the business we looked at some of the emerging markets, we looked at gaps, we had an interesting sector and then we have done a lot of recruiting and we are still recruiting in those areas and as I think Scott mentioned before, you have a 12 to 18 month gap if you will in which folks will takes the time to get up the speed and secondly Europe is lagged a little going into the recession as like coming out. We mentioned earlier, I think Julie mentioned earlier we are seeing a sequential growth in the confirmations in September, October now and hopefully we will see that trend continue. We have seen anecdotally a lot of business come in over the course of the last few weeks as well across all industry sectors so we are pretty positive with them.

Europe picking up and going in the next year and we would hope that with opportunities in Germany considering it a pick up with the UK coming back as well that we see March is start creeping back up going into 2011.

Mark Marcon

I mean we are coming off of what it looks like you are kind of going to be at break even for this year and you are up I mean this assuming that there is some improvement in the fourth quarter. So, I guess what I am wondering is are we thinking that we could have a huge improvement, how long do the, because you did say that it takes 12 to 18 months for the people to ramp up and a lot of them have just come on.

Kevin Kelly

So, answer to your question I will say that obviously we will continue to invest in Europe and I would see an increase next year and a continued drive to get back up to the numbers grew over four which is mid to high teens for corporate applications in terms of margins, secondly I want to see that we will continue to invest and recruiting there and this will be an ongoing process. We would like to get it back up to if we in the revenue level margins levels we saw in 2007 and 2008 and we believe we can get there over the next couple of years. I was going to say at the same time in Asia and in Europe. You also see a fundamental shift in terms of talent moving towards the Asia Pacific region. So we have to get the balance right in terms of where we're investing.

Mark Marcon

And then can you just discuss financial services. I really appreciate the color, Kevin that you brought up at the beginning. How much of financial services are in the -- are in Americas and Europe. In terms of 34% of your total revenue is in financial services and of that how much of that is in Americas and Europe?

Kevin Kelly

That's interesting Mark because that's challenging internally as well as probably externally because for example, you know the large Indian bank we're working with now, it was looking to expand globally. We have consultants working on that in not only North America but Asia and Europe as well and the way we allocate that revenue depends on where the individual is sitting. So right now I'd say roughly we have a -- the bulk of our revenue based in North America but simultaneously you see Asia Pacific right now really getting a lot of headwind in terms of the revenue in financial services that you see a lot of these international banks, particularly Japanese banks, Chinese, Korean, etcetera. Particularly India is looking to expand internationally. So I guess the short version is when an Indian bank is expanding into North America we can't fit that revenue there and not necessarily in Asia Pacific. So the bulk historically had been in North America but we'll see a fundamental shift to that revenue now move overseas.

Mark Marcon

And Kevin, given your experience in this sector, you read the same things that we all see. I guess the other way of asking the question is of that 34%, how much do you think are in areas where you would think there is going to be -- there is potential challenges or there have been signals that things are going to slow down as opposed to areas that are still picking up. Or how would you think that growth for next year in financial services will provide with those assuming constant currencies.

Kevin Kelly

Mark its been an interesting year because historically we focus a lot on investment banking and asset lost management etcetera and you are seeing they shift to not only helping these boutiques that I mentioned -- U.S based boutiques expand internationally but also the foreign limit to Russian banks, Indian banks etcetera to expand internationally. We've also moved into a lot of different areas vis-à-vis financial services, particularly as it relates to the back office and infrastructure side of the business which has been critical as well. So we all see and read the newspapers in terms of investment banking but that hasn't been the bulk of our not recruiting this year across the board, a broad and wide portfolio when it comes to pick our financial services practice and I think that trend will continue next year, going into next year.

Mark Marcon

So you're saying financial services should grow next year?

Kevin Kelly

At this point in time we're pretty confident that financial services will continue to grow next year. You may see it fall off in one or two sectors and maybe investment banking if you will given the activity -- the lack of activity I should say. It will fall off a bit but we'll also see continuously see international expansion as well as a lot of buildup in the infrastructure side.

Mark Marcon

Great and can you just discuss the turnover issues? It sounds like you've made some adjustments to the compensation plan. What's the feedback now? Should -- it would appear that turnover would slow down in the fourth quarter just because we're in front of bonuses and for consultants whereas people in financial services but then as we go into next year postpone. Is this your sense that moral is it a level that and things have been set so that we should see more normal attrition rates?

Kevin Kelly

I would if you look at the going back three or four years we have been 8% to 10%. This year we are a little higher, 14% to 15% but Mark we are really focused on a performance driven culture and I personally I know our leadership team Scott said we are comfortable with an attrition rate around 10% a lot of that will be managed by us.

I think what you don't see is and I am out here, I am in Asia right now, I was in Europe a few weeks ago. I have been in numerous offices and we have a great throughput people and part of the investment that we made in Harvard and Duke because investing in training and development towards our leadership advisory strategy and a piece that many don't see is that we have, the competitive nature in all of us would love to go out and recruit from our competitors and in fact I was in Europe. I got a call from one of our competitors is poaching from us and said would you take 10 of our consultants into Heidrick & Struggles and a part of you says, yeah I would love to do that but on the other hand it's not good for us. It's not good for our consultants and it's not good for our shareholders sticking to our strategy and with for historically if developing people internally or simultaneously making sure that we can get best invites from consulting firms and we take to something that we are going to adhere to and we are sticking to it. We are proud of that; simultaneously we don't want to go out in that a number of consultants from our competitors because we have struck a culture that live, spend so much time building.

Secondly, I would also add we just brought under the consultant for last four months, go back today and we have a number of consultants who have left say the grass isn't always greener, we would love come back in some cases we are looking at bringing them back. In other cases it's just isn't going to work because Scott mentioned earlier we have a great bench and some of our best producers this year principal consultants who have stepped up and really taken a range over from others who have left the firm and it wouldn't be fair to them.

So, I think one of the benefits of our firm and our talent development program is we give opportunities to a number of people. So, I guess the long version is that we'll continue to execute our strategy and recruiting strategy and drawing the business that way. We will continue to look at gaps across the globe and leveraging our bench internally. We have moved a number of consultants to different geographies which is something that a great organizations do and we aspire to be continue to be a great organization. We will continue to do that so we are comfortable where we are, yes it is bad when you lose people and you lose good colleagues.

We're going to continue to driving towards our strategy of leadership advisory and brining on great people and development others.

Mark Marcon

And then on a very positive note, Asia Pac succeeded prior peek revenue at this point and growth there has been terrific. I was wondering if you could talk a little bit about how you are sitting from a capacity perspective in Asia Pac and how we should think about the growth prospects there or the challenges in terms of managing that.

Kevin Kelly

I think I would say that the challenges would be for us recruiting again from it's a very discrete industry, a fragment of industry. You have a lot of boutiques. So we are looking at recruiting certain industry sectors across places like India, like China, even here, Australia and Singapore etcetera to fill an industry gap. So the biggest challenge we have is really adding leadership advisory consulting capacity, adding industry expertise and we are in a process of recruiting out here. There is a lot of wide space, simultaneously. It's -- And I just mentioned a few minutes ago Mark, we're also looking at moving individuals from both Europe and North America to fill in some of the gaps and have provided that connectivity to help us with the European companies expanding over here and American companies simultaneously being able to handle a gap in capacity in terms of these Asian companies expanding overseas is something that's top of mine too but we see -- you see in the investment banking world, you mentioned investment banking earlier. You got a lot of investment banking firms moving senior executives to Asia right now to help with the expansion and we're looking to do the same to make sure that we keep up with the demand from our clients. The biggest challenge I think we have is keeping up with demand from our clients at the senior level in this spectrum. So its something that's I think near and dear to all of our hearts, making sure that we get the right people on board, that we can grow with our clients and we can also leverage a higher circle of global network and provide great expertise and service to them, as both these companies expand in Europe and North America as well.

Mark Marcon

Great, thanks for the color.

Julie Creed

I'm conscientious of the time. It's been an hour. So operator, we'll take one more call from the next call. And if there is anyone else that didn't get queued up, feel free to call us after the call.

Operator

And our last question comes from Kelly Flynn. Your line is open.

Kelly Flynn

Sorry to come on again but just two quick ones. Can you talk a little about the other income? I think there is seasonality but that's jumping around a lot. What do we expect there for Q4 and even for next year?

Scott Krenz

Other income from -- that was driven by the adjustment in the earn out of the acquisition in Europe that we made. So it's more of an accounting -- and accounting artifact and the answer is that it's jumping around because it is not predictable and I don't expect a lot of activity there going forward.

Julie Creed

Kelly, you are looking at the nine months result, the line item called the other operating income or other net non operating income?

Kelly Flynn

Hold on. No, other non operating. Non operating.

Julie Creed

Other net non operating.

Scott Krenz

Oh, okay. Okay, it's a different line. Okay. That's principally tax right?

Julie Creed

In our company….

Scott Krenz

Yeah. So that's principally being driven by foreign exchange variations and your guess is as good as mine on what's going to happen in the foreign exchange next year.

Kelly Flynn

Okay. And then just going back to the tax rate, if you use what you said in the press release and you keep everything else GAAP for the first nine months, to me it comes out more like 35% in the fourth quarter but you said 20% in your remarks. So…

Scott Krenz

No, no. I was doing some -- I think 35% is closer to what it is. 35%, 38% in there I think is what we're predicting.

Kelly Flynn

Okay, great, thanks a lot.

Julie Creed

And Kelly, there was -- the reason it jumped around in the second quarter that the other net non operating income -- it's usually pretty steady like this quarter but representing a gains and losses on cash and our company balances. But what you saw on the second quarter was $1.1 million in there that was unusual, that represented a cumulative adjustment for the accounting of our minority interest with our operations in China. So that was definitely a special event of 2Q. But normally its just exchange gains and losses in our cash and our company balances.

Kelly Flynn

Okay. Great. Thank you.

Julie Creed

Okay. Thank you very much. That's all the call will take for now again. If anyone didn't get a chance to ask questions we're around. Just give us a call.

Scott Krenz

Yeah. Either call, Julie Creed or Scott Krenz, myself will be happy to continue the conversation

Julie Creed

And thank you very much for your time. Have a great day.

Scott Krenz

Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the conference and you may now disconnect. Everyone have a wonderful day.

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