Resources Connection Inc (RGP) 2004 Q4 法說會逐字稿

Good day, and welcome everyone to the Resources Connection Fourth Quarter Fiscal Year 2004 Earnings Results Conference Call. This call is being recorded. With us today from the company is Miss Kate Duchene, Chief Legal Officer; Mr. Steve Giusto, Chief Financial Officer; and Mr. Don Murray, Chief Executive Officer. At this time, I’d like to turn the call over to Kate Duchene. Please go ahead ma’am.

Thank you Operator. Good afternoon everyone, and thank you for participating with us today. Joining me, as you know, are Don Murray, our CEO, and Steve Giusto, our CFO. During the call, we will be providing you with comments on our results for the final quarter of fiscal 2004. By now you should have a copy of today’s press release in front of you. If you need a copy, and are unable to access a copy on our Web site, feel free to call Margaret Porter at (714) 430-6363, and she’ll be happy to fax a copy to you.

Before Don Murray starts his remarks, I’d like to read an important announcement about certain statements that we may make during this call. Specifically, we may make forward-looking statements – in other words, statements regarding future events or future financial performance of the company. We must caution you that such statements are just predictions. And actual events or results may differ materially.

We refer you to our 10-K report for the year ended May 31, 2003, and subsequent 10-Qs, for a discussion of some of the risks, uncertainties, and other factors, such as seasonal and economic conditions, that may cause our business, results of operations and financial condition to differ materially from results of operations and financial conditions expressed or implied by forward-looking statements made during this call.

I’ll now turn the call over to Don Murray, our Chairman and CEO, to give an overview of the quarter.

Thanks Kate. Well, welcome to our conference call for fiscal 2004. Resources Connection is a professional services firm, originally founded within the Big Five accounting industry, now the Big Four. In the United States and the Asia Pacific region, we were originally part of DeLoitte & Touche, and in Europe, part of Ernst & Young.

We provide accounting and finance, human capital, information technology professionals to serve companies’ internal consulting needs on a project-by-project basis. Through our subsidiary, Resource Audit Solutions, which we refer to as RAS, we serve our clients with compliance and consulting and internal audit services, including outsourcing and co-sourcing.

We deliver supply chain management services, through our division Resource Connections Supply Chain Management. We provide our services to clients through more than 60 offices worldwide. We have been best known for accounting and finance services, and have added these additional service offerings to meet our clients’ needs. This has been an eventful year for Resources. We have taken substantial steps during the year to develop our international capabilities, and to make our company more relevant to our clients. And at the end of the call, we will describe the risks and opportunities that we expect for fiscal 2005.

First, let me summarize our operating results in the fourth quarter of 2004 and for the entire year. As indicated in our press release today, revenues for the quarter were $107m. This revenue is higher than the fourth quarter of a year ago by 81%, and is sequentially higher by 22%. I should note that the fourth quarter a year ago had an extra week. So on a comparable weeks basis, growth for the quarter was 95%.

Revenues from our operations that had been part of Resources for 12 months or more – and that is excluding our revenue from recent acquisitions – were higher by 56% than the year ago period. For the year, revenues totaled $328.3m, 63% higher than the previous year. Organic growth for the year was 37%. Steve will provide additional detailed revenue trends in his review of operations later in the call, as well as giving you a recap of domestic and international revenues.

These revenue results reflect the continued strong demand from recent previous quarters. Most of the dynamics we discuss at the end of the third quarter continued into the fourth quarter of the year. Our domestic practices experienced growing demand for the quarter. And our domestic weekly revenues reflected an improving trend.

Our pace of growth in the fourth quarter was slower than that experienced in the third quarter. Revenues internationally continued to be impacted by the softer continental European economy, but grew elsewhere. Our U.K. practice grew sequentially by 25%. And Asia Pac grew 19%. The Dutch practice revenue was less in the third quarter by about 1%. And, on a consolidated basis, strong demand contributed to improving operating margins and earnings during the quarter.

Our continued implementation of our ongoing growth strategies is responsible for these improved results for the quarter and the year. First, we are continuing to penetrate our largest clients. Total revenue in the quarter from our 50 largest clients was 73% greater than the revenue from the top 50 clients in the fourth quarter of fiscal 2003.

Year to date, the comparable percentage increase in revenues from our top 50 clients was 70%. Now we’re 121 clients, who each generated $500,000 or greater revenue during the year. We feel our position in the marketplace is as an alternative to the Big 4 for the work that we specialize in. We refer to our skills as internal consultants.

Second, we are adding new significant clients. Some of our new clients this year generated more than a million dollars each in revenues. Of our 50 largest clients in fiscal 2004, 13 were not clients two years ago.

Third, our international geographic expansion has allowed us to become more relevant and useful to major and multi-national clients. We believe we are working on the types of large-scale geographic projects that in the past could have been done only by a major accounting firm. When recently announced a start-up effort in Japan, as we continue to expand in the Asia Pacific region. We believe Japan will be a challenge for us. But we are confident our model has timely relevance there.

Fourth, we continue to diversify our revenue base across our five services, so that we can expand our services to clients in a variety of professional areas. While accounting and finance is still our largest service offering, it is less significant as our other services grow to scale. These are the four components of the strategy we laid out when we started Resources, and later went public. We continue to look for ways to improve our client service and become more useful to our clients. We can do this without the burden of independence necessary for the Big 4 audit firms.

Gross margins for the fourth quarter were about 41.5% domestically, and about 34.6% internationally. Overall gross margin for the quarter was just over 40%. These results reflect solid pricing and few holidays during the fourth quarter. Gross margin is reduced by low conversion fees, less than 1% of revenues, and high reimbursable costs. Neither of these factors affects our actual pricing. And our overall pricing remains strong.

For the year, gross margins on a fully consolidated basis were 39.1% versus 39.8% in fiscal 2003. The slight change in gross margin percent is mainly due to the lower gross margins in our international practices that were not part of our operations in 2003.

Results across our service lines were as follows. Our accounting and finance business, which represents the majority of our revenue, grew 44% year over year. Our information management services grew 40%. Human capital services grew slightly. Supply chain management grew slightly, as it repositioned itself with the Resources entity.

And Resource Audit Solutions, which was formed during our last fiscal year, was 13 times larger than the quarter a year ago, and contributed 15% of our revenues for the year. And not all of this revenue was related to Sarbanes. We continue to experience strong demand from engagements dealing with Sarbanes-Oxley compliance. However, we look at our 50 largest clients this year, and we’re doing significant Sarbanes work for just 17.

We are currently working hard to address the very strong ongoing demand from clients who need assistance in meeting the deadlines for complying with the various sections of Sarbanes-Oxley. We expect that clients who engage us for Sarbanes work will engage our services in other areas where they need help. We also expect ongoing annual work in updating the initial work and annual compliance with the Act.

Many companies may need help in complying with Section 409 of the Act, which mandates much shorter deadlines for financial and regulatory clients. Other regulatory changes may also increase demand, such as the New York Stock Exchange Mandate requiring internal audit departments.

Revenues from our 50 largest clients represented 48% of total revenue during the quarter. And our largest client in the quarter was about 9% of revenues. And this was related to a Sarbanes-Oxley compliance. We are providing service to this client throughout the world. And our first engagement with that client was not related to Sarbanes, but allowed us to build a relationship, so that they trusted us to help with the current 404 project.

Our largest client for the year was about 5% of revenues, and has not been a Sarbanes related client. Our client retention among our largest clients continues to be excellent. As we had previously discussed, the most significant strategic move we made this fiscal year was the purchase of the Ernst & Young Executive Temporary Management [BV] [ph] in the Netherlands. As of today, that practice has now been part of Resources a full year.

The Dutch practice was in our results for 10-1/2 months, and generated over $40m of revenue in that time. It was modestly profitable during Q4, even though on a dollar basis revenues were down a little from Q3. Strategically, this acquisition has met our expectations, by providing a foundation on the European continent. We are not yet achieving the sort of operating results we expect over the long term. The Dutch practice is fully integrated into our company. And we expect continued tough competition for revenue in the Dutch market until the economic environment there improves.

Now here is Steve with additional information on the results for the fourth quarter and the year.

Thanks Don. Revenues totaled $107m for the quarter, versus $59m in the comparable year ago quarter, and $87.8m in the previous quarter. These results represent year-over-year growth of 81%, and a sequential improvement of 22%. Revenues for the year totaled $328.3m, 63% better than the year before.

To help put this in context, let me give you some information on how weekly revenues progressed during the quarter. I’ll start with data, excluding the Dutch operations. Revenue trends were positive through the quarter. The average weekly revenue, excluding the Dutch practice in the fourth quarter, was approximately $7.2m per week. As we entered the new fiscal year, revenue performance remained strong. Revenues, excluding the Dutch practice during the first five weeks of the new quarter, grew to about $7.6m per week.

Now let me discuss the Dutch practice. Revenues for the quarter on a local currency basis were 3% higher than the third quarter, but down 1% on a dollar basis. We feel the practice is stable, and has a platform for growth as the European economy improves. Total revenues for the Dutch practice in Q4 were $13.3m. This represents a year over year increase of 2% on a dollar basis, but a decline of 3% on a local currency basis.

Now let me give you weekly amounts on a fully consolidated worldwide basis. On a consolidated basis, revenues averaged $8.2m per week during the quarter. And we closed out the quarter at about $8.4m of revenue per week. As we entered the new fiscal year, revenue per week on a consolidated basis grew slightly. There have been six weeks since the end of the year. And revenues have improved to a run rate slightly above $8.5m per week.

This quarter includes two significant holidays, and is typically a seasonally slower period in July and August, especially in Europe. We currently project a modest sequential decline in revenue from Q4.

Now let me switch to gross margins. I will first discuss domestic gross margins on a basis comparable with prior disclosures, and then margins in newer international operations. As we mentioned in last quarter’s call, gross margins in Q4 tend to be seasonally higher. Q4 tends to see high demand for services, and is not impacted by any significant business holidays.

Domestic gross margins were about 41.5% for the quarter. Conversion fees, which have a disproportionate impact on gross margins, were still less than 1% of revenues during the quarter, similar to Q3. Client reimbursement revenue, which is just a pass-through of out-of-pocket costs to our clients, and has 0% gross margins, was 4% of revenue during the quarter.

We actively manage only gross margin factors we control – bill rates and play rates, excluding reimbursable expenses. On that basis alone, domestic gross margins during the quarter were well above our 40% target. Our international practices have historically maintained lower gross margins. Gross margins for these practices were approximately 34.6% during the quarter.

The reasons for a lower gross margin include a different employment model to fit the laws and customs of several of the countries. Gross margins for the year were 39.1%, slightly higher than the blended 39% rate we expect. As we move into fiscal 2005, we expect reimbursement revenue to remain more or less consistent with this quarter as a percentage of revenue. And we are unable to predict the conversion fee impact, as this is not a revenue source that is managed.

We expect, however, continued low conversion fees. It is possible that strong pricing could help us maintain levels similar to this quarter. But we are not planning on it. Gross margins on a consolidated basis are projected to be about 39% - about a full point below what we reported this quarter. Associate head count at the end of the quarter was 2,086, compared to 1,175 a year ago, and 1,980 last quarter.

Now to the other components of our fourth quarter and year-end financial results. Selling, general and administrative expenses for the quarter were $23.9m, or 22.3% of revenues. In the year ago quarter, SG&A was 28.0% of revenues. And in Q3 of this year, SG&A was 25.9% of revenues. This improvement is due to the leverage experienced with strong revenue growth. For the year, SG&A as a percentage of revenues was 25.7%. This is an improvement from a year ago, when SG&A was 28.8% of revenue.

Increases in the dollars of SG&A, both sequentially and year over year, are primarily the result of internal head count additions from our newly acquired businesses, and in domestic offices where demand is the strongest. SG&A was $16.5m in Q4 a year ago, and was $22.7m in the previous quarter, and for the full year was $84.3m.

Depreciation and amortization were just over $1m for the current quarter versus $535,000 a year ago. The increase is due to the amortization related to the acquisitions previously described. Interest income was $171,000 for the quarter, versus $238,000 a year ago. And our invested cash earned 1.2% during the quarter. Interest income was negatively affected by the very low interest rates available in current market conditions, and by lower cash balances as a result of the cash used in acquisitions.

Our operating margin for the fourth quarter was 17.8% compared to 12.2% in the year ago quarter. This increase is attributable tot the rapid improvement in revenue during the quarter, and the resulting operating leverage. Earnings for the quarter were $10.7m, or $0.43 per share, versus $4.1m and $0.18 per share a year ago. Earnings for the year were $24.3m, or $1 per share, versus $12.5m or $0.55 per share a year ago.

Now let me turn to our balance sheet. Cash and investments at year-end were $69.8m. That is about the same amount we had at the end of last year, despite the fact we expended over $30m during the year for acquisitions. Receivables at year-end were $59.8m. Day sales outstanding at year-end were 47 days, compared to 49 days at the end of the previous quarter.

As we said last quarter, making headway and getting DSOs back to historically lower levels is hard when revenues are growing so fast. This is a challenge we are pleased to face, since it’s the result of ongoing revenue strengths. Our evaluation of outstanding receivables at year-end and related reserves leads us to believe that, while larger in the past, our receivable portfolio does not present an unusual risk to our very strong balance sheet.

Now let me return the call to Don for some final comments.

Thanks Steve. To summarize, the fourth quarter is normally our strongest quarter. Our employees are proud of what we’ve accomplished this year, as the operating results validate their hard work during the recession to implement our strategies and lay the groundwork for our growth. We believe we have positioned resources to capitalize on the potential increase in demand for professional services, and the independence issues that have affected the Big 4.

It’s important to recognize that our continued success is subject to significant ongoing business, economic and political risks. We live in an uncertain world. We are building a business with the goals of adding value for our clients, our employees, and our shareholders. The business model is continuing to evolve into a true multi-national and multi-services one.

Our long-term growth targets continue to be 20-30% revenue growth per year, with similar growth in earnings. During better demand environments, we intended to exceed targets. And during the portion of the U.S. recession, we were below that range. We are building a business with sustainable long-term value, and not just focused on quarterly results.

Our plans include continuing to rationally build out our international footprint and add new appropriate service lines. We remain focused on building our new service lines, and positioning resources as an alternative to the Big 5 for internal consulting and projects.

Internationally, we’re working to penetrate some of the larger accounts, where as part of the Big 5 our predecessor practices had conflicts in trying to service audit clients of their parent. These conflicts have been removed. Our growing international footprint is important to our positioning as a real alternative to the Big 4 for their non-core services.

The improving demand for help implementing Sarbanes-Oxley, and the additional breadth of services we have developed over the course of the recession, position us to continue serving multi-nationals. Our business is helping clients with change. We believe clients have only so much budgeted for accounting and systems projects in their changes.

A disproportionate amount may be going to regulatory compliance today. Part of this may be a permanent cost of being public, and may create repeatable projects. But we do expect clients will continually have other needs that we can fix. And they will have budgets to deal with those needs. I believe the company has made excellent progress during this year. We will work hard to try and continue the progress in the future.

We will continue to be opportunistic, to expand geographically, and diversify our services. This expansion may be from appropriate acquisitions, or through organic efforts. We continue to believe if there are services performed internationally by divisions of the Big 4 that may no longer be viable for appropriate for them, as they are precluded from working for their audit clients. And we continue to see unprecedented change in the professional services marketplace. And this creates opportunity. At this time, we’d be glad to answer your questions.

(Caller instructions.) And we’ll take our first question from Adam Waldo with Lehman Brothers.

Good afternoon everyone. Congratulations on a very strong end of the year.

Thank you.

Steve, I wonder if we could talk a little more specifically about guidance for the fiscal first quarter. I think you said that you would expect revenue to be down a little bit sequentially, given the seasonality of the quarter. And if we take the $8.5m of revenue that you averaged in the first five weeks of the quarter, that would imply about $102m or so of revenue.

Is that something you’re comfortable with? Or maybe could you just help us think a little bit more about what the fiscal first quarter might look like, and what your expectations for fiscal ’05 as a whole might look like directionally.

Adam, I would say, first of all, that we are, as I mentioned in the prepared comments, entering the period in the latter part of July and August where it’s most difficult to know how our business will be impacted by the holidays. It’s particularly impactful in Europe. And so while we are quite comfortable with the trend going into this quarter and where we started, it’s a little bit difficult to know exactly how soft the remaining part of this quarter might be, because of the holidays. That said, I think that the number that you used is a fair guess at this point.

Okay. Fair enough. I mean if you just step back, obviously, from this quarter and from the implicit guidance you’re giving for next quarter, give us a sense Don, if you would, in fiscal ’05 what other major initiatives you have underway to drive revenue levels above the kind of $10-110m a quarter range, and specifically with respect to existing practice expansions, new office openings, new practice line launches – that sort of thing.

Yeah. Let me just explain that when we do a – or implement an initiative to open a new office, open a new service line, that doesn’t affect the next quarter’s revenue, or even the next year’s revenue very much. It usually takes several years for us to build some kind of critical mass, where it actually starts affecting us.

So some of the services that we started two years ago, like RAS, this was a first year of real contribution that you would say was significant. For this coming year, we’re looking at expansions in continental Europe. We’re looking at different ways of expanding – whether that would be a similar type of boutique acquisition, or whether that would be an organic growth opening of offices. We are committed to expanding our footprint in continental Europe.

The two biggest economies on the continent are Germany and France. And while we’ve done work in Germany and France using our Dutch business, it’s not the same as serving clients in the country. So we’re looking at some way to expand in continental Europe. And we right now are looking at two or three different things that we might do in the next quarter.

Okay. If you were to offer acquisitions, is it fair to say that, given that none of the shares on the existing buy-back authorization of October 17, ’02 have been used, and given your prior comments around your views on share buybacks around current valuations on the stock, would you be more inclined to use stock or cash or a combination of the two for these acquisitions that you may be contemplating?

I – my philosophy would be to use a combination. And the reason being, when you’re acquiring a professional services firm, you’re really buying the people. When you acquire it from a Big 4 firm, they don’t want to hold stock. So it limits your ability to negotiate. But if you’re acquiring a firm that say has already left the Big 4, where the principals of the business are very relevant to the future success, we would want them to have a share stake in the company, and want to tie them to our business, so that they, like the rest of us, are all going in the same direction. So for those types of acquisitions, we would look for a combination of cash and shares.

Okay. And then finally, just a quick question about options expensing. Obviously the options program has been a significant driver of incentives for people to join the company and obviously wealth creation for them. How are you in thinking about options expensing in fiscal ’05, given the significant level of option grants you all undertake?

We are using an outside firm to advise us on our stock equity type program for our employees, because we feel it’s integral to the success and the culture of our business. Without it, we don’t think we’d have the success that we have, and that our turnover would be much greater. We are not inclined to early adopt expensing of stock options. But we will, of course, comply with the regulatory requirements [inaudible].

So if binomial lattice expensing goes in, in calendar ’05, as seems likely, given FASB’s recent comments, would you all perhaps implement it mid-year? Or how would you look at that? Would you have until fiscal ’06 to implement it?

Adam, we would have until fiscal ’06. We would likely implement it for that period. In the meantime, the information is available in our footnotes that they’re really – and from our perspective, this is not a cash flow issue. This is really just an accounting issue. And we believe that the fundamentals of our business don’t change, whether we expense or not expense. And we expect that that’s how investors should analyze our business.

Thanks very much.

And we’ll take our next question from Andrew Steinerman with Bear Stearns.

Hi there. Steve, 22% of revenues is the SG&A level before depreciation and amortization. And of course, looking throughout the whole company’s history, we’ve never been down this low. It sort of makes me feel like business was going so quick that you didn’t have time to invest in the infrastructure. What’s your sense of sort of the reason why we’re at this level, and what might be a target level of SG&A as a percentage of revenue, again before depreciation and amortization, in the first quarter and longer-term?

Yeah, I would say that the level of leverage that we got in the fourth quarter was better than expected, and not something that we would expect to sustain over a long period of time. Though certainly we have said that the investments we made during the recession would pay off when revenue improved. And what you saw during this quarter was the result of very rapid revenue growth. And when that happens, it’s very difficult, if not impossible, to grow SG&A at the same pace. And so you saw very rapid operating leverage improvement.

As we head into 2005, we are certainly not budgeting at that low level of SG&A. We continue to, as Don said, make appropriate investments in our business internationally and in services, and in certain of the markets where we’ve seen extraordinary growth. And so I would expect that SG&A levels in the 25% range is something that we would hope for, though we still have the full year to see how the revenue trends continue, and also what other sorts of investments we might be interested to make, that we think affect us in the long run.

But you think it would pop from 22 to 25, even in just the August quarter? Or do you say 25 might be a target for the whole year? And if so, what might it be in the August quarter?

Well I guess let me put it this way, is we have said publicly before that we thought a 15% operating margin was a pretty reasonable target for us. And if we maintain the sorts of gross margins that we saw in the fourth quarter, or as we described in the call, even a percent below that, about 25% operating margin would get us to 14% or 15%, or, excuse me, 25% G&A would lead to 14% or 15% operating margins, which is where we’re hoping to be over the long-run.

Right. And do you feel infrastructure constrained right now with the growth that we just experienced? Or are there places throughout the world where you feel like there is still excess capacity in the system?

Well, we have plenty of excess capacity in our system in Europe. Continental Europe continually is affected by this recession that appears to me, from what I’ve read, to be mostly driven, I guess, by the German economy, which is so strong there, which is having the weakest performance.

Right.

So we have excess capacity in Europe. And we’re trying to figure out how to use it, if we can, around the world. We’re doing some international exchanges, where we’re sending people from the United States to go to the U.K., to help them with their growth, because they’re doing very well. We had one of our European people come over here to help recruiting.

So we are trying to leverage some of our international capacity. But our biggest constraint really is right now for accounting and finance people in the United States, it’s a very tight market.

Right.

The Big 4 firms all see to be out trying to hire people for their Sarbanes, and do permanent hires for “Sarbanes”, and to build up their audit staff. So that’s our biggest constraint.

And Andrew, let me just add one other thing – and we don’t disclose and don’t intend to disclose specific results by market domestically. But we certainly can tell you that while we’ve had very substantial growth domestically in the aggregate, there are still offices of some size in our domestic practice that have not enjoyed that level of growth. So there is still capacity in those markets for excellent growth, we believe.

Cool.

And I would say the level of hires that our U.S. offices are looking to do internally doesn’t appear to me to be significantly different than in the past.

Okay. All right. Thank you very much.

And we’ll go next to Thatcher Thompson with CIBC World Markets.

Good afternoon guys.

Hi Thatcher.

It looks like we’re going to have a Big 5 here someday at this growth rate.

We would hope so.

One question. The pace of hiring associates seemed a little slower in the fourth quarter than in the third quarter. You added nearly 300 or maybe a little more than 300 in the third quarter, and just over 100 this quarter. Is there some seasonality to that?

Well, there is a seasonality, because our fourth quarter is normally our strongest quarter. To get there, the projects start within the third quarter, because remember the third quarter includes all of the holidays.

Okay.

And usually it’s sometime mid-January-ish on – that client’s start projects. So you get the full effect of the revenue growth in the fourth quarter, only a partial effect of that revenue growth in the third quarter.

Okay.

That’s where the seasonality comes in.

All right. So it’s not an indicator of a harder time finding people. It’s just you’ve got all those people working now, and that’s as it should be?

Yeah. But we are having a harder time finding people than we were a year ago.

Okay. Fair enough.

Yeah.

And then you mentioned, I think, an $8.2m weekly run rate throughout the fourth quarter. And you’re $8.5m a week in the first six weeks, that includes two holidays? Would that be Reagan’s funeral and Fourth of July?

It would be Memorial Day and Fourth of July. And the $8.5m is where we were as we got towards this conference call. So I wouldn’t tell you that you could use $8.5,

The $8.5m does not include July 4.

Okay. So that’s just the recent week – most recent week?

Yeah. That includes the week up to July 4, but not the July 4 holiday weekend.

Okay. All right. Fair enough. And then you mentioned that Resources Audit Solutions is about 15% of total revenue for fiscal year ’04?

Yes.

So that’s about $50m for the year. How much - ? What percentage of the fourth quarter revenue was made up from that division?

About 24%.

Okay. And have you had any experience yet with clients that have finished their Sarbanes-Oxley, and you’ve either maintained them as clients on other financial projects, or you’ve actually begun doing that recurring Sarb-Ox work that you’ll be doing on an annual basis?

Well I don’t think there is any recurring Sarbanes work yet, because this is the first year they have to comply. I’ll just give you some anecdotal information around Sarbanes. Number one, we’ve got at least three Fortune 100 type clients, where we finished the 404 documentation work and have add-on projects with them.

So our strategy with clients is if we prove our value, if we add value, they’re always going to have needs that need attention. They’re always going to be going through changes. And we help them manage change. So we’ve got three examples where we finished the 404 work, documentation work, and we have follow-on projects. Now those companies have not had their auditors come in to certify this.

And one of the audit partners at a Big 4 firm, again, was expressing his opinion to us that they’re going to have a very hard time trying to cleanly certify Fortune 100 type 404 projects. And they’re not sure how much work they’re going to require once they go in to look at these things. So this is not a zero sum game, where it’s going to stop and fall off the cliff. It’s an ongoing process, that hasn’t even begun to play out.

And Don, how much of the RAS work would you guess is 404 documentation work?

I don’t know. I mean we haven’t even looked at it that way.

Okay.

We’re providing internal audit co-sourcing. We feel that’s a long-term growth strategy in this area. Part of that internal audit co-sourcing is going to, I think, will increase, because a lot of public companies on the New York Stock Exchange don’t have internal audit departments.

Right.

And they’re going to need them.

And I agree. I just think one of the concerns that has been out there is that everybody is in a rush to meet this compliance deadline. How much of that RAS work that’s growing so quickly is something that may drop off and not come back? And I would guess the 404 work is a big – I don’t know if it’s a big chunk or half or what it is. But it’d be interesting to know.

Yeah. I mean I would say over the next few years – and again, I don’t think it’s going to drop off a cliff on December 31. I think over the next few years, the 404 type of work will be going down. But other work around the same risk management audit assurance will be going up.

We know that clients have to implement the much quicker reporting deadline. We know major companies who have a hard time meeting the current reporting deadlines.

Right.

And we’re in there helping them. So we just think there’s a lot of other work that’s going to come out of this. I also believe that Europe, and probably Japan, will follow with also Sarbanes type of legislation.

Hmm. Okay.

So this is – it’s not going to be just a U.S. pony. It’s going to be, I think, a worldwide issue, because we’re going to worldwide capital standards.

Right. Okay thanks. Great quarter.

Thank you.

We’ll take our next question from Greg Capelli with Credit Suisse First Boston.

Hey guys, it’s Jeremy, in for Greg. Great quarter.

Thanks.

Just a couple quick questions. You had made a comment that Japan will probably be a struggle for a little while. But I didn’t want to read too much into that. Can you talk about - ? I know it’s really early, very early in your stage. Is that going kind of as expected so far?

Well, I didn’t say Japan was going to be a struggle. I said our business model has some questions of how we adapt to it, because the Japanese is a much different employment model, employment for life, etc. We don’t think our business itself is going to struggle from the standpoint of demand.

Okay.

We have had very, very strong demand so far. And we’ve been able to fill the majority of it. So it’s going probably better than we expected, with the size of the office that we opened. You know, Japan and Tokyo itself is such a huge financial market. It’s going to take us a while to fiddle around with the employment model, to get the right model that can give us fast growth. But it’s doing fine right now.

Okay. Great. And then just with the strength of the overall gross margins in the quarter, I know you talked about the reimbursable expenses, you talked about convergences. Can you just give us a sense for the trend in pricing, pricing as an issue, overall pricing trends during the quarter?

I would say the pricing trend in the U.S. has been about the same.

Okay.

Our pricing was up about 7% in the quarter, and up about 9% for the year. So we’ve continued to see strong pricing. As Don mentioned, it’s getting a little bit more challenging to attract people. So there is also some slight pressure on what we’re paying people. But, on balance, we think we are managing the gross margins to a level that is appropriate for our associates, for our clients, and still generating the sorts of returns that we want for our shareholders.

Okay.

The majority of the pricing increases is followed by salary type increases.

Right. And then just lastly, you talked about the SG&A spending level probably creeping up a bit as we move through the year. Can you talk about cap-ex?

We continue to be a company that has very limited cap ex needs. It could be somewhat higher in terms of dollars than it’s been in the past. But, as a percentage of revenue, it’s still going to be substantially below 3% of revs.

Okay. Thanks a lot guys.

And we’ll go next to Randy Mehl with Robert W. Baird.

Yeah, hi Don and Steve. Great job finishing the year. I wanted to follow up on a couple of questions that have been asked. One, Steve you had mentioned a 15% EBIT margin target. And I think Andrew was asking it a slightly different way. So I just wanted to get clarification here. Is 15% a number you expect to hit kind of quarter after quarter? Is it a full year number?

No. No. I think what we’ve said in the past is that we would target that over a long term. And we haven’t hit that very often, frankly. There have been – and this is the first quarter where we had very substantial operating leverage. But we wouldn’t expect that that level of leverage would be sustainable over a terribly long period of time, because at some point substantial revenue growth has to be supported again by additional infrastructure investments.

So I think everyone is searching for first quarter guidance. And our history is that we give revenue guidance, and we don’t give particular guidance with regards to specific other aspects of our P&L. But we do expect that we will continue to make investments in the size of our practice to support the revenue strengths.

Typically we said – we’ve always said that we have thought the business, if it was a mature business, would generate – and was run like a mature business – would generate 15% plus EBITDA type margins. But we don’t believe we’re a mature business. We keep investing in new geographic locations, and new service lines, and new expansion. And we plan to use the investment to create, as we said, a much bigger company in the future. So we’re not mature. We don’t plan to be mature.

Right.

Okay. And then you had mentioned bill rates, I think, up 7%. Roughly what was the wage rate increase?

Year over year, the change from the previous year quarter was about 13%.

Okay. And is that something that you’re – it doesn’t sound like you’re at all concerned about that, about wage rates growing a little bit faster than bill rates. Is that something you would expect to reverse itself, or move around?

I would say our plan is and has been to continually hit about a 40% gross margin in the U.S. And the margins internationally are different. But so is our cost structures. So we try to manage to a 40% gross margin in the United States. We do add, and we’ve had to add, and will continue to add, more benefits for our associates. And then we try to price that into the next set of pricing negotiations with clients, etc. So at least personally, I am not troubled by our wage – the increases in our wage rates, because we’re maintaining our 40% margin.

Right. And you’re doing that. I mean the fourth quarter margin was obviously very good. You’re – and I’m just talking about the non-ETM business. How is it that you’re doing that, with the spread – the wage rates growing that much faster than pricing, no contributions from conversions, and increased benefits?

We did not, in what we just gave you, break out domestic versus international. And we’re not really planning to break out the pricing strengths in the U.S. versus the international. But we did break out the gross margins internationally. And it was down a little bit from the previous quarter. So you kind of have to address the international mix. And then also, in the fourth quarter, with such rapid improvements in revenue, there are certain fixed components of our costs that are in gross margins that get spread over a bigger base. So that also helps a little bit.

Okay. That’s helpful. And then just a final question on the Netherlands practice. It doesn’t look like it went into growth mode in the quarter. And now we’re going into a seasonal dip. Generally, how are you feeling about the health of that practice? Would you expect it to come out of the seasonally slow period with significant growth as we work through the year? Or how are you looking at that?

I just came back from Europe. And while I was there, I also met some business leaders and economists on the continent. And I would say that there is not a lot of optimism on the continent. Now, again, a lot of that is driven, at least from what I was told, by the German economy. Our Dutch economy and most of Europe is very dependent on Germany’s economy, because it’s the biggest exporter. And so I don’t anticipate that we’re going to see a turnaround in the growth trend in Holland until we see some more positive economic activity on the continent, and specifically Germany.

Okay.

But we’re not asking them or anticipating it.

Okay. Thank you very much. I appreciate it.

And we’ll go next to Brandt Sakakeeny with Deutsche Bank.

Thanks. Hi Steve and Don. It’s a great quarter. Actually just a couple of quick clarifications. Don, do you mind clarifying, did you say something like 17 of your top 50 clients are doing Sarbanes work? And then you said your largest client – could you just repeat that part?

Sure. I said of our top 50 clients for the year, and these are all very large revenue clients for us, we’ve only done Sarbanes work with 17 of them.

Okay.

Number one. And then the second thing –

During the quarter, our largest client was 9% of rev.

And what I also said was during the quarter, that our largest client for that quarter was 9% of revenue, and was a Sarbanes project. We have since finished most of that work, but have also gotten some follow-on work. But our largest client for the year, which is 5% of revenue, which is still our biggest client, is not a Sarbanes client.

Okay. I got it. Thank you. Next question, is – can you just comment on the acquisition pipeline? Obviously, is - ? Do you see a lot of opportunities, like the Dutch business, when it came up last year? Are there similar things out there that you’re looking at?

We have seen a lot of opportunities. I would say that not a week goes by that somebody doesn’t bring us an opportunity. We’ve only – well, I would say we’ve looked at two or three opportunities like the Dutch practice. And I declined those – the larger opportunities because of the – number one, we didn’t need it for a strategic reason. It would have been more buying growth, because we already had a presence where that company was.

So we didn’t do it. Another company that I looked at in a place where we do need a strategic location, the company doesn’t really appear to fit our business model. While they’re doing accounting and finance work, they’re doing it at a much different level. And so it doesn’t really culturally fit or fit our targeting. So the majority of the other acquisitions we’re looking at are smaller businesses, that may have already spun out of a Big 4.

Okay.

But not the size of the Dutch practice.

Okay. Another question is on the, I guess the differential in pricing, where you think you are, despite the raises that you’ve seen in your business, versus the Big 4. What type of pricing discount do you think you are? And has that pricing discount come in a little bit? Or has it expanded over the last quarter and sort of six to twelve months?

To be honest, Brandt, we don’t really – we couldn’t tell you real factually, because we don’t see us going against the Big 4 very often. I do know that the Big 4 use our people on their own projects, where they can find the right people. And I guess they mark our people up. So I guess you could call clients and ask them. But I mean I think we still have, probably, a very similar advantage that we’ve always had in pricing.

Okay, which is actually a good segue into my final question. I apologize. But just in terms of – can you just remind us how much business you’re actually doing for the Big 4 on a subcontractor basis maybe?

Our total revenue from the Big 4 from all of the four last year was way less than probably 5%. So one of them – I think the most significant Big 4 client was about close to $3m.

Oh, okay.

So we don’t do a lot of work for them. But I mean a $3m client for us is a nice client. So –

Yeah.

We’re very happy to have them.

All right. Great. Well thanks so much, and congratulations again.

Thanks.

And we’ll take our next question from Jim Wilson from JMP Securities.

Oh, thanks. We’ve had a lot of questions. So I’ll keep it to one, which, if you look at the areas outside of Sarbanes-Oxley that have had the greatest strength, can you characterize it by M&A underwriting, or just general internal work? Or how could you characterize what you’re seeing, and sort of shape it and contrast it with what people might be thinking about the overall economy?

I don’t think we’ve seen a lot of M&A work yet. And we haven’t seen a significant amount of IPO work. So the majority of our work has been a lot of operational improvement projects. Whether it’s – some of its systems, with accounting and finance changes. Some of our biggest projects are continuous clean up of the old systems, because you can’t put something on a new system, when the old system is presenting garbage. So some of our biggest clients right now – our biggest client right now is not a Sarbanes client, is more operational improvement, and clean-up type projects.

Do you see any thoughts on how that’s changing on the horizon, or anything you’re starting to see in work that your consultants are taking a look at?

Well, operational improvements in implementing changes I think is going to be a growth area, because one of the things Sarbanes will do, if you do it right, will point out your weaknesses. We had one big client that didn’t have a standardized internal controllers manual for 43 different subsidiaries. So they had to implement an internal control manual for 43 subsidiaries. So I think we’ll see a lot of process improvements over the next few years come out of this whole process. And it sort of coincides with the anecdotal information we’re getting from some of the Big 4 partners we talk to.

Hmm. Okay. All right. Very good. And excellent quarter.

Thank you.

(Caller instructions.) And we’ll go next to Adam Waldo with Lehman Brothers.

Sorry to beat a dead horse here. But just want to follow up on Randy’s question on the gross margin issue. If you all did a 38.9% gross margin in U.S. operations in the February quarter, and you did a 41.5% in the May quarter, and average bill rate inflation system wide was 7%, average pay rate inflation was 13%, just help me understand why such a big sequential increase in U.S. segment gross margin. I mean were you getting low to mid teens average bill rate increases in the U.S. in the latest quarter? Or was there an unusual performance-based bonus or something that aided gross margin?

As I said, we’re not – we didn’t give geographic breakdowns, though that is a portion of the answer. There is a component that is not just pure bill rate/pay rate. There is a component of our benefits that is essentially fixed in the short run. And so when you have very quick revenue growth, you spread those costs over a base that is bigger. And that, therefore, decreases the impact on the overall gross margins. So, during the fourth quarter, we were the beneficiaries of that. And that helped our gross margin.

Okay. And Steve, could you just remind us what the total revenue was from all international operations in dollars in the quarter, if you’re at liberty to give those out before the K?

About a little over $20m.

Thanks.

And we’ll take our next question from [Andrew Rexchasen] with Green Light Capital.

Hi guys. Two questions. One is, I had always thought of your gross margin in the domestic business as being a purely variable margin. And I was wondering if you could just help clarify how much of the cost there is fixed cost – because I think I am hearing this for the first time now – versus variable cost?

Well, I think what Steve means by fixed versus variable is our gross margin is not a variable cost, per se. Our salaries are related to the hours our people work, which is related to our business model. This part of our salary cost that is fixed per person would be like their benefit cost. So if they’re paying X dollars for their health insurance and life insurance, and they get a base increase and we get a billing rate increase, we’re not increasing those health costs marginally the same way.

So those – that percentage will go down, because the dollars stay the same, even though the salary rate is higher. Our cost per train that people earn, and what we do in training typically is not going to change because the person is getting paid more. So I think that’s what Steve is referring to.

Right.

Got it. Okay. Thank you. Second question I had was you mentioned that the RAS group was about 24 odd percent of revenue this quarter. What was the comparable number for – if you had even the last two quarters, that would be helpful, just as a percentage of the total quarterly revenue.

I don’t know that we’ve got that with us. But I’d be glad to share it with you. I think –

We didn’t disclose it in the past.

I don’t think we’ve disclosed it in the past. I think what we said last quarter was that it was running at about, at the end of the third quarter, about 20% above our total.

The thing about it that’s, for us, is that the types of projects that we’re doing in RAS, before we had RAS, we did them before in accounting and finance. So we didn’t add a lot of a new type of work. What we did is we basically started a subsidiary, where we could really focus on it, and build up our reputation around it.

So when you look at accounting and finance growth, what was impressive to me is that accounting and finance growth over the last few years has happened, even though we’ve pulled out the RAS work, and put it in a separate bucket. So it’s always hard to compare apples to – from year to year, because of the way we’ve positioned RAS separately. And a lot of the people that do the RAS work are the same accounting and finance associates, so that they can do other types of projects at clients other than RAS.

Right. But – okay. Thank you very much.

That does conclude our question and answer session. At this time I’d like to turn the call back over to you Mr. Murray for any additional or closing remarks.

Well I just want to, again, thank our investors and thank the people interested in our business. And we look forward to talking to you after the next quarter.

That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.