Resources Connection, Inc. Q2 FY2021 Earnings Call

Good afternoon, ladies and gentlemen, and welcome to the Resources Connection Inc. 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. As a reminder, this conference call is being recorded. At this time, I would now like to remind everyone that management will be commenting on results for the Second Quarter Ended November 28, 2020. They will also refer to certain non-GAAP financial measures. An explanation and reconciliation of these measures to the most comparable GAAP financial measures is included in the press release issued today. Today's press release can be viewed in the investor relations section of RGP's website and was also filed today with the SEC. Also during this call management may make forward-looking statements regarding plans, initiatives and strategies and the anticipated financial performance of the Company. Such statements or predictions and actual events or results may differ materially. Please see RGP's report on Form 10-K for the year ended May 30, 2020 for a discussion of risks, uncertainties and other factors that may cause the Company's business results of operations and financial condition to differ materially from what is expressed or implied by forward-looking statements made during this call. I'll now turn the call over to RGP's CEO, Kate Duchene.

Thank you, operator. Good afternoon, everyone, and thank you for joining us. With me today are Tim Brackney, our Chief Operating Officer, and Jen Ryu, our Chief Financial Officer. I will start with an overview of the second quarter, including the ongoing progress we are making to overcome the COVID-19 impact. Then I'll share updates on our two most significant priorities this fiscal year: our digital transformation and evolving our delivery model to be more flexible, virtual and borderless to drive growth within our client base — existing and new geographies, client programs and health care. This evolution also supports our focus on EBITDA improvement. I'll then share client continuity statistics to reinforce our stickiness in a blue-chip core client base and improving continuity quarter-over-quarter. Finally, I will close by touching on a few highlights from our new investor deck added to our website today. From a revenue perspective, we saw steady improvement in top-line results as we moved through the quarter, the impact of the global pandemic notwithstanding. In Q2, our revenue was $153.2 million with a 4% sequential improvement over Q1 and grew 6.4% when comparing revenue based on the same number of billing days in constant currency. Excluding our restructuring charges, SG&A also improved as expenses were reduced 4.7% sequentially. Adjusted EBITDA margin increased 120 basis points sequentially to 8.1% as a result of our cost reduction initiatives and expense discipline. We are continuing to pursue bottom-line growth through operational efficiencies, lowered real estate investment and headcount management. In his remarks next, Tim will discuss some of the positive revenue trends that are emerging as well as steps we're taking to maximize opportunity in our core geographies, client programs and health care industry practice as we continue to position the Company for sustained success in the coming years. Now let's turn to our two primary growth priorities this fiscal year. The first is to grow revenue by providing more digital transformation services and building out new digital pathways to engage for staffing services. Over the last several years, explosive technological innovation has fueled the rise of digital transformation as a corporate imperative. Our clients have been forced to rethink the way they do business, to stay ahead and compete with digitally native new entrants. In order to support our clients, including these digitally native businesses, RGP has evolved significantly to help clients automate, streamline and drive efficiency through functional process redesign, technology migration, project management and communication services. These initiatives are happening in every functional area of our clients: finance and accounting, risk and compliance, tax, human resources and project management. To effectively address this evolution, we had the foresight to acquire Veracity in 2019 to help us build end-to-end digital solutions for our clients who strive to automate workflows and increase collaboration, which has become even more important given the increasingly virtual nature of today's workforce. The past year has not only reinforced and accelerated the digital mandate for all corporations, it has placed an emphasis on the employee experience given remote work, which is a specialty of Veracity's. Given an integrated go-to-market plan in fiscal '21, RGP and Veracity are uniquely positioned to capitalize on the emerging trends. Combining Veracity's robust capabilities around workflow automation, leveraging premier platforms like ServiceNow and Akumina, with RGP's deep functional expertise and process orientation. Veracity achieved record revenue during the quarter, and this trend has continued in Q3. We've also experienced growth in our cross-selling success across the enterprise, with Veracity bringing RGP into project work and vice versa. We expect this positive momentum to continue through the second half of the fiscal year, although remember, Q3 for all parts of our business is impacted by holidays. With respect to our digital engagement platform development, HUGO progress continues as planned. We have finished the talent management release and that part of the software is in active use with a select set of candidates and internal management. We're on track to bring this digital engagement offering to market by the end of this fiscal year. We will, however, ensure that the macro environment is stronger and more fully recovered from lockdown scenarios when we bring the product to market, and we'll share more detail as that timeline approaches. We're excited that this new digital engagement model will bring transparency, choice, efficiency and speed in striking the right professional match for much sought-after talent in the finance and accounting realm. Our second growth priority initiative this fiscal year is to continue to evolve our delivery to be more fluid, virtual and borderless. This initiative is intended to enhance both revenue and earnings as it is directly linked to client acquisition, new and existing, and cost efficiency. For example, we've recently closed several projects with consultant teams pulled together from multiple geographies to deliver an exceptional experience for clients. This type of approach would not have happened pre-COVID when we operated with a more traditional geographies-focused mindset. We're also demonstrating that we do not need physical offices to serve clients effectively. For example, we just closed a new multi-consultant engagement on a project out of Des Moines, where we do not have a physical office or go-to-market team. This exemplifies the opportunities we're starting to uncover with new client sets. As Jen will also outline, we've made strong progress on our real estate consolidation plan, which will continue to drive forward. All of these actions help us continue to streamline our cost structure while bringing our client delivery teams closer together and closer to client buyers. Next, RGP's client continuity was outstanding this quarter. These retention statistics demonstrate the value-add we bring to clients each and every day. During Q2, we served all of our top 50 clients from fiscal 2020 and 46 of the top 50 from 2019. This stickiness has remained consistent year-over-year despite the global pandemic. In addition, for Q2, our top 50 clients represented 44% of total revenues, while 50% of our revenues came from 70 clients. Our largest client for the quarter was approximately 3.5% of revenues. Also during the second quarter, 90% of our top 50 clients procured multiple services or functional expertise from RGP, which demonstrates our ability to build revenue beyond the origins of our finance and accounting roots and is an improving trend as we start the second half of the year. In closing, I'm also pleased that we've posted to our website today a new investor deck to kick off 2021. Our new presentation synthesizes our heritage, our exciting future and our relentless focus on shareholder value creation. We've also expanded our disclosure around environmental, social and governance topics. This is particularly important to us in our efforts to become the employer of choice for high-quality professional talent who want to work differently with a community and company that cares about profit and purpose — the importance of diversity, equity and inclusion and operating as a force for good in community and individual life. The advent of the fifth industrial revolution is here and it will be squarely focused on bringing humanity back to the workplace. When you have a look at our new investor presentation, we think you'll agree that RGP is very well positioned to deliver what talent and clients want today. I'll now turn the call over to Tim for his operational update.

Thank you, Kate, and good afternoon, everyone. During the quarter, we continued to embrace our de facto operating model of virtual delivery and utilization of borderless talent. We saw positive movement in revenue and operating metrics as well as an appreciable increase in project teams working on large client initiatives. As the overall macro environment began to improve, our weekly revenue and pipeline also gained strength. As Kate touched on, sequential revenue trended up 6.4% on a same-day constant currency basis, buoyed by increased client spend on project initiatives and some seasonal tailwind tied to year-end activities. Project management and communication became even more important with rising demand as we continue to operate mostly virtually traversing time zones to deliver projects. We've seen this demonstrated on numerous occasions, whether it be assisting an operational transformation for a West Coast entertainment client, leveraging talent from Honolulu, Miami and Houston, or assisting a Pacific Northwest healthcare client transform their delivery operations with talent from Atlanta, Orange County and the San Francisco Bay Area. This more seamless matching of supply and demand has allowed us to operate with greater efficiency which was increasingly important as demand continued to rebound during the quarter. Our ability to successfully deliver in a remote fashion provides a critical qualification which will impact the buying decisions of clients in a post-COVID environment. We believe the successful evolution of project delivery, coupled with our clients' increased leverage of the distributed workforce, has permanently changed our commercial environment. It opens up our ability to fashion solutions using a mixture of traditional and virtual delivery models, bound together by our strength in Agile co-delivery, project management and commitment to holistic communication. This new market dynamic will provide a strong foundational underpinning as we enter into the second half of the fiscal year and initiate planning for FY '22, which will include expansion of client programs, leveraging broader market talent for virtual delivery and increased focus on account penetration. Now let me turn to our second quarter operations. As noted in our first quarter remarks, we began to see a strengthening pipeline and increased daily revenue rates. This strengthening increased throughout the quarter as daily revenue rates reached levels that were the highest since April. While Q2 demand was still impacted by the pandemic, North America and Asia Pacific saw sequential increases in daily revenue rates, as did Europe, which I will focus on in a moment. Client programs and health care led the charge in North America, which also saw strengthening in key core markets, including Tri-State and the California and Texas markets. Asia Pacific also delivered positive rates and was consistently trending at nearly pre-COVID rates by the end of the quarter. We neared completion of a significant restructuring in Europe during the second quarter, impacting approximately 40% of the workforce and resulting in a cessation of operations in France and Italy. I am extremely proud of the European team and their unwavering focus on clients and consultants during very difficult economic times. Despite working through this reorganization, our European practice banded together, renewed its focus on our most important clients and actually increased daily revenue over Q1. Notable growth in demand, especially related to larger projects, also positively drove volume and quality of pipeline. In fact, activity and pipeline were both strong in the quarter. And while there remains uncertainty related to the macro environment, given current operating trends, we could see sustained progress emerge as we move forward. While we remain keenly focused on growth and expansion opportunities within existing clients and markets, we are also concentrating heavily on operating leverage and efficiency. We are utilizing a more virtual and agile footprint, and this new operating style, coupled with continued focus on expense management has yielded SG&A improvements of 4.7% sequentially and 11.1% from the prior year quarter after excluding restructuring costs. We will continue to be judicious about our expense discipline, and we'll continue to invest in areas where we can achieve higher returns. In particular, digital and technology, health care and client programs continue their strong performance and offer opportunity to deepen and widen our relationships with important clients. Before handing over to Jen, I want to provide some additional insight on early third quarter trends. The early weeks of Q3 have shown a continuation of positive trends in both revenue and growing pipeline with daily revenue up approximately 8% over Q2. While we remain wary given the fluid macro environment, these positive indicators and some of the news around vaccine development and distribution are certainly encouraging. I will now turn the call over to Jen for a more detailed review of our second quarter results.

Thank you, Tim, and good afternoon, everyone. Starting with an overview of our second quarter results, revenue notably improved this quarter compared to the first quarter. Gross margin was in line with our expectation given typical seasonality with Thanksgiving holidays. SG&A continues to benefit from our restructuring initiatives as well as our increasingly virtual operating model. As a result, we delivered a solid 8.1% adjusted EBITDA margin despite the ongoing pandemic. Our balance sheet remains strong, with an increase in available liquidity during the quarter and we continue to generate positive cash flow from operations. Now let me provide more color on our operating results, starting with revenue. We generated $153.2 million of revenue, a 4% increase sequentially and a 17% decrease from the comparable quarter a year ago. After adjusting for business day and currency impact, revenue increased 6.4% sequentially and decreased 15.6% year-over-year. Same-day constant currency revenue increased sequentially by 5% in North America, 14.3% in Europe and 10.2% in Asia Pacific. Compared to the prior year quarter, same-day constant currency revenue decreased 16.8% in North America, 7.9% in Europe and 13% in Asia Pacific. Our second quarter gross margin was 38%, down 130 basis points sequentially and down 230 basis points from the prior year quarter. The reduction in gross margin was largely due to more holiday pay as a result of Thanksgiving as well as a decline in the bill-pay spread. Compared to the first quarter of fiscal '21, lower payroll taxes toward the end of the calendar year mitigated a portion of the gross margin decline. The average hourly bill rate for the quarter was approximately $1.24 compared to $1.23 in the prior year quarter and $1.24 in Q1 of fiscal '21. The average pay rate for the quarter was $63 compared to $61 in the prior year quarter and $62 in the prior quarter sequentially. SG&A expenses for the quarter were $47.8 million after excluding $6.8 million of restructuring charges, a meaningful improvement of $6 million compared to the prior year quarter. We continue to realize more cost improvements this quarter as we make progress executing our restructuring initiatives. Management compensation costs were reduced by $2.5 million, and occupancy costs were reduced by $0.8 million compared to Q2 of fiscal '20. General business expense also improved, down $1.8 million due to reduced travel and reduced discretionary spend. Turning to the other components of our financial statements. Income tax provision was $2.3 million for the second quarter, representing an effective tax rate of 178.5% compared to 30.2% in the prior year quarter. The effective tax rate for the current quarter was driven by higher international losses, largely resulting from the restructuring costs incurred in our European entities, and our inability to realize any tax benefits due to the required valuation allowances. Adjusted diluted EPS for Q2 of fiscal '21, which excludes the net of tax impact of restructuring charges, stock compensation and contingent consideration, was $0.21 per share compared to $0.42 per share in the prior year quarter. Next, let me provide an update on our progress in executing the restructuring plan. We have substantially completed the reduction in force, including those carried out under the European plan in Q2. We set out to exit from 22 real estate locations under the restructuring plan, of which 11 have been completed. To date, we incurred total restructuring charges of $12.8 million, of which $7.8 million was incurred in the first half of fiscal 2021. We expect between $2 million to $4 million of additional charges before completing the remaining actions, mostly related to real estate. The timing of the planned real estate exits will depend on a number of factors, some of which are not within our control, but we are committed to executing on our plan. As I mentioned earlier, we have already realized significant cost reductions in the current fiscal year as a result of these actions. We anticipate additional savings in the remainder of the fiscal year as the benefits from the European plan take full effect. Longer term, we expect to continue to rationalize our real estate footprint beyond what's planned under restructuring and continue to control our discretionary and travel spend by taking a blended approach between traditional and virtual methods of client engagement and delivery. Now let me turn to our balance sheet and liquidity. Our balance sheet remains strong. We ended the quarter with cash and cash equivalents of $97.2 million, up slightly since the end of fiscal '20. We generated approximately $30 million of positive cash flow from operations in the first half of the fiscal year and paid down $20 million of outstanding debt under the amended credit facility. The Board of Directors maintained a $0.14 per share quarterly dividend in the second quarter. We remain vigilant in managing our liquidity, considering the ongoing pandemic, the near-term restructuring-related cash obligations as well as other cash requirements to fund our digital transformation efforts. In the long term, we continue to evaluate our capital allocation strategy and expect to return cash to shareholders through both dividends and share repurchases, while balancing debt repayment and the capital requirements of growing our business, both organically and strategically. I'll close with our recent change in segment reporting and a discussion of third quarter trends. The execution of the European plan in the second quarter resulted in changes to our internal management structure and our reporting structure of financial information used to assess performance and allocate resources. Effective second quarter, our businesses are organized and managed in three operating segments: RGP, Taskforce and Citrix. RGP is over 90% of our business and drives the trends of our consolidated enterprise. Please refer to our press release and Form 10-Q for additional disclosure regarding segments. Now looking ahead to Q3. Average weekly revenues for the first three non-holiday weeks for the quarter was $13.3 million. We expect typical seasonality in the third quarter around our revenue as well as gross margin. From an SG&A perspective, while we anticipate cost savings from restructuring to continue, we typically experience higher SG&A in Q3 due to the reset of payroll taxes at the start of the calendar year. Lastly, consistent with our approach last quarter, we will not issue any specific revenue or earnings guidance for the third quarter of fiscal '21, given the ongoing uncertainty as it relates to the pandemic. Now we're happy to take questions.

Our first question comes from Josh Vogel with Sidoti. You may proceed with your question.

My first question: we saw some modest bill-pay spread pressure in the quarter. And I think with regard to bill rates, when you're at the table and you try to win and deliver projects remotely, it doesn't seem to affect pricing at all. I'm curious where you think that is?

Josh, it's Tim Brackney. Happy New Year. Well, a lot of the projects that we take on have an outcome orientation to them. Since we don't have to deliver locally, it's really about what expertise you need to deliver and how it is delivered. So theoretically, we should be able to get some actual arbitrage from that if we're able to locate talent from other parts of the country, and we're starting to see some of that. But the reality is that we're basing our bill rates on the project itself versus the locality of the delivery resource.

Understood. And on the other side, though, with your consultants no longer having the constraint of geofencing, couldn't we assume maybe that gives you some leverage over time on the pay side?

Yes. That is something we anticipate. It kind of comes down to everybody getting used to this new model. As we open up the catalog that allows us to match talent efficiently irrespective of locality, we will have the ability to think about labor costs in a different way. One advantage we had through this is that we erred on the side of being fair to our consultants. We didn't renegotiate downwards, and that was intentional because we want to keep our best talent with us, and we want our platform to be sticky. As a result, as demand picks up, that will be an advantage for us as we move forward.

All right. Great. And with the vaccine rollout and getting back to a normal life, hopefully in the next few months or quarters, do you think that you can and will still have success in selling and delivering remotely? Is that going to remain the new de facto delivery model? Or do you expect it to revert back at all?

I think there will be modulation, but the important thing is we've learned there are parts of engagements and access to talent that we can utilize from a virtual perspective. That doesn't mean we need to go all one way or the other. We'll start to see teams where we'll have some on-site delivery supplemented by folks who are on-site part of the time and some folks who aren't on-site at all. It will depend on the composition of the team and the project itself.

Sure. And last quarter, you talked about some challenges onboarding at new clients due to hardware and software constraints. I'm curious if that's eased at all.

It has eased a bit. The hardware element was a real challenge for a couple of clients, and they've been able to get a handle on their own supply chain. But as more people are working remotely, access to some technology is not as efficient as it once was. It's better than it was in the second quarter, but we still have challenges.

Okay, great. If I could just sneak in two more questions. You referenced how you're seeing good traction from your most significant client accounts and the health care client base. How much do those clients represent in pay and maybe what that looked like a year ago and even from Q1?

Josh, I can take that. Our client program revenue represents roughly around 30% of our consolidated revenue, and it's grown sequentially from Q1; our client program revenue on a same-day basis grew almost 7%. Health care is roughly around 20% of our North America revenue, and we've also seen similar sequential growth in health care clients.

Okay. Great. And just last one, maybe for you, Jen. I just want to make sure I'm calculating the workdays for Q3 and Q4. Do you have that handy?

For Q3, our North America workdays is officially 63 days. But remember, due to the timing of the Christmas and New Year's holiday, we do have some adjacent impact of those holidays as well as Martin Luther King and Presidents Day, even though we're not officially counting them as holidays. So Q3's holiday impact will definitely be more significant than Q2.

Let me just jump in there, Josh, because we don't have the day off as our roots come from accounting firms. We don't have Martin Luther King and Presidents Day off. Many of our clients do. So we always debate whether we should count that as a working day or not. I think you err on the side of not counting it as a working day, even though we're open because so many of our clients take the day off.

And Josh, Q4 in North America, you're looking at 65 days.

Your next question comes from Mark Marcon with Baird. You may proceed with your question.

Good afternoon and Happy New Year. Wondering, can you talk a little bit about the improvement that you're seeing with regards to Tri-State, California and Dallas? That all sounds like a marked improvement. What are you seeing exactly? Is it better execution, better leadership or are the orders starting to really increase as you've repositioned?

Hey Mark, and Happy New Year. First, let me say we have new leadership in those markets, and we have focused teams. I think we've got the right people in place, and we're executing better. In the Tri-State market, we are seeing a market rebound in financial services. In California, while we thought we'd see more impact in entertainment, with reorganizations and pivots that industry is doing, we're actually getting some tailwind from that. Northern California, with a lot of technology, is showing strong demand again. The Texas markets are three distinct markets: Houston, Dallas and Central Texas. Dallas and Central Texas have been really strong. Houston has new leadership and we are hopeful to see momentum there. Out of all those markets, Tri-State and Northern California are showing substantial steps forward in revenue velocity.

That's great. Can you talk a little bit more about the cadence in terms of orders and how they built up through the quarter and then early into this quarter. Has there been any sort of pause with regards to the surge in COVID or any hesitancy? Or does it seem like people are continuing to build?

Go ahead, Kate.

I'll share a few thoughts, and then Tim can add some specific color. It feels to us, and our pipeline and revenue trend is telling us, that the initial panic and standstill of COVID has given way to decision-making. The decisions may look different than they did a year ago, but we are starting to see opportunity open up. Clients are moving forward on large projects, and we don't see a regional distinction; that's happening across the board with our core client base. Remember, our core client base are larger organizations that tend to have more budget and firepower to move their business forward.

Great. Can you talk a little bit about the size of Veracity? It continues to do really well. How big is it now?

Veracity hit record revenue, and while I don't have the exact figure in front of me, on a year-to-date basis compared to last year, they grew roughly 8.5%, which is a substantial improvement.

Roughly what percentage of revenue is Veracity now?

It's roughly 4%.

Okay, great. And HUGO: it sounds like you've got the talent management capabilities up and running. What's the next technical step to be ready for launch? I know you're waiting for the economy to be in a good position as well so the launch has meaningful impact. But from a technical perspective, where are you?

The next element of the platform will be the client side, and that's what we're working to finish now. When we're done with that, we'll be ready to bring the product to market as a minimum viable product, and we'll continue to make enhancements from there. There are two things at play in our timeline: internal product development, which is a lot of software development and perfecting the match algorithm, and an assessment of the macro environment to ensure the market is healthy and ready for launch. We plan to launch HUGO in an adjacent market one or two levels down from where we operate primarily in finance and accounting, and that kind of work may require more on-premise delivery, so we want to make sure the market is ready.

Totally makes sense. Regarding SolarWinds and cyber implications and your push on digital transformation, what impact are you seeing? Are you seeing more audit opportunities? Any slowdown or pause from clients until they get a better handle?

I'm not aware we're seeing any pause. I think we have opportunity there in terms of assessment work and audit work.

In terms of gross margins, how much was the increased healthcare utilization a function of the lower gross margin?

It's roughly about 25%.

Do you anticipate that continuing, Jen, or was that just a blip?

The health care trend is somewhat unpredictable. We saw health care costs come down at the start of COVID and then tick back up in Q1 and Q2. Depending on where COVID stands and participant behavior, it's hard to predict. We've seen some pent-up demand coming back in Q1 and Q2. I don't know that it's going to materially go up going forward, but it's possible.

How should we think about gross margins for this current quarter given holidays and payroll tax reset?

Given the holiday impact, Q3's gross margin is likely to be relatively lower compared to this past quarter, and when you take into consideration the payroll tax reset, that also contributes to a lower gross margin percentage in Q3.

Would it be in line with historical seasonal patterns?

Correct.

You said SG&A is going to go up a little sequentially because of payroll reset but offset by restructuring benefits. Roughly speaking, how much of a delta should we see in SG&A in the short term?

As a reference point, normally in Q3 our payroll taxes run about 10% of payroll costs versus 7.5% in Q2. Excluding restructuring costs, you're probably looking at a couple of million higher from the payroll taxes increase, potentially a bit more.

Terrific. And in Europe, how were you able to maintain revenue while doing the significant restructuring? It sounds like there was really good performance there.

That was the case. We have a couple of large clients in Europe where we have been working on both existing projects and expanding our footprint. Our team there remained engaged and dedicated, managed to keep clients happy and ensured consultants felt connected. It was a story of good performance.

Our next question comes from Andrew Steinerman with JP Morgan. You may proceed with your question.

Happy New Year, everybody. I wanted to focus on the $13.3 million, which was the three weeks in December trend. What kind of percentage change would that be on a year-over-year basis on a same-day constant currency basis?

Based on the first few weeks' trend compared to a year ago, we're roughly down about 9% on a same-day constant currency basis for the total company.

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back over to Kate Duchene for any further remarks.

I just want to thank everyone for attending with us today, and we look forward to reporting after our third quarter of fiscal '21. Happy New Year, everyone.

Thank you, ladies and gentlemen. This concludes today's conference call. Thank you for participating. You may now disconnect.