Kforce Inc (KFRC) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kforce Incorporated third quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. (Operator Instructions). As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Michael Blackman, Chief Corporate Development Officer. Sir, you may begin.

Great. Good afternoon and welcome to the Q3 call. Before we get started we 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 SEC. 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 also provide substantial disclosure in our earnings release to assist in better understanding our performance and to improve the quality of this call. We have published our prepared remarks within the Investor Relations portion of our website.

Revenues in the third quarter of $336.5 million were largely as anticipated across all business lines as we continued to make progress in diversifying our client portfolio. We are encouraged by the late-quarter and early October trends in our Tech and F&A businesses that are providing momentum heading into the fourth quarter and should allow us to return to positive year-over-year growth overall and in our Tech Flex business.

We have largely completed our organizational realignment, which we began earlier this year when we consolidated and streamlined our field operations and certain revenue-enabling support functions. We also made the decision during the quarter to onshore our support operations in Manila to our corporate headquarters in Tampa, Florida. During the quarter we incurred $0.10 in severance and related costs relative to these organizational changes. This resulted in a reduction in earnings per share to $0.34. Exclusive of these costs, earnings per share would have been $0.44, which was in excess of expectations for the quarter.

We are confident that this streamlined organization will enable us to take advantage of a solid market environment that continues to be in need of skilled technology resources. We are now nearing the end of the seventh year of an economic recovery where the average annual GDP growth has been approximately 2%, which is the lowest rate in any recovery since World War II.

Since mid-2009, both our Tech Flex and FA Flex businesses have grown at an approximately 10% compound annual growth rate, both nearly doubling in size over that period. Over the same time period, the U.S. technology temporary staffing market has roughly doubled in size and is nearing the size of the U.S. industrial temporary staffing market.

This sustained growth, despite the modest GDP environment, is a reflection of the health of the skilled labor markets in the US, the low unemployment rates for college educated workers, and a growing usage of flexible labor, as exhibited by the temp penetration rate remaining near all-time highs.

The expanding and evolving regulatory and employment law environment, including new wage and hour requirements, mandatory sick leave benefits, and increased employee classification scrutiny, among others, have created a higher risk and burdensome employment environment for clients, which is one of the drivers of the secular shift. We expect this trend to continue and that should benefit the staffing industry and, in particular, larger staffing firms with greater capacity and infrastructure to tackle the heightened focus on compliance.

Skilled technology talent is in particularly high demand as companies are becoming increasingly dependent on the efficiencies provided by technology and the need for innovation to support strategies. Technology investment, in particular mobility, cloud computing, cyber security, e-commerce, digital marketing, big data, and business intelligence have contributed to the demand landscape for technology resources. Advancement in these areas will be critical across all industries for companies to remain competitive and meet evolving customer expectations. The shortage of supply for these resources and the need for specialized skill sets in this project-oriented discipline will continue to drive demand. The market remains strong for the higher-skilled talent.

We have previously mentioned KGS' March 2006 (sic - see prepared remarks, "2016") award of a prime contract with the United States Department of Veterans Affairs on its T4 next-generation contracting vehicle. During the third quarter, task orders began to be awarded on this $22 billion contract vehicle. This initial group of awards were more concentrated than we anticipated with small businesses as a result of Congressional mandatory set-aside provisions requiring competition in certain instances to be restricted to service-disabled, veteran-owned small businesses, which were reinforced in June 2016 at a Supreme Court decision. As a result, KGS was not eligible to submit responses as a prime contractor on some task orders for which it believed it was well-qualified.

KGS was awarded four new contracts with one as a prime and three as a subcontractor with an aggregate contract value of $6.5 million over three years. We were also successful in retaining existing business as a subcontractor under two large re-competes, one of which was bid under the T4 contract vehicle, which have overall contract values of nearly $60 million, which should provide further stability to KGS' revenue base in 2017 and beyond.

KGS has been supporting the VA for over 20 years and we believe this relationship is highly valued by our client. We believe that this contract vehicle could be an important growth driver for our government business over the next several years, though the pace of growth and composition of prime versus subcontract awards remains uncertain.

In summary, we are confident in the structure and strength of our organization and believe that the actions taken during the quarter position us well to maximize our market opportunities and we are confident that we are on track to achieve our operating margin commitment of 7.5% at $1.6 billion in annualized revenue.

In addition, despite continued modest economic growth, we believe we have the ability to grow in the skilled markets and clients that we serve. As such, our bias is to continue to invest in our business to generate long-term shareholder value. These investments include measured and balanced additions to our revenue-generating talent, enhanced training and tools, as well as continued investments in technology to increase the effectiveness and efficiency of our people.

I will now turn the call over to Joe Liberatore, President, who will provide further details on our Q3 operating results. Dave Kelly, Chief Financial Officer, will then add further color on our Q3 operating trends and financial results as well as provide guidance on Q4. Joe?

Thank you Dave and thanks to all of you for your interest in Kforce.

A key component of the realignment efforts that Dave mentioned has been to ensure we are putting our revenue-generating talent in a position to succeed. This entails not only providing them the proper tools, training, and direction, but also making sure they are supported by the best leadership and are working efficiently as a team.

We've been focused over the last two quarters of rebalancing our talent to increase the ratio of sales talent to recruiters, particularly in our Tech Flex business. The intent of this plan was to reaccelerate our client-facing activities and further diversify our client portfolio over a broader range of our largest clients. We are making progress, as seven of our Top 25 Tech Flex clients in Q3 2016 are new to this customer segment as compared to a year ago.

Our overall revenue-generating talent is up 1.5% year-over-year, while our Tech Flex sales talent is up 23.7% year-over year. Though aggregate year-over-year growth rates in our associate base have declined in recent quarters, we believe the shift in mix to more appropriate ratios will result in improving productivity and we believe significant capacity exists to grow revenue within the current talent population.

We're seeing positive momentum in our leading indicators with four-week averages improving over 13-week averages for client visits, job orders, submittals, and send outs in both Tech Flex and FA Flex, as well as recent momentum in billable consultants on assignment in both businesses, which is encouraging as we move into the fourth quarter.

Let me get into a bit more detail with each business. Tech Flex, our largest business unit, which accounts for 65% of total revenues, improved 0.4% sequentially and was down 2.7% on a year-over-year basis. We have seen improving sequential trends in mid-summer and early October, with notable improvements in our overall top 25 client portfolio.

Contributing to these positive trends is an increase in average assignment length. This is another clear indicator that companies value their critical technology resources, while balancing their use against the flexibility provided by using staffing firms to procure and manage talent. In terms of performance by industry, we experienced sequential growth in eight of our top 10 industry verticals, which suggests to us that the demand environment is broad-based. Financial services, which is our largest industry vertical concentration, saw disproportionately better growth on both a sequential and a year-over-year basis.

Our Tech Flex sales talent is being allocated to the markets and clients that have the greatest level of opportunity. From a skillset standpoint, our teams continue to focus on areas of greatest demand in high demand development skill sets, such as .Net and Java, as well as cybersecurity, project management and business intelligence.

We expect Tech Flex revenues to increase sequentially in the fourth quarter on a billing day basis and return to growth on a year-over-year basis. We are encouraged by the trends we are seeing in Tech Flex and the broader technology demand environment.

Our FA Flex business, which represents 23% of total revenues, declined 0.6% sequentially and 0.5% year-over-year. We have seen recent softness in project work within certain financial services clients, which we believe is predominately a result of internal spend rationalization pressures with the uncertainty in the future interest rate trends and greater focus on technology initiatives. Project ends in the first half of the year negatively impacted growth in FA more broadly, but we have seen encouraging trends in September and into October. We expect FA to grow sequentially in Q4, but may be flat to slightly down year-over-year against a difficult comp from last year.

Revenues for Kforce Government Solutions increased 6.0% sequentially and 10.1% year-over-year, driven by both services and product revenue increases. The KGS leadership team has done a nice job over the last several years of building a solid foundation for growth. There was no revenue of significance derived from the T4 next-gen contract in Q3.

We expect revenues for KGS to decline sequentially due to less product revenue and three less billing days in Q4, but to grow on a year-over-year basis due to growth in services revenue. As we look into 2017, we expect that the two large successful re-competes that Dave mentioned in his remarks, along with a relatively low re-compete cycle in 2017, provides a solid revenue base to build upon for KGS.

Direct hire revenues from placements and conversions declined 8.2% year-over-year and 4.4% on a sequential basis. This revenue stream continues to represent approximately 4% of total firm revenues. Our objective is to meet the talent needs of our clients through whatever means they prefer, and providing the highly-skilled capability to deliver resources through direct hire remains important in meeting those needs. We expect direct hire revenues to decrease in Q4 2016 sequentially at a rate reasonably equivalent to what the sequential declines we experienced in Q3 2016 due to typical seasonal declines in the fourth quarter as well as the overall uncertainty in the political and economic landscape.

We expect comparable year-over-year talent growth rates in Q4 2016 as we experienced in Q3 2016, providing our teams the opportunity to intensify their efforts toward relationships with clients that provide the firm with the greatest level of opportunity in a demand environment that we continue to believe is favorable. As I previously mentioned, we believe our purposeful shift in talent investment and expansion of our focus on existing clients will result in greater client penetration, market share, and better execution of sales and delivery. We are focused on the appropriate actions to take advantage of our platform, infrastructure and client base to put our great people in an environment where they can be successful and delight our clients and consultants.

Dave Kelly will provide further detail into our flex gross profit percentage. We are seeing some spread compression in our flex gross profit percentage, especially in our large client portfolio, as a result of vendor consolidation efforts at our clients where they are looking to increase spend with fewer providers and take advantage of escalating discounts and rebates. We expect that this trend may continue as clients continue to consolidate spend to improve their profitability with those providers capable of delivering at scale across multiple geographies.

The last critical step in building a foundation of sustained productivity growth for our sales talent is to provide them with proper tools. To that end, we have been working over the last several quarters towards the implementation of a new front-end customer relationship management system that we expect to begin rolling out in 2017. We believe this, along with other technologies we are investing in, will enable our talent to be more effective and efficient in performing their roles, give us the necessary business insights, and allow us to better serve our clients and consultants.

At the same time, we have recently engaged an organization to assist us in the fourth quarter, refining our sales methodology, messaging, and process and assist in the training and development of our sales talent. We believe these investments will generate a significant return by improving how we consistently engage with and deliver services to our clients and expect enhancements our efficiency and effectiveness.

I will now turn the call over to Dave Kelly, Kforce's Chief Financial Officer, who will provide additional insights on operating trends and expectations. Dave?

Thank you, Joe. Total revenue for the quarter of $336.5 million was in line with our guidance. Revenues grew 0.4% sequentially and declined 1.5% year-over-year. Total flexible staffing revenues, which exclude our government business, grew 0.2% sequentially and declined 2.1% year over year, as the year-over-year decline in Tech Flex narrowed slightly on improving trends in the quarter.

Earnings per share of $0.34 in the quarter included $4.3 million in pre-tax severance costs related to realignment efforts, which impacted GAAP earnings per share by $0.10. Excluding the impact of the severance-related costs, earnings per share would have been $0.44, which exceeded the top end of our guidance.

Our gross profit percentage in Q3 of 31.3% decreased 40 basis points sequentially and 90 basis points year over year. The year-over-year decline in gross profit margins was driven by a 60 basis point decline in flex gross profit margins, coupled with a reduction in the percentage of high-margin direct hire revenues as a percentage of total revenues.

Our flex gross profit percentage of 28.6% in the third quarter decreased 20 basis points sequentially and 60 basis points year over year. These declines are primarily due to compression in bill-pay spreads in both our Tech Flex and FA Flex businesses. We also had greater than anticipated health insurance expenses during the quarter driven by a few large claims.

Specific to our Tech Flex spread, the success we have had in growing revenues due to allocation of resources within our largest clients has created an increased concentration of revenues in this portfolio, which, in the aggregate, have margins approximately 100 basis points lower than the rest of the portfolio. Flex revenues from our 25 largest clients now represent 47.2% of total Tech Flex revenues. These customers represented 41.7% of total Tech Flex revenues a year ago.

In addition to this increased concentration, most of these significant users of flexible resources are increasingly looking to consolidate spend with fewer providers and, for that, gain escalating discounts based upon volume increases. Our FA Flex business has seen similar spread declines as our Tech Flex revenue.

We expect our flex gross profit margins to be negatively impacted in Q4 by typical seasonal impacts due to increased paid time off. As we look ahead, the organizational changes we have made reinforce our ability to compete efficiently and profitably in these larger clients and we anticipate success in growing client share. As a result, we expect spreads to be slightly under pressure, though for operating margins to continue to improve as we benefit from a lower marginal cost of delivery in these large clients.

SG&A as a percentage of revenue was 26.1% including a 120 basis point impact from the severance-related charge. Excluding the impact of this, SG&A as a percentage of revenue would have been 24.9% in Q3 versus 24.6% in Q3 of last year. This is roughly 50 basis points less than we anticipated when providing guidance last quarter and reflects the beginning of some of the savings we anticipate from our more streamlined organization.

Q3 2016 operating margins were 4.6% including the 120 basis point impact from the severance-related charge. Excluding the impact from this charge, operating margins declined 100 basis points year over year to 5.8% in Q3 2016. The year-over-year reduction in operating margins is driven primarily by declines in gross margin.

We continue to take a longer-term view of our business and expect to continue to make measured investments in additional revenue-generating talent and technology enhancements. We expect to absorb these incremental costs and are well-positioned to recapture the margin lost from spread compression through reductions in SG&A expense resulting from our streamlining, the effects of which should be fully realized by Q2 of next year.

With respect to our balance sheet and cash flows, our accounts receivable portfolio continues to perform well. Operating cash flows in the third quarter were $13.7 million. Capital expenditures for Q3 were approximately $6.2 million. Q3 operating cash flows were impacted by the timing of certain payments and we expect operating cash flows to accelerate in the 4th quarter, with the range expected to be between $16 million and $20 million.

We continue to maintain significant borrowing capacity under our $170 million credit facility. Long-term debt at the end of the quarter was $105 million, an increase of $5.3 million from Q2. Debt is slightly greater than one times trailing twelve month adjusted EBITDA.

We repurchased roughly 490,000 shares for $9.3 million during the third quarter and have returned $38.5 million year to date to our shareholders; $29.1 million in share repurchases and $9.4 million in quarterly dividends. We continue to believe that our strong balance sheet and strong cash flows provide ample resources to continue to invest in the growth of our business, while returning the cash we generate to our shareholders using these mechanisms.

With respect to guidance, the fourth quarter of 2016 has 61 billing days, which is 3 days less than the third quarter of 2016 and one day less than the fourth quarter of 2015. We expect Q4 revenue to be in the range of $325 million to $330 million, and for earnings per share to be between $0.31 and $0.33, which includes the approximate $0.05 impact from the sales transformation training initiative that is taking place in the fourth quarter. The seasonal decline in total revenues, lower direct hire mix, and reduction in gross margin percentage negatively impacts sequential EPS by approximately $0.09.

Gross margins are expected to be between 30.9% and 31.1%. SG&A as a percentage of revenue is expected to be between 25.9% and 26.1%. Operating margins are expected to be between 4.2% and 4.5%. This guidance assumes an effective tax rate of 38.7% and weighted average diluted shares outstanding of approximately 26 million for Q4.

This guidance does not consider the effect, if any, of charges related to the impairment of intangible assets, any one-time costs, costs related to any pending tax or legal matters, the impact on revenues of any disruption in government funding, or the firm's response to regulatory, legal, or tax law changes.

There will be certain changes in the accounting for equity-based awards beginning in January 2017, one of which results in excess tax benefits and tax deficiencies recognized upon the vesting of equity awards being recorded in our income statement through income tax expense. The impact of this change depends upon the valuation of our common stock on the vesting dates. If you assume the current valuation of Kforce stock, the impact is expected to be insignificant.

We believe the actions taken over the last several quarters to realign our leadership, rebalance our sales and delivery talent, and streamline our operations, as well as those actions we plan to take in the fourth quarter to refine our sales strategy, set us up to take advantage of a strong sustained market for highly-skilled talent during 2017 and beyond. We believe the combination of these actions will enhance our ability to accelerate revenue growth and create additional operating leverage. We intend to supplement our capabilities with selective additions to our revenue-generating talent and technology enhancements and that this collective strategy will lead to longer-term success that is in the best interest of our shareholders.

We will remain attentive to the economic landscape and the state of our clients' level of confidence and we will adjust our actions as needed. The actions we have taken reinforce our confidence in honoring our longer-term commitment to shareholders to achieve an operating margin of at least 7.5% at $1.6 billion in annualized revenue. This is true even if gross margins don't return to prior levels. At these lower gross margin levels we also still expect operating margins to be in excess of 6.3% at $1.4 billion in annualized revenue.

Chanel, we'll now open the call up for any questions.

(Operator Instructions). Kevin McVeigh, Deutsche Bank.

Great, thanks. Hey, and thanks for all the detail. Just I wanted to understand just a little more what kind of drove the decision to invest. And then, how does this ultimately impact the go-to-market strategy of the NRC, if at all?

Yes, Kevin, Joe.

Hey, Joe.

So, when you said to invest; invest in sales headcount and the training, I'm assuming is where you're going with that.

Yes, that's right. And just because it sounds like, obviously across the group there's been some concern about the duration of this cycle, but, to me, it feels like this one is starting to feel a little bit longer and that's what the fundamentals suggest. And, really, the actions you're taking kind of support that. But we're just trying to figure out does it tweak the NRC strategy at all, Joe? Or is this going to be investments more pushed down at the local level? Or how should we think about just at a higher level? I mean I understand and it makes total sense. But just where do those dollars go, if you would?

Yes. It's really aligning strength for strength based upon what client buying models are and the most effective way to service and deliver those. So, there is not one size fits all. So, that's really where what we're doing. We're looking at our overall portfolio and where it makes sense to deliver that in a decentralized fashion, leveraging our field operations, we're doing that. Where it makes sense to centralize that, we're doing that.

As we mentioned starting about a year ago, we've been ramping up our sales headcount so that we can get deeper and wider in those 3,000 Technology Flex customers that we service on an annualized basis. And we're starting to get some traction there. What that really led us to -- and you heard my statistic with that headcount being up 23.7% on a year-over-year basis. We were getting to the point here where we're about ready to get into requirements definition on our CRM and it really made sense to tighten up our processes, our methodology, our go-to-market messaging because there is nothing more powerful than when you implement technology and the technology supports your overall methodology and your processes.

So, in essence, by engaging this third party to help refine all of that, it will provide us with a more effective means so that all of our people, market to market, are communicating in the same way, bringing the same value proposition, supported by the technology. So that helps with our existing population, with getting everybody onto the same page. And then, as we onboard and bring on new individuals, as we continue to ramp up that population, we believe that will allow us to more effectively ramp them more quickly. Does that help give you some color on that backdrop?

It does. And is there kind of, without getting too specific, any sense in terms of goals on what the client mix looks like going forward, kind of large versus small to medium?

Yes. Well, we're working through those things at this point in time so more to come on that front. The first place that we're doing is we're stepping back and we're looking at our existing client base and where we should be going deeper and wider. And then, we ultimately have to start putting together some pro formas on how we view we can grow those various clients basis. So, no, I mean, at this point in time, for me to give you an absolute percentage, it just wouldn't be right. So, we're just going to look at the overall picture.

Because, by the way, and Dave Kelly covered this in some of his comments, when we look at the continued landscape in and around the Fortune 1,000, the Fortune 1,000 continue to get more sophisticated in terms of how they procure resources, in terms of escalating rebates based upon volume, continued consolidation of vendors servicing those customers. And that's incumbent upon us, which is why we're making these investments we are in methodologies and training and technologies, because we have a responsibility to be able to bring down our cost structure. If I'm sitting in one of their procurement offices, if I'm giving you more business, you need to figure out how to do it more effectively. So, we're being proactive on all of those fronts.

Got it. And then, one more. Just if you said this I missed it. How were we thinking about buyback in the quarter? And then, just the stock along with the rest of the group's been under some pressure. Any thoughts on kind of use of buyback as we kind of work through Q4?

Yes. So, Kevin --

Hey, Dave.

This is Dave Kelly, yes. So, obviously we continued to buy back stock in the third quarter. We spent over $9 million in the third quarter alone. I think we spent $28 million or $29 million, which is in excess of the cash that we generated as a firm year to date. And, additionally, we continued to pay a quarterly dividend.

So, we continue to believe that those avenues to return cash are extremely beneficial to us, to our shareholders. And so, as we look forward, cash flow in the fourth quarter we expect will be very strong. We've got ample availability on the board authorization. As a matter of fact, we've got $65 million left under board authorization, plenty of resources under our credit facility. And so, we think that's an efficient way to use the balance sheet. Absolutely.

Super. Thanks.

Thank you. Randy Reece, Avondale Partners.

Afternoon.

Afternoon.

You've had a little bit of bouncing around in the Tech Flex gross margin this year. I was wondering what changed from 2Q to Q3.

Yes. So, Randy, this is Dave Kelly. So, I think a couple things. And I mentioned one of them is somewhat discrete in that health insurance cost. So, we had a couple large claims. That negatively impacts margin in the third quarter, relatively speaking.

But I think more fundamentally is, as we've seen the growth of these large clients, and as Joe, I think, just alluded to, the sophistication of those large clients and the fact that they're looking to consolidate their spend with fewer providers, there's an increasing trend for them to look to and for the vendors to provide escalating discounts based upon volume. And, frankly, that, for us, is a great place to be given the design of our organization. It, frankly, is the place where I think we see a significant amount of money continue to be spent because of the technology demands at those providers. So, that's part of the -- those are the two drivers, really, to where we've seen some margin compression, frankly over the last year, and certainly from Q2 to Q3.

Yes. And I would say there was a third area specific to Q2 to Q3; not as material, but is in there. We had a client that rotated certain resources. And we have a pretty large population of international resources, which we carry the paperwork on. So, we had to carry a little bit more bench in the quarter associated with redeploying some of those individuals, which shows up in margin as well.

So, from Q3 to Q4, should we expect an improvement, a modest improvement in the flex gross margin or is it going to be similar?

So, Randy, no, you should actually, as you would typically see from Q3 to Q4, you'll see a decline in flex margins. But that's driven not by an expectation at a transaction level spread compression, but rather the fact that we've got more paid time off we pay. This is not anything we would typically expect to be any different than what we see on an annual basis.

As a matter of fact, I think I quoted gross margins to be 30.9% to 31.1%. And part of the reason that we expect gross margins to go down is that our direct hire business as a percentage of the whole will go down. So, I wouldn't expect any different characteristics in flex margin than we see in prior years.

Alright, thank you.

Thank you. Mark Marcon, Baird. Mr. Marcon, your line is now open. Your phone is on mute. Please take it off mute. Tobey Sommer, SunTrust.

Thanks. Could you maybe refresh me on the gross margin expectations and a percent of perm associated with your longer-term goals of operating margin?

Sure. Hi, Tobey. This is Dave Kelly. So, right now, and it of course varies by basis points quarter to quarter, our direct hire revenues are about 4% of total revenues and that's 100% gross margin business. As we model our expectations prospectively, we expect that percentage to remain relatively constant. It may trickle down a little bit as we think about the growth in the flex business, but it certainly is not expected to be in excess of where it is today.

And are flex gross margins expected to be as they were in the quarter or is there a different expectation? So, I was trying to get a sense for overall gross margin.

Sure. Sure, and I think it's an important question, Tobey. Because it relates to a lot of the things that we've been talking about and doing as a firm to make sure that we're prepared to take advantage of market opportunities where they exist while still ensuring that we're going to meet the profitability goals that we have established, the bottom-line goals.

So, as I look forward in some of the measures that we've put out, specifically an expectation of being at 6.3% operating margin at that $1.4 billion in annualized revenue and then, of course, the 7.5% at $1.6 billion, the model that we have currently built we'll be able to realize those operating margins at gross margins that exist as they were in the third quarter, which is, as I mentioned, lower than they were previously, a year ago. So, that's how we're thinking about it right now. We're not planning in those targets to see an expansion of those gross margins or flex margins, therefore.

Okay. Dave, a couple other questions from your prepared remarks if I could. When you talked about contract value in KGS, is that funded or unfunded? Kind of could you describe that with a little bit more detail?

Yes. So, Tobey, what we're effectively talking about funded value in this business. And so, as we look at KGS, as we look forward, Dave alluded to, frankly, I think what was our largest contract that we won to re-compete on in the fourth quarter and there were two significant contracts.

So, as we look into, and you may be curious, as we look into 2017, it's a very low re-compete year. As a matter of fact, I think only about 10% of the base is up for re-compete in 2017. So, fundamentally, that business is well-set in terms of the current revenue base and can focus, obviously, on new opportunities at T4 and other places.

Yes. And, Tobey, to give a little perspective there, if you were to go back to 2016, we had about 25% of the business that re-competed and if you were to go back to 2015, we had about one-third of the business that re-competed. So, that's why we're pretty optimistic in terms of new contract acquisition opportunity, as well, as we look out.

Okay. And then, on the revenue -- or, excuse me -- the talent growth being kind of in the low-single digits in terms of headcount. When did you kind of shift your thoughts, thinking that that would be sufficient to generate the revenue growth that you're hoping to achieve? Because I can recall not too long ago we were targeting a faster rate of headcount growth. So, when did that shift and how might you be offsetting that to drive productivity gains through your investments either in training or technology? Thanks.

Yes. No, I mean -- and I kind of referenced it in my remarks. I mean we see kind of a comparable here on the back end of we're in Q4. But as we start to look forward, providing market dynamics stay intact we will migrate back towards that 10% year-over-year growth. So, we've been just working on rebalancing our overall workforce in terms of the amount of salespeople to delivery people and aligning those in and around customers.

So, what's been happening as we go through that, as I mentioned, our sales population is up 23.7%. We've brought down some of our unproductive recruiting resources. But, as I mentioned also in my comments, our submittals and our send-outs are actually all up. So, we've actually improved productivity on the front-end indicators with those populations. So, we're very pleased with the progress that we're making on that front.

Where do you think you are in the rebalancing effort in terms -- so, when could we reasonably think about starting to increase the headcount towards that 10% growth target?

Yes. I mean we'll probably have a little bit more guidance as we get on the Q4 call. But, based upon now and our models, I mean we're looking at a reacceleration in that in Q1 if everything were to remain intact economically.

Okay. Thank you for your help.

Sure.

Mark Marcon, Baird.

Good afternoon. Can you give us a little bit of color with regards to how quickly you can get the SG&A associated with some of the larger Tech Flex accounts down even further than what you have? And then, obviously we've gotten a partial impact thus far from some of those new bill rates. But how do you think that's going to evolve over the next year to two years in terms of large accounts?

Sure. Sure, Mark. Yes, so this is Dave Kelly. I'd give you a couple data points to think about to reinforce some of the comments that I made in the prepared remarks.

So, I think we've started to see some of that in the third quarter, as SG&A itself was less. That is a reflection of some of the refinements that we maybe saw a little bit earlier than we expected in the third quarter. As we look ahead to the fourth quarter, I'll reflect back on the comments that I made giving you some thoughts around the impact of the revenue declines and the cost of the sales enhancement, the work that we're doing. You strip those things out and I think you'll realize that we're going expect to see some additional operating leverage. And that's driven in the large client space even in the fourth quarter, which leads us to a high degree of confidence that, as we get to that $1.4 billion even at these lower gross margins, that we'll still attain 6.3% or better operating margins.

And then, as we look forward, there's still -- obviously, it takes a little bit of time with the changes that we're making to settle. We think we'll fully realize these benefits as we're in the second quarter. And we believe we're well-positioned, as I think Dave and I both stated, to continue to get to that 7.5% level. So, we're already seeing it. We expect more over the course of the next couple quarters.

Great. And then, can you just talk a little bit more about the anticipation in terms of further volume increases with some of those larger players? Can you just give us a little bit more scope with regards to the paring back of their approved vendor lists and how much of a volume bump you could potentially get?

Yes. As I mentioned, we've seen pretty broad-based demand across eight of our 10 largest industry verticals. And so, within those verticals typically is where our larger customers sit within those verticals. And so, we're continuing to push on those customers. I mean some of the newer customers that we're bringing on that are just cracking into our top 25, we have just, just tremendous upside.

And, by the way, even customers that were in our existing top 25, we still have tremendous client share opportunity that exists with them.

And that's not to mention that those customers that have migrated out of our top 25 is not necessarily because they've decreased. It's because other ones have outgrown them and jumped into the top 25. So, we still have that client portfolio that we're going after. So, our customer share within any one of these given customers is so nominal that it's all about execution and applying more resources in those customers to capture greater share.

And is that primarily going to be a function of widening the sales funnel with those particular clients? Or are you also hoping to increase the number of orders filled through increased or improved recruiting efforts?

Yes and yes. So, the reality is, is we, like most organizations, when you're inside these Fortune 1,000, you typically have successes in given areas. We're looking to parlay those successes and take that messaging across into other departments where we haven't done quite the volumes of business.

And, as I mentioned earlier in my comments, I mean we view it's our responsibility. With the volume of business and the amount of req's that we're getting with each one of these clients in terms of submittals and taking people through the interview process and ultimate start process, it's incumbent upon us to become more effective and efficient for those customers. They expect it from us. But, to be honest with you, they don't need to put that pressure on us. We put more pressure on ourselves on that front than they place on us.

I mean, in many of these customers, that's one of their score-carding of how they view our effectiveness. It's not just on output, on placements, or revenue. There's compliance aspects. There's productivity aspects. So, I think it's a really balanced approach and we're aligned with our customer needs.

Okay. And then, can you just give a little more color with regards to either geography or industry in terms of the areas where you're seeing a reduction in terms of the level of demand?

Yes. I mean probably the one industry which we are still seeing a lot of choppiness is the manufacturing. We still haven't seen manufacturing turn back around. That's probably the biggest outlier from an industry.

When I would talk about, really, any other industries, I would really say, like in the ninth industry that I'm not talking about because eight out of 10 were up, that I would say is more specific to us versus any dynamics going on within the industry. It's the nature of the client mix that we have within that industry.

Great. Thank you.

Sure.

Thanks, Mark.

Thank you. (Operator Instructions). Anj Singh, Credit Suisse.

Hi. This is Anj Singh from Credit Suisse. Thanks for taking my questions. I guess, first off, on your commentary regarding the larger clients getting more volume or spend and compressing spreads as an offset. I guess could you walk us through why we aren't seeing the uptick in revenue, but we are seeing the gross margin and spread compression? What would be the lag time to see that revenue uptick?

Yes. I think, first of all, I think in terms of the top 25 clients we are seeing some benefit here. We have seen some sequential growth in those 25 clients that are now 47% of our revenues have been positive. But, as we see it, the way that this will typically work is we'll win new business and it will take some time to grow those gradually and they will build in these discounts that are based upon volume. And, as they increase, we'll hit additional markers. So, is there a lag? There is a growing trend of these discounts and there is a slight lag.

Okay, got it. And then, on direct hire, I know it's not a huge priority for you guys, but in light of it impacting the gross margin outlook, I wanted to just get a little bit more color. We haven't seen this trend of declines in this business in a long time. I think last time you had this trend of down year over year was early 2008. So, what's driving this? Are you losing market share or are you walking away willingly from some of the direct hire business or is it just lower demand? Could you just walk us through some of the puts and takes there?

Yes. I think if you listen to anybody else that has commented on direct hire, I think everybody is experiencing a little bit more challenging fourth quarter. I mean it is an election year and we've gone back and looked historically during election years. There is a little bit more uncertainty so you see a little bit more pause.

And similar to, I think, what some of our competitors have said on earlier calls specific to direct hire because, by the way, we're not seeing this on the flex side of the business, clients are very selective. They are being more cautious. They are asking for more candidates. They're looking for a higher degree of fit for the roles that they have because they're trying to use those wisely. So, all those things are stretching out the process.

By the way, the top candidates, it is a highly-competitive marketplace. So, often, clients are moving slow and that candidate is going somewhere else. And we also are seeing people accepting many more counter-offers in this client.

Got it. And just I have a couple questions on the T4 next-gen. When do you expect the next cycle of these task orders to come? And any sense of what your win rate was on the task orders that you were eligible to submit responses as a prime contractor for?

Yes. This is Dave Dunkel. The orders are continuing to flow. The issue comes down to what the mix of the orders there are and who is allowed to bid on them as primes because there's 12 large and 12 small. And so, the nature of the task orders really determines who gets to bid on them.

So, there is a constant flow. There are still pending task orders that we're awaiting awards on that are pending now for the balance of this quarter and they'll continue throughout the balance of the contract period. So, we expect that we'll see more of those awards and we'll have more to say about that in the first quarter.

In addition to T4, by the way, we also have other customers and we're working within other departments and there are other still substantial opportunities that, as we move into 2017, that we're awaiting on as well. So, we'll hopefully have more to say about that in Q1.

In terms of percentage, you want to comment on that Dave?

Yes, I think -- hi, Anj -- it was a lower percentage that was even let out to large in this initial round of task orders than we had anticipated. Somewhere in the neighborhood, I think, 10% or 20% was all in terms of the volume of contracts that were full and open. The rest were veteran-owned, small, disadvantaged businesses.

The other thing that I would say, to Dave's point, and this is true for us as being well-positioned in the VA; though, we, in some cases, aren't eligible to bid on some of the contracts, that doesn't preclude us from taking advantage of our relationship with these small businesses that do bid and the relationship we have with the VA to also subcontract on those. So, there is some of that for us as well. So, it's not an all-or-nothing type of thing for us, which is part of the reason why we still think and continue to think, as a prime and as a sub, the T4 work and the amount of money that the VA has allocated under this IDIQ is an important contract vehicle for us.

Okay, got it. That's super helpful. Just one quick follow-up from me. What is the timeframe to recognize the re-competes that you spoke to, the $60 million? I'm just trying to understand what number of years that will be recognized over. Thanks.

So, Anj, to recognize that, first of all, obviously re-compete, it means that we're sustaining the revenue that we have already had. And that, as we would typically see it, contract-dependent of course, you see an average contract length of about four or five years. So, again, we've got 10% re-competes. That's means 90% of our base at KGS is not up for re-compete already in 2017.

Perfect. Really appreciate the time. Thank you.

Thank you. And I'm showing no further questions at this time. I would now like to turn the call over to Mr. David Dunkel, Chairman and CEO, for closing remarks.

Okay, great. Thank you, Chanel. First of all, I want to say thank to our folks, our field leaders, our team. They did a fantastic job during this quarter where there was quite a bit of change going on with the realignment activities. And, in the process, they were still able to execute and deliver on revenue and actually position us for a growing fourth quarter. And we're excited about what we've set the table for in 2017. There's a lot of good things that have come together and our team has just done a great job. So, I just want to tell you guys I'm proud of you.

And I also want to thank the rest of you for your interest and support of Kforce. And our corporate teams have done a great job. And, finally, to our consultants and our clients, thank you for allowing us the privilege of serving you. We'll look forward to talking with you again in Q1 and maybe we'll know who won this crazy election by then. Thank you very much.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.