Heidrick & Struggles International, Inc.

Good morning, everyone, and thanks for participating in Heidrick & Struggles 2012 Second Quarter Conference Call. Joining me on my call today are Kevin Kelly, Chief Executive Officer; and Rich Pehlke, our Chief Financial Officer.

As a reminder, we'll be referring to supporting slides that are available on our website at heidrick.com, and we encourage you to follow along or print them.

As always, we will advise you that this call may not be reproduced or retransmitted without our consent. In today's call, we'll be using the term operating income and operating margin, excluding restructuring charges.

These are non-GAAP financial measures that we believe better explain some of our results. A reconciliation between GAAP and non-GAAP financial measures can be found on Slide 30 in our supporting slides.

Also, we'll be making forward-looking statements on today's call and ask that you please refer to the Safe Harbor language contained in our news release and on Slide 1 of our presentation. Our slide numbers refer to the slide numbers in the bottom right-hand corner of each individual slide.

And now I'll turn the call over to you, Kevin. Please start on Slide 2.

Thanks, Julie. Good morning, everyone, and thank you for joining today's call.

We hope you've had a chance to review our press release issued early this morning. The quarter fell short of our expectations.

While confirmation and revenue trends improved relative to the first quarter, as we expected, the Special and Financial Services, they did not improve enough. Second quarter 2012 revenue of $116.1 million was up 9% sequentially, but down 19% over the same period last year.

The good news is that we're working from a much improved cost structure than we were a year ago. Year-over-year, salary and employee benefits expenses were lower by 20%, and our general and administrative expenses declined 13%.

So despite the decline in revenue, we produced $7.2 million of operating income and an operating margin of 6.2%, excluding restructuring charges.

For the first 6 months of 2012 to the first 6 months of 2011, revenue declined by 14%, but operating income increased by 60%. The economic uncertainty is challenging our executive search in our Leadership Consulting business in every region, and in every industry practice globally.

As shown on Slide 3, the Americas declined 15% year-over-year, Europe was down 21%, although 13% on a constant currency basis, and Asia Pacific declined 25%. Compared to the first quarter, the Americas revenue increased 11%, Asia Pacific's revenue increased about 15% and Europe was flat.

Looking at Slide 4, you'll see that every practice group except Education and Social Enterprises experienced year-over-year revenue decline.

Slide 5 reflects the result of our practice revenue in the second quarter compared to the first. As expected, the Financial Services practice showed improvement as did the Industrial and Education and Social Enterprise practices.

However, the other 3 practices did not meet our expectations. Consolidated global practice trends essentially mirrored the regional practice trends for year-over-year and sequential results.

Turning now to Slide 7. Revenue from Leadership Consulting was $9.6 million, down 22% compared to last year's second quarter and essentially flat compared to the first quarter.

Now on Slide 8, total search confirmations in the second quarter were down 24% compared to last year's second quarter and about 4% sequentially. Every industry practice in every region experienced a year-over-year decline.

And while it's true that we have 12% fewer consultants than last year generating searchers, the decline in confirmations was driven more by the increase in global uncertainty about the pace of a global recovery in each region, unemployment reports that continue to fall short of expectations, underscoring the weakness in hiring trends and a lack of investment spending in general. This economic volatility continues to be the biggest factor clouding our visibility.

When searches were awarded though, Heidrick & Struggles were the major player. During the quarter, we completed a number of mentionable higher-profile searches, including CEO placements at Fannie Mae, Citizens Property Insurance Corporation, one of the nation's largest insurance carriers, and at PPD, one of the leading contract research organizations in the world.

In addition, we placed the Finance Director of the International Olympic Committee. So with that brief overview, I'll turn the call over to Rich.

Thanks, Kevin, and good morning, everyone. I'll start with a review of some of our other key operating metrics and a deeper dive into our operating expenses.

On Slide 9, we ended the quarter with 340 consultants, down 3 compared to the end of March. While we promoted 16 Associate Principals to Principal Consultants effective April 1 and hired 8 new consultants in the quarter, 27 consultants departed during the quarter for a variety of reasons.

Turnover is always part of professional services environment, but it was higher than we had anticipated in the quarter, and it did have an impact on revenue, in particular in the Americas and in Europe.

Slide 10 is a look at our average revenue per search, which is search revenue in the quarter divided by the number of search confirmations from the quarter. This metric is more meaningful on a trailing 12-month basis, which normalizes the quarterly volatility of recognizing confirmations, upticks, retainers, backlog and revenue recognition.

No doubt our goal is to achieve and maintain higher fees per search. This is partly driven by general pricing conditions in the market but also by our continuous effort to serve the highest levels of an organization with premium search and leadership consulting services.

Productivity on Slide 11, as measured by annualized net revenue per consultant, was $1.3 million in the quarter. This is lower than last year's second quarter given economic conditions, but sequentially improved and is higher than in the first quarter.

Since it takes new hires approximately 12 to 18 months to get fully up to speed, we expect that the new hires we made in 2010 and 2011 should continue to help us realize higher productivity levels in 2012.

Now let me go into a bit more detail about salaries and employee benefits and the G&A expenses. Starting with Slides 12 and 13, as Kevin mentioned, salaries and employee benefits expense declined $19.4 million or 20% year-over-year.

Fixed compensation expense accounting for $11.5 million of the decline and mostly reflects a reduction in worldwide employee headcount of approximately 10% compared to last year's second quarter. Variable compensation accounted for the other is $7.9 million of the decline, which reflects lower bonus accruals related to the lower net revenue levels.

Turning to Slide 14, G&A expenses declined year-over-year by $4.3 million or 13%, reflecting cost reductions in many areas, the 2 largest being travel and entertainment and premise-related costs.

Looking at Slide 15 and 16, excluding restructuring charges, operating income was $7.2 million and operating margin was 6.2%. Given the improvements we've made over the last year to our cost structures, the declines compared to last year can be primarily attributed to the decline in net revenue quarter-over-quarter.

Moving to Slide 17 and 18, net income in the second quarter was $1.9 million, and diluted earnings per share was $0.10. The effective tax rate in the quarter was 66.3%, which was based on the full year projected tax rate of approximately 57%.

The full year rate is up from where we expected to be after the first quarter, at that time approximately 47%, primarily due to the change in the mix and projection of income worldwide for 2012.

Please turn to Slide 19. Our cash position remains strong with $96.9 million in cash and cash equivalents, well above our global cash needs of between $40 million and $60 million.

Net cash provided by operating activities was $22.2 million in the quarter compared to $17.6 million in the last year's second quarter.

Slide 20 shows our backlog and Slide 21 shows our monthly search and leadership consulting confirmation. The headwinds in the global economy and the general business environment have been difficult to navigate.

The volatility of global economic and business conditions have resulted in the lack of visibility beyond the near term. Our clients and companies aren't investing capital or hiring as aggressively due to uncertainty throughout Europe and in Asia as well as continued concern about the pace of recovery in the Americas.

Therefore, we are withdrawing our previously issued guidance for 2012 net revenue of between $510 million and $540 million and the 2012 operating margin of between 7% and 9%, and we'll no longer provide guidance on an annual basis for these measures. We will continue to provide guidance for net revenue on a quarterly basis.

We believe this is the most relevant information we can provide and based on confirmation trends in June and July, as well as continued business volatility, which is not just in the Financial Services practice but across all regions and across all practices, we are forecasting third quarter net revenue of between $115 million and $125 million. As you know, we've been keenly focused over the last year on lowering costs and improving our cost structure in general so that we can operate profitably despite any economic condition.

We remain vigilant in lowering costs and reiterate our commitment to an operating -- to operating a more sustainably profitable business as evidenced by our progress through the first 6 months of this year.

And with that, I'll turn it back over to Kevin.

Thanks, Rich. In our press release this morning, we mentioned that we held a Partners Conference earlier this month.

It provided an incredible opportunity for our partners to connect as a global team to discuss our business strategy and how to ensure that Heidrick & Struggles is positioned to capitalize on talent trends, emerging markets and technology. The meeting generated an incredible amount of momentum, and was just what we needed in the middle of a difficult year.

Our consultants returned to their offices energized and committed to accelerating our initiatives in support of the leadership advisory strategy. Our vision is to be a best-in-class professionals support services firm that partners with leading organizations globally to acquire, develop, challenge and sustain leadership talents.

Based on the trends we are seeing globally, it's becoming increasingly clear that human capital will be the key whether an organization gains a competitive advantage or not.

Heidrick & Struggles is well positioned to help its clients with their leadership needs, and we will use our strong balance sheet to ensure we have the platform to support these needs well into the future. This includes taking a more systematic approach to serving the premier executive search and leadership consulting markets.

It's a market that we know well. It's one that is increasingly receptive to a wide range of leadership offerings and it's one that is least susceptible to the risk of disintermediation by options available online.

We will continue our disciplined approach to ensure that our resources support the needs of our clients. This includes aligning our incentives to reward teaming, cross-selling and the development of long-term client relationships.

In addition, we will build and scale our Leadership Consulting platform by expanding our current product and service capabilities. We will continue to differentiate Heidrick & Struggles in the marketplace by investing in talent, thought leadership and client satisfaction.

After our people, our most valuable asset is our brand and our goal is to elevate it to increase and expand our client relationships throughout the globe.

Our second quarter performance fell short of expectations in what continues to be a very difficult market for our business. But there's no doubt that we are the best professionals in the industry.

As a company, we have adapted our business strategy many times over in the past 6 decades. But our mission has remained steadfast.

Through our commitment to integrity, teamwork and quality, we provide best-in-class service for our clients. By staying focused on its client-centric mission and running the business with an optimal cost structure, Heidrick & Struggles will foster long-term relationships with clients and sustainable growth for our shareholders.

Thanks for taking the time to join us this morning. And at this time, Rich and I would be happy to take any questions.

Yes. Just want to start off on the turnover topic, and can you talk a bit, and maybe in percentage terms, how that differs from years past, and I know you always see some turnover after kind of the payment of bonuses.

But how much more was it than you expected? And was it concentrated in any particular parts of the business?

Sure, Tim. It's Kevin.

For the perspective, our consultant turnover last year for 2011 was 8.8%, and if you look at the first half of this year, it was 10.6%, mostly in the second quarter. So it was a little higher probably than expected for a number of different reasons, but that's the differential.

And can you -- the reasons for it, I guess, the parts of the business, I mean, any trends or conclusions to draw from where it came from?

Where it came from, we probably had the biggest impact in Europe followed by the Americas. In terms of actual numbers of consultant, it probably was Europe, Americas and Asia Pacific, in that order.

There's a combination of retirements, people leaving the business and as well as some people that went to competitors.

We've seen a trend of individuals going to work at clients as well and in-house recruiting. So that's something new that we've seen over the last 12 to 18 months.

Okay. Along those lines, can you talk about how much of that is the competition from LinkedIn and those sorts of solutions?

And has your view of that and the impact that you're seeing from that changed at all over the last 12 to 18 months? Did you see it as a bigger threat today than you did back then, or do you still view it relatively similar?

Well, at the level on which we operate, it's not as significant vis-à-vis disintermediation but what we have seen to the point that I made earlier is you have a number of clients, larger clients, global clients that have built fairly significant in-house recruiting capabilities, where they do recruit individuals from our organization and other search firms to come in and leverage some of the technologies that you're speaking about. So I think that, given the macroeconomic environment has some impact, but not to the degree that we see it in terms of the work at the senior level at which we operate.

Okay. And Rich, one numbers question.

The Partners Meeting, how big of an incremental expense do we need to assume for G&A in Q3 because of that?

I think you'll see the run rate in G&A, approximately what you see -- what you saw in the second quarter. We had a couple of Professional Services expenses that ramped up our G&A on a one-time basis in the second quarter, but nothing that material and not sustainable.

As we've said before, we actually planned for this meeting all year. It's built into our plan.

We were able to do it pretty efficiently. It's probably a couple million bucks.

And it shouldn't be a sustainable expense beyond that. And we believe the return on investment, quite frankly, is going to be well worth it.

Tremendous energy came out of the meeting, as Kevin indicated.

Can you talk a little bit about the trends as the quarter progressed? I mean, did business stabilize or decelerate as we went through April, May and June?

Actually, we probably expected to accelerate more than it did. That was a more disappointing part.

We knew we were up against tough comparisons at the end of the second quarter last year, and we really thought, based upon what we were hearing from our people, as well as what we we're seeing in the market, that we'd see more sustainable progress through the quarter as it built. A couple of things happened.

Number one, we just saw, again, tremendous volatility driven largely in part by some of the activity in the Financial Services environment, where we've seen probably the weakest performance as a practice just because of instability of what's happening in that environment right now. There were some major issues that caused some of the concern in risk overregulation and sustainable profitability with some of the larger financial institutions that caused things to be put on hold or canceled, as well as just making the business environment tougher in general.

So what we actually saw was where we expected to ramp up a little bit, it didn't, and it weakened in a few areas. Europe has been -- as we've said even from last year when we did our restructuring, European economies had a very tough impact on our business, and it's been very slow to recover and there's constant news, even this morning, about the European financial stability and issues around sovereign risk.

And then in Asia-Pac where we were impacted a little bit more by some tough comparisons and some drop-off in business, both in the Financial Services and Industrial year-over-year.

Okay. Did you see -- I mean, are you seeing any type of recovery going into July?

While there's no question we are seeing good levels of activity, the Q3 outlook reflects what we've seen in July so far, and we don't comment on individual months. And then we factor in, but we also run into the fact that in August is the vacation season in Europe, and we see client behavior drop off, so we take that into account.

But the good news about what we've seen so far is that it's about where we've expected it, and our pricing and search fees are remaining very strong.

Okay. And then looking at the Leadership Consulting, that fell off a bit faster than executive search did in the second quarter.

Is that -- did you -- is that business coming in more cyclical, maybe, than you expected?

There's a couple of things. Number one, we made a concerted decision in our Leadership Consulting business to move more upstream and take on larger and more significant engagements.

So we got away from a lot of the one-off assessments, the $10,000 to $15,000, and we got into longer at 3-, 6- and 9-month engagements at $0.5 million, $1 million. Number one and number two, quite frankly, we had an individual, who was a significant producer in the area, leave to start his own Leadership Consulting business, and that had some of the impact.

When you have a $45 million, $50 million business globally, and you see somebody leave and take a couple of $3 million out of your business, that has the impact that you're seeing right there. The good news, again, is we have moved upstream considerably, in terms of the level of engagements we're seeing and we have a great pipeline of individuals coming in.

And in terms of growth, Rich and I are focused on how we can continue to grow and scale that business, and that's one of our key focal points this year.

What are your plans for headcount kind of in 3Q and for the balance of the year?

Tobey, we have a very strong pipeline in terms of recruiting right now, globally, by both practice and by region. There's a number of gaps that we're looking to fill in our business where we see potential and continue potential growth, both, I should say, across every industry in which we're operating.

So we have a very significant pipeline, but as we get into recruiting in Europe, it takes a little longer, so we will continue to see growth on the consulting side throughout the end of this year and going into next year.

And Tobey, this is Rich. As I've mentioned on previous calls, our initial plan we're to have net hires up year-over-year.

We still are looking to try and make that happen. As Kevin indicated, the external pipeline is strong, and we're working that every day.

This is also evidenced by what I said in my commentary, we made some promotions early in the year, and we expect further contributions from some of the people that we've moved up into the consultant ranks earlier in the year as well.

So when you say year-over-year increases, would that mean for the average of 2011? Or are you thinking, the fourth quarter '11, ending point of 300?

I'm talking about the ending point, obviously, because of the structuring last year, that's a hard number to overcome in 1 year and that was not our intention.

Understood. And then the tax rate was kind of high in the quarter, do you have an expectation for where that may end up in 2012?

As I kind of indicated, one of the issues with the tax rate is the fact that we have certain markets where we have historically, because of our scale, had lost -- have losses that we can no longer benefit from that we had valuation allowances. So our tax rate can be very volatile on a quarter-to-quarter basis in terms of our projection, simply by where we earn money and where we don't.

And in our case, just because the slightly lower expectations for the balance of the year as 6 months results played out, combined with where we are were seeing the flow of income come in different countries, has an impact on our projected tax rate. And so we'll just keep commenting by quarter and deal with it as best as we can.

But there's no question that our effort and where I look at investing our dollars and our resources based on market opportunity. If we can make some of this turnaround, it can be quite profitable and drive a lot of cash flow as well.

Okay. 2 last questions for me.

The customers that you said might have been recruiting to augment their internal capabilities, were they recruiting senior or junior consultant -- consultants?

You see a combination of both. We've seen some very high-level partners go into client organizations of large scale.

And is that related specifically to use of social media and new initiatives at the client, or is that a more traditional HR and recruiting roles, just at a senior level?

Well, they're more of using an internal recruiting role, but they're also using the Web 2.0 technologies, and they want somebody with a search background to help them. As I mentioned, I think, in the last couple of calls, when you have -- and advertise on one of these Web 2.0 technologies, you can end up with 1,500 to 1,700 applications and you need somebody to go through and assess and work through, and filter those applicants.

So that's what we're doing. We do that.

What we provide to client is really our assessment and judgment, and the cultural fit versus providing them with 1,500 resumes because it's just not conducive to their time. How they spend their time, excuse me.

Absolutely. And then lastly, with the -- in this environment, the kind of uncertain demand and slightly lower profitability, are you comfortable deploying some capital for M&A?

Or are you kind of sitting tight and waiting and perhaps growing organically in your leadership business, et cetera?

Tobey, this is Rich. We're comfortable at the end of the day, anything we do, many kind of skills, we'll have to discuss with our board, obviously, but our board supports the strategy.

And clearly, we are comfortable deploying capital. And at the end of the day, it's all about building growth for the business.

What's driving our strategy and where we want to invest our dollars is really what the client is telling us that they want. And at the end of the day, we want to play at the high end of our clients.

We want to provide the services that will a have long-term relationship that will feed our core business, which is executive search but also are developing business, which is leadership consulting. So there's no question that and we've stated that we will deploy capital where necessary.

I wonder, if the consultants have left, any sense to how much revenue or production was associated with those consultants?

Well, we don't speak about individual consultants. You can take our average productivity and get a pretty good idea.

Some people were more productive as others -- and we aren't going to focus that much. I mean the reality is what Kevin said earlier.

We had slightly higher than what we expected. We normally expect somewhere probably in the 6% to 8% range and it crept up to 10%.

Some of that is due to a variety of conditions, including -- toughest business is getting and it changes the nature of what people want to do, too.

And Rich, in terms of just kind of the revenue trends more recently, how much of it is kind of cyclical versus some structural creep, creeping in the business in terms of people going into industry. And then just if you look at -- and I don't know if there's a way to quantify this, how much for the people that are going to kind of the C-level organizations, are they taking pay cuts or is it on par with what they make as a partner of Heidrick & Struggles, or is it -- what's driving that decision?

Is it just secular challenges, or is it lifestyle changes, just any comments around that.

Well, I'd need a psychiatrist couch to answer all those questions, right? But look, some of it can be certainty of income, some of it can be lifestyle changes, some of it can be all the things.

Look, the business is changing. There's no question.

And our best people are very busy right now. And we have very good people, as Kevin indicated, and we continue to develop very good people.

But the business is changing, particularly at C-suite level. It's a lot more intense.

A lot of the volume activity is driven more by secular things in terms of capital investment and where companies are going and how willing they are to invest in their businesses and are they may used at throwing more loads on executives and teams that they have today. It's a combination of everything you mentioned.

And some of that is driving some people that are trying to be in this business a little crazy, frankly.

I got you. And then just any sense -- I know it's hard but just from a longer-term perspective, the structural margins of the business, any sense of kind of a range, just...

Look, I think we've proven that we've got a pretty solid handle on our run rate right now on the expense level. Our business now is about growing scale and growth.

Kevin and I have indicated many times in the past that we want to continue to diversify the revenue stream into some businesses that will drive higher operating margins from their operating leverage. Our search business, we do need to scale a bit because of the turnover and that will drive operating leverage.

But I feel very good about our ability to control the expense environment, and it becomes an issue of scale.

So I want to thank our consultants and our employees globally for what they continue to do on a daily basis and the support of our analyst and investor. So thank you, and we'll talk to you soon and everyone have a good day.