LECG Q3 2007 Earnings Call Transcript

| About: LECG Corp. (XPRT)
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LECG Corp. (OTCPK:XPRT) Q3 2007 Earnings Call October 30, 2007 5:00 PM ET

Executives

Erin Glenn - IR Manager

Michael Jeffery - CEO

Steve Fife - CFO

Analysts

Andrew Fones - UBS

Tim McHugh - William Blair

Operator

Good day, ladies and gentlemenand welcome to the LECG Third Quarter Earnings Call. My name is Jen, and I’llbe your coordinator for today. At this time all participants are in alisten-only mode. We will be facilitating a question-and-answer session towardsthe end of today's conference. (Operator Instructions). As a reminder thisconference call is being recorded for replay purposes.

I will now turn the presentationover to Ms. Erin Glenn. Please proceed ma'am.

Erin Glenn

Thanks, Jen. Good afternooneveryone and thank you for joining our conference call. Before we begin ourformal comments, I'd like to remind you that in our financial news announcementreleased today and also on this call, LECG Corporation is providing specificforward-looking statements as defined in the Private Securities LitigationReform Act of 1995 concerning LECG's future business and operating andfinancial conditions.

These forward-looking statementsare based upon management's current expectations as of today, October 30, 2007, afterwhich there may be events that occur to cause actual results to differmaterially from expectations. Information on these risk factors is included inthe company's filings with the Securities and Exchange Commission, which weurge you to consider. The company cannot guarantee any future results, levelsof activity, performance or achievements and undertakes no obligation to updateany of its forward-looking statements after the date of this press release.Finally, you can find a reconciliation of the non-GAAP financial measures thatwe use in our news release and on this call to GAAP financials in today'searnings release. We'll start with opening remarks then followed with Q&A.I'll now turn the call over to Michael Jeffery, LECG’s Chief Executive Officer,Michael?

Michael Jeffery

Thank you Erin, and goodafternoon everyone, I will begin the call today with a discussion of thequarter and then review the progress that we have made on our recovering valueplan, I also want to share my thoughts on how we are positioning ourselves for2008. I will then turn the call over to Steve Fife, our CFO, to take youthrough the financials. Following Steve's remarks we'll open the call up forquestions. Overall I'm very pleased with our third quarter results. LECG’soperating margin increased 100 basis points over Q2 and we are benefitingdirectly from the actions taken under our recovering value plan.

We also enjoyed strong revenueperformance, however, this quarter's margin improvement was largely due tosaves in G&A and the incremental pick-up in gross margin is yet to be fullyrealized. As we discussed on the last call, the first half of the year wasabout right sizing our cost structure through headcount reductions andoperating expense controls. We also organized our experts and professionalstaff into sectors to better manage utilization and drive organic growth. Ourstrong revenues were achieved on lower expert and professional staff headcountresulting in record utilization levels.

The quarter demonstrates that ourrestructuring actions have not disrupted our top line and speaks to ourrecognized ability to deliver high quality service to our clients. Demand forLECG services remains robust and we continue to benefit from the excellentreputation of our experts. We experienced particularly high demand in the ITand damages sector and in our Londonoffice. Engagements of note in our economic based practices include, workingfor Whole Foods in a merger challenge by the FTC and evaluating a majorairlines approach to help network congestion.

Matters secured by the newlyformed FAS group show the benefit of a more organized approach, for example, wehave been retained on a number of engagements in the subprime mortgage space,which tapped into several of our core skill sets including complex damages,risk management, regulatory evaluation and litigation strategy.

In addition the stock option backdatingcases have moved from the audit and investigation phase to the criminal andcivil phase and we expect the matters will ramp up over the next couple ofquarters, driving additional opportunities, the high utilization and highleverage. Our ability to use Bates as a support engine for FAS has alsoresulted in decent revenue recovery for this group in the quarter. Prior rightsizing in electronic discovery has begun to restore the profitability of thatpractice. Revenues increased in the quarter contributing to a strongerutilization. While the performance of this group may be a little uneven throughthe end of the year, the renewed focus on internal synergies and qualitydelivery will allow us to capture increased value from E-Discovery in 2008.

Overall LECG's professionalstaffing levels have stabilized and utilization soared to 86% in the quarter.In fact in some sectors we appear to be somewhat understaffed, which hasadversely impacted the gross margin. As high margin staff work was done byexperts and subcontractors.

However, these are verymanageable problems to have. And as we hire staff in a disciplined targeted waywe will be able to balance utilization across the sectors and gross marginshould improve. We intend to build in response to sustain demand.

In Q4 we have two things to focuson to achieve the right positioning for 2008. One, we need to better alignexpert incentives with the interest of our stockholders. And two we need to getahead of the industry wide problem of attracting and retaining top talent on along-term basis.

To address these things we willbe finalizing a new equity based incentive compensation program that contains asignificant element of retention. In addition as mentioned in the secondquarter call, we will also finalize our retention agreements with Dr. Teece aswell as three other key [ray makers].

We are most pleased that theyhave made long-term multiyear commitments to LECG and that they have alsocommitted to enhanced performance targets. As we close in on the last stages ofour recovery plan we want to make sure that we're well positioned for creatingvalue in 2008.

We're finalizing our 2008strategic and operating plans including a detailed assessment of our coststructure and geographic footprint.

As we complete this process, wemay identify additional one-time charges in Q4, which would largely benon-cash.

We are determined to enter 2008unencumbered by recovering value issues and with the manageable business modelthat is well-positioned to deal with today’s competitive market forces, whiledelivering attractive and sustainable returns to our stockholders.

We are confident that LECG willremain the first choice for our clients seeking top talent. Here the expertsworking on high stakes matters or the professionals who support them.

As we emerge from our recoveringvalue phase, I look forward to emphasizing real organic growth through thedevelopment, training, mentoring of staff and emerging experts.

I am impressed with thecommitment from the EMT and extremely pleased with the high degree of cohesionand team work with corporate management. With continued strong demand for ourservices, I believe we are well positioned, as we emerge from the recoveringvalue phase.

Now, I’ll turn the call over toCFO, Steve Fife, for review of the numbers and an update on our financialorganization. Steve?

Steve Fife

Thank you, Michael. Goodafternoon everyone. I’ll review the financials and bring you up to speed onsome of the operational changes in finance and accounting. Then we’ll open thecall up for Q&A.

Let’s begin with the P&L.Third quarter revenues grew 9% over the prior year, with organic growth of8.7%. We had 63 billing days this quarter compared with 64 in Q2 and 63 lastyear.

For Q3, 74% of our experts wereon an at-risk model.

The average billing rates for thequarter were $446 per hour for experts and $226 per hour for professional staff.Reserves against revenues were 3.9% compared with 4% in Q2 and 4.4% in Q1.Reserves were 2.6% of revenues in Q3 last year. I anticipate reserves willcontinue to run at 4%, and we’ll let you know when we anticipate a change tothis rate.

Reimbursable expenses were 4.7%of revenues during Q3, 07 which is consistent with our normal rate of 4.5% to5%. In Q3 of 2006, reimbursable expenses were 6.5% of revenues as a result ofthose Electronic Discovery Services provided by third parties, which in subsequentquarters were billed directly to clients.

Gross margin was 33.9% in Q3compared with 34.9% in Q2, excluding second quarter restructuring expenses, andbasically flat with third quarter of 2006.

Expert compensation as a percentof expert revenue or the pass through rate was 79.1% higher than Q2s rate of75.2%, although lower than 83.4% than the same period last year. The sequentialchange was largely a result of incremental expenses, due to improvedE-Discovery profitability and higher reserves for expert gross deficits.

Finder fees were 11.2% of staffrevenues including subcontractors flat with Q2 and up from 10.1% a year ago.

Gross profit was also negativelyimpacted by higher levels of lower margin subcontractor fees. We usesubcontractors to manage overflow work and maintain utilization. They aretemporary resources before we decide to add permanent staff.

Professional staff bonus accrualsmore than doubled over Q2, largely as a result of our 86% utilization rate.Annual junior staff salary increases were also implemented in July of thisyear.

Equity-based compensation expensefor cost of services was $723,000, and amortization of bonus expense was $2.7million. We expect improved gross margins during Q4, as we more effectivelymanage our utilization and drive higher leverage.

General and administrativeexpenses were 22.6% of sales versus 24.6% in Q2, excluding second quarterrestructuring expenses.

Cash operating expenses declinedby almost $1 million.

Compensation expense decreased$360,000 reflecting benefits from our recovering value actions.

The remaining decline was inmarketing and business development expenses, a seasonal benefit due to timingof marketing events in Europe and the US.

Depreciation and amortization was$1.8 million flat with Q2, and equity-based compensation for G&A was$634,000, including the amount contained in cost of services. Totalequity-based compensation for the quarter was $1.357 million.

Turning to balance sheet metricsand cash flow, DSOs at the end of the quarter were 114 days, consisting of 82days build and 32 days un-build of receivables. This is unchanged from thesecond quarter.

Cash flows from operations, was$8.6 million including $2.9 million of capitalized bonus payments. Capitalexpenditures were $822,000 from lease hold improvements and acquisition earnout payments were $3.7 million.

We ended the quarter with $3million improvement in our net cash position compared with Q2. Our ending cashbalance was $13.5 million and we had no outstanding balance from our creditfacility.

We completed the review of ourfinancial organization and made two significant hires during the quarter, a newcorporate controller and a new director of [FP&A], both on board and arebeginning to contribute.

We've made significant progresson updating our financial reporting including preliminary sector basedprofitability reports, and a revised P&L, which makes it easier to examinesome of our key performance drivers.

We've also introduced a financingaccounting sub committee within the [EMT]. Working together with this team andour new head of FP&A I expect report on our Q4 calls a final set ofoperating and financial metrics that we will be using to benchmark our progressand performance going forward.

We confirmed our fourth quarteroutlook. We still anticipate revenue of $95 million to $98 million and earningsper share of $0.24 to $0.26. Incorporating the third quarter results, therevenues for the full year of 2007 would be between $385 million and $388million and earnings per share of $0.80 to $0.82. This includes $0.09 ofrestructuring charges taken year-to-date.

While Q4 has the same number ofbilling days as Q3, this is typically the seasonally down revenue quarter forus due to the holidays. As Michael mentioned, we are performing a final reviewof our recovering value plan and operating asset days.

Our fourth quarter guidanceexcludes any potential charges resulting from actions we may take associatedwith this review. We are now conducting our 2008 planning process and plan toissue our financial outlook for 2008 when we report our fourth quarter 2007results.

This concludes our preparedremarks, and we are now ready to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. (OperatorInstructions). Your first question comes from Andrew Fones with UBS.

Andrew Fones - UBS

Yeah, hi, thanks. I was wonderingif we should expect any restructuring charges in the fourth quarter?

Michael Jeffrey

Yeah, Andrew, as we have said we'recontinuing to look at our overall cost structure. We -- our real goal is to beable to enter 2008 as strong as we can and as we finalize our strategic andoperating plans here over the next couple of weeks we're looking forward at ourcost structure and our geographic foot prints and out of that we may be takingsome additional charges but as of this point in time we haven't quantified whatthat might be if any.

Andrew Fones - UBS

Okay. And then obviously, we sawthe utilization make some perfect sense as though you might be looking to bringon some additional staff, can you walk us through what the time line might bethere and also what practice areas you might be looking to add people?

Michael Jeffrey

Yeah, what we want to do is, wedid have strong utilization during the quarter and certainly in certain areaswe were really running too hot for us and as a result it had a negative impacton some of our costs. What we're looking to do really is, to level load in someof the offices where we're -- we realize we're under staffed right now and sowe'll selectively be adding in those offices where utilization is running highand we're starting that process now and it's not something that we can justeasily turn on. Fortunately, we do have the benefit of utilizing subcontractorsto help bridge the gap, so we don't miss any of our commitments to our clients.But we are looking to add some of the resources selectively in offices whereutilization is high at this point.

Andrew Fones - UBS

Okay, and then on thesubcontractors. Can you just remind me, what's the pass-through rate is forthose? What the gross profit is on the subcontractor revenue?

Steve Fife

Yeah it runs at around the 50%level. This is actually quite a good problem first to have, Andrew. And as muchthat our gross margin was slightly impacted by the fact that work was beingpicked up by experts and subcontractors instead of the higher margin staff, insome of our offices, we were running at about 120% utilization, so we arerunning very hot. And again, I think, this is a good problem for us to dealwith because as we higher into this, we will see an improvement in our grossmargin.

Andrew Fones - UBS

So, I understand you viewsubcontractors instead of staff rather than using subcontractors instead ofexperts because obviously your 50% gross margin was publicly.

Steve Fife

I think the large part of it, wassubcontractors instead of staff but in certain instances, in certain officesthat we have used some subcontractors or I would say more affiliates, as thework really has picked up, as we've always said, we don't have a real problemin terms of demand for our business, in September source with the considerablegrowth in demand to fulfill our expertise.

Andrew Fones - UBS

And so, are you able to quantifythe impact on the margin from the subcontractors, what would your gross marginhave looked like, if you having a few subcontractors?

Steve Fife

Well, I think we’re not in aposition to kind a get into that right now, but it would have been healthierthan as it looks at this point in time. And it's surprising to say that I feelvery comfortable without gross margin at this point knowing that we have thatunderline issue there.

Andrew Fones - UBS

Okay. This answers all myquestions. Thanks guys, good job.

Steve Fife

Thank you.

Operator

The next question is from TimMcHugh with William Blair.

Tim McHugh - William Blair

Hi, guys. Just wanted to touch onyou mentioned the uptick in demand in September. Can you talk at all about hasthat flow through to October?

Michael Jeffery

Well, we continue to have robustdemand for our services. And I think that we look forward to the fourthquarter. As we’ve mentioned on many, many calls before, Tim that, we are in endurable position we've been in, what we callthe non-discretionary spend element of the world and we have an inelasticdemand aspect.

So, we continue to benefit fromthat.

Steve Fife

Our utilization has remain strongthrough the first three weeks, three weeks of the month and that, should bodewell for our demand or it's consistent with the demand that we saw in Q3.

Tim McHugh - William Blair

Okay. Thank you. And then youwere talking about having to or looking to add professional staff in certainareas. Are you at a point yet, where we should start seeing positive growth ona sequential basis the number of experts? Are you still in the process ofcalling out what you would consider under performance?

Michael Jeffery

Well, I think we will continue torun more of the performance focused business. So, I don’t think that there willbe a time in LECG, where we’re not focused on the performance of our experts.But we are looking now to -- you know the key thing for us is to positionourselves well for 2008. And that’s our focus. And as we come out of thisrecovering, as we call it add recovering value plan because we come out of thatphase we are looking towards -- enjoying to be in more of a growth mode nextyear.

Tim McHugh - William Blair

Okay. And then, turning to, youmentioned that in the fourth quarter you hope to finalize some cash and equitybased retention compensation. Can you talk about the impact both on in terms ofcash payments, as well as, on the income statement in terms of equity comp?

Michael Jeffery

We’re still in the process offinalizing these and I think that once we’ve got to finalize we’ll make theright kind of announcement and you’ll be aware of.

Tim McHugh - William Blair

Okay. And lastly I guess, as welook to the fourth quarter, the level of profitability implied in yourguidance. Are you at a point now where some of the restructuring initiativesyou took earlier this year, the full impact in terms of cost saving isreflected? And what you are looking at for the fourth quarter here or are someof the benefits still on the comments we look out to '08?

Michael Jeffery

I think that you are not going toturn something like this around in the quarter or in two quarters. I think wealways said that. We’ve also recognized there is going to be some lumpiness aswe get to the point where we feel really comfortable. And again, our focus inmy eyes are really on coming into January 2008 in a very strong position. Andwe would still as we have done in this quarter, we will still look to reinvestsome of those savings into interesting practices. And in fact, we have grownand moved into a couple of areas that were right on target for usstrategically.

So, we have reinvested some ofour gross margin sales into buildings some very attractive practice areas forus. Because we know as we come out of this -- you can't be in a business thatdoesn't grow because you have been recalcitrant and we need to get a buzz backaround this organization and that comes with being back into a growth modealbeit a controlled measured growth as we said. We are looking at really try tofocus on true organic growth in the 10% level and we want to make sure we arein good position for that for 2008.

Steve Fife

And I am just tagging on to thepreviously announced savings that we anticipated realizing through the recoveryplan activities. During the Q3, I think it's fair to say we are pleased withthe amount of savings that we did in fact realize both in the [cards] area andin G&A and as Michael said we have reinvested some of that as again we saidwe were going to do. But the fact is we did realize savings through the actionsthat we took in Q1 and Q2.

Tim McHugh - William Blair

Okay. Thank you very much andcongratulations.

Operator

(Operator Instructions). As thereare no more questions in queue, I will turn the call back to management forclosing remarks.

Michael Jeffrey

Well thanks everyone forparticipating today. We're cautiously optimistic about the progress that we havemade today. We believe that we are on track to enter 2008 with a nimbleoperational base, a very focused business model that delivers an attractivereturn to our stockholders, and a solid platform for profitable growth. We lookforward to giving you a comprehensive update next quarter. Thank you very much.

Operator

Ladies and gentleman we thank youfor your participation in today's conference. This concludes the presentationand you may now disconnect. Have a good day.

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