CRA International, Inc. (CRAI) Q3 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to Charles River Associates' Third Quarter Fiscal Year 2012 Conference Call. Today's call is being recorded. You may listen to the webcast on CRA's website located at www.crai.com. In addition, today's news release and prepared remarks from the company's Chief Financial Officer are posted on the Investor Relations section of the site. With us today are CRA's President and Chief Executive Officer, Paul Maleh; and Chief Financial Officer, Wayne Mackie. At this time, for opening remarks and introductions, I would like to turn the call over to Mr. Mackie. Please go ahead, sir.

Thank you, Lewis. Statements made during this conference call concerning the future business; operating results; anticipated, expected or intended impact of restructuring actions in key hires; estimated cost savings and financial condition of the company; and statements using the terms anticipates, believes, expects, should, prospects, target, on track or similar expressions, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are subject to a number of factors and uncertainties. The information contained in these forward-looking statements is inherently uncertain, and actual performance and results may differ materially due to many important factors. Such factors that could cause actual performance and results to differ materially from any forward-looking statements made by the company are included in the company's filings with the SEC and in today's news release and prepared CFO remarks. The company cannot guarantee any future results, levels of activity, performance or achievement. The company undertakes no obligation to update any of its forward-looking statements after the date of this call. Let me remind everyone that we will be referring to some non-GAAP financial items on this call. I would encourage everyone to refer to today's earnings release for a full reconciliation of these non-GAAP items to their GAAP equivalents. Let me now turn it over to Paul Maleh for his report. Paul?

Thanks, Wayne, and good morning, everyone. Our third quarter results reflect the initial benefits associated with our previously announced restructuring actions combined with solid performance by a number of our practices. Let me first update you on our restructuring activities and then talk about the quarter and outlook for our markets. As previously announced, during the third quarter, we eliminated 2 underperforming businesses and restructured select practices, all with an eye towards intensifying the focus of our portfolio, increasing the cohesiveness of our services and how we market them, enhancing our margins and profitability and ultimately improving the long-term prospects of the company. Within our Management Consulting business, we closed our Middle East operation and eliminated our Chemicals practice, while maintaining some sector expertise with a core team of individuals within our broader Management Consulting business. We expect these actions will enhance profitability on a margin percentage and dollar basis going forward and lessen the drag on our overall tax rate, which Wayne will discuss in further detail. As part of our plan, we also repositioned select underperforming practices. In total, our restructuring activity resulted in a reduction of more than 60 consulting staff. As previously announced, we expect the reduction in consulting staff will reduce net revenue on an annual basis by approximately $8 million to $10 million while generating an annualized cost of service savings of approximately $17 million. We're also taking significant actions to lower our SG&A costs. In Q3, we reduced our administrative staff, lowered administrative spending on outside contractors and professional fees and eliminated excess office space. We continue to expect the majority of these SG&A savings will be completed by the end of fiscal 2012 and will generate an annualized cost savings of approximately $8 million. We expect the shedding of these lines of business, the repositioning of select underperforming practices and the SG&A initiatives to improve overall profitability by approximately $15 million to $17 million annually. We are on schedule with our plan, and we expect these restructuring efforts to enhance our performance in future quarters. With that, I'd like to turn to our results in the quarter. Our performance in the third quarter demonstrates one result of restructure; the beginning of a positive effect on our margins. Our Q3 restructuring activities helped increase our non-GAAP operating margin to 8.1% in the quarter from 5.9% in Q2. From a top line perspective, we delivered solid results with $64.7 million in non-GAAP revenue. In addition, we generated from operations for the quarter -- we generated cash from operations for the quarter of $4.2 million. The performance of the Litigation and Regulatory business was led in the quarter by strong contributions from our Intellectual Property, Competition and Labor & Employment practices, among others. In particular, our Intellectual Property practice won several large projects that resulted in more than a 50% revenue increase for the third quarter on both a year-over-year and sequential basis. In addition, our European Competition group continued to perform well, growing more than 50% in the quarter relative to a year ago and more than 30% on a year-to-date basis. Overall, our Litigation and Regulatory business produced good Q3 results and a comparable performance level to Q2 despite some industry headwinds. During the quarter, demand for our management consulting services continued to improve from its slow start at the beginning of the year led by our Marakon practice, which achieved year-over-year growth in the third quarter. Although clients remain cautious about undertaking large consulting engagements with the current economic uncertainty, we are continuing to take on new engagements. We're continuing to focus on growing organically, supplemented by new senior hires. Throughout Q3 and in recent weeks, we have issued a number of press releases announcing key senior hires who joined CRA in Competition, Finance, Energy & Environment, International Arbitration and Intellectual Property. CRA remains an attractive destination for top-tier consultants within our service areas. We expect as these consultants get fully up to speed at CRA, they will more meaningfully contribute to our revenue and operating profitability going forward. We intend to remain aggressive in recruiting additional rainmakers, as well as pursuing broad-based growth across our portfolio. Looking ahead, we remain on track to achieve our established target of double-digit non-GAAP operating margins in Q4. We believe our Q3 performance is an early indicator in demonstrating that our actions will be effective at enhancing our margins and better positioning the company for long-term profitable growth. With that I'll turn things over to our CFO, Wayne Mackie. Wayne?

Thanks, Paul. Our fiscal Q3 over Q2 improvement in non-GAAP operating income as a percentage of revenue reflects the initial impacts of the Q3 restructuring. This improvement of over 2 percentage points represents only a portion of the cost savings we expect to realize from the full impact of the restructuring. As Paul noted, we expect to see the non-GAAP operating income increase into the double-digit range next quarter, with further improvements in 2013. Moreover, the 8.1% Q3 non-GAAP income from operations includes the effect of an operating loss from our discontinued Middle East operation. Not only did these Middle East operating results pull down our Q3 GAAP and non-GAAP operating income performance, they pushed our GAAP tax rate to an extraordinary level of nearly 170%. Our non-GAAP tax rate of 48% would have been under 40% without the impact of the Middle East operation. With the negative earnings impact of our Middle East operation behind us, we expect a more normalized tax rate in Q4 and beyond. Let me provide some other factors that you should consider when assessing our Q3 2012 performance and our outlook going forward. In terms of consulting headcount, we ended the quarter with 485, which consisted of 351 senior staff and 134 junior staff. We eliminated more than 60 consultants as part of our restructuring, the new influx of new senior hires that Paul mentioned, along with target additions from -- to our junior ranks within our practices resulted in a net decline of only 26 consultants in Q3 from the 511 reported at the end of Q2. Our leverage ratio of junior staff to senior staff improved during the quarter, an indicator of the progress we are making towards achieving one part of our strategy to increase overall profitability of the company. Our company-wide utilization for Q3 of fiscal 2012 was 67%. However, when you exclude the consultants involved in our workforce reduction, that rate would have been -- would have risen to 71%. This is lower than the 73% we reported in Q2 of fiscal 2012, but the number reflects the transition of -- transitional effects of the restructuring activities, which reduced Q2 headcount very slightly but more fully impacted Q3. In addition, the ramp up of several of our key hires likely affected Q3 utilization. We are maintaining our target utilization in the low to mid-70s going forward. Our non-GAAP SG&A was approximately $600,000 lower in Q3 2012 compared to Q3 2011 and essentially flat compared to Q2 2012. Commissions to nonemployee experts, which are included in SG&A expenses, were approximately $600,000 higher in Q3 2012 versus Q3 2011 and $400,000 higher as compared to Q2 2012. If these commissions were excluded from SG&A expenses, our Q3 2012 non-GAAP SG&A expenses would have been 21.4% of revenue versus 21.9% for Q2 2012. A reduction in SG&A expenses reflects our restructuring efforts and our ongoing emphasis on expense management in order to enhance our margins. Turning to our international operations. Our international revenue contribution for the quarter was approximately 22%, which was below the 25% we reported in Q2. Despite economic conditions in that region, several of our European practices, specifically the larger competition and Marakon practices had a good quarter, which partially offset the performance of other smaller practices in the Middle East operation. Turning to the balance sheet, DSO were 115 days in the quarter, flat with the 115 days we reported in Q2. We are disappointed that we did not lower DSO during the quarter. We have increased our efforts related to our DSO and expect it to return to historical levels. DSO in Q3 consisted of 77 days of billed and 38 days of unbilled, as compared to 69 days of billed and 46 days of unbilled in Q2. We anticipate that the third quarter increase in billed DSO and decrease in unbilled DSO should translate into a stronger cash flow during the fourth quarter. In terms of our cash position, we concluded the third quarter with approximately $42 million in cash, cash equivalents and short-term investments, which is essentially flat with the end of Q2. However, I should note that during Q3, we repurchased approximately 214,000 shares of our common stock at a cost of approximately $3.4 million and paid the majority of the approximately $4.4 million of restructuring charges. That concludes my comments with respect to Q3. I also want to cover an accounting measurement we are required to make each year that may impact our Q3 -- excuse me, our Q4 noncash GAAP results. Each year in the fourth quarter, we are required by GAAP to perform a test of the value of our intangible assets, principally goodwill, for impairment. If the test indicates the value of CRA, as determined under GAAP, is less than the book value, an impairment write-down is then calculated. If a write-down is required in Q4, it may be material to our financial statements as reported under GAAP. However, any such write-down would have no effect on cash or non-GAAP results of operations. Lewis, we now would like to open up the call for questions.

[Operator Instructions] Our first question comes from line of Tim McHugh with William Blair & Company.

First, I wanted to ask if you can give us a little more clarity on kind of how much of the cost savings were impacted or reflected in the Q3, and then as we go into Q4? It seems like you're still expecting some cost to come out of the business, so I'm trying to understand how you're getting to the double-digit margin next quarter, just how much is revenue versus the cost coming down further?

Sure. I think when we talked about our savings, we tried to break apart those savings estimates into things that impact our cost of services and things that impact our SG&A. The third bucket, which I'll get to at the end, is the expected reduction in revenue. So let me begin with the cost of service estimates. We believe that in Q3, we realized about 50% of the expected savings on a quarterly basis associated with the staff reductions. We also believe that the majority of the remainder of that savings should be realized during Q4. With respect to the SG&A, we're probably a little less than the expected 50% on the cost of service. Those savings will probably be fully materialized through Q4 and Q1 of 2013. With respect to the expected reduction in revenue, it is probably also in the magnitude of about 50% of the $8 million annual run rate that was experienced in Q3. So let me break that down a little bit. It's $8 million to $10 million in revenue reduction that we announced during Q2. On a quarterly basis, that translates into about $2 million to $2.5 million. So in terms of what we -- what we felt during Q3, is about 50% of the revenue reduction of $2 million to $2.5 million.

Okay, that's very helpful. And then Wayne, what is the normalized tax rate once you get past the Middle East wind down? Is -- you said 40%, is that a number we can use going forward?

Tim, that should be a reasonable number. There's opportunity for the rates to be even lower than that across the company, depending on the mix of profitability between the North America and Europe. Right now, the European tax rates, U.K. for example, is 25%. Our rates here, depending on what happens following the election, when you add state taxes in, at least 40%. So that's a pretty substantial differential in the tax rates. So depending on the mix of taxable income, it could drop below 40%. But 40% is probably a good rate to think in terms of as we go forward.

Okay. And then can you talk about -- you referred to some of the new hires. I think there's a large group of them that are scheduled to start middle of next year. Can you talk about the impact that those would have, as well as the speculation in terms of the cost of hiring those people and what the impact on margins would be as you bring them in?

Yes, we're not prepared to reveal what the revenue impact is for those parties. There are some very significant additions that we're looking forward to having join CRA. In terms of the relation between what we paid and what we expect the impact is, they're all positive NPV projects, they're all going to be accretive in the year they join us. So we don't anticipate any margin compression through the addition of these new colleagues.

Okay. And one more, on the market, you talked about -- there was a comment in the press release about the Litigation business was flat even though the market was tougher. Can you tell me -- tell us a little bit how the market was tougher and, I guess, what got tougher?

I think if you look at a number of the surveys, you talk to the law firms, there's clearly been an increase in headwind as 2012 has progressed. So our ultimate clients are becoming a little more hesitant to undertake large consulting engagements. They're delaying the retention of some experts. So we have seen all these impacts, say, the opportunities that we're being presented. We're converting on a great rate of those opportunities. But it's just, again, general headwinds that we're experiencing. With that, many of the large practices that you would expect to be impacted really have performed exceptionally well, and some of those I highlighted during the call.

Okay, great. And my last one, I'll turn it over. Wayne, cash flow for the year, will you be able to be positive for the year? And given -- and I don't know how much of an improvement in DSO and cash flow you're hoping for?

Cash flow from operations, we're hopeful it will be positive for the year. I guess it will -- well, let me actually step back that. Cash flow through -- from operations, through Q3 for the full year is actually $22 million negative, Tim. So I would say, frankly, we're not going to close that gap in Q4 although we certainly expect to be positive in cash flow in Q4.

Our next question comes from the line of Joseph Foresi with Janney Montgomery Scott.

This is Jeff Rossetti in for Joe. Paul, just to follow up on Tim's last question about demand. I know you had mentioned IP, Competition and Labor & Employment being healthy in the quarter, just any commentary on the Finance practice and the Life Sciences practices?

The Finance practice performed just fine. It wasn't of the extraordinary levels that we experienced when we're talking about 36% sequential year-over-year growth. They're maintaining the pace that they've realized throughout the year, so there's no concerns there. With respect to Life Sciences, a lot of those efforts have been more on the Management Consulting side as opposed to the Litigation side, and we're also seeing improvements in Life Sciences as the year's progressing, but again, not to the magnitude of the exceptional performances that we're seeing in Competition Europe, IP and Labor.

Okay. And is there any way to sort of quantify, Paul, I think you mentioned that the conversion rates were improved from, say, a year ago? Is there any additional detail you could provide on that?

We don't provide the actual percentages. When I'm talking about conversion rates, clearly, CRA gets business opportunities. So these are leads that we have. And when we talk about conversion rates, it's our ability to take one of those opportunities and convert it into a revenue-generating project. So we track how we do on converting opportunities into revenue. And the firm has done really well in those situations. We track it because, one, it's an indication of the market we're facing. But two, it's also one of the best indicators of how we're doing relative to our competitors, whether we're winning competitive assignments and how our share is looking at the market as a whole. We have not seen any negative trends on those ratios over time. So we're pleased with that. We would love to have more opportunities, but we're happy with our conversions.

And Wayne, I think you had mentioned in your comments that the recent hires had impacted utilization for the quarter. Is there -- was there any revenue contribution from the recent hires and how do you see maybe the utilization heading into Q4, given that there's going to be a -- it's seasonally weak given the holidays?

Go ahead, Paul.

Let me start with the utilization. I guess we're going to maintain our utilization goal of the low- to mid-70s utilization in Q4 and beyond. We believe there's no reason why our portfolio shouldn't be able to deliver those results going forward. With respect to the new hires, to date, they have met our expectations. With any new hire, there's always a ramp up period. We're pleased with the opportunities they're presenting and also pleased with the conversions they've had year-to-date. There has been a positive contribution on the revenue line from these new hires, but really nowhere near what we anticipate to be their full capacity contribution.

[Operator Instructions] Our next question comes from the line of David Gold with Sidoti & Company.

A couple of things. One, the easy one, Wayne, I think you gave a number of 485 for headcount at quarter end. Just curious if you can also give an average number?

Well, the quarter started with 511, David. The 485, obviously, has a number of things in it. It has the over 60 consultants who left the company as part of the restructuring, as well as the seasonal new hires that come in. We don't have an exact average that we've calculated for it. But clearly, it swings, I would say, that the restructuring, as I think you know, occurred was announced at the end of July. Obviously, everybody didn't leave that day, so it took a little bit of time for those folks to roll out. The new hires, again, start arriving during the July, August and even September timeframe. So it's very much a blended rate that would occur between that 511 and 485 [indiscernible]

I mean, if you wanted to think of it in terms of an average, the fact is that many of the impacted -- our impacted colleagues who left as a result of the restructuring, left towards the end of August into September, with our new hires happening earlier on. So if I were to look at an average headcount, it's probably north of the 485. But we don't necessarily compute that number.

Okay, that's helpful. And that topic, can you speak a little bit about -- obviously, since some of the hiring which you've done, but practice areas where you still basically have seen the strong enough demand or not enough talent in house where you're still hiring?

I like my portfolio. And right now, I'm not hesitant to hire across any of the practice areas that comprise my portfolio. And that goes from our smaller practices. We are looking for opportunities all the way to our largest practice, Competition. Competition has enjoyed a wonderful year on recruiting ranks. And I think that speaks to the fact that there is still room in the marketplace for that practice to grow significantly. And it's about as attractive a destination as professionals out there in the marketplace see. So we believe there's opportunities for expansion across all these practice areas.

Okay. And then on Marakon Management Consulting, returning to growth. Obviously, easier comp last year. But I think you also commented in the release a pickup in demand there. And was curious if you can also give some color on that, I guess, given some of your commentary that folks are a little slower to spend, yet you've seen some success there.

I think, let me talk a little more broadly about Management Consulting and not necessarily only specifically about Marakon. I think our Management Consulting practice received quite a bit of negative press in the beginning of the year. But to a consultant across this organization, they took responsibility and have largely reversed that slow start, and that is by finding new opportunities in the marketplace, by doing an exceptional job of converting those opportunities and maintaining margins through that whole process. So we have had a lot of pickup that has occurred through the year. They're working hard. Is there -- is it a tougher environment? Yes. I don't think there's any way else to say that when you look at the global economic uncertainty that we're seeing in Europe and in North America. But the quality of the work is speaking for itself. The referral network is paying dividends, and we continue to see new opportunities and conversions all the way into October here.

There are no further questions at this time. I'd like to hand the floor back over to Mr. Maleh for closing comments.

Okay. Again, I want to thank everyone for joining us today. As always, we do appreciate your time and interest in CRA, and we look forward to updating you on our year-end conference call in early 2013. This concludes today's call.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.