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Kforce (NASDAQ:KFRC)
Q3 2019 Earnings Call
Oct 30, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Q3 2019 Kforce Inc. earnings conference call. [Operator instructions]. Please be advised that today's conference is being recorded.

[Operator instructions]. I would now like to hand the conference over to your speaker today, Mr. Michael Blackman, chief corporate development officer.

Michael Blackman -- Chief Corporate Development Officer

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?

Dave Dunkel -- Chairman and Chief Executive Officer

Thank you, Michael. You can find additional information about this quarter's results in our earnings release in our SEC filings. In addition, we have published our prepared remarks within the investor relations portion of our website. Unless otherwise indicated, our commentary relates to results from our continuing operations.

We are very pleased with our third-quarter results, as both revenues and earnings per share exceeded the top end of our guidance. The better-than-expected results were driven primarily by an acceleration in new assignment starts in our technology business as the quarter progressed. We are excited about our focused footprint with technology now comprising almost 80% of overall revenues. Our business is now completely dedicated to meeting our clients' domestic needs in technology, and finance and accounting, which are two of the largest and fastest growing segments.

Clients, particularly in Technology, are looking for partners that are able to provide resources at scale with multiple skill sets across multiple geographies and with a focus on compliance. We have built a business that is able to do just that without distraction, and it is helping us increase clients and market share. Growth in our technology business has now outpaced the market for the eighth consecutive quarter. We continue to look to deepen relationships within our existing client portfolio, which is comprised of predominantly Fortune 500 companies.

These companies are increasingly looking for their partners, such as Kforce to provide the resources necessary to execute on critical projects and to also assume a greater role in more complex technical projects that require managed services and solutions. Our clients have increasingly expressed the desire to engage with us to serve as an effective, more cost-efficient alternative or complement to the larger scale integrators, as evidenced by our success and recently winning several strategic engagements. This growing demand significantly expands our market opportunity beyond the $30 billion domestic technology staffing market. Demand for flexible staffing resources continues to be quite strong.

Every organization across every industry is being confronted with the imperative to invest and rapidly adapt to ever-changing business models, new competitors and the changing preferences of their customers. Market-leading companies understand the value of utilizing flexible technology resources to execute on the project work needed to address this changing landscape where speed and flexibility are critical. Discussions with many of these companies indicate that they are targeting an increased proportion of flexible resources within their technology teams to meet these project-driven needs. We believe these secular drivers of demand have fundamentally changed the trajectory and persistence of technology investments and utilization of flexible labor to meet this demand.

Given the strength in the secular drivers of demand and technology, we would expect the performance of the domestic technology staffing and solutions market, to perform well, relatively speaking, even during adverse macroeconomic environments. What is true for our clients is also true for Kforce. As demand for our services grows, we are constantly evaluating and testing and enabling technologies that can significantly enhance the experience of our clients and candidates and improve the effectiveness and efficiency of our people. Before I turn the call over to Joe, I wanted to let you know that during the quarter, we repurchased 1.2 million shares, roughly $40 million in the third quarter.

And in early October, we made additional purchases that exhausted the $102 million in estimated net proceeds from our divestitures earlier than we had anticipated. Looking forward, our low debt level and strong cash flows provide significant flexibility to both pursue strategic acquisitions and still consider opportunities to return additional capital to shareholders. I will now turn the call over to Joe Liberatore, president, who will give greater detail into our operating results and trends. And then Dave Kelly, our chief financial officer, will add further color on third-quarter results, our intentions with use of cash proceeds and provide guidance on Q4.

Joe?

Joe Liberatore -- President

Thank you, Dave. And thanks to all of you for your interest in Kforce. Our technology service offerings continue to be the engine that is fueling our growth. This business saw meaningful improvements and starts activity in the second half of the quarter, which drove an improvement in year-over-year growth rates to 6.5% in the quarter.

However, both our FA Flex business, which grew sequentially and our Direct Hire business, which has seen improvement in growth rates for four consecutive quarters, were important contributors to exceeding our expectations in the quarter. Collectively, we have excellent service offerings that set the firm up versus same growth at rates exceeding the market. Let me provide some details about the performance in each of our service lines. We continue to take a larger share of business at existing clients and technology.

The increase in billable consultants on assignment at clients where we have our longest and deepest relationships is driving our growth, which has now exceeded the market for eight consecutive quarters. We believe our continued focus on furthering deepening relationships with existing clients is the right path given our enviable client portfolio. We have established the relationships with roughly 70% of the Fortune 500, many of which are long standing. These companies continue to be the largest consumers of technology talent.

We are aligning our service offerings and operating model to best fit with how these clients purchase our services. We have made a concerted effort to align our teams by industry and size of relationship to drive enhanced customer intimacy. Overall, technology bill rates have increased modestly by 2.9% over last year and 1% sequentially. Our strong relationships, coupled with the quality of skilled technology talent, we provide our clients is contributing to an increase in the average duration of consultant assignments, which is approaching 10 months.

We believe this trend may continue due to the scarcity of supply and the growth we're experiencing in higher value-add managed service solutions projects. We are leveraging the longevity of our relationships and the resulting deep understanding of existing client needs to provide talent through traditional staff augmentation, while also increasingly seeing success in areas, including resource and capacity management, as well as managed services and solutions. While the size of this business for us is still relatively small, it continues to grow at a faster rate with higher margins and is an important part of our strategy. We believe significant opportunity exists to expand our capabilities and provide differentiated value-add services to our clients.

We've experienced growth across the majority of our top industry verticals, with particular strength in business and professional services, technology and health services, with some weakness in telecommunications and financial services. We are expecting an increase in conversion activity with some of our largest clients in the fourth quarter, but are planning to offset this and expect year-over-year technology growth rates to approximate third-quarter levels on a billing-day basis. FA Flex revenues increased sequentially for the second consecutive quarter, though declined 5.3% year over year. The market for our FA Flex business continues to be healthy, and we expect revenues to remain stable at these levels for the near term.

Average bill rates within FA Flex were up 3.9% year over year and 0.9%, sequentially. Revenues in the fourth quarter last year were positively impacted by a federal government disaster recovery project related to the hurricane relief that did not reoccur. Consequently, revenues will be down from Q4 levels last year. We expect year-over-year revenue declines in the high single digits.

Direct Hire revenue increased 11.8% year over year and has been performing well in 2019. 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. We expect a seasonal sequential decrease in the fourth quarter and for year-over-year growth rates to be impacted by a tougher comp in the fourth quarter of 2018. 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, which will be rolled out to our associates over the next several quarters. This system should improve our capabilities and more effectively and efficiently sourcing, evaluating and deploying talent. Continued productivity improvements and the expectation of further improvements have allowed us to accelerate revenue growth while maintaining a relatively stable level of sales and delivery associates. We expect this trend to continue, and believe, we have significant capacity available to further drive growth.

We don't expect to make material additions beyond specific areas where productivity levels are extremely high and building further capacity as warranted. Our simplified business model, client portfolio and focused service offering has us well positioned for long-term growth. Our focus on relationships with our clients and candidates is well recognized as we carry a world-class net Promoter score for our clients and Glassdoor's highest rating among our competitors. I truly appreciate the trust our clients and candidates have placed in Kforce, and our team's effort in driving the firm forward.

I'll now turn the call over to Dave Kelly, Kforce's chief financial officer, who'll provide additional insights on operating trends and expectations. Dave?

Dave Kelly -- Chief Financial Officer

Thank you, Joe. Revenues of $345.6 million in the quarter grew 4.2% year over year and earnings per share from continuing operations of $0.68 grew 21.4% year over year. Our gross profit percentage in the quarter of 29.8% increased 40 basis points year over year as a result of a higher mix of Direct Hire revenues and a higher Flex gross profit percentage. Our Flex gross profit percentage increased 10 basis points year over year.

While we are seeing an increase in rebates and discounts from our largest clients, we're having success growing revenues at other clients, where our share of client spend is not quite as significant, and the margin profile is more attractive. Additionally, revenue from managed services projects, which also have a more attractive margin profile is increasing. The 30-basis-point improvement in Tech Flex margin, which is 26.8% in the third quarter was driven by some favorable pricing adjustments. We expect margins, subject to seasonal impacts, to remain closer to Q2 levels, prospectively.

Our portfolio is well diversified. No single client represents more than 4.2% of total revenues, and our 25 largest clients represent only 40.2% of total revenues. SG&A expenses increased as a percentage of revenue by 10 basis points year over year as a result of increased accruals for variable compensation costs related to improved full-year performance. Absent these costs, we continue to make progress generating SG&A leverage as our revenues grew.

This leverage has been achieved while also significantly increasing our technology investments. We expect to continue to make incremental technology investments to improve productivity and drive operating efficiencies while continuing to improve profitability. Our third-quarter operating margin of 6.4% was in line with expectations and on track with our operating margin objectives. During this economic cycle, our gross margins have declined by approximately 200 basis points due to a decline in the percentage of Direct Hire business and a compression in our Flex spreads.

Despite this compression, operating margins have improved over 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 and serving these larger and more complex clients. Our effective tax rate in the third quarter was 25.3%, which was slightly higher-than-expected due to the nondeducibility of certain performance-based compensation costs. Our business continues to generate significant operating cash flows, which were $24.2 million in the third quarter. These cash flows, coupled with the $102 million of estimated net cash proceeds from the sale of KGS have allowed us to return significant capital to our shareholders.

Through the third quarter, we've repurchased $91.3 million or 2.6 million shares and paid cash dividends of $12.7 million for a total of $104 million return to shareholders this year. Additional share repurchases in October marked the completion of the full deployment of the $102 million and estimated net cash proceeds, which was accomplished ahead of schedule. The efficient redeployment of proceeds from the divestitures has allowed us to fully offset the negative impact to our earnings per share from the loss of profitability from the divested businesses through the accretion derived from lowering our share count. Our net debt at the end of the third quarter was approximately $24 million.

The strength of our balance sheet, healthy operating cash flows, low capital requirements and $300 million credit facility provide us maximum flexibility to pursue strategic acquisitions that enhance our service offerings to our clients, while being appropriately balanced with returning capital to our shareholders. There were 62 billing days in the fourth quarter, which is two days less than Q3 and the same as the fourth quarter of 2018. A single billing day equates to roughly $5.4 million in revenue. With respect to guidance, we expect Q4 revenues to be in the range of $336 million to $341 million, and for earnings per share to be between $0.65 and $0.69.

Gross margins are expected to be between 29.2% and 29.4%, while Flex margins are expected to be between 26.8% and 27%. SG&A as a percentage of revenue is expected to be between 23% and 23.2%, and operating margins should be between 5.7% and 5.9%. Weighted average diluted shares outstanding are expected to be approximately $22.1 million. Our anticipated tax rate, effective tax rate of 19.7% as expected in the fourth quarter.

As a reminder, fourth quarter operating margins are impacted by approximately 40 basis points due to the seasonal decline in Direct Hire revenues and the impact of two fewer billing days on our fixed cost infrastructure. Additionally, earnings per share estimates included negative impact of approximately $0.02 related to our share of quarterly losses from the WorkLLama joint venture. We anticipate that our share of the losses in this joint venture could approximate these levels for the next several quarters. These costs are reflected in other income and loss on the income statement.

Our expected effective income tax rate of 19.7% for the fourth quarter includes estimated tax benefits on the vesting of restricted stock of approximately $1.1 million, which positively benefits earnings per share by $0.05 in the fourth quarter compared to our normalized tax rate of approximately 26%. Due to the vesting schedules of our long-term incentive grants, the impact of this adjustment is reflected almost entirely in the fourth quarter each year. Our guidance does not consider the effect, if any, of charges related to any onetime costs, costs or charges related to any pending tax or legal matters, the impact on revenues of any disruption in government funding or the firm's response toward regulatory, legal or future tax law changes. Finally, having completed the KGS divestiture earlier in the year and finish deploying the related capital, we thought it would be helpful to provide some initial perspective on 2020, as well as to provide additional information on the quarterly impacts of seasonality on our profitability and how that might affect full-year results.

We've included a table in our press release for illustrative purposes to assist in your understanding. We will continue to provide quarterly guidance, which, obviously, will provide our investor base with the most up-to-date information and expectations. The table reflects our expectation of continuing to grow our technology business at year-over-year growth rates of 6% or better than for our finance and accounting revenues to be stable on a billing-day basis. We've provided detail on quarterly operating margin expectations consistent with the targets we have previously established of attaining 6.5% when quarterly revenues reached $350 million and 7.7% at $400 million.

You will note the seasonality impacts to these margins in Q1 of 180 basis points, primarily due to annual payroll tax resets in Q4 of 40 basis points, consistent with the impact we expected this year. We expect a fairly linear progression toward our operating margin targets. Operating margins are expected to improve by approximately 10 basis points for each incremental $4 million in revenue. The strong performance noted suggests that revenues will grow between 4.6% and 6.1%, and we will generate full-year operating margins of between 6% and 6.2%, taking into account our reduced share count of approximately $22 million, this would result in an improvement in full-year earnings per share of between 18.2% and 25.1%.

We're excited about our prospects and well positioned to take advantage of a strong market and our exceptional foundation to sustain above-market revenue growth rates while improving profitability. Jimmy, we'd now like to turn the call over for questions.

Questions & Answers:


Operator

[Operator instructions] And our first question comes from Tobey Sommer with SunTrust.

Tobey Sommer -- SunTrust Robinson Humphrey -- Analyst

I wonder if you could start out by giving us a little bit of color regarding your decision to, kind of, offer us a preliminary outlook at 2020. Historically, most companies in the industry only give a look out one quarter and it's after half the quarter is done. So how did you arrive at that choice?

Dave Kelly -- Chief Financial Officer

Yes, Tobey, this is Dave Kelly. So I think a couple of things. Obviously, we've done a lot of work over the last few years, and there's been a lot of, I guess, effect on our income statements, and I think it becomes increased -- it has become difficult for you guys, in particular, to say where are we going. Now that we've completed the divestitures.

We've got a couple of quarters ahead of us. And frankly, we had finalized the deployment of all the cash and looking at where the public and the analyst base is in terms of models, there's a lot of differentiation there. So we thought since we finished that work, we'd give you a look at: Number one, how things look on a clean basis; and number two, there seem to be quite a few questions from time to time on the seasonality impacts of the business. So we wanted to provide, although we verbalized that in quarters past, we wanted to provide you a little bit more easily understandable look at that.

So I think those are really the drivers as well as, I mean, obviously, reiterating our belief that the market for 2020 for tech, in particular, is going to be strong.

Operator

[Operator instructions] Our next question comes from Greg Mendez with Baird.

Greg Mendez -- Robert W. Baird and Company -- Analyst

It's Greg on for Mark Marcon. I was wondering, could you talk a little bit about how you're thinking about 2020 -- the Flex IT gross margins? I mean, you improved here, normalized a little bit in Q4. But I mean, is the expectation that maybe we can hold those stable? Or would larger crown still be a little bit of pressure? And could you offset that with some of the stuff you're seeing with statement work?

Dave Kelly -- Chief Financial Officer

Yes, Greg, this is Dave Kelly. Yes, to your point, we have seen some nice stability in margins in general. I think we've done a very good job in managing our business, looking for opportunities to drive improved margins and increase our clients here, as we mentioned. I think as we look forward, I think we look at relatively stable margins going forward.

Clearly, it's a competitive environment out there and growing client share in some respects requires us to obviously, put some pressures on bill pay spreads. But I think we do look for stability. I would say if there is any degradation, it would be along the lines of what we've seen, our ability to grow revenues and drive at least as good operating margin unit, those declining margins because we're taking client share and being more efficient is, it's been very beneficial for us. So I think gross margin stability, even if there's a degradation, I think our operating margin expectations continue to be very solid.

Greg Mendez -- Robert W. Baird and Company -- Analyst

OK. And just also thinking, with the productivity gains you're seeing, we've done a lot from a technology perspective here. I know you had the talent management system rolling out. I mean, what else is on the road map to help drive further productivity gains.

If you could just talk a little bit more about that?

Joe Liberatore -- President

Yes, Greg, this is Joe Liberatore. I would say, even from a technology standpoint, we've yet to realize what we truly believe the productivity gains could be there from technology. So we're in the early innings there. So we think there's a lot of opportunity, especially when we look at the activities from candidate acquisition through match, where we're seeing the majority of investment being made in the marketplace, really addressing opportunities in those areas.

So I'd say that's one leg of the stool. This is ongoing technology. This is going to continue to provide opportunities, and we haven't realized what we believe the opportunities are there just yet. The other, I would say, is that the consistency of our team's execution.

We've been really relentlessly focusing on the business to drive a greater consistency into our overall operating model, which has a byproduct effect of allowing us to ramp people faster, improve our retention of individuals. So it all, kind of, dovetails together with our technology strategy and our -- really our human capital talent strategy, putting those two things together, and then the overall operating environment.

Greg Mendez -- Robert W. Baird and Company -- Analyst

OK. So I mean, you still think there's more room within the headcount that you have?

Joe Liberatore -- President

Yes. No, we're very comfortable. We've continued to see our productivity levels, especially in our more tenured people move up on. They're actually at all-time highs right now, and we still see room there when we look at metrics such as average amount of placements that somebody is making on a weekly or monthly basis, the amount of billable consultants that we have for associate.

We see plenty of runway there. And then when we get into our less tenured populations, just a lot of opportunities continue to move those up.

Operator

[Operator instructions] Our next question comes from Tobey Sommer with SunTrust.

Tobey Sommer -- SunTrust Robinson Humphrey -- Analyst

It seems like your assignment lengths in Tech have elongated quite a bit. Could you talk about that? And to elaborate on kind of what's driving that?

Joe Liberatore -- President

Got it. I mean, Toby, as you're well aware, I mean, this is an interesting time when you have every organization across every industry competing really for the same type of talent. We're seeing trends in the marketplace that, personally, I haven't seen prior in my career. We're seeing a lot of organizations looking at extending their tenure limits, in fact, I just met with the client last week that was talking about moving their tenure limits from two years to four years.

And mainly, the reason that they're doing this is because they see the ongoing need for these skill set. And also they're battling to get the skill sets on board. And so by the time they're getting these people oriented and ramped up and productive in their environments, they're having to turn them over from a tenure standpoint. So we're seeing expansion in tenure limits is one driver of it.

The other is the statement of work business. When we look at the different ways that we're engaging in statement of work, whether it's through managed teams, managed services solutions. These types of initiatives usually have a multiyear facet associated with them. So as that continues to be a higher percentage of our overall business, that's also extending out those contract durations.

So Toby, the last piece that I would add, and I don't know if you saw the Wall Street Journal article a couple of weeks ago, where they talk about Tech employment, currently, 7.6% of overall employment in the U.S., and they're projecting that to go into double digits in the coming years. So I think customers are really seeing the demand for these technology people, especially on these front-end customer-facing systems. It's not going away.

Dave Kelly -- Chief Financial Officer

And this is Dave. I would add that it's going cross-functional as well. So you see F&A people are becoming more information analysts, and so they're taking on additional technology skills. So technology is clearly driving business models, productivity and really transformation in moving into the digital realm for a lot of these nontraditional competitors as they're moving into new space.

So I don't see that ending anytime soon.

Tobey Sommer -- SunTrust Robinson Humphrey -- Analyst

Great. I appreciate the answer. You talked about investment in Tech in, kind of, new tools. Could you just for a second talk to us about whether these are proprietarily developed or you're buying, kind of, industry off-the-shelf things and maybe doing some customization to them.

Joe Liberatore -- President

Yes. It's a great question. Actually, what we've done is we've got. We've componentized all of our front-end systems.

So that allows us an opportunity to basically plug-and-play as different technologies are evolving. So we all see it. I mean, today, XYZ search engine might be the best search engine, somebody might be developing a better search engine in their garage tomorrow. And so when we went through our system rearchitecture, basically, we broke everything apart so that we'd have ultimate flexibility in plugging and playing.

So we're really doing both. I'd say it's a combination of partnering with organizations that are very focused in specific areas. Because here's the reality. I mean, Kforce is not going to help technology on the massive technology providers and everybody's after human capital in one way or the other.

So we're partnering. We're acquiring SaaS-type licensing. And then we're also bringing in platforms and customizing to a certain extent. So it's really a combination of all the above.

Tobey Sommer -- SunTrust Robinson Humphrey -- Analyst

Last question for me. In your 2020 outlook, you gave us a little bit of color on Tech and F&A, about Direct Hire, what would the assumption be for 2020?

Dave Dunkel -- Chairman and Chief Executive Officer

Yes. So again, yes, we're trying to give you an illustration here of how 2020 might look. I think, obviously, the Direct Hire market has been -- is very good. Joe talked about, and you were talking about average duration of assignment, right, to strengthen the Direct Hire market probably reflective of the same thing, trying to identify talent.

And I think we're looking at a very good year for '19. And as I look forward here, a relatively stable good outlook for Direct Hire for 2020. But again, I wouldn't read too much into specific numbers here, Tobey, this is for illustrative purposes.

Dave Kelly -- Chief Financial Officer

Yes, from a per Direct Hire standpoint as well, Tobey. I think it's important to note, it was probably about three years ago, we saw our conversion levels really move up. And we've seen those stay at elevated levels. So it's clear, the end clients are utilizing staff augmentation as also a means to accommodate their full-time hiring, more in the try and buy.

So we're seeing really a lot of right to hire being executed within our contracts. Once those consultants become proven, they see an ongoing need. It's a right fit for the consultant. It's a right fit for the organization.

So that's another means where Direct Hire. And we don't really, in many instances, derive revenue in our Direct Hire line item associated with that because after certain duration of assignment, basically, those consultants can convert, and there's no fees associated with that. So that employment space in tech has been very healthy.

Operator

And we have a follow-up from Greg Mendez with Baird.

Greg Mendez -- Robert W. Baird and Company -- Analyst

Just one more follow-up. I was wondering if you could just talk a little bit more on the growth with managed services in the quarter. And then how we're thinking about that next year? I mean, obviously, you continue to grow, but I think previously, we're at about 5% of revenue. So just thoughts there and for next year would be helpful.

Joe Liberatore -- President

I remember one of our previous calls, I believe, Dave had managed the expectations, our objective over the course of the next five years is to really evolve this service offering to be roughly 20% of our overall revenue mix or better hopefully. And so we're continuing to make the investments. The pipelines continue to build that we're building out the teams. I'm also refining our processes and methodologies.

We've aligned our more dedicated people to focus on these efforts. So we're very comfortable with staying on track to hit those objectives that Dave put out there.

Operator

And I'm showing no questions in the queue at this time. I'd like to turn the call back to David Dunkel, chairman and CEO, for any closing remarks.

Dave Dunkel -- Chairman and Chief Executive Officer

All right, great. Well, thank you for your interest and support for Kforce. While we always have much more to do. I'd like to again say thank you to each and every member of our field and corporate team and also to our consultants and our clients for allowing us the privilege of serving you.

We look forward to speaking with you again soon. Thank you.

Operator

[Operator signoff]

Duration: 36 minutes

Call participants:

Michael Blackman -- Chief Corporate Development Officer

Dave Dunkel -- Chairman and Chief Executive Officer

Joe Liberatore -- President

Dave Kelly -- Chief Financial Officer

Tobey Sommer -- SunTrust Robinson Humphrey -- Analyst

Greg Mendez -- Robert W. Baird and Company -- Analyst

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