Heidrick & Struggles International's (HSII) CEO Tracy Wolstencroft on Q4 2016 Results - Earnings Call Transcript

| About: Heidrick & (HSII)

Heidrick & Struggles International, Inc. (NASDAQ:HSII)

Q4 2016 Earnings Conference Call

February 27, 2017 5:00 PM ET

Executives

Julie Creed - Vice President, Investor Relations and Real Estate

Tracy Wolstencroft - Chief Executive Officer

Richard Pehlke - Chief Financial Officer

Analysts

Stephen Sheldon - William Blair & Company

Kevin McVeigh - Deutsche Bank Securities, Inc.

Kwan Kim - SunTrust Robinson Humphrey

Operator

Good day, everyone and welcome to the Heidrick & Struggles’ Fourth Quarter and 2016 Quarterly Conference. This call may not be reproduced or retransmitted without the Company’s consent. At this time, all participants are in a listen-only mode and later we will conduct a question-and-answer session. Instructions will be given at that time.

Now I’d like to turn the call over to Ms. Julie Creed, Vice President of Investor Relations and Real Estate. Please go ahead ma’am.

Julie Creed

Good afternoon, everyone and thank you for participating in Heidrick & Struggles’ fourth quarter and 2016 conference call. Joining me on today’s call is our CEO, Tracy Wolstencroft; and our Chief Financial Officer, Rich Pehlke. During the call today, we will be referring to supporting slides that are available on the IR homepage of our website at heidrick.com. We encourage you to follow along or print them.

Today, we are going to be using several non-GAAP financial measures that we believe better explain some of our results. A reconciliation between adjusted EBITDA and adjusted EBITDA margin is found on Slide 12 and 27 in our supporting slides. Throughout the course of our remarks, we will be making forward-looking statements and I ask that you please refer to the Safe Harbor language contained in our news release and on Slide 1 of our presentation. The slide numbers that we are going to be referring to are shown in the bottom right hand corner of each slide.

And now, Tracy, I will turn the call over to you.

Tracy Wolstencroft

Thank you, Julie, and good afternoon, everyone. Today, we reported fourth quarter and 2016 results that reflect continued solid progress on our strategic initiatives and a return on the investments we made over the last year in growing our business.

Let me begin with the few remarks about the fourth quarter. We saw the positive movement of our third quarter continue. Net revenue increased almost 11% year-over-year and grew 11% sequentially compared to the third quarter. Executive Search delivered good growth, up 6% year-over-year. Leadership Consulting has become a more meaningful part of our overall business just under 10% of net revenue in the fourth quarter with a 28% operating margin.

As such you've seen from our press release, we are now reporting all three business lines as separate segments, namely Executive Search, Leadership Consulting, and Culture Shaping. The growth in consolidated net revenue help drive 45% year-over-year growth in operating income and 31% increase in adjusted EBITDA in the fourth quarter.

Looking back at what we achieved for the full-year of 2016, I'm pleased with many of our accomplishments. A few that I would highlight include number one; net revenue grew 10% or $51 million in 2016, 12% in constant currency and more than half of the revenue growth was organic. Separately, we acquired three companies, two that bolstered our Leadership Consulting capabilities, and one in Search that improved our brand and positioning in Europe and specifically in the UK.

And we also made significant progress on our strategy to develop a diversified portfolio of Leadership Advisory and Culture Solutions that permit us to partner more significantly with boards and senior executives to improve individual, team and organizational performance. In fact, half of our top 10 clients utilized both our Search and Leadership Consulting Services in 2016.

Two other comments, the strategic investments in people that we made over the last year through hiring and acquisitions have helped us build a larger more stable, higher quality base of consultants, which positions us for growth and profitably in our business going forward. And lastly, operating income improved 3% and adjusted EBITDA grew 10% both good improvements given the investments this year.

With those quick highlights to the fourth quarter and 2016 I'll now turn the call over to Rich to go into more detail and then I'll come back in a few moments and give you additional and specific thoughts on where we want to go in 2017.

Richard Pehlke

Thanks, Tracy, and good afternoon, everyone. I'll begin with some additional details on the fourth quarter results beginning on Slide 3 and 4. Fourth quarter net revenue of $159.8 million was up 11% compared to last year’s fourth quarter or 14% in constant currency and increased 11% sequentially compared to the third quarter.

Executive Search grew 6% year-over-year, all three regions contributed to the growth and every industry practice group except Global Technology & Services achieved growth as well. Leadership Consulting grew 117% driven mostly by the inclusion of three acquisitions we’ve made over the last year, but also good organic growth as well. And Culture Shaping declined 10% year-over-year, but increased 11% sequentially compared to the third quarter.

Referring to Slide 5, we ended the quarter with 335 Executive Search partner and principal consultants, 22 Leadership Consulting partners, and 17 Culture Shaping partner and principal consultants.

Looking at Slide 6, salaries and employee benefits expense in the fourth quarter increased $7.6 million or 7%. Fixed compensation expense increased $7 million and reflects compensation related to four acquisitions as well as the investments we made in new and existing talent for all of the businesses. In periods of high investments, the fixed portion of our compensation expense will tend to be higher due to the incentives and guarantees that are part of the consultant hiring process.

As a result of higher fixed compensation expense and an increase in the use of third-party consultants and contractors whose costs are included in our general and administrative expenses, variable compensation increased slightly in the quarter. Salaries and employee benefits expense was 70.1% of net revenue for the quarter compared to 72.3% in the 2015 fourth quarter.

Turning to Slide 7, general and administrative expenses increased 15% or $5.3 million to $40.1 million. More than half of this increase or $3.6 million reflects G&A from acquisitions of Co Company, DSI, JCA Group and Philosophy IB, including the use of third-party consultants and contractors. Excluding the G&A of these acquisitions, our G&A expense increased 5% in the fourth quarter.

Now looking at Slide 8 and 9, operating income increased 45% or $2.4 million, and the operating margin was 4.8% in the quarter. From a segment perspective, Leadership Consulting 28% operating margin was the main driver of the improvement in consolidated operating.

And now I’ll turn to the annual results, which start at Slide 18. Tracy hit on most of the 2016 highlights at the beginning of the call, but I’m going to walk through some additional details that aren't covered in the release. 2016 net revenue increased about 10% or $51.2 million to $582.4 million.

Salaries and employee benefits expense as shown on Slide 20 increased 8% or $30.7 million, mostly attributable to the increase in fixed compensation expense. Again, the increase in fixed compensation expense is related to the four recent acquisitions, as well as new hires and Search and Culture Shaping over the last year and severance expense related to the repositioning of the Leadership Consulting business, which were recorded in the first quarter. Salaries and employee benefits expense was 68.7% of 2016 net revenue, compared to 69.5% in 2015.

Turning to Slide 21, general and administrative expenses increased 15% or $19.4 million in 2016, $11.9 million or 61% of this increase reflects G&A expenses related to the four recent acquisitions including the use of third-party consultants for client work. In addition, another $1.5 million related to the LC restructuring costs announced in the first quarter.

Our organic growth in G&A was just under 5% for the year driven mostly by higher technology related expenditures. I want to take a moment to talk about or effective tax rate for both the quarter in the year with the results reflected in Slides 13 through 16 for the quarter and Slide 28 through 31 for the year.

Our book effective tax rate has always been volatile due to the operating results in many of our foreign jurisdictions. During the course of a year, as results come in, we are often changing our tax rate accruals to reflect our best estimate of our taxable income will ultimately end up.

We finished the year strong with most of the increase in regions where we have higher effective tax rates in particular the U.S. At the end of the third quarter, we were estimating there are effective tax rate for this year was going to be 48%. However, as you've seen in our press release, our fourth quarter book effective tax rate was 95% and for the year was 59%.

This was a result of several non-recurring items. One is that we took the opportunity to repatriate foreign dividends to the United States, which increased our book tax expense. We offset the majority of the tax liability from these dividends by utilizing foreign tax credits that were close to expiring.

We also had a couple of non-recurring discrete tax items that took place in the quarter. If adjusted for the impact of these items, the adjusted book effective tax rate would have been 54% for the fourth quarter and 48% for 2016. As we look ahead the 2017, we're currently estimated an effective tax rate of between 44% and 46%, which would be more of the norm.

Now referring to Slide 32, cash and cash equivalents at December 31 were $165 million compared to $190.5 million at December 31, 2015. The primary drivers of the difference compared to 2015, reflects higher cash bonus payments in early 2016 in approximately $30 million of acquisition payments made in 2016, and then retention and earnout payments made to Senn Delaney.

The Company's cash position bills throughout the year as we accrue bonuses, which are paid early in the following year. Earlier this month, we paid approximately $12 million in variable compensation related to the portion of consulting bonuses that are deferred each year. In March and April, we will payout an additional $128 million in variable compensation related 2016 performance.

Now let me give you the guidance for the first quarter and then Tracy will talk more generally about the year. Our Executive Search backlog is shown on Slide 33 and monthly confirmation trends are shown on Slide 34. Other factors on which we based our forecast include anticipated fees, the expectations for our Leadership Consulting and Culture Shaping assignments, the number of consultants and their productivity, the seasonality of the business, the current economic climate and foreign currency exchange rates. We are forecasting 2017’s first quarter net revenue of between $140 million and $150 million. Reported net revenue was $130.2 million in the first quarter of 2016.

And with that, I will turn the call back over to Tracy.

Tracy Wolstencroft

Thanks, Rich. By virtually every metric, we further strengthened our business in 2016, building of our achievements in 2015. I want to express my appreciation to all of my colleagues for the work they are doing to contribute to the success of Heidrick & Struggles.

First of all, we believe that market conditions are favorable for our business in 2017 as reflected in our first quarter guidance. The rapid pace of change and rising uncertainty has placed an even bigger premium on leadership. Never before as talent, leadership, and culture meant so much to building and sustaining competitive advantage.

We still have much more to accomplish in helping our clients identify, attract and develop talent and to provide their leaders with the analytics and insights to drive their organizations forward. Internally, we still have work to do in driving more synergy among our three business lines and advancing our key account focus to bring the full power of Heidrick to our clients.

All that said, there will be two key components of our growth. One is from our core Executive Search business, capitalizing on the investments we have made in consultant teams globally, and the second is from Leadership Consulting and Culture Shaping. There is a good opportunity for Heidrick enabled by our brand to take a bigger shareholder market for increasingly valuable advisory services.

So specifically let me highlight the goals for each of our three businesses and the year forward. First in Executive Search, we intend to build on our momentum. Key to our growth objectives is improving the productivity of the consultant hires we made in 2016 and a new class for 2017 consultant promotions, reflecting our well established development and training program, we promoted a record 28 people into the Search consultant ranks as principals effective January 1.

We also promoted six from principal to partner. As with new hires we will invest in developing the new principal consultants, for sure they are highly successful with support throughout the organization at every level. We want to continue to grow our market share in the Americas and in Europe. In Europe in particular, we will continue to integrate the JCA acquisition and drive more focusing growth at the Co in Board level.

Our focus in Asia will be to maintain share and look for opportunities to drive improved profitability as we focus on higher value searches. Globally, we will continue to hire selectively, targeting specific practice, functional or geographical gaps, but are not planning the same level of hiring that was accomplished in 2016. In growing our key account base, which was also an important part of our growth story in 2016 will continue in 2017 with a further emphasis and cross service line collaboration.

For Leadership Consulting, our goal is to continue to scale the business to increase our impact with clients. We made significant strides in 2016. We developed a consulting platform, which we call accelerating performance. It’s designed to help clients, move their businesses forward with both speed and agility in an increasingly unpredictable operating environment.

Our methodology behind accelerating performance based on more than four years of research was launched last month at a CEO panel in Davos at the World Economic Forum. This year we look to further integrate our advisory presence globally, investing in consultant expertise, new service offerings and scalable tools and methodologies.

We expect to see an increase in revenue and profitability as we progress the integration of the three acquisitions and continue to grow the business. Overall, we believe we are building an LC business that has higher growth characteristics in Search and upon achieving scale we will have returns that are no less.

And third, Culture Shaping. Our Culture Shaping business fits prominently into our growth strategy both as an important source of revenue and earnings growth, but also with a fundamental part of our client offering that is critical to maximizing our client impact. 2016 was a year of significant investment in Culture Shaping. Specifically, a new consultants, who will help us capitalize on what we have today as well as drive incremental new growth going forward.

The scale of the investment made in Culture Shaping in 2016 will not recur in 2017. We expect to see a much higher operating margin contribution from this business segment in the low-to-mid teens. Assuming revenue growth accelerates, the mix of enterprise revenue and consulting revenue remains balanced and with investment and retention cost being less of a factor. By 2018, we expect the margin should exceed 20% returning to historical levels.

Overall, across our business we are making good progress. We are delivering on our strategy to deepen and expand our presence with clients at the top and to offer more services as a trusted and valued advisor. Balancing our investments in the growth of each of our businesses, the shareholder returns will require our continued focus and outstanding operational execution.

Let me pause there and Rich and I will be delighted to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] We'll go first to Tim McHugh with William Blair.

Stephen Sheldon

Hey, good afternoon. It’s Stephen Sheldon for Tim. Thanks for taking our questions. I guess, first on the Leadership Consulting business, the $16 million of revenue that you generated there in the fourth quarter it’s a little higher than we would have expected. And as we're looking forward, is that kind of a reasonable revenue run rate to think about and also how much of that was driven by the acquisitions in the quarter?

Richard Pehlke

And Stephen I’ll take that and let Tracy add to it. It's not – in businesses like Leadership Consulting just like in Culture Shaping, we might see some – a little bit of lumpiness, it won't necessarily always be a sustained run rate, but I don't think it's far off in terms of the size of the business that we're kind of looking at going forward. And certainly it will be incumbent upon our ability to continue to add consultants as well as support resources to fulfill client engagements. So we do like the progress of what we've seen in the fourth quarter as the Leadership Consulting business is kind of come together. And certainly it started to show the momentum of building the business that we've been looking to build for some time now. And what was the second part of the question?

Stephen Sheldon

The acquisition contribution.

Richard Pehlke

Yes. This is a tough one because I would say a lot of it is driven by the fact of the newer businesses and the newer consultants that are coming through the course of both. You remember Co Company wasn’t a new acquisition this year; it came in late in 2015. So a much of the – it drove a lot because Colin came as part of Co Company, it drove a lot of the revenue, but certainly there was decent contribution from DSI and small amount from [PIV] because they came in the latter part of the year.

Tracy Wolstencroft

Stephen I would just add that what you see happening in the fourth quarter is you clearly see the contributions coming from acquisitions that happen in 2016 DSI and PIV, but you also see the content that we've built which I reference around accelerating performance and you see that being flexed in the marketplace. And that accelerating performance is really new IP for us. It's based on market research among which we look at is the best performing companies across the FTSE 500. And you really saw all that coming together in the fourth quarter of 2016. So it maybe a bit on the high side, but the direction is the right statement to take from it.

Stephen Sheldon

Okay. That's helpful. Second, I guess did it feel like something changed in the overall environment for Executive Search especially in terms of client behavior? It looks like things are slightly better based upon higher confirmation trends in December and January and I know there are some noise in February given the leap year, but just I guess from a qualitative perspective did you notice anything different in the environment?

Tracy Wolstencroft

I think what we in generally say is that if you follow the geopolitical headlines over the last couple of weeks or couple of months, you could find reasons to pause in terms of what that impact might be in the economy. We just don't see it in the economy. We certainly don't see it in United States. We don't see it – if we see it anywhere, we see it in maybe a tad more in Asia, but even there, we had increased growth in the fourth quarter. Europe, there's all sorts of reason to reflect or concern yourself with noise, but it just hasn't shown up in the economy.

Stephen Sheldon

Okay, and then I guess last question. You scaled the business quite a bit over the last couple of years from a revenue perspective, but it hasn't really led too much adjusted EBITDA margin expansion. So I guess as we think about 2017, you talked about hiring more selectively in Executive Search and Improving Margins, and Culture Shaping. I guess just overall are we with a point where we should expect to see higher margin expansion?

Richard Pehlke

We certainly are seeking to achieve margin expansion and you know we certainly saw it more in the EBITDA side than the operating income side this year because of the acquisition accounting. So we were a bit more pleased with that. But certainly and we knew that this would be a year of investment largely driven by what we did in LC in terms of one of our more profitable business recently turning that into almost a breakeven business for the current year and expect that to turnaround next year. So we should see some margin expansion there.

I think from a standpoint the margin expansion will come as we continue to hold or increase the size of the Search business, because we serve their operating level - at a better level now for our expense base. And second of all, it will also continue it will be incumbent upon us to continue to grow the Leadership Consulting business as well as return LC back to profitability in the phase of which that happens will certainly be a big factor in driving margin growth.

Stephen Sheldon

Great, thank you.

Operator

[Operator Instructions] We will move next to Kevin McVeigh with Deutsche Bank.

Kevin McVeigh

Great. Hey, congratulations on a real nice quarter. It looks like you’ve seen really nice revenue upside of essentially flattish headcount, any thoughts on that? Is that just more leverage out of existing consultants? And then just never really heard you talked, partner versus principal, but any sense of what the mix there is and is that system with where it's been in a past or is that kind of a new way to kind of optimize the consultant headcount?

Richard Pehlke

So I make the two overall comments Kevin. One is what you're seeing is the investment in the consultants that we've had over the past 18 months to start to generate that return. And that's why you see those numbers holding, but we feel good about having productivity in the $1.6 million range, even with all the hiring that we've done. You have a sense for – you don't always get that return without some time on the investment side and we're starting to see that return.

And on the principal side, we just have a strong amount of confidence in the principals in the firm as well as the principals to be that are being groomed in the firm. And we want to balance our hiring between the experience partner level and the principal side for a whole bunch of reasons. But we see – you saw at the margin a little bit more investment by us in 2016 at that principal reason because of the confidence we have.

Kevin McVeigh

Got it, and what show the decision to kind of re-segment kind of into the three, at this point was it just a maturation of the business or – and then just any thoughts on – because the margin across to kind of Culture Shaping was helpful, any thoughts on kind of the other two segments as we think about 2017 and 2018?

Tracy Wolstencroft

Sure. I think overall, Rich pick this up, but overall the reason to the segment is frankly just transparency, transparency to you, but frankly also transparency within Heidrick. We want people who are managing the business to feel accountable for it, to feel connected very directly with it, but also we’re aware of how the other businesses are doing. So I'd say transparency and accountability with the main drivers certainly for investors, but also frankly within Heidrick.

Richard Pehlke

Yes. Kevin what I'd add to that too is that we pretty much at this point in time have almost three relatively distinct business models now that we're managing with clear management teams within the business that have now come up to a different level of scale. So it became the right time to pull LC out of the Search business and give that transparency that Tracy referred to as well as more directly coincide with how we’re managing the business.

I will take a moment also to go back to your first question just to make sure that you kind of mentioned about the flattish headcount. We actually are up in headcount relative to both total employees and consultants. So part of – one of the challenges and opportunities we have that relates even back to the first question of margin expansion is that we have to balance that continued investment in people to support the growth of the business and talent is still at a premium in our industry and try and drive that leverage across the business while we are supporting higher amount of headcount.

In part it's due to the fact that we use different leverage models in each of the businesses as well because in LC we are a much more of a consultative partner with a lot of operating leverage underneath and in Culture Shaping that's a slightly different leverage model as well and then Search is a little bit more of what we've been used to in the path which is a little bit more of kind of a 1:1:1 ratio across our business.

So three very distinct businesses on lots of dynamics going on relative to the headcount, trying to shrink the overall G&A, our operating basis is as we continue to grow these businesses and at the same time take some of those savings and reinvest them back into technology to try and hopefully grow the productivity of the business.

Kevin McVeigh

Got it, understand. It’s taken more sequentially on the revenue and headcount. And then just one last one, you kind of highlighted that $12 million of incremental outside contractors and consultants. Does that start to runoff in 2017 or we’re going to kind of use that to reinvest in the business?

Tracy Wolstencroft

Well, the tradeoff that we hope to happen over time there is that if we can continue to build the support ranks of the LC business, we're going to need those types of people to actually fulfill the jobs that we – the assignments we have from our clients. The opportunity for margin expansion there is to get a better return because the cost of the labor will be cheaper if we bring it in-house over time.

Richard Pehlke

We are paying a premium to use outside consultants. And while we're comfortable doing as we grow the business and as we deploy the IP, we have in LC that Leadership Consulting were eager and are increasing their ranks at the principal and more original levels in LC for exactly that reason that you're asking.

Julie Creed

And then Kevin I just add one other thing that the $11.9 million also includes general ongoing G&A. It's not all just third-party contractors and consultants.

Kevin McVeigh

Okay, got it. That’s helpful. Okay, super. Thank you.

Tracy Wolstencroft

You’re welcome.

Operator

We’ll hear next from Tobey Sommer with SunTrust.

Kwan Kim

Hi. This is Kwan Kim on for Tobey. Thank you for taking my questions. Could you talk about how the revenue mix will look like in 2018 and maybe 2019 compared to today? Is there a longer term goal you are aiming in terms of the mix and if you could talk about how those changed since previous quarters? Thank you.

Tracy Wolstencroft

Yes, Kwan, we're not going to be able to give you as specific number on that, not because we don't want to, but you understand we're not going to able to do that. I would say in general and this goes back to the earlier question as well about why are we breaking out this business? We're breaking about because we have confidence in our ability to break them out. We have confidence in the growth in LC. It's an area of the firm that we're looking to grow for the reasons we described in terms of margin opportunity as well as what it does to add value to our client.

So I think the way you can view it is, we're looking to grow all these businesses and we invested in all three of them in 2016 in a meaningful way. Just the math, just the numbers is really going to see more growth at the Leadership Consulting and consulting level on a percentage basis.

And we're going to want to grow those businesses meaningfully is a way I would say it and we're going to want to continue to achieve scale for all the complimentary margin reasons as well as just footprint and impact we can have on the search business in acquiring talent.

What you see happening at Heidrick is we want to help companies both acquire the talent, but then as that talent comes in-house, how can we improve their performance. How can we improve into our Leadership Consulting, IP and platform and how can we do it with respect to Culture Shaping.

Kwan Kim

Got it. Thank you very much.

End of Q&A

Operator

[Operator Instructions] And we have no further questions at this time.

Tracy Wolstencroft

Okay. Operator, thank you very much. All of our participants thank you as well and we will leave it there. Have a good rest of the day.

Operator

And again that will conclude today’s conference. Thank you all for joining us.

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