Kforce, Inc. (NASDAQ:KFRC) Q2 2019 Results Earnings Conference Call July 31, 2019 8:30 AM ET
Michael Blackman - Chief Corporate Development Officer
David Dunkel - Chairman and Chief Executive Officer
Joe Liberatore - President
Dave Kelly - Chief Financial Officer
Conference Call Participants
Tobey Sommer - SunTrust
Trevor Romeo - William Blair
John Healy - Northcoast Research
Good morning. My name is Summer, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2019 Kforce Inc. Earnings Conference Call. [Operator Instructions]. Please note that today's call is being recorded. Thank you.
I will now turn the conference over to Mr. Michael Blackman, Chief Corporate Development Officer. Please go ahead.
Good morning. Before we get started, I would like to remind you that this call may contain certain statements that are forward-looking. These statements are based upon current assumptions and expectations and are subject to risks and uncertainties. Actual results may vary materially from the factors listed in Kforce's public filings and other reports and filings with the Securities and Exchange Commission. We cannot undertake any duty to update any forward-looking statements.
I would now like to turn the call over to David Dunkel, Chairman and Chief Executive Officer. Dave?
Thank you, Michael. You can find additional information about this quarter's results in our earnings release and our SEC filings. In addition, we have published our prepared remarks within the Investor Relations portion of our website. The second quarter marked the completion of a multiyear strategy to position the firm as a dedicated domestic provider of technical and professional staffing and solutions where we, as a top 5 provider in both Tech and FA, can focus on solving the most critical talent needs in our information and technology driven society. As we finalized the divestitures of our prime federal contracting businesses this quarter, we also delivered continued above-market growth in our Tech Flex business and strong earnings per share.
Over the course of this strategy, we've divested over $320 million in revenue. And now, nearly 80% of our revenues are derived from our domestic Technology segment. We firmly believe that the technology staffing and solutions market provides extremely deep and sustainable growth prospects. We continue to experience strong secular drivers in the technology space. Every industry and organization is being confronted with the imperative to invest and rapidly adapt changing business models and new competitors to improve its customer experience.
Virtually every Fortune 500 company now understands the value of utilizing flexible technology resources. Many of these companies that we speak to indicate to us that they're targeting a greater percentage of their overall workforce for flexible resources. These are our target clients, and they make up a significant majority of our revenues. These companies are looking to partner with firms with the necessary scale and compliance infrastructure with the breadth of services such as Kforce to both provide the resources necessary to execute on critical projects and to also assume a greater role in more complex engagements that require managed services and solutions.
Our clients have increasingly expressed their desire to engage with us to serve as a viable alternative or complement to the larger-scale integrators. While the size of this business for us is still relatively small, it continues to grow and is an important part of our strategy. We believe significant opportunity exists to expand our capabilities and provide a differentiated service to our clients. In addition, we're executing a disciplined acquisition strategy for niche solutions providers that fit our technology offerings. With respect to Kforce's internal technology, we have clearly stated our strategy is to embrace enabling technologies and focus on relationships by delivering exceptional service to our customers. We believe that with the speed of innovation and change, that they necessitate an open architecture as new tools are rapidly introduced.
In addition to our service capabilities, our financial position, which includes strong cash flows and no net debt, gives us maximum flexibility to deploy our available capital in ways that best serve our shareholders. Our priorities are to sustain our dividend yield, pursue acquisitions within the technology solutions space and return capital to shareholders through share repurchases.
During the quarter, we were able to deploy $37 million of the $102 million in net cash generated from our divestitures and share repurchases and expect to continue being aggressive until these proceeds have been exhausted. We are able to comfortably undertake these actions without reducing our flexibility to make acquisitions that improve our capabilities and offerings and make other strategic investments that may arise.
The steps we've taken have positioned Kforce to be able to dedicate our focus on an important and growing market. We are well-positioned to invest in becoming an even more valued partner to our clients, and I'm excited about our future growth prospects. I'll now turn the call over to Joe Liberatore, President, who will give greater detail into our operating results and trends. And then Dave Kelly, CFO, will add further color on second-quarter results, our intentions with the use of cash proceeds and provide guidance on Q3. Joe?
Thank you, Dave, and thanks all of you for your interest in Kforce. Overall revenues from continuing operations in the second quarter fell within our range of guidance as Tech Flex continued to gain market share and our FA Flex revenues stabilized at Q1 levels. Tech Flex grew 6.2% year over year. The majority of this growth is being driven by an increase in billable consultants on assignment as bill rates modestly improved by 2.4% over last year.
The above-market growth is reflective of our efforts to align our service offerings and operating model to best fit with how our clients purchase services. We have made a concerted effort to align our teams by industry and size of relationship to drive enhanced customer intimacy.
Consequently, our strongest growth continues to come from clients that are significant users of the services we provide and where we have established long-standing relationships. Further, the demand we are experiencing from these clients has been relatively consistent and reliable.
Conversely, growth rates of clients where we don't have as fully established relationships were slower in the quarter. We believe the continued focus on deepening our relationships with existing clients is the right path given our stellar client portfolio while also selectively establishing relationships with prospects possessing the attributes aligning to our value and capabilities to continue expanding our client portfolio.
Our strong relationships and scarcity of quality and skilled technology talent to execute the numerous technology initiatives of our clients have also driven an increase in the average duration of our consultant assignments to almost nine months. We believe this trend may continue, especially as we expand our capabilities and offerings, to provide a higher value-add service to our clients.
Fortune 500 companies continue to be the largest consumers of flexible technology talent in which we have established the relationships with many and do business with 70% of the Fortune 100. We are able to leverage our deep understanding of their needs and craft solutions through both traditional staff augmentation and also by providing a greater level of managed service and solutions offerings. We've experienced growth across virtually every significant industry vertical in which we do business with particular strength in business and professional services, as well as health services. Our weakest industry vertical was telecommunications. However, the business dynamics and the depth of client relationships within this vertical lead us to be optimistic about our long-term prospects for the services and solutions we provide.
We expect continued above-market growth in our Tech Flex business in the third quarter. Year-over-year growth rates in the third quarter should remain in the mid-single digits, and sequential growth should be in the low single digits.
Our FA Flex business declined 9.4% year-over-year and was essentially flat sequentially. We continue to make progress, repositioning this business in more highly skilled positions that are less susceptible to being disrupted by technology advancements, though it's taking longer than anticipated and the volume of new assignment starts has been below our expectations.
With this transition, average bill rates within FA Flex were up 4.7% year-over-year. The market for our FA Flex business continues to be healthy, and we believe our efforts in this area should lead to improving performance in the second half of the year. Current trends suggest that FA Flex revenues will be stable in Q3 from Q2 levels and year-over-year declines may improve to mid-single digits. Direct Hire revenues increased 7.7% year-over-year and has been a solid performing business. Our Direct Hire business continues to be an important capability in ensuring that we can meet the talent needs of our clients through whatever means they prefer, which is paying dividends. We expect a seasonal sequential decrease in the third quarter and for year-over-year growth rates in this business to be consistent with second quarter levels.
Over the long-term, we have built our model with the belief that Direct Hire will continue to decline as a percentage of overall revenues due to higher growth expectations in our other lines of business. With respect to our revenue-generating talent, we continue to make significant technology and process investments in order to continue improving associate productivity.
We are particularly focused on our new talent relationship management system along with continued efforts to leverage technologies in areas such as sourcing, talent assessment, automated intelligent matching capabilities and consultant engagement. The number of sales and delivery associates has been relatively stable this year. We don't expect to make material additions beyond those areas where productivity levels warrant, as we believe significant capacity exists to accelerate and sustain revenue growth through at least the remainder of the year.
Our simplified business model, client portfolio and focused service offerings has us well positioned for long-term growth. Our narrowed focus is yielding brand recognition and reputational results, as demonstrated by Staffing Industry Analysts' #1 ranking of Kforce as the most recognized brand by IT consultants, a world-class Net Promoter Score from our clients, and Glassdoor's highest rating among our competitors.
I appreciate the trust our clients and candidates have placed in Kforce and our team's effort in driving the firm forward. I will now turn the call over to Dave Kelly, Kforce's Chief Financial Officer, who will provide additional insights on operating trends and expectations. Dave?
Thank you, Joe. As previously noted, during the second quarter, Kforce completed the sale of our KGS and TraumaFX businesses. The operating results from these businesses through the effective date of the transactions and the gains on sale resulted in the earnings per share from discontinued operations in the second quarter of $2.40. Further commentary will focus exclusively on results from continuing operations unless otherwise noted.
Revenues of $338.9 million in the quarter grew 2.8% year over year, and earnings per share were $0.66, which is an increase of 10% year over year. Our gross profit percentage in the quarter of 29.8% declined 60 basis points year over year, primarily as a result of a decline in our Flex gross profit percentage.
Tech Flex margins of 26.4% declined 80 basis points year over year, though Tech Flex spreads were stable sequentially. Year over year, spreads have compressed, primarily as a result of our success in growing revenue with our larger clients which have a slightly lower margin profile than the overall average for Tech Flex.
As we look to the future, we expect to continue to be more deeply penetrate our existing clients. This will likely create slight declines in overall flex margins since our pricing structures typically include tiered discounts for greater volume at our largest clients. However, we believe this strategy will benefit operating margins as greater scale as individual clients allows our associates and support infrastructure to be more efficient and drive profitability that is accretive to current operating margins, even at slightly lower flex margins. Our overall portfolio is well diversified.
No single client represents more than 4.3% of total revenues, and our 25 largest clients represent only 39% of total revenues. Significant growth of a single client will not unduly create risk to the enterprise overall. SG&A expenses declined as a percentage of revenue by 30 basis points year over year. We continue to make progress in generating SG&A leverage as revenues expand.
This leverage has been achieved while also significantly increasing our technology investments. We are also aggressively pursuing opportunities to partner with leading technology firms to embrace applications that enhance our client and candidate experiences and further improve productivity and strengthen client and consultant relationships.
In the second quarter, operating margin of 6.3% was in line with our expectations at these revenue levels. During this economic cycle, our gross profit percentage has declined by approximately 200 basis points due to a decline in the percentage of direct hire business and compression in our flex spreads.
Despite this compression, operating margins have improved by approximately 400 basis points which reflects the success of our efforts to deepen relationships in our existing client base while aligning our infrastructure to optimize efficiency in serving these larger, more complex clients. Our effective tax rate in the second quarter from continuing operations was 23.4%, which was slightly lower than expected due to a change in the treatment of foreign taxes attributable to our Philippine operations which was sold in 2017.
Our business continues to drive significant operating cash flows. These cash flows, coupled with the $102 million of net proceeds from the sale of KGS and TraumaFX, allowed us to repurchase approximately 1 million shares of stock in the quarter and exit the quarter with zero net debt.
The repurchase activity in the quarter was substantially better than we had anticipated, and we now expect to deploy the remaining proceeds by the end of the year. The strength of our balance sheet, healthy operating cash flows and $300 million credit facility provide us maximum flexibility to execute quickly on strategic or tuck-in acquisitions or other ventures and strategic partnerships, even while aggressively repurchasing stock.
I wanted to provide you a sense of how our weighted average shares outstanding could trend for the remainder of 2019 given current repurchase expectations. Based upon expected Q3 and Q4 activity, we would expect weighted average diluted shares outstanding of approximately 23.4 million in Q3 and 22.5 million in Q4. This assumes the repurchase of approximately 1.1 million shares in Q3 at current price levels. Actual results, of course, could vary significantly depending upon stock price and volume.
Our billing days are 64 days in the third quarter, which is the same as Q2 and is 1 day more than the third quarter of 2018. With respect to guidance for continuing operations, we expect Q3 revenues to be in the range of $337 million to $341 million and for earnings per share to be between $0.65 and $0.67.
Gross margins are expected to be between 29.3% and 29.5%, while Flex margins are expected to be between 26.8% and 27%. SG&A as a percentage of revenue is expected to be between 22.5% and 22.7%. And operating margins should be between 6.2% and 6.4%. Weighted average diluted shares outstanding, as I mentioned, are expected to be approximately 23.4 million in Q3.
Included in our guidance is an anticipated increase in the other expense line of the income statement of between $0.01 and $0.02 per share, related to our share of quarterly losses of a joint venture we entered into late in the second quarter. This impact is essentially offset by a lower than previously anticipated effective tax rate of 24.5%.
The guidance does not consider the effect, if any, of charges related to any onetime items, costs or charges related to any pending legal or tax matters, the impact on revenues of any disruption in government funding or the firm's response towards regulatory, legal or future tax law changes.
We are excited about our prospects and pleased with the successful execution by our teams to focus our business in the areas of greatest need in our economy and to improve our processes and technology. We remain committed to our operating margin objectives. While we still have work to do, we are poised to take advantage of a strong market and our exceptional foundation to sustain above-market revenue growth rates while improving profitability.
Summer, we'll now open the floor for questions.
[Operator Instructions]. Your first question comes from Tobey Sommer of SunTrust.
Dave, you mentioned increased penetration among your customers of something they're talking to you about. What sort of room do you think there is for increased use of flexible staff within your kind of core target customers?
Yes, Tobey, this is Joe. I'd say, I'm out and I meet with a lot of clients, and unlike the days of the past, I mean you consistently hear a higher percentage of the overall population being targeted for flex for a variety of reasons. One, obviously, the flexibility that it provides them from a workforce standpoint. And then I think what's driving a lot of this is just the technology changes, how projects are being handled. And a lot of it really has to do with demand, very challenging for clients to find the full-time resources they want. So they're bringing people in to help get projects moving along. And we've consistently seen for the better part of this cycle or at least the second half of the cycle our conversion rates versus where they were historically have been much higher, which again, I view as a good thing, because we're getting people inside organizations. It gives us credit on the match that we're making with the talent into the organization.
So, we're only seeing increased demand from that standpoint.
Great. You mentioned also assignment durations lengthening. How would you frame that versus historic norms? And is there a tendency in sort of the new orders you're getting from customers so that duration could elongate further?
Yes. It was part of what I mentioned in my comments on the nature of the type of work we're performing has something to do with duration. But even if we just look at the pure staff log, another fundamental shift that I've seen at being around the tech business for the last 31 years is I've never heard so many large, and I'm talking Fortune 500 companies, reevaluating what their tenure limits are from a co-employment standpoint on the flexible side. So we've seen organizations expand that.
In fact, I was just out with a Fortune 100 company that has a 12-month tenure limit. And so by the time they get somebody ramped up, they're having to exit them. And they're in the process of evaluating if they're going to take that to 24 or 36 months. So I think that's playing a big piece of it.
And all of this still comes back to the great imbalance of the demand side versus the talent that exists. I mean, when people are getting talent that can perform the duties, they're wanting to hold on to that talent because the work isn't slowing down.
Okay. Last question from me, and I'll get back in the queue. Could you give us a little bit of color on the JV that you cited as incurring a little bit of other expense?
Yes. Sure, Tobey. This is Dave Kelly so just at a high level, and we've talked about technology investments and looking at opportunities to expand our business and enhance our proposition. So the joint venture is really an entity just briefly that provides mobile technology products to the staffing industry really to aid in critical aspects within the overall staffing process and from a pretty broad spectrum, from identification through engagement, so a nice tool, again applicant-facing tool.
Thank you very much.
Your next question comes from Tim McHugh of William Blair.
Good morning. You've actually got Trevor Romeo in for Tim today. First, I know you said that growth was a bit slower this quarter for clients that don't have fully established relationships compared to the ones that, where you have well-entrenched relationships. Do you have any thoughts on what may have caused that?
Yes. This is Joe. Really what's driving that is, I think, it's the market forces. Supply demand being in balance, the amount of competitors that have entered the space, I mean, I think Staffing Industry Analysts reported it last year.
While the space has doubled in size, the competitive landscape has also doubled. And many of these competitors who we would consider the local organizations that typically have come out of larger organizations and started their own shops, so they have very narrowed relationships, but those relationships are very deep. So when we're in there what one would consider really more the retail or the local market business, it's a nice fight. It's highly competitive.
It's where the majority of the competitors exist, and then they're well entrenched in the local market. So our people have to work a lot harder to win that business. And in many instances, we'll have people that maybe have two years of industry experience, and they're competing with people that have been in this industry for 10, 15 or 20 years. So I think our brand and our capabilities internally help our people to balance that differential in terms of just experience and exposure.
But our yield at the market level has always been a little bit higher, meaning it requires more effort to yield the same outcome ala a placement. We saw that really expand a little bit in Q2.
It could just be a blip, I wouldn't say that it's a trend at this point in time, but we just wanted to call that out as we recover in the quarter.
Yes. I would add to Joe's comment. As we think about the client segmentation, but just overall demand, when we look at those large clients that we do business with, growing well in excess of our average growth rate, the demand, the ratios that we see for those clients continue to really sustain at very, very favorable levels. So this is a dynamic, I think, in terms of our relationship and the size of those clients.
Okay, got it. That makes sense. And then you also mentioned that you're looking at acquisitions for niche solution providers that fit your technology offerings. So are you primarily focused there on sort of just staff augmentation for staff that can provide those types of solutions? Or are you looking more for consulting or managed services types of companies, I guess?
Yes. Trevor, these are the ladders really where our focus is, those organizations that are really more up the value chain that we can plug into our advanced services offerings for what really our client demand is.
[Operator Instructions]. Your next question comes from John Healy of Northcoast Research.
Just wanted to ask a little bit more about the F&A business. Clearly, not what we would like to see, but we can understand some of the pressures there. And was just hoping to understand what could be done that maybe that's not being done to get that business into growth mode. And do you think that, that's something that could likely occur in the current framework? Or are we waiting for something maybe next cycle before the F&A business kind of turns green again?
Yes. And I mean we've spent some time on this on prior calls. This is a Kforce-specific dynamic. It is not a market dynamic. And I think you can see that when you look at some of the competitors that publicly announced and that are performing in the FA space. This just happens to be how our footprint has shifted into high volume, really lower skilled roles because of our unique capability to deliver to those through our national recruiting centers. And we got out of balance in terms of the amount of revenue that was coming out of those areas, rev cycle and a number of other call centers, various other things where there's been a lot of changes that have happened in those marketplaces.
Some of it, technology disintermediation of replacement of certain of the skills, and then some of it, that space has just changed with some of the competitive dynamics. So our team is doing a nice job on repositioning what I would consider more back into the core FA business and focusing on those skills of moving us upstream there. It's just one of, I believe our strategy is the right strategy. The space is not going away. It's just going to take us time.
Got you. And I wanted to ask a little bit about the topic from last call, the managed services and of opportunity. I know you have laid out kind of 20% bogey over the next few years and maybe try to ascribe to. Do you need to do M&A to get to that level? And any kind of important developments on that process that maybe happened in the quarter?
No. I mean, we're continuing to have wins, mostly within existing clients where we have pretty strong relationships and the opportunity to go upstream a little bit more as presented to ourselves. But, yes, I think when Dave had put that out, just so that we're clear, because you said a couple of years, we had pretty, David pretty much mentioned, that was really what our five-year objective was, so I don't want to get ahead of ourselves on that front. When we look at that as a five-year objective, now when we run our models, we believe we can accomplish that organically.
But we will look for strategic, selective opportunities that will fit within Kforce, fit within the right service offerings and bring a greater breadth and maybe accelerate some of the things that we're doing. So it is a very narrow or I should say a small pond that we're fishing in because a lot of the pieces have to fall in place to make it make sense. We're not going to just do an acquisition for acquisition's sake. It's going to have to really dovetail and fit into where we're going strategically.
Great. Thank you, guys.
At this time, there are no further questions. I'll turn it over for closing remarks.
Well, thank you for your interest and support of Kforce. And while we always have much more to do, I would like to say thank you to each and every member of our field and corporate teams and to our consultants and our clients for allowing us the privilege of serving it. Thank you very much.
This concludes today’s conference. You may now disconnect.