Kforce Inc (KFRC) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. And welcome to the second quarter 2011 Kforce Incorporated earnings conference call. (Operator instructions.) As a reminder, this conference is being recorded.

And now I'll turn the program over to Michael Blackman, Chief Corporate Development Officer. Sir, the floor is yours.

Thank you. Good afternoon, and welcome to the Q2 Kforce conference call.

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 on current expectations and assumptions that are subject to risks and uncertainties. Actual results may differ 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 Kforce in our 10-Q, 10-K, and 8-K filings with the SEC. We provide substantial disclosure in our release, and our hope is that this will improve the dissemination of information about our performance and the quality of this call.

Overall, we are pleased with our record second quarter revenues of $274 million and earnings per share of $0.17, which represent year-over-year growth of 11.3% and 30.8%, respectively. We are pleased with the performance of our Tech Flex and HIM businesses and the continued strength in Search, which performed well in both Technology and F&A.

However, results for the quarter were mixed as we continued to experience headwinds which negatively impacted a number of our businesses. Our government business continues to be impacted by the challenging government contracting environment, and the mortgage related component of our F&A business continues to be negatively impacted by the slow-down in mortgage refinancing and foreclosure activity.

Kforce clinical research also did not grow sequentially in the quarter as previously anticipated due to a slower than expected ramp at a major client project and some headcount reductions at two large customers.

Management is focused on being flexible and constantly adapting to the changing landscape across each of our businesses, particularly those experiencing challenges, to mitigate any negative external impacts and position the Firm to take advantage of future opportunities.

We have made progress repositioning these business units and have confidence in our Teams. Over time we continue to believe that though all of our businesses rarely are performing at their peak at the same time, diversification in our revenue footprint provides the best platform for long-term success.

We remain committed to our goal of surpassing prior peak earnings with a higher quality revenue stream that is less dependent upon permanent placement revenue. However, the challenges mentioned and the fact that margins, particularly in our Tech Flex business, are not expanding as quickly as in previous cycles suggests that peak earnings will not be achieved as quickly as originally anticipated.

As a result of these unexpected challenges and the significant changes that have taken place in the economic outlook since February, 2011 revenue and earnings growth targets previously discussed will likely not be achieved and long-term revenue and earnings growth targets will need to be assessed in the context of this uncertain global fiscal landscape.

Since February 2011, Q4 '10, Q1 '11 GDP have been revised downward. 2011 GDP expectations have been significantly reduced. [BLS] employment data has been contracting, and the macroeconomic environment remains uncertain due to the U.S. fiscal issues.

However, despite the GDP backdrop, which historically correlates to decline in temp staffing revenues, we have continued to see an environment where a disproportionate amount of private sector hiring is being created through the temp sector. Our thinking remains that this uncertain environment which has persisted for more than two years continues to drive our clients' increasing desire for a more flexible workforce. This is particularly true in high-scale niches, as college educated unemployment was just 4.4% in June. Talent shortages are particularly acute in Tech, which is project driven by nature and constitutes over half our revenues.

In fact, we believe the decline in GDP expectations for the U.S. economy reinforces our clients' desire to utilize flexible staffing, which allows them to quickly adjust to this constantly shifting economic environment and the significant uncertainty surrounding regulatory, tax, and healthcare reform. Many client meetings have confirmed that they are reluctant to go long human capital in this macro backdrop.

We remain confident in our belief that there is a sustained secular shift toward a flexible staffing model and that temporary staffing penetration of the workforce may achieve historic highs in the United States. We also remain confident in our highly leverageable operating model and anticipate continued revenue and earnings growth, both in the near term and over the long term.

I will now turn the call over to Bill Sanders, Kforce President, who we welcome back. Bill will provide additional insights on operating trends and expectations, and then Joe Liberatore, CFO, will provide remarks on overall financial performance. Bill?

Thank you, Dave. And thanks to all of you for your interest in Kforce. We at Kforce are committed to revenues and earning growth. We will accomplish this by quickly adapting to the dynamic issues facing our clients. We will provide exceptional service to our clients which will accelerate growth.

We also expect to continue to improve profitability through the leverage that exists in our highly advanced operating platform and by further evolving the NRC which allows us to (inaudible) serve certain clients and which would not be possible under our traditional staffing model.

In Q2 we continued to have success in pursuit of these objectives, and our largest business unit, Technology Flex, which represents 55% of total Firm revenues. Q2 revenues increased 7.6% sequentially and 15.4% year-over-year. We have been successful allocating Firm resources, such as the NRC, to our best performing verticals, such as the financial services and healthcare, and are also taking advantage of the continued widespread strong demand for highly skilled tech professionals in the marketplace.

Our key performance indicators, such as job orders and client visits, are stable. And fill ratios are improving, which reflects increased efficiency in prioritization of requisitions. However, the candidate pool is tight for skill sets in demand. Maintaining pipeline and finding candidates through passive recruiting and social media is a necessity. We expect sequential revenues for Tech Flex to increase in the third quarter.

Revenues for our Finance & Accounting Flex business, which represents 17% of our total revenues, decreased 0.7% sequentially, and increased 24.6% year-over-year. This business was again impacted by a larger than expected decline in activity and lower bill rate positions, inclusive of the mortgage refinancing and foreclosure space which constitutes approximately 18% of our F&A business. This portion of our F&A business declined 14.7% sequentially, and we anticipate a flat to slightly declining revenue trend for this portion of our F&A business in Q3.

Management is adapting to changes in this business to allocate resources to stronger performing sectors of our business. July performance indicators for FA Flex in total are up slightly from June levels, and we expect revenues for this unit to be flat to slightly up in Q3.

Both of our Tech Flex and FA Flex businesses benefit from the continuing maturation of our cost effective and highly elastic National Recruiting Center, coupled with our Strategic Account strategy, as well as our highly tenured workforce serving all of our clients. Currently 27% of Technology and F&A revenue is being supported by the NRC. This percentage increased from 25% in Q1, and we expect this percentage to grow as our Strategic Account strategy gains further momentum and increasing tenure in the NRC leads to additional productivity improvements. We believe the continued evolution of these teams and their related success provides significant additional revenue and earnings leverage.

Our HLS business segment, which represents 16% of total revenues in Q2 2011, is comprised of our clinical research and our health information management businesses. HIM revenues increased 4.8% sequentially, and increased 21.2% year-over-year. Our HIM revenue trends continue to be promising. Its hospital span continues to improve, particularly in the project services and remote [coating] areas. This business has performed nicely over the past five quarters as it continues to evolve its business model to better embrace the evolving technological changes in the space.

We believe in the long-term demand for this profitable business and, in particular, the opportunities that should evolve for both HIM and Tech Flex are the transitions to electronic medical records and with the October 2013 deadline for the adoption of [ICD10]. We expect HIM revenues to be up again in the third quarter.

During Q2 revenues in our clinical research business decreased 0.2% sequentially and 6.2% year-over-year. We experienced an unexpected decline in revenue during Q2 at two large clients due to increased turnover as well as a slower than expected ramp of a significant project that was awarded in Q1. Management continues to monitor this changing space as many long-term drug patents are scheduled to expire shortly and industry consolidation continues. We will adapt to these changes as they occur and continue to position this business for success. We are expecting revenues to be flat in Q3.

Revenues for Kforce Government Solutions, our prime government contracting business, decreased 6% sequentially and declined 19% year-over-year. This profitable business unit continues to see the negative impacts of the challenging Federal procurement environment. We remain focused on our key competencies and consistent with our philosophy during difficult periods are challenging all aspects of this business and its processes. We have recently made significant upgrades in our Senior Management and Business Development Teams so that we are fully prepared to take advantage of opportunities and niches where we excel as the external environment improves. As we look ahead to Q3 we anticipate revenues will be flat with a stable profit picture in this unit.

Perm revenues from direct placements and conversions, which constitute 4.4% of total revenues, increased 20.6% sequentially and 23.5% year-over-year. We continue to make measured investments in our field and NRC search teams to support our high quality revenue stream, though our financial targets are not predicated on returning to prior peak perm revenue levels. Perm revenues are very difficult to predict in Q3 since a significant portion of revenues are generated in September. Thus, we are projecting perm revenues to remain flat to slightly down in Q3.

In terms of headcount trends, we continued to make selective investments in our sales headcount during Q2, while ensuring the allocation of existing headcount in areas of greatest demand. Sales headcount inclusive of the NRC and strategic accounts has increased 3.9% year-over-year. We continue to believe that continued development of our National Recruiting Center and our Strategic Account Teams provides a leverage to increase productivity well beyond historical highs and at a cost of delivery well below historic levels. And, therefore, we expect near-term headcount additions to remain selective.

We began our diversified service offerings, fortified by our tenured Field Teams and our National Recruiting Center and Strategic Account executives for a result in continued revenue growth as we move further through this economic recovery. We remain focused on adapting to the changing needs of all of our (inaudible) to optimize performance to position the Firm for long-term success. Our priorities are continuing, relentless focus in retaining our great people and in improving client satisfaction, while driving continued profitable revenue growth.

I will now turn the call over to Joe Liberatore, Kforce CFO and Executive Vice President, who will provide additional insights on operating trends and expectations. Joe?

Thank you, Bill. Total revenues for the quarter of $274 million increased 4.4% sequentially and increased 11.3% year-over-year, driven by continued growth in our Technology Flex, HIM, and Search businesses.

Quarterly revenues for Flex of $161.8 million increased 3.8% sequentially and increased 10.8% year-over-year. Search revenues of $12.2 million increased 20.6% sequentially and 23.5% year-over-year. Overall, revenue trends improved each month within the quarter but results by segment were mixed.

Sequential monthly revenues for Tech Flex improved April to May, and again May to June, though the rate of improvement slowed in June. Sequential revenue trends for FA showed improved in June after sequential declines in April and May. HLS revenues declined from April to May and then remained flat in June. Search was strong in April and May but slowed in June, as typical entering the summer months.

Flex revenue trends for the beginning of the third quarter of 2011 are up slightly from June. For the first three weeks of July Tech Flex is up 18.2% year-over-year, Finance & Accounting Flex is up 13.5% year-over-year, and HRS is up 4.9% year-over-year. Search revenues are up 2.2% year-over-year for the first four weeks of Q3 2011. We caution that early quarter trends do not necessarily accurately reflect potential full quarter results. We also note that in 2010 revenue trends strengthened significantly late in Q3.

Net income of $6.8 million and earnings per share of $0.17 in Q2, 2011 increased sequentially 40.2% and 41.7%, respectively, compared to Q1 2011. Year-over-year net income and earnings per share increased 31.9% and 30.8% from $5.1 million and $0.13 in Q2 2010.

Our solid bottom line results despite an environment in which gross margin expansion, particularly in our Tech Flex business, have proven difficult as a result of discipline related to controllable costs and improving cost efficiencies from our operating platform, as well as increased use of our cost efficient National Recruiting Center.

Our overall gross profit percentage of 31.6% increased 170 basis points sequentially but decreased 30 basis points year-over-year. The sequential increase was driven by a combination of mix shift, a decrease in payroll, tax related costs, and a slight improvement in bill pay spreads. The year-over-year decrease is a result of a combination of compressed bill pay spread and increased payroll taxes.

Our Flex gross profit percentage of 28.4% in Q2 2011 increased 130 basis points sequentially due primarily to a 110 basis point reduction in payroll taxes from Q1. Year-over-year Flex gross profit percentage decreased 60 basis points primarily as a result of decreased bill pay spreads and the increased payroll taxes. Bill pay spread in Tech Flex are essentially flat sequentially and year-over-year, and FA Flex spreads have improved 40 basis points sequentially and 30 basis points year-over-year.

Over the past two years the U.S. economy has been growing at a relatively slow rate, though we've had success in growing revenue it remains very challenging to improve bill pay spreads across our business lines. We continue to be highly focused in this area and believe that the current supply, demand environment suggests that pricing power will improve over time but not at a rate previously anticipated.

Impacting the improvement in bill pay spreads, particularly in our Tech Flex business, is the continued growth of our strategic accounts, which typically have lower margin and where spreads are more difficult to expand. In order to continue to expand operating margins in this environment Management continues to reinforce its use of the NRC, in particular to support the Strategic Account portfolio. This significantly lowers the cost of delivery and results in a highly profitable business despite lower gross margins.

Additionally, we continue to have a relentless focus on all controllable costs. Overall we anticipate continued moderate improvement in bill pay spreads across all our staffing businesses into Q3 and into 2012, though at a slower pace than originally anticipated.

We're very pleased with the declining trend in operating expenses over the past two years. Operating expenses were 27.5% of revenue in Q2 2011, which increased 60 basis points from Q1 2011 but decreased 70 basis points from 28.2% in Q2 2010. The sequential increase was driven largely by a whole quarter of headcount additions made in late Q1 and incentive based compensation related to the pay for performance plans.

In addition, as we continue to adapt our changing environment we are incurring some onetime costs during Q2 and Q3 related to the relocation of our back office functions for our government business to Tampa, Florida. We expect to realize long-term savings as a result of this centralization effort.

The continued year-over-year reductions in our operating expenses as a percentage of revenue are a reflection of our diligent management of operating expenses and the expansion of our National Recruiting Center. The NRC currently services approximately 27% of our Tech and F&A revenue, yet comprises only 12% of compensation related to these businesses as compared to servicing only 6% of Tech and F&A clients three years ago.

Another key benefit from investments in our National Recruiting Center and Strategic Accounts Group is to improve the performance of our field and sales associates thereby improving retention and reducing the cost of expensive turnover. Field associate turnover continues to be low. As the percentage of NRC usage increases across the Firm we anticipate additional operating expense leverage. Additionally, as revenues increase we continue to see operating leverage from the technology investments made over the past seven years.

Our accounts receivable portfolio continues to perform very well. Write-off continued to be small and the percentage of receivables days over 60 days remain at low levels, increasing slightly to 4.1% on June 30th as compared to 3.5% on March 31st.

The Firm cash flow continues to be strong. EBITDA was $17.3 million or $0.43 per share in Q2 as compared to $14.1 million or $0.34 per share in Q1. Year-over-year EBITDA increased 25.8% from $13.7 million in Q2 2010.

Bank debt at quarter end of $18.9 million is down from $25.3 million at the end of Q1. Borrowing availability under our credit facility, which expires in November of 2011, is currently $88 million. We've actively been in discussions with various parties for a replacement facility and expect to finalize a transaction in Q3.

The Firm repurchased approximately 425,000 shares of stock for a total of $5.6 million in Q2. There's currently $54 million available for future stock repurchases under the current Board of Directors' authorization. We will continue to be opportunistic in the future repurchases as cash flow and market conditions warrant.

With respect to guidance, the third quarter of 2011 has 64 billing days, same as the second quarter. We expect revenues may be in the $276 million to $283 million range. Earnings per share may be $0.17 to $0.19. Our effective tax rate in Q3 is expected to be approximately 37.7% with approximately 40.5 million weighted average diluted shares outstanding. This guidance reflects flat to modest gross margin improvement and continued SG&A leverage. This guidance does not consider the affect, if any, of charges related to the impairment of goodwill, acceleration of equity incentives, or the Firm's response to regulatory, legal, or tax law changes.

We continue to be confident in our long-term success as we strive to adapt to the changes to the external environment and our businesses. Our mix of service offerings, particularly in Tech, FA, and HIM, position us well as we see continued secular shifts towards flexible staffing.

Our gross margin profile is already one of the most attractive in the industry, but the capability to cost effectively meet customer needs with the speed and quality allows us to drive EBIT both through increased gross margins and through operating efficiencies and flexible compensation structures.

We have a high quality revenue stream and balance sheet, a highly tenured associate population, as well as the strongest Management Team in the Firm's history. We expect to capitalize on the capacity that exists in our associate base to grow revenues and improve earnings.

Operator, we'd like to now open up the call for questions.

(Operator instructions.)

Our first questioner in queue is Mark Marcon with Robert W. Baird. Please go ahead.

Good afternoon. I was wondering if you could talk a little bit about the SG&A, the sequential jump that you saw, you mentioned that there was a portion of that that was due to shifting over some of the back office functions from KGS over to Tampa. Can you quantify how much that was? And once those steps are done what sort of savings should we see?

Yes, Mark, this is Joe. Really there were really three main things that impacted that 60-basis point increase. One of those being the back office, nominal impact in Q2 associated with that. We'll feel a little bit more of the impact in Q3 because we'll be running almost completely redundant operations for that period of time. And then the people in San Antonio and Fairfax will be exiting the organization, and so we'll get some of those pickups as we head into Q4.

We also had added some headcount in our NRC on the back end of Q1, so we had the full quarter impact of that headcount addition in the quarter. And then also when I was referencing our performance based plans, they really hit us from three points -- search performed very well, so we get some increase in SG&A, while that helps us from a bottom line standpoint, it does show-up with a little increase in SG&A because of that mix, as well as we have people moving through our Flex ladders because of their performance, and then Management had an extremely good quarter because of the way that we do our current quarter based upon the average of the prior two quarters.

Got it. So how much of an increase are we going to see sequentially going into Q3 because of the shift in terms of KGS?

Well, in Q3 actually I just mentioned, Q3 we'll have more expense in our Q3 than we had in Q2 because of KGS because we added people in Tampa throughout the quarter, and so we'll have the full impact of that in Q3 as well as carrying those people in San Antonio from the transition standpoint. However, as I mentioned, I mean all this is contemplated in our guidance, so we do anticipate that SG&A will decrease as we move from Q2 to Q3.

SG&A will decrease as you go from Q2 to Q3?

Percentage basis, yes, it will, even in spite of the KGS redundancy.

Okay, and just can you quantify how much that KGS redundancy will be?

Yes, no, we're really not going to break that out at this point in time.

Can you talk a little bit about what the savings might be later on?

I mean our initial transition is focused on the compliance act, that's in making sure that we do no harm to the business. As part of our assessment we've been looking at this for quite some time. We do believe once we get that in Tampa and stabilize because of the leverage we'll get from a communications standpoint and various other aspects that we will get SG&A pick-up, but we haven't broke-out what percentage of F&A because that's within the KGS.

Okay, and can you talk a little bit about the anticipation with regards to the Flex gross margins going into the third quarter just sequentially?

Yes, Flex gross margins and guidance, I mean we're being conservative so we're anticipating flat to slight improvement from a Flex gross margin standpoint, albeit that we are -- we're tracking this on a weekly basis and we have continued to see week-over-week improvements early in the quarter.

Okay, great. And then are you anticipating that government stabilizes here or given all the headlines that are out there does it make sense to just assume that we're going to continue to see some deterioration with regards to the top line?

Mark, this is Bill. Certainly the government is not going anywhere. In the area that is a sweet spot for ourselves, we believe that there will be continued funding although funding at different times and different places are certainly unpredictable compared to prior periods. So we think that we're in the right spot, technology primarily was about 50% of our prime government business. And we think that we will continue to see growth in that area. We have reorganized our Management Team. We've upgraded our Senior Management Team. We have upgraded substantially our Business Development Team.

So we think it's a good diversification of our revenue stream. It's good, solid risk management for us. And we are as confident as you can be in this very uncertain environment that we will have a flat third quarter for us, fourth quarter for the government. And we expect to take market share. We expect to grow this business over time.

Great. It's good to hear your voice again, Bill. Who is -- in terms of the change, in terms of the KGS Management Team, are you talking about more recently or are you talking about what happened awhile ago?

No, I mean it's basically in the second quarter, but we brought in some top people from some of the larger groups around here. As you know, [Glenn Schaefer] retired. He's now Chairman of the Board of KGS, and he would (inaudible) at [Moneymaker], is the Vice Chairman of that Board. So we believe we have built an excellent Team. It's time for them to produce, I agree with you, but they're somewhat new. We brought in a number of different people, and we're pleased with what we see today.

Okay, thanks. I'll jump back off.

Thank you, sir. Our next question in queue is Kevin McVeigh with Macquarie. Please go ahead, your line is open.

Great. Thank you. Hey, Dave, I wonder if you could give us just a little perspective on kind of the core, what I'll call more cyclical businesses, like IT as opposed to government and clinical research where it seems like we're seeing some slowing there, as well as the F&A side? Just kind of your thoughts on that in terms of where we were, expectations into Q2, and then how that progressed, particularly given kind of revenue coming in below the low end of the range? Thanks.

Sure. I would say that Tech actually performed well. It was up 15% year-over-year and 7.6% sequentially. So Tech is actually performing well for us, and we believe that reflects what's happening in the market. We expect it to continue to perform well. HIM, as you know, performed well. Search performed well.

Now, if there were areas that didn't meet our expectations in Q2 it was certainly in the government space, it was in the clinical space. And we saw a decline and a slow-down in the orders in the mortgage related and the real estate related activities within F&A. So as we had gone through and done our modeling and given our guidance for Q2 it's those three units really that did not come to meet our expectations for our second quarter numbers.

So the rest of our business has remained strong. We're still very confident in Tech. I think the marketplace overall for Tech remains very strong. What we're hearing from our clients and what we're seeing in our KPI said Tech is strong.

And, as is typically the case, you know, it's having a diversified revenue stream works for you sometimes and works against you sometimes. And today everybody would say, boy, you should be 100% Tech. And a year from now they'll say, boy, we're really glad that you have a diversified revenue stream when things change.

So we've done what we've done with the four legs of the stool intentionally. Certainly three, four years ago we couldn't have foreseen what would have happened in the government space or even in the clinical space, and when you look at what's happening with bio pharma.

But with that being said, we're playing the cards we're dealt. We're making the adjustments. And, most importantly, I have confidence in our Team. We've got a great Team, and our Team is used to winning, particularly in those three units, and they're working aggressively and fighting aggressively to make the adjustments necessary to accomplish what we set out to do there.

So overall Kforce has performed well. We were up 11.6% year-over-year in revenue. We expect to continue to grow revenue year-over-year, and we're confident in our Team. Although we certainly have a couple of challenges in those businesses.

Understood. And just on the mortgage side was that more kind of the processing the application? Because I know it's kind of full circle in terms of doing some work on the foreclosures, as well, or is it just generally across the whole sector on the mortgage side?

This is Bill, Kevin. We certainly were very lucky to have the NRC employees when the mortgage refi business, when it started. There were some large companies putting out anywhere between 300 and 600 orders at a time. Because of our NRC we were able to capture a significant portion of that that we would not have been able to capture before.

So it's a little bit of a sugar high. You take advantage of some things and, of course, when it declines it comes down a little bit. But I mean we've gone from mortgage refinancing to now foreclosures, and litigations, and reconciling. You know what the industry is, the financial services industry is going through. And we're kind of moving a little bit with that but certainly the mortgage refi business, loan was really cranked up last year. The comps for us are a little tough but year-over-year we're up, as Dave just said, 24% but sequentially pretty flat.

And, Kevin, that business as a percentage of F&A in one quarter declined from 23% to 18%, so we're -- our core F&A business is still performing and still growing. And, as you'll see looking ahead, as Bill said, we expect it to be flat to slightly up, and that component of that F&A business we expect will be the more traditional core business, even as some of the larger financial services firms have reduced their expectations on refinancing and also have slowed down their foreclosure activities and some of their other activities. So, and you're very familiar with the space so, as Bill said, the comps became more difficult for us as that space changed.

The regulatory environment changed, too. You've got the [Safe Act]. You've got the (inaudible) Bill that the banks are sitting back and waiting to see. So there's a lot of things that are dynamic in that Group, and we're very fortunate to have the NRC that can move quickly from vertical to vertical.

Super. Thanks.

Thank you, Kevin.

Thanks, Kevin.

Thank you, sir. Our next question in queue is Paul Ginocchio with Deutsche Bank. Your line is open.

Thanks for taking my question. Just on -- maybe talk about smaller accounts -- is your revenue that's outside the NRC up year-on-year or however you'd look at it? Just wondering how the smaller accounts are doing within Kforce? Thanks.

Sure. A year ago Strategic Accounts was 22.9% of our business, and second quarter it was 22.6%. So as we have grown, I mean it's been pretty stable of what the Strategic Accounts and the other what you would call basically the spot market or the transition market has stayed pretty constant. So when you consider all the things that we have talked about I mean we have been quite strong in that market and we'll continue to be.

Just if I look at maybe some of your competitors it seems like the spot market gross margin is doing a little better than you had implied from the third quarter, so I'm just trying to know is it just that your Strategic Accounts gross margin is declining year-on-year that much and it's not being made-up for the small accounts?

Yes, I would say from a Tech Flex standpoint, Paul, that'd be very accurate. I mean we're noticing nice margin improvement in the stock market and somewhat flat in our Strategic Account portfolio. In fact, from a Tech Flex standpoint we did notice a nice improvement and then slight decline in spot. From an FA standpoint very similar. I would say that on the FA front we're really seeing actually some improvement in our higher volume accounts in terms of margin, and actually a little bit more flat in the spot market. And a lot of that just has to do with the nature of the business that we're focused on.

Well, I want to correct a stat that Bill gave you. He gave you 22% of total Tech business or total revenue being in our strategic accounts, it's 32%.

Basically flat, 32%?

That's just Tech. My percentage was total revenue of the Firm. I will add a little bit to what Joe just said, in Strategic Accounts we had longer term contracts, and as we replaced people pay rate increases. So there's some lag between pay rate and bill rate from Strategic Accounts. Now that gap will close as we renew contracts, and as these clients find that they can't attract the people at these kind of rates. So it's much more gradual because of the mix that you see within Strategic Accounts versus the spot market.

Great. And then just maybe sort of talking about longer term guidance, you talked about I think it was gross margins not going up sort of as much as planned, so you sort of changed your guidance or your longer term guidance. Was there any certain events or contracts or things that took place that kind of changed your opinion? Can you kind of just help us, what happened between -- over the last three months? Thanks.

No, I wouldn't say anything contract wise had really changed from that front. It's more so, you know, we're very much looking at what's happened in historic cycles, and then map-out the current cycle. And we were having an experience that was very similar, and we've noticed a tempering of that, so that was really why we had raised the awareness. So, obviously, this cycle very different than anything else that we've experienced in the past when we look at all the dynamics that are coming at us, whether it be from when we look at healthcare reform, lack of job creation, as Dave referenced the GDP environment. So just with all those dynamics coming into play we just tempered that back a little bit.

And, Paul, I would comment also that in Tech Flex specifically as we've picked up the additional volume in strategic accounts the more efficient delivery of the NRC actually has lowered our SG&A and the comp related to that, as Joe said. And as we've modeled this out and, frankly, strategically when you look at the industry the adoption of VMS tools and VOP is continuing to accelerate not only large accounts but middle market accounts, as well.

So we expect over the long term that the more efficient delivery system is going to gain us additional share and actually give us a little bit more leverage on the SG&A front. So what we're doing isn't a quarter-by-quarter thing, it's really a part of a much longer term strategy to address what we think are macro trends in the industry. Yes, go ahead?

I appreciate that. It's just it's tough to see this quarter because of the spike in SG&A and the gross margin, which was at least versus my expectations a little bit below. So unless we can size the impact of the changeover in KGS it's just very hard to see that you're getting any efficiencies.

Yes, I mean -- and, again, this is -- if you look at it quarter-by-quarter or point in time that's very difficult because you have different events and dynamics that happen in any given quarter, which is I think the best thing to reflect upon is look at what's happening on a year-over-year basis and what type of improvements are taking place because I think our SG&A has been continuing to come down.

I mean just to give you an example, from a Tech margin standpoint, there in the last cycle our Tech Flex margins improved about 450 basis points off the trough to the peak levels that we hit at 29.4. This time around we only declined 240 basis points at the trough, which was in Q4 of 2009. So for comparison purposes margins troughed at 24.9% in the last cycle in Tech Flex as compared to 27% this cycle, and then we've improved 10 basis points off of the trough here.

My point being is this has a lot to do with this shift into these more stable, larger customers. It reduces the risk of the Firm. So, for example, in the downturn our Tech Flex business decreased 11.2% whereas most of the sector was decreasing 25% to 30%. So when you start to look at those impacts that our Tech Flex business has grown 35% off of that trough level, had we decreased like the rest of the industry we would have had to grow 60% to get back to the $150 million Tech Flex business, where we are today.

Thanks.

Thank you, sir. Our next question here in queue is Gerry Krishnan with Credit Suisse. Please go ahead.

Hi. Thank you. I guess a question on Tech Flex. You addressed some of what's going on in Tech, but when you look at the GDP and how it's taken longer the cycle for -- it's not risen as much, is any of that also due to sort of the mix shift of assignments you're servicing, at all, or not?

I don't believe -- our bill rate has been pretty constant so it's really -- it's not driven by the mix if we were to compare this cycle to last cycle. It's really the points that I had mentioned. It's the focus on the customers that we're going after, which are the more stable, longer term contracts. Now, the down side with stable, longer term contracts is it's not like the stock market where it's re-pricing itself every four months on their longer commitments. But, again, I think it proved through the downturn that it protected our revenue stream more effectively, and we're seeing the opportunity in the up cycle here, as well. So that will serve to change over time as those clients have to adjust to what the market demands are in terms of bill rate expansion.

Okay, and on the F&A business, clearly the mortgage refis, we've seen that impact for more than a quarter, but given some positive commentary on F&A from some of the competitors and looking at I think you would expect a modest growth in Q3. Could you talk about how the rest of your F&A business, drill-down into what sort of trends you're seeing and any implied bill pay spreads for Q3?

That's a two-part question, and I'll handle the one part, and Joe will handle the other part. Certainly, again, we don't overreact to a short run quarter results. We are up 24.6%, I said, I believe that's the number, year-over-year. And that's very important to us. That is our core business, and F&A continues to grow and we continue to invest in that Group. So I would tell you we expect that core business to continue to grow. KPIs are strong in July, so we expect things to continue.

Joe, you want to talk about bill rate?

Yes, from a bill pay spread standpoint FA collect spreads improved 30 basis points on a year-over-year, they improved 40 basis points sequentially. So we saw bill rates, basically they -- basically the bill rates increased 0.9% sequentially while pay rates increased 0.2% sequentially, just to give you a feel on the actual numbers.

Okay. Thank you.

Thank you, sir. (Operator instructions.)

Our next question in the queue is Tobey Sommer with SunTrust. Your line is now open.

Thanks. Could you review the percentage of revenue from strategic accounts? I got a little confused with the sets of numbers that were given. How much in the year-ago period and how much now, and then I think you gave a separate Tech number specifically, as well?

Right. Dave mentioned the Tech number, which was 32% Strategic Accounts at Tech. As a full revenue, total revenue of the Firm, one year-ago quarter it was 22.9%. This quarter 2011 is 22.6%.

Okay, good. How long are the contracts typically in National Accounts or maybe asking the question a different way what percentage of those accounts will have contract renewals over the next year or so?

There's -- it's approximately, if you wanted to take a general number, they are three-year contracts, it depends. Obviously, everybody's is a little bit different, but I would say that would be the median if you were to pick it. And I would say that -- I mean I don't have a real clear view of that, but I would say that it's pretty equal over time. It depends on how -- as I said, if it's a stable amount of our total revenues you would anticipate the churn would be somewhat equal year-over-year.

Okay, so about 7.5% of total revenue.

In terms of -- remember that I mentioned now clients are having -- some of these large clients with these contracts are also having a hard time finding the quality of people that they need at those rates. And, therefore, we are experiencing some increases from these clients already, and this will continue, especially in the Tech side where finding the right skill sets in high demand is difficult for them at lower rates. And so you have more than just contracts that will accelerate as time goes on if there is continued strong demand.

Yes, just to add on to that, I mean we saw a 2.1% sequential increase in Tech Flex pay rates, which that's a very healthy increase, and I have been in the Tech Flex business for going on 25 years at this point in time. While it's painful when that first starts to happen because you can't move bill rates immediately overnight, especially in these larger customers it's a great indicator of supply, demand in terms of what opportunities are available to these individuals. And over time bill rate does ultimately start to gap from that pay rate. So they don't move in concert. I mean there's lead lag affects that have always taken place from that standpoint. So I would say the front end indicators are what we want to see in terms of where the opportunity exists for expansion of bill rate and, hence, margins.

Joe, what was the figure you gave, was that 2.1%?

Yes, it's 2.1%.

And that was sequential?

That's on a sequential basis.

Okay. Okay. Thanks. If I was to look at billing days which you give for the whole Firm, do they vary by industry, as well, or is it pretty much comparable segment-to-segment?

Yes, they do vary a little bit. They do vary a little bit segment-by-segment just because like the government has typically more holidays than the commercial business. The pharma entities, you know, can get in that mix. The only time that we really start to break that out and differentiate it is in Q4 because it becomes more material in Q4, especially on the government side and on the KCR side for how long they shut-down with holidays. But in any given quarter, yes, in fact, we technically would have more or less billing days in KGS than we might have in some of our commercial businesses.

Okay. And then in terms of the -- I think you touched on this in your prepared remarks a little bit, Joe -- the gross margin, if you were to isolate and try to segment the impacts of the bill, pay rate spread compression and the payroll taxes how would you kind of allocate it?

Yes, well, we -- basically, as I mentioned, about 110 basis points of that improvement was because of payroll tax pick-up. Is that what you're looking for? And then I would say 10 basis points would be associated with spread, and then 10 basis points would be associated with kind of -- there's a number of other things that go into the make-up of the margin, benefits and various other things go into play there which fluctuate on any given quarter.

Okay. Could you guys comment on the clinical trials business? We do have I guess from a general sense you've got a bunch of generics coming online and I just wondered what your kind of longer term outlook is there, particularly I think in the second quarter it looked like Pfizer announced they were going to try to consolidate their vendors?

This is Bill. True, there is a significant consolidation in the pharma industry. Six of the top 10 selling drugs are coming off patent in the near future. And, therefore, you're seeing great pressure on expense reduction results from those companies, and they're looking for more global providers as part of that expense reduction.

So I would say certainly there's more uncertainty in that particular industry but in the next two years we don't see that great a change to us. Again, there's huge uncertainty here. Yes, we mentioned the Pfizer operation, that continues to be something that is being worked out over time. We continue to be a large vendor there. We expect to be, to continue through time to have some exposure there, but we are diversifying and adapting, the word that I've been -- we've been using a lot -- adapting by growing our smaller and medium sized businesses. So in conclusion I would say there's risk. We are adapting to that risk, and we will continue to work very closely with all of our clients.

Thanks. What percentage of revenue, Bill, is derived from Pfizer?

Total revenue less than 5%.

Less than 5%. And just maybe just one final question, just kind of an overview. How do you feel, you're a big player in Tech, you're sizable in Finance & Accounting, as well. But relative to standalone CROs or government services companies you're not as large. Do you feel strategically that you need to get bigger in those areas in order to compete more effectively?

If you look at the government space, this is Dave -- I would say that that was a part of the opportunity that we saw that we would be able to come in and take advantage of the staffing delivery capabilities in our Technology and F&A footprint. And, in fact, we were quite successful in doing so until the current administration came in, in which we've seen a significant change in terms of insourcing, the awarding of contracts to [8-A] firms, which you're familiar with. So with those things, and now with the government debt situation it's certainly a challenging environment, to say the least.

With that being said, we have very, very minimal market share. So the disruption that's happening in the government space actually creates a very significant opportunity if we're able to adapt to it. For example, the larger firms that are entrenched are going to have to adjust margins, they're going to have to adjust footprint. So competitively if the smaller firms, like ours, are able to adapt and adjust and take advantage of the areas that we have a competency and expertise we actually believe that we can win business, where these other firms are unable to adjust. So that's the theory. We've had some success with it, and time will tell whether or not that works. And certainly those are -- that's a consideration as we look and say, okay, over the long term how are we doing strategically in that space?

The clinical business, clearly we've got major challenges there and question marks. But, with that said, our Team has adapted and adjusted. We've made quite a bit of progress actually in going after smaller and middle market clinical firms. And as that space evolves we've seen more of the new research and development for drug development shifting to some of the smaller firms, and we think the industry is kind of evolving, where the larger firms will actually be manufacturing and distribution, smaller firms and even private equity firms will be taking more of the development risk. So as we look at what's happening in that space it's still uncertain. There may be significant opportunities but at this point it's too early to tell.

And I would also add on the government side, especially where it's really easy to isolate, we like the areas where we're operating and the agencies that we're working with, especially when you look at any of the proposed budget cuts that are out there. Being in Veterans Affairs and the (inaudible) Reduction Agency, [Tricare], Defense Logistic Agency, you know, U.S. Coast Guard, Custom and Border Protection. I mean those are all areas that we feel very comfortable in terms of a lot of the talk about the big reductions are on the big block items, you know, the $180 million planes, very large carriers and those types of areas where a lot has to come out. So we do write the agencies where we've penetrated and we think we have opportunity to capture additional market share.

Thank you very much for the detail.

Thank you.

Thank you, sir. Our next question in our queue is Josh Vogel with Sidoti & Company. Your line is open.

Thank you. I was just curious, you mentioned that the reduction in payroll taxes was at a 100 basis points sequentially. Do you have an idea of what that would be Q2 to Q3?

It'll be nominal in comparison. Most of it would be burn-off from Q1 to Q2. So when I talk about any margin improvement Q2 to Q3 I'm really talking about the spread improvement, not just something that we're naturally going to get from a payroll tax standpoint. And historically it's been 20 basis points, somewhere in that range.

Okay. Thank you. And now just looking at KGS, outside of the back office relocation are there any other levers there that you can pull to get margins higher?

This is Bill. Margins are -- in KGS are the highest in the Firm. And so are we reducing Management, or not Management, core employees? Yes. Are we making sure that we have the utilization and realization on our existing billable employees? Yes. But this is, to me, this really is an issue of the right Leadership Team, and I think we have built a very significant Team, there are a lot of new people, very happy with them.

In fact, my best example I'll give props to, the guys may be on the call, we really put together -- had to do a lot of reorganization in our Midwest markets, and the market of the quarter was our Detroit and Cleveland market. Wow. And so it shows that the right Leadership Team and the right organization, it doesn't matter where the economics are going. We are such a small percentage of what's happening in the government, and we have confidence in my Team. They can do the same thing. They can grow this business, and we are looking forward to them growing the business.

Yes, what Bill is really referencing is the profitability of the unit. I mean our government unit is on a percentage basis one of our highest profit contributors to the bottom line. If you are also looking from a Flex margin standpoint what opportunities exist there, the dynamic in the government space has really shifted in terms of it's really moved from quality to price is probably the number one driver, and you see this in a lot of recompletes I think as we have discussed on our Q1 call, we had about a $1.2 million impact on a sequential basis of a recomplete that we had won, but that recomplete was at a lower bill rate level across all of those bills. Those are the types of things that you've also seen happening in the government space. It's a very different operating environment and landscape than where it traditionally has been.

Okay, that's helpful. And one last one, if I may? In clinical research you talked about the large project you won in Q1, it's been a little bit slower than expected to ramp. I was just curious if you had a status update as of today?

It is ramping, yes. The people are up, being put in place, are still fighting some turnover, but we believe that we should have a stable third quarter in [KCI].

Okay. Thank you very much.

Thank you.

Thank you, sir. And we do have time for one final question. Our final question comes from Mark Marcon with Robert W. Baird. Please go ahead.

On the Tech Flex side could you talk about the verticals that you're seeing the strongest strength out of? And what are some of the areas that have flattened out a little bit?

Well, certainly the strongest areas are healthcare, when you talk about electronic medical records, and just the general activity in Tech Flex is very, very strong. The skill sets and demand are Java, [dot net], program managers, [Pega], and it goes on and on. I mean there's even a need for COBOL people as you look at that. So it's a strong sector, and we expect it to continue to be strong, Mark.

Any areas where you're seeing any sort of flattening from a vertical perspective for any of the large clients?

Well, obviously, we talked about the mortgage refi and that particular area, which was quite big for us, and the F&A vertical of financial services. But I wouldn't point out any particular ones, though.

Not from a tax standpoint. I mean we're seeing stability, growth really across every particle that we're operating in from a Tech standpoint. We haven't seen anybody [stop].

And I would add every geography.

Yes.

There isn't a geography in the United States that isn't having significant skill shortages in Tech, and it's been, as Bill and Joe mentioned earlier, that it's a prioritization game now as opposed to it's a coverage game. So we're having to go back and reprioritize and really across the United States. So the demand on the Tech side is certainly way, way greater than supply.

I guess from a geography standpoint the best example I can give you is our top performer from Q1 to Q2 was in Chicago and the Detroit marketplaces, which we obviously all know in terms of the economic climates that they're operating it's not real optimal but I mean that just gives you a feel for how broad based it is.

With that level of supply, demand imbalance how are you -- how is that impacting the way that you internally prioritize the clients? I've been to the NRC a few times, and seen how you've done some of that prioritization. Would you shift a little bit away from the strategic accounts if they don't take the bill rates up?

Oh, client selection certainly is important to us, and we are not the right match for every client. That's true, Mark. I would say from a prioritization standpoint, when we talk about our infrastructure we call it world class, we now have electronic names and large screens in every office where we prioritize it in that office and in the NRC, our requisitions. And so we are using technology to its highest and best advantage here, and prioritization is becoming quite a science in Kforce rather than the art that it used to be.

Mark, I would even go further, I would say that the primary driver now is speed, and if the client responsiveness isn't there we'll move on to the next client. So, yes, ultimately Strategic Account pricing is going to be impacted by the market, and we expect that pricing will come-up. So ultimately the consultant makes the decision who he wants to go to work for. So to the extent that we get a response faster, to the extent that we get more realistic market pricing, those are the clients that are going to get prioritization in our servicing.

So, and all of those things, by the way, are done against a larger backdrop of who are the firms, the firm sponsored accounts that we have targeted that we want the longer term relationship for all the reasons that Joe mentioned, for stability, for diversification, and so forth. Because the day will come when Tech will turn down, and we don't know when it's coming. Hopefully not until after I'm long gone and buried, but the day will come, and we'll be glad we have a diversified revenue stream. In the meantime, we're going to grab as much as we can, and we're going to balance not only our service portfolio but also our Tech client portfolio, and that's really what we're trying to do.

Yes, because it's important to know when you're dealing with these large consumers and what they've done with their vendor list and the way that they've narrowed their vendor list, it's not just -- I mean we're spending a lot of time here talking about the margin exchange for stability and for volumes of business, but the part that really isn't referenced enough is the strategic nature of that relationship. That is a very different relationship, and there's much more dependency in that relationship than there is in a spot market relationship.

And, again, I'll go back to the proof and the facts associated with that is when you look at what happened to our Tech Flex revenue during the downturn in comparison to the general market, and that's because that is a much more strategic relationship, it's not just a transactional relationship. So there's exchanges here, and these are long, much longer term relationships, as well.

I would say we've got a pretty easy formula, Mark, as we look at that, that's the volume, rate, duration, and effort. And when we look at those things and that's how we prioritize it.

Great. Hey, can you talk just a little bit about the, you know, when you would expect the SG&A leverage to come through in a more significant way? You mentioned there are a couple of onetime things that are occurring in the third quarter, but as we go out towards the fourth quarter at that point should we see a resumption in terms of the SG&A leverage that you were showing progress towards?

As I mentioned, SG&A based upon our models, barring a surprise of a carve-out item, SG&A in our models, our operating models and in our forecasting models, SG&A as a percentage of revenue will come down as we head into Q3. It will come down further as we head into Q4.

So this isn't going to be some big bang type event where you're just going to see some big tranche down. You're going to see a continued march down and, yes, there might be independent quarters, no different than here in Q2, where it bumps back up a little bit. But if you look at that trending in all of our models, if we look at that trending out over the next eight quarters I mean that's a trend that's is on a linear, it's on a downward path.

Yes, I appreciate that, Joe. What I was speaking to was that in the first quarter SG&A as a percentage of revenue was down 130 BPS year-over-year. Here in the second quarter we were down basically 60 BPS year-over-year. Based on the way and I think what you're saying, you know, it sounds like we're closer to like 20, 30 BPS in the third quarter. And so I was just wondering if we were going back to expanding that leverage?

Yes, no, the way that I would look at margin, you know, Q1 was probably a little bit lower on a normalized basis because we didn't have a lot of performance based compensation that went out. So if you want to look at the comparison of Q1 to Q2, Q1 is probably, was probably a little lower if you just look at all of the fixed aspects of it, and Q2 performance was extremely low when we start to look at year-over-year comps and some of the stellar performance in some of our operations, and search performed real well. So that's why you get that little bump up. But as we move through the year those things stabilize typically a little bit more. The beginning of the year is a little bit choppier so, like I said, I believe you'll see that come down in Q3 and continue to come down in Q4.

Great. Thank you.

Thank you. And, with that, I'd like to turn the program back over to Mr. David Dunkel for any closing comments.

All right. Well, thank you very much for all of you and your interest in Kforce. And, once again, we want to give thanks to our people, our consultants and our customers, for allowing us the privilege of serving them. Thank you very much. We'll look forward to talking with you then at the end of Q3.

Thank you. Ladies and gentlemen, this does conclude today's program. Thank you for your participation, and have a wonderful day. Attendees, you may disconnect at this time.