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Exponent Inc. (NASDAQ:EXPO)

Q2 2008 Earnings Call

July 16, 2008 4:30 pm ET

Executives

Michael Gaulke – Chief Executive Officer and Chairman

Richard Schlenker Jr. – Chief Financial Officer

Brinlea Johnson – Director, Blueshirt Group

Analysts

Tobey Sommer - SunTrust

Rob Ammann - RK Capital

David Gold - Sidoti & Company

Jim Gentrup - Meadowbrook Capital

Timothy McHugh - William Blair & Company

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Exponent Q2 2008 earnings call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions). This conference is being recorded today, Wednesday July 16, 2008.

I would now like to turn the conference over to Brinlea Johnson of the Blueshirt Group.

Brinlea Johnson

Good afternoon, ladies and gentlemen, and thank you for joining us on today’s conference call to discuss Exponent’s second quarter 2008 results. Please note that this call is being simultaneously webcast on the Investor Relations section of the company’s corporate website at www.exponent.com/investors.

This conference call is the property of Exponent, and any taping or other reproduction is expressively prohibited without Exponent’s prior written consent.

Joining me on today’s call are Mike Gaulke, Chairman and CEO; and Rich Schlenker, CFO of Exponent.

Before we start, I would like to remind you that the following discussion contains forward-looking statements, including statements about Exponent’s market opportunities and future financial results that involve risks and uncertainties, and that Exponent’s actual results may vary materially from those discussed here.

Additional information concerning factors that could cause actual results to differ from forward-looking statements can be found in Exponent’s periodic filings with the SEC, including those factors discussed under the caption Factors Affecting Operating Results and Market Price of Stock in Exponent’s Form 10-Q for the quarter ended June 27, 2008.

The forward-looking statements and risks stated in this conference call are based on current expectations as of today, and Exponent assumes no obligation to update or revise them, whether as a result of new developments or otherwise.

And now I’d like to turn the call over to Mike Gaulke, Chairman and CEO of Exponent.

Michael Gaulke

Thank you for joining us today. We are pleased to report strong financial results for the second quarter of 2008. For the quarter, net revenues increased 11% over the same period last year; net income grew 16%, and earnings per share were $0.36 as compared with $0.30 in the second quarter of 2007.

During the quarter, we had strong performances in our Biomechanics, Human Factors, Defense Technology Development, and Mechanics and Materials practices, in addition to our Health Sciences group.

Project activity in the quarter included Biomechanics practices work to help an orthopedic surgical device manufacturer defend its design of a product, which a major competitor claimed infringed upon its intellectual property.

We continue to see demand from the energy sector where we are currently assisting a major utility with an audit of maintenance procedures at its gas distribution stations. This assignment includes professionals from our Electrical and Semiconductors, Thermal Sciences, and Mechanics and Materials practices.

The firm’s Health Sciences group is experiencing strong growth in Europe, assisting clients in complying with new regulations known as REACH which is short for registration, evaluation, authorization and restriction of chemicals.

More specifically REACH is the new European Union chemicals policy that became effective throughout the E.U. in January 2007. REACH covers all chemical substances manufactured or imported into the E.U. in quantities greater than one ton per year.

During the quarter, we continued to support the U.S. Army through the Rapid Equipping Force with development of technologies for deployment in Iraq and Afghanistan. We also supported the Army’s Natick Soldier Systems Center with the development of Future Force Warrior technologies and demonstrations.

Additionally, we received follow-on orders of $7.4 million for Rapid Deployment Integrated Surveillance Systems, which we expect to generate approximately $2 to $2.5 million of net revenue during the third quarter of 2008.

In the area of recruiting, we have started 2008 with strong hiring, increasing FTEs 7% year-over-year and positioning the company for future growth.

In summary, we are pleased with our results for the first half of the year and remain optimistic that we are well-positioned to capture future growth opportunities. I will now turn the call over to Rich for a detailed discussion of our financial results.

Richard Schlenker

Thanks, Mike. As Mike discussed, we reported another quarter of strong results including double-digit revenue growth and expanded margins. For the second quarter of 2008, revenues before reimbursements, or net revenues as I will refer to them from hereon, increased 11% over the prior year to $50.8 million.

Total revenues increased 9% to $55 million. Net income for the second quarter of 2008 increased 16% to $5.8 million or $0.36 per diluted share as compared to $5 million or $0.30 per diluted share for the same period in 2007.

For the second quarter of 2008, EBITDAS increased 17% to $11.9 million as compared to $10.1 million in the prior-year period.

The average full time equivalent employees in the quarter were 614, an increase of 7.2% versus the second quarter of last year. Utilization for the quarter was 69% versus 71% in the same period in 2007. We expect to continue to grow head count 1% to 1.5% sequentially, each of the next two quarters.

Operating margins for the second quarter improved to 17.3% of net revenues from 15.4% of net revenues last year. In the second quarter of 2008, our margins benefited from overall improvements in the operating model.

Operating margins also benefited from a $380,000 swing in a deferred comp expense, which was offset by a $380,000 loss taken against miscellaneous income.

Turning to more detail on the operating expenses in the second quarter, compensation expense increased 9.9% to $33.2 million. This increase is a result of growth in FTEs, the impact of annual raises and the bonus accrual.

Stock-based compensation expense for the second quarter was $1.8 million, up from $1.3 million reported last year. We expect stock-based compensation will be between $7.5 and $8 million for 2008.

Other operating expenses for the second quarter increased 5.3% to $5.6 million including depreciation and amortization in the second quarter of $980,000.

G&A expense for the second quarter decreased slightly to $3.2 million, reimbursable expenses for the second quarter decreased to $4.2 million as compared to $4.8 million last year when we had more reimbursable expenses related to the development of RDISS. Our tax rate for the second quarter of 2008 was 39.8% as compared to 39.9% in the second quarter of 2007.

Turning to the balance sheet, we closed the quarter with cash and short-term investments of $60.2 million. During the quarter, we repurchased $11.2 million worth of common stock. We also recently announced that the Board approved an additional $35 million for future repurchases.

Overall, over the first six months of the year we have generated $10.4 million in cash from operations and used $16 million for repurchase activity. Capital expenditures for the second quarter were $1.6 million. DSOs were 96 days.

In summary, we are pleased to report solid financial results for the second quarter, marking a good first half of 2008. We are optimistic about our ability to achieve high single-digit to low double-digit revenue growth for the full year and continue to post solid bottom-line profits through the second half of 2008.

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

Michael Gaulke

Thanks, Rich. In the remainder of 2008, we will continue to pursue new opportunities in our strategic growth areas, including health sciences consulting, product design consulting, and energy consulting.

We will work to position ourselves to capture future growth opportunities and follow-on contracts in our Defense Technology Development business. We will focus on achieving solid revenue growth and profitability.

Lastly, we will seek to enhance shareholder value by generating additional cash from operations, maintaining a strong balance sheet, and continuing to buy back stock to our recently refreshed share repurchase program. We look forward to reporting more success to you in the coming quarters.

I will turn the call back to the operator for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of David Gold - Sidoti & Company.

David Gold - Sidoti & Company

Couple of questions for you. One on the hiring side, where add-on people over the next couple of quarters, which practices you would be targeting? I know there was some commentary in the release on the practices where you have seen particular success but if you can give a little more color to that it would be helpful.

Richard Schlenker

We continue to actually have recruiting efforts in all of our practices. As we’ve said before, we tend to put together a plan that identifies either region or technical area and client service areas within those that we think are growing and try to target those.

So we are continuing the recruiting effort across the board. Some of the practices where we are seeing some strength, and think we’ve got some good efforts going forward do include some of those higher growth areas, Mechanics and Materials has been doing a good job and bringing people on board in the Failure Analysis area, but also in the area of trying to help clients in design consulting.

We continue our effort in recruiting in the Health area. In particular, we’ve seen that we’ve got some people coming on board over in Europe to support our efforts in REACH as Mike has discussed.

We believe in Biomechanics, both on the accident reconstruction side and the medical device side that there is opportunities for hires there and have been seeing some good candidates as well.

So, those are just a few of the practices and the reasons that we see some opportunities for growth there.

David Gold - Sidoti & Company

Okay. And then Rich, from a utilization perspective, would you expect in the second half of the year to catch up with putting some of the newer folk to work? In other words, would you expect utilization second half year-to-year to be maybe flat to modestly up?

Richard Schlenker

I think we had a great momentum coming out of the second quarter last year. So, at this point in time, what I am expecting is utilization to trend off of where we are. I wouldn’t expect it to be higher than it was last year in the second half.

I think we had some good activity going on there; still we’re going to end up with this 6% year-over-year growth there, I think at the higher end of our growth range. We are going to see a little short-term impact on utilization.

But at this point in time, I would be expecting utilization to be, based on that, and where we are in the second quarter, I would expect to just be slightly down versus a year ago.

David Gold - Sidoti & Company

Okay. I think you said 614 was the average head count?

Richard Schlenker

Yes, it was.

David Gold - Sidoti & Company

Did you have a quarter-end number?

Richard Schlenker

June heads, 619.

David Gold - Sidoti & Company

Terrific. Thanks so much.

Operator

Our next question comes from the line of Timothy McHugh - William Blair & Company.

Timothy McHugh - William Blair & Company

I just want to ask about, firstly, Technology Development business. Your comment about the incremental projects you won for the third quarter. Any additional color there as well the $2 to $2.5 million of net revenue; is that on top of the typical run rate for that business of about $2 million a quarter or is that the total of what you’re referring to for Tech Development in Q3?

Richard Schlenker

First of all, the order is an order that came under the IDIQ that we won last year in the September-October timeframe. That was a $25-$26 million IDIQ for which they made first an original order of about $11 million last year.

We have gotten some follow-on orders for spares but we got a more substantial order during the quarter to deliver another 103 units in addition to some spares for them here during the next quarter.

So that is the contract vehicle and what the units are for. We do view that the product sales here of $2 and $2.5 million out of this are part of what we’ve said in the past where we would expect to have $0.5 million to $1 million of product sales in a quarter. That $1 million would come out of this figure as far as product sales go.

Timothy McHugh - William Blair & Company

Okay, and then, in the second quarter, how did the Tech Development business perform? Were there any significant product sales that came in during the quarter?

Richard Schlenker

Yes, those would be the ones that came in. Most of those tend to be ones that come in, we don’t deliver until the next quarter. So this fits into that. We ended up, as Mike said, working primarily on the contracts that we had in hand, the Rap Afghan support in Iraq, as well as the Future Force Warrior activity, in addition to our continuing work in the area of smart cards.

For the quarter though, we ended up with about $640,000 in product sales, so that was some of the spares on the RDISS systems. In total, including that 640,000, we did about $2.9 million in net revenues in Technology Development, which was about flat with the same quarter last year. Last year, we did $2.9 million as well.

Timothy McHugh - William Blair & Company

Okay, and then on the share repurchases, that picked up a little from the last few quarters, but the share count was still up modestly sequentially, can you talk about, were those repurchases weighted towards the back half of the quarter? If so, what’s the carryover impact that we should model in for Q3?

Richard Schlenker

The purchases did tend to be on the second half of the quarter, and we ended the quarter with about 200,000 shares less than the basic we have out there right now. So, that would be where we would be starting off the quarter going in.

Just a reminder, we do do our stock grants and distributions on March 15 of Q1. So that’s a little bit of why on a weighted average basis you have got the weight of the ones coming in from late in the first quarter, some of the late purchases here in the second quarter, that need to balance into those numbers.

Timothy McHugh - William Blair & Company

Okay, great. Thank you very much.

Operator

(Operator Instructions). Our next question comes from the line of Tobey Sommer - SunTrust.

Tobey Sommer - SunTrust

Maybe you could give some color on pockets of strengths and/or weakness within your different end markets, just areas that have shown some more resilient growth and maybe others that are lagging a little bit? Thank you.

Michael Gaulke

The market areas where we have experienced the best demand here recently has been in the product design consulting arena, and that from a practice standpoint probably has the biggest impact on M&M’s revenues.

Biomechanics has also been in a good practice area. Medical Devices, in particular, has been good for us. We have every reason to believe that that’s going to continue to be an attractive area.

We’ve had this initiative to build in the energy sector, increase our activities there, and this last quarter, in particular, we’re beginning to get real traction with some of the hiring decisions we’ve made over the last couple of years. The work that I commented on in my early comments, this is a significant piece of work for us, and we will continue to build on that.

And then lastly in terms of real market drivers here, to come back to a comment on REACH again. REACH is a very extensive piece of legislation. It covers all of the E.U. and runs over multiple years in terms of a time period, as there is additional demands in future years.

So this is not just a one-time Y2K kind of event. It will be a piece of legislation that I think is going to be a good driver for our business. We have seen a substantial pick-up in activities of our staff in Europe, in particular, and we are looking at ways to continue to be able to grow in that area.

Tobey Sommer - SunTrust

Thank you. In terms of the segments that may have shown less robust growth, anything that stands out?

Richard Schlenker

I think our Vehicle practice, while we haven’t seen any pull back in that area, I would say that based on the market out there, the fact that we are just holding flat in our performance in our Vehicle or Accident Reconstruction area, we think is good.

We’ve seen that here over the first half of the year where we have been able to hold at that level. Last year, in particular in the first half, we had a very strong performance in Environmental. Again that practice area is holding flat to slightly up and has a number of proposals that look like they are coming through, and things should be picking back up, but that’s been a little bit slower than we saw last year, in the first half as well.

So those would probably be the two areas in addition to our Civil Engineering and Structures. Last year, we were completing some work related to the Hawaii earthquake. Had a few larger natural disaster projects going on. Right now, there are no large projects like that in the Civil and Structures area.

Tobey Sommer - SunTrust

Thank you. Very helpful. I will ask one other question, and then get back in the queue. Just dovetailing on your answer regarding pockets of strength, you cited prior hires and your initiative there to build up the energy practice.

You said, I think, that year-over-year head count up about 7%; was there any particular focus, perhaps even a continued focus on that energy practice among others, and was there any change in the difficulty level of attracting talent to the firm? Thanks.

Michael Gaulke

Energy definitely had a position toward the top of the priority list in terms of attracting talent. Yes, it got attention, and as I said I think we’re seeing some of the benefits of that.

Richard Schlenker

As far as the overall competitiveness in the market, I think energy people with industry experience, there is a high demand for them. We seem to be able to make the hires that we’ve been wanting, but I would say we are probably working a lot harder at it, in that area because it’s a focus, but to this date, it is not a limiting factor for us in our growth.

Tobey Sommer - SunTrust

Thank you very much, very helpful.

Operator

Our next question comes from the line of Jim Gentrup - Meadowbrook Capital.

Jim Gentrup - Meadowbrook Capital

The first question I have is in regards to your guidance; you’ve done, I think, 13% revenue growth for the first six months of the year and the guidance still is leading us to maybe 8% to 12% overall growth. Is this just being conservative or do you expect to have a slower second half as far as rate of growth?

Richard Schlenker

I think that one of the key things in looking at our year-over-year performance is that last year in the fourth quarter, we had a significant project come through for the first phase of building these RDISS systems which was that first $12 million order that came through on gross revenues, ended up producing $3 – $3.5 million on net revenues for us out of that program.

So, we’ve continued to be trying to communicate to the market the last couple of quarters that we still have that hurdle in front of us out here in the fourth quarter; we don’t have a enough of a backlog to or length of time that we are able to predict if what we are going to be seeing in the products area out in the fourth quarter.

So, for us, the core business outside of that, we continue to think that we can grow that in the high single to low double-digit growth. We’ve been doing that here over the last couple of quarters; that will continue. Where we come out on a year-over-year basis related to the defense product sales area, only time will tell.

So that’s a key reason for wanting to leave that guidance where it was. In addition to that, our business is one that when we talk to our business leaders, we can get a sense for the next six weeks out.

Reasonably beyond that it’s just a matter of if it’s trending up or trending down for the remainder of the quarter. But basically those are the key reasons that we’ve stayed with that guidance at this point in time.

Jim Gentrup - Meadowbrook Capital

Very well, thank you very much. And just to clarify, the contribution from Technology Development products is normally $2 to $2.5 million per quarter?

Richard Schlenker

From the products side, no, it’s typically somewhere between $0.5 million and $1 million per quarter, is what we’ve been talking about. Having $2 to $2.5 million is a step-up from there.

Jim Gentrup - Meadowbrook Capital

Okay. And the $2.9 million total this quarter...

Richard Schlenker

That includes our consulting revenues of about $2.2 million plus the $650,000 in product sales.

Jim Gentrup - Meadowbrook Capital

Okay. And then the next quarter, the gentleman asked I think before I think, the $2 to $2.5 million that you expect from that, I think it was from the RDISS follow-on order?

Richard Schlenker

That’s correct.

Jim Gentrup - Meadowbrook Capital

Was that going to be incremental next quarter, or is that included in that?

Richard Schlenker

That $2 to $2.5 million is included in the normal estimate of product sales.

Jim Gentrup - Meadowbrook Capital

Okay. Then the last question I have is the fees that you charge, will you or do you expect or are you seeing right now any pressure on what you ask for in the marketplace?

Richard Schlenker

We are not seeing a pushback on our billing rates for individuals. We increase those effective January 1 each year. In this past year, we increased overall, about 5% to 6%. We’ve been able to go out to the market and realize that.

Jim Gentrup - Meadowbrook Capital

Okay, thank you.

Operator

Our next question is a follow-up question from the line of David Gold - Sidoti & Company.

David Gold - Sidoti & Company

Just a quick follow-up. Uses of the capital, obviously, you’ve expanded the buyback. Just curious, read into anything on the acquisition landscape based on that or do you still think maybe we do both?

Michael Gaulke

David, the answer is that you shouldn’t read anything into that relative to acquisitions. As you saw, we ended up with about the same level of cash, around $60 million. So the fact is we’re generating a lot of free cash flow at this point in time, and so we think that continuing the buyback program makes a lot of sense for shareholders.

Aside from that, parallel to that, we continue to very much look for the right acquisition candidates here.

David Gold - Sidoti & Company

Got you. Perfect, thanks.

Operator

Our next question comes from the line of Rob Ammann - RK Capital.

Rob Ammann - RK Capital

Can you provide the revenue breakdown between Health and Environmental and Engineering?

Richard Schlenker

Yes. The reportable revenue for the quarter here was $42.1 million for Others Engineering and Scientific, and Environmental/Health was $12.8 million.

Rob Ammann - RK Capital

Okay. And do you have the utilization and FTE numbers as well?

Richard Schlenker

The utilization number for Health and Environmental was 66%, and Others was 70%. The FTEs were 161 for Environmental and Health and 453 for Other Engineering.

Rob Ammann - RK Capital

Okay. So Other Engineering was only up, basically 1 or so in the quarter, is that right, sequentially?

Richard Schlenker

That’s correct.

Rob Ammann - RK Capital

Okay. And from here, would you expect both practices to see similar sequential FTE growth of that 1% to 1.5% sequentially, or will Environmental continue to grow a little bit faster?

Richard Schlenker

We’ve got a number of growth opportunities and recruiting efforts going on in both larger segments in the company. I just think it’s one quarter of data there of a net number of hires and (turns?) and such. So, at this point in time, I don’t see it being very different across those two.

Rob Ammann - RK Capital

Okay. Anything competitively in any particular practice area where you are seeing more significant competition or a little bit more pricing pressure?

Richard Schlenker

I would say there has been no real change over the last couple of months or quarter. We continue to find that the most price sensitive in competitive markets that we are in include the Environmental consulting area.

Our work for the insurance industry where they tend to be very price sensitive, we tend to get involved in their higher exposure issues. Construction consulting, as we have talked before, is a much more broader, more competitors out there in that marketplace, but none of those things are any different than they were a year ago as far as I’m concerned.

Probably the only place that we felt a little bit is in our Hydrology, Geotech area where there’s lots of development going on and so there is a little more resources out there and that has some impact on our Civil Engineering practice.

Rob Ammann - RK Capital

Okay. Then following the RDISS order this quarter that came off that IDIQ, what does that leave left on that IDIQ, about $5 million...?

Richard Schlenker

No, that’s about all of it between the two orders and the work that we’ve done through that period of time; there is probably another $1.5 million to $2 million in gross but not a whole lot left.

Rob Ammann - RK Capital

Okay. Anything new on other technology development whether it’s Covert Denial, Non-Lethal Vehicle or any new robot technology that’s worth talking about?

Michael Gaulke

I would just say that there is work and discussions going on in all of those areas. There is nothing that we can talk about more concretely at this point.

Rob Ammann - RK Capital

Okay. But still, it’s a good pipeline of potential opportunities that have a chance to becoming something similar to RDISS, maybe not in size, but in thought progress?

Michael Gaulke

We believe so.

Rob Ammann - RK Capital

Great, thank you.

Operator

Our next question is a follow-up question from the line of Tobey Sommer - SunTrust.

Tobey Sommer - SunTrust

Just in terms of details I wanted to ask you, any movement on the balance sheet or DSOs that you think is noteworthy?

Richard Schlenker

No, we had $1 million in an auction rate security that at the end of the first quarter, we moved that down into other assets. We’ve actually continued to monitor that and actually have gotten notice that the issuer is going to restructure that. So we have not taken a discount, but because of the illiquid market, we did move that down from investments down to other assets.

Other than that, our CapEx for the quarter, was a little bit higher than we would typically find. We are entering a new lease on new moving facilities in the Boston area, and this landlord instead of doing a turnkey, we did the TIs on the space.

They are funding half of those TIs, but based on the accounting, the $0.5 million they are giving us for the TIs needs to go against rent expense versus against CapEx. So, CapEx is a little bit higher in the quarter than we would have normally had.

Tobey Sommer - SunTrust

Okay. Thank you very much.

Operator

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

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