The Daily Magic Formula Stock for 02/13/2008 is Kforce Inc. According to the Magic Formula Investing Web Site, the ebit yield is 17% and the EBIT ROIC is 50-75 %.
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Organization. Kforce Inc. and its subsidiaries provide professional staffing services and solutions in 68 locations in 41 markets in the United States and one location in Manila, Philippines. Kforce provides its customers staffing and solution services in the following specialties: Technology (‚ÄúTech‚ÄĚ), Finance and Accounting (‚ÄúFA‚ÄĚ), Health and Life Sciences (‚ÄúHLS‚ÄĚ), and Government Solutions (‚ÄúGovernment‚ÄĚ). Kforce provides flexible staffing services and solutions (‚ÄúFlex‚ÄĚ) on both a temporary and contract basis and provides search services (‚ÄúSearch‚ÄĚ) on both a contingency and retained basis. Kforce serves clients from the Fortune 1000, the federal government, local and regional companies and small to mid-size companies.
Principles of Consolidation. The consolidated financial statements include the accounts of Kforce Inc. and its subsidiaries. References in this document to ‚ÄúKforce,‚ÄĚ ‚Äúwe,‚ÄĚ ‚Äúour‚ÄĚ or ‚Äúus‚ÄĚ refer to Kforce or its subsidiaries, except where the context otherwise requires. All intercompany transactions and balances have been eliminated in consolidation.
Basis of Presentation. The unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (‚ÄúSEC‚ÄĚ) and, in management‚Äôs opinion, include all adjustments necessary for a fair presentation of results for the periods presented. The accompanying comparative condensed consolidated balance sheet as of December 31, 2006 has been derived from audited financial statements. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (‚ÄúGAAP‚ÄĚ) have been condensed or omitted pursuant to those rules and regulations; however, Kforce believes that the disclosures made are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the financial statements and the notes thereto for the year ended December 31, 2006, included in the annual report on Form 10-K.
Use of Estimates. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications. Certain amounts reported for prior periods have been reclassified to be consistent with the current period presentation.
Cash and Cash Equivalents. Kforce classifies all highly liquid investments with an initial maturity of three months or less as cash equivalents.
Allowance for Doubtful Accounts and Fallouts. Kforce has established a reserve for expected credit losses and fallouts on trade receivables based on past experience and expectations of future write-offs. Kforce performs an ongoing analysis of factors including recent write-off and delinquency trends, changes in economic conditions, and concentration of accounts receivable among clients, in establishing this reserve. No single client had a receivable balance greater than 3.1% of the total accounts receivable.
Fixed Assets. Fixed assets are carried at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The cost of leasehold improvements is amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the terms of the related leases, which range from three to fifteen years.
Income Taxes. Kforce accounts for income taxes under the principles of Statement of Financial Accounting Standards (‚ÄúSFAS‚ÄĚ) 109, Accounting for Income Taxes . SFAS 109 requires the asset and liability approach to the recognition of deferred tax assets and liabilities for the expected future tax consequences of the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. SFAS 109 requires that unless it is ‚Äúmore likely than not‚ÄĚ that a deferred tax asset can be utilized to offset future taxes, a valuation allowance must be recorded against that asset. The excess tax benefits of deductions attributable to employees‚Äô disqualifying dispositions of shares obtained from incentive stock options and employees‚Äô dispositions of shares obtained from non-qualifying stock options are reflected as increases in additional paid-in capital.
Fair Value of Financial Instruments. Kforce, using available market information and appropriate valuation methodologies, has determined the estimated fair value of financial instruments. However, considerable judgment is required in interpreting data to develop the estimates of fair value. The fair values of Kforce‚Äôs financial instruments are estimated based on current market rates and instruments with the same risk and maturities. The fair value of long-term debt approximates its carrying value due to the variable interest rate applicable to the debt.
Goodwill and Intangible Assets. In accordance with SFAS 142, Goodwill and Other Intangible Assets (‚ÄúSFAS 142‚ÄĚ), Kforce does not amortize goodwill but performs an annual review to ensure that no impairment of goodwill exists. On December 31, 2006, Kforce completed a valuation of its four reporting units which consist of FA, Tech, HLS, and Government. The results of that valuation indicated that the fair value of each of Kforce‚Äôs reporting units exceeded the carrying values of those reporting units. Therefore, Kforce concluded that there was no impairment of goodwill. In some of Kforce‚Äôs acquisitions, a portion of the purchase price has been allocated to non-compete agreements, customer lists, contractual relationships, customer contracts and trademarks with finite useful lives. Intangible assets, primarily non-compete agreements, customer lists, contractual relationships, customer contracts and trademarks, are amortized over their estimated period of benefit, generally ranging from one to ten years. Certain trade names and trademarks have been determined to have an indefinite life and are not being amortized.
Impairment of Long-Lived Assets. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets , Kforce periodically reviews the carrying value of long-lived assets to determine if impairment has occurred, which requires significant judgment. The determination is made by evaluating expected future undiscounted cash flows or the anticipated recoverability of costs incurred and, if necessary, determining the amount of the loss, if any, by evaluating the fair value of the assets. Impairment losses, if any, are recorded in the period identified. There were no impairment charges recorded during the three and nine months ended September 30, 2007 and 2006.
Capitalized Software. Kforce purchases, and in certain cases develops, and implements new computer software to enhance the performance of its accounting and operating systems. Kforce accounts for direct internal and external costs subsequent to the preliminary stage of related projects under the principles of the American Institute of Certified Public Accountants (‚ÄúAICPA‚ÄĚ) Statement of Position (‚ÄúSOP‚ÄĚ) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use . Software development costs are being capitalized and classified as other assets and amortized over the estimated useful life of the software using the straight-line method. Direct internal costs, such as payroll and payroll-related costs, and external costs incurred during the development stage of each project are capitalized and classified as capitalized software. Kforce capitalized development stage implementation costs of $1,490 and $5,592 during the three and nine months ended September 30, 2007.
Deferred Loan Costs. Costs incurred to secure Kforce‚Äôs Credit Facility were capitalized and are being amortized over the term of the related agreement using the straight-line method.
Commissions. Associates make placements and earn commissions as a percentage of actual revenue or gross profit pursuant to a calendar year basis commission plan. The amount of commissions paid as a percentage of revenue or gross profit increases as volume increases. Kforce accrues commissions for actual revenue or gross profit at a percentage equal to the percent of total expected commissions payable to total revenue and gross profit for the year.
Stock Based Compensation. In December 2004, the Financial Accounting Standards Board (‚ÄúFASB‚ÄĚ) issued a revised version of SFAS 123, Share-Based Payment (‚ÄúSFAS 123R‚ÄĚ). This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services, but focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement supersedes Accounting Principles Board (‚ÄúAPB‚ÄĚ) Opinion No. 25, Accounting for Stock Issued to Employees , and its related implementation guidance. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, with limited exceptions. That cost is recognized over the period in which the employee is required to provide service in exchange for the award, which is usually the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. On January 1, 2006, Kforce adopted SFAS 123R using the modified prospective method, and the adoption of this standard did not have a material impact on Kforce‚Äôs consolidated financial statements because all of Kforce‚Äôs outstanding stock options were fully vested as of December 31, 2005.
Pension and Postretirement Benefits Accounting. In December 2006, FASB issued SFAS 158, Employers‚Äô Accounting for Defined Benefit Pension and Other Postretirement Plans‚ÄĒan amendment of FASB Statements No. 87, 88, 106, and 132(R) (‚ÄúSFAS 158‚ÄĚ). This statement requires Kforce to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This statement also requires Kforce to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Several estimates and assumptions are required to record these costs and liabilities, including discount rate, return on assets, compensation increases, health care cost trends, and longevity and service lives of employees. Management reviews and updates these assumptions periodically. In accordance with SFAS 158, Kforce recognized the underfunded status of its pension and postretirement plans as a liability in its Consolidated Balance Sheet. See Note E ‚Äď Pension Plan and Other Postretirement Benefits to the Unaudited Condensed Consolidated Financial Statements for additional information about Kforce‚Äôs pension and postretirement plans.
Self-Insurance. Kforce offers employee benefit programs, including workers‚Äô compensation and health insurance, to eligible employees, for which Kforce is self-insured for a portion of the cost. Kforce retains liability up to $250 for each workers‚Äô compensation accident and up to $250 annually for each health insurance participant. Self-insurance costs are accrued using estimates to approximate the liability for reported claims and claims incurred but not reported.
Revenue Recognition. Net service revenues consist of search fees and flexible billings inclusive of billable expenses, net of credits, discounts, rebates and fallouts. Kforce recognizes flexible billings based on hours worked by assigned personnel. Search fees are recognized upon placement, net of an allowance for ‚Äúfallouts‚ÄĚ. Fallouts are search placements that do not complete the contingency period. Contingency periods are typically ninety days or less.
Revenues received as reimbursements of billable expenses are reported gross within net service revenues in accordance with Emerging Issues Task Force (‚ÄúEITF‚ÄĚ) Issue No. 01-14, Income Statement Characterization of Reimbursements Received for ‚ÄėOut-of-Pocket‚Äô Expenses Incurred .
Business Combinations. Kforce accounts for acquisitions of businesses in accordance with the requirements of SFAS 141, Business Combinations (‚ÄúSFAS 141‚ÄĚ). Pursuant to SFAS 141, Kforce utilizes the purchase method in accounting for acquisitions whereby the total purchase price is first allocated to the assets acquired and liabilities assumed, and any remaining purchase price is allocated to goodwill. Kforce recognizes intangible assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged. Assumptions and estimates are used in determining the fair value of assets acquired and liabilities assumed in a business combination. Valuation of intangible assets acquired requires significant judgment in determining fair value and whether such intangibles are amortizable or non-amortizable and, if amortizable, the period and method by which the intangible asset will be amortized. Changes in the initial assumptions could lead to changes in amortization charges recorded in our financial statements. Additionally, estimates for purchase price allocations may change as subsequent information becomes available.
Earnings per Share. Under SFAS 128, Earnings per Share , basic earnings per share is computed as earnings divided by weighted average shares outstanding during the period. Diluted earnings per share include the dilutive effects of stock options and other potentially dilutive securities such as non-vested stock grants using the treasury stock method
David L. Dunkel has served as Kforce‚Äôs Chairman, Chief Executive Officer and a director since its formation in 1994. Prior to August 1994, he served as President and Chief Executive Officer of Romac-FMA, one of Kforce‚Äôs predecessors, for 14 years.
John N. Allred has served as a director of Kforce since April 1998. Mr. Allred has served as President of A.R.G., Inc., a provider of temporary and permanent physicians located in the Kansas City area since January 1994. Prior to that time, Mr. Allred served in various capacities with Source Services Corporation (‚ÄúSource‚ÄĚ) prior to its merger with Kforce in 1998, including Branch Manager of the Kansas City branch (1976-1983), Regional Vice President (1983-1987) and Vice President (1987-1993).
W. R. Carey, Jr. has served as a director of Kforce since October 1995. He is currently the Chairman and Chief Executive Officer of Corporate Resource Development, Inc., an Atlanta, Georgia based sales and marketing consulting and training firm which began in 1981 and assists some of America‚Äôs largest firms in design, development, and implementation of strategic and tactical product marketing. Mr. Carey serves on the Board of Directors of Outback Steakhouse, Inc. and is also the National Chairman of the Council of Growing Companies.
Richard M. Cocchiaro has served as a director of Kforce since its formation in August 1994. He currently serves as Vice Chairman. Previously, Mr. Cocchiaro served as Vice President of National Accounts for Kforce from 2000 to 2004, Vice President of Strategic Alliances for kforce.com Interactive (1999) and National Director of Strategic Solutions within Kforce‚Äôs emerging technologies group (1994-1999).
Michael Ettore has served as Kforce‚Äôs Senior Vice President and Chief Services Officer since October 2004. Mr. Ettore joined Kforce in 1999 and has served as the Vice President, Leadership Development and Vice President, Operations. Prior to joining Kforce, Mr. Ettore served in the United States Marine Corps as an Infantry Officer, retiring in 1998, after 24 years of service.
Mark F. Furlong has served as a director of Kforce since July 2001. He currently serves as the CEO of Marshall & Ilsley Corporation (since April 2007) and served as President of Marshall & Ilsley Corporation from July 2004 to April 2007. He also served as Chief Financial Officer of Marshall & Ilsley Corporation from April, 2001 to October, 2004. Mr. Furlong‚Äôs prior experience includes service as an audit partner with Deloitte & Touche LLP.
Joseph J. Liberatore has served as Kforce‚Äôs Senior Vice President and Chief Financial Officer since October 2004 and Corporate Secretary since February 2007. Prior to his appointment as Chief Financial Officer, Mr. Liberatore had served as Senior Vice President since June 2000, Chief Talent Officer since September 2001 and Chief Sales Officer from September 2000 to August 2001. Mr. Liberatore has served in various roles in Kforce since 1988.
Stephen McMahan has served as Kforce‚Äôs Senior Vice President and Chief Sales Officer since January 2006. Mr. McMahan also serves as the President of the Atlantic Region. Prior to his appointment as Chief Sales Officer, Mr. McMahan served as Group President (2002-2005), Business Unit President-East (2000-2002) and Regional Vice President, Northeast (1998-2000) responsible for Tech, Finance and Accounting staffing and search businesses. Mr. McMahan came to Kforce through the acquisition of Source Services Corporation, where he served as Managing Director of the Boston Tech, Finance and Accounting practices.
Elaine D. Rosen has served as a director of Kforce since June 2003. Ms. Rosen currently serves as a consultant for a variety of clientele. From 2001-2004, Ms. Rosen served as the Chair of the Capital Campaign for Preble Street Resource Center, a collaborative for the homeless and low income community in Portland, Maine, a volunteer position. From 1975 to March 2001, Ms. Rosen held a number of positions with Unum Life Insurance Company of America. Ms. Rosen serves as trustee or director of several non-profit organizations and is also a director of AAA of Northern New England, a travel club serving Maine, New Hampshire and Vermont, and Downeast Energy Corp., a provider of heating products and building supplies, and is the Chair of the Board of The Kresge Foundation.
William L. Sanders has served as President of Kforce since October 2004. Mr. Sanders also served as Kforce‚Äôs Secretary from April 1999 to February 2007. Prior to his appointment as President, Mr. Sanders served as Kforce‚Äôs Chief Operating Officer since December 2002 and Senior Vice President since April 1999. From April 1999 to September 2003, Mr. Sanders also served as Kforce‚Äôs Chief Financial Officer. Mr. Sanders‚Äô prior experience also includes serving as a partner with Deloitte & Touche LLP.
Ralph E. Struzziero has served as a director of Kforce since October 2000. Since 1995, Mr. Struzziero has operated an independent business consulting practice and since 1997 has served as an adjunct professor at the University of Southern Maine. Mr. Struzziero previously served as Chairman (1990-1994) and President (1980-1994) of Romac & Associates, Inc., one of Kforce‚Äôs predecessors. Mr. Struzziero is also currently a director of AAA of Northern New England, a travel club serving Maine, New Hampshire and Vermont, Downeast Energy Corp, a provider of heating products and building supplies.
Howard W. Sutter has served as Kforce‚Äôs director since its formation in August 1994. Mr. Sutter currently serves as Vice Chairman, and oversees mergers and acquisitions. Prior to August 1994, Mr. Sutter served as Vice President of Romac-FMA (1984-1994), and Division President of Romac-FMA‚Äôs South Florida location (1982-1994).
A. Gordon Tunstall has served as a director of Kforce since October 1995. He is the founder of, and for more than 25 years has served as President of, Tunstall Consulting, Inc., a provider of strategic consulting and financial planning services. Mr. Tunstall previously served as a director for JLM Industries, Inc., Orthodontics Center of America, Inc. and Discount Auto Parts, Inc.
(1) Includes the number of shares subject to purchase pursuant to currently exercisable options or options exercisable within 60 days of April 19, 2007, as follows: Mr. Dunkel, 1,418,048; Mr. Allred, 49,326; Mr. Carey, 78,238; Mr. Cocchiaro, 29,837; Mr. Ettore, 136,022; Mr. Furlong, 29,855; Mr. Liberatore, 352,928; Mr. McMahan, 80,948; Ms. Rosen, 10,000; Mr. Sanders, 631,865; Mr. Struzziero, 14,464; Mr. Sutter, 164,767; and Mr. Tunstall, 25,000.
(2) Includes 19,000 shares as to which beneficial ownership is disclaimed by Mr. Cocchiaro (shares held by spouse). Also includes 1,739,041 shares as to which voting and/or investment power is shared or controlled by another person and as to which beneficial ownership is not disclaimed, as follows: Mr. Cocchiaro, 38,845 (shares held by mother), 23,080 (shares held by sons), and 60,463 (shares held by Cocchiaro Family Foundation); Mr. Struzziero, 1,987 (shares held by spouse) and 10,100 (shares held by his sons); and Mr. Sutter, 5,000 (shares held by spouse) and 1,595,316 (shares held by Sutter Investments Ltd. of which H.S. Investments, Inc. is the sole general partner).
(3) Includes the number of shares of restricted stock that are beneficially owned as follows: Mr. Dunkel, 95,570; Mr. Ettore, 41,456; Mr. Liberatore, 60,422; Mr. McMahan, 40,456; Mr. Sanders, 60,996; and Mr. Sutter, 10,000.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
This overview is intended to assist readers in better understanding this MDA. Item 1 of this Form 10-Q includes additional information.
Who We Are
We are a national provider of professional and technical specialty staffing services and solutions. At September 30, 2007, we operated 68 field offices in 41 markets and we currently provide services in 50 states and the District of Columbia through these offices and/or from our headquarters in Tampa, Florida. We also have a field office in the Philippines providing offshore outsourcing solutions. We provide our clients staffing and solution services through four business segments: Technology (‚ÄúTech‚ÄĚ), Finance and Accounting (‚ÄúFA‚ÄĚ), Health and Life Sciences (‚ÄúHLS‚ÄĚ) and Government Solutions (‚ÄúGovernment‚ÄĚ). Substantially all Tech and FA services are sold and delivered through our field offices. The HLS segment includes our Clinical Research, Scientific, Healthcare-Nursing (‚ÄúNursing‚ÄĚ) and Health Information Management (‚ÄúHIM‚ÄĚ) specialties. The sales and delivery functions of substantial portions of HLS, particularly Clinical Research and HIM, are concentrated in our headquarters. Substantially all the services of our Government segment are sold and delivered through contracts with federal government agencies by a subsidiary company located in the Washington, D.C. metropolitan area. Our headquarters provides support services to our field offices in areas such as human resources, nationwide recruiting, training, and national sales initiatives, in addition to the traditional ‚Äúback office‚ÄĚ support services such as payroll, billing, accounting, legal, tax, data processing and marketing, which are highly centralized.
Kforce is focused on providing staffing services and solutions to our clients. Our staffing services include flexible staffing and solution services (‚ÄúFlex‚ÄĚ) and search services (‚ÄúSearch‚ÄĚ). Kforce anticipates continued growth which may be organic and/or through acquisition of other entities that enhance or expand our existing businesses. We believe that we are positioned to acquire and integrate other businesses that are strategically beneficial.
Through Flex, we provide clients with qualified individuals (‚Äúconsultants‚ÄĚ) on a temporary basis with the appropriate skills and experience, when it is determined it is ‚Äúthe right match.‚ÄĚ To be successful, our employees (‚Äúassociates‚ÄĚ) endeavor to: (1) understand the clients‚Äô needs; (2) determine and understand the capabilities of the consultants being recruited; and (3) deliver and manage the client-consultant relationship to the satisfaction of both the clients and the consultants. Typically, the better job Kforce and our consultants do, the longer the assignments last and the more often those clients turn to Kforce for additional needs.
Flex revenues also include solutions provided through our Government segment. This revenue involves providing longer term contract services to the customer primarily on a time and materials basis.
The Flex business comprised 92.2% of our revenues for the quarter ended September 30, 2007. Flex revenues are driven by hours billed, billing rates and billable expenses. Flex gross profit is determined by deducting consultant pay, benefits and other related costs from Flex revenues. Flex associate commissions, related taxes and other compensation and benefits as well as field management compensation are included in Selling, General and Administrative expenses (‚ÄúSG&A‚ÄĚ) along with administrative and corporate costs. The Flex business model involves attempting to maximize consultant hours and billing rates, while optimizing consultant pay rates and benefit costs and commissions and other compensation and benefits for associates, as well as minimizing the other operating costs necessary to effectively support such activities.
The Search business is a smaller, yet important part of our business that involves locating permanent employees for our clients. We primarily perform searches on a contingency basis, with fees being earned only if personnel are hired by our clients. Fees are typically structured as a percentage of the placed individual‚Äôs first-year annual compensation. We recruit permanent employees from our Flex consultant population, from the job boards, and from candidates we identify who are currently employed and not actively seeking another position. Sometimes consultants initially work with clients on a Flex basis and then later are converted into permanent employees, for which we also receive Search fees. Clients and recruits are often targets for both Flex and Search services, and this common focus contributes to our objective of providing integrated solutions for substantially all of our clients‚Äô human capital needs.
Search revenues are driven by placements made and the fees billed. There are no consultant payroll costs associated with the placement and thus all Search revenue generally increases gross profit by a like amount. Search associate commissions, compensation and benefits are included in SG&A. Search revenues comprised 7.8% of revenues for the quarter ended September 30, 2007.
We serve Fortune 1000 companies and the federal government, as well as small and mid-size local and regional companies, with our top ten clients representing approximately 18.4% of revenues as of September 30, 2007. The specialty staffing industry is made up of thousands of companies, most of which are small local firms providing a limited service offering to a small local client base. We believe Kforce is one of the ten largest publicly-traded specialty staffing firms in the United States, that these ten firms combined have a market share of less than 24% of the applicable market and that no single firm has larger than an approximate 7% market share. Competition in a particular market can come from many different companies, either large or small. However, we believe that our geographic presence, diversified service offerings within our core businesses, and focus on consistent sales and delivery that is highly disciplined, may provide a competitive advantage particularly with larger clients that have operations in multiple markets.
Selected industry reports indicate the United States temporary staffing industry has shown revenue levels of approximately $81 billion in 2004, $107 billion in 2005, and $119 billion in 2006. While no predictions can or should be made about the general economy, the staffing industry as a whole, or specialty staffing in particular, we believe that sustained economic growth could stimulate continued demand for substantial additional U.S. workers or, conversely, an economic slowdown will cause demand for additional U.S. workers to contract. We also believe that our three areas of functional focus, Tech, FA and HLS, will be among the higher growth categories in both the short and long-term and that over the long-term, temporary staffing may become a higher percentage of total jobs, particularly in the professional, technical and government areas. We also believe that the Government segment could have more stable growth during variable economic cycles due to the growth of the federal agencies that are customers of Kforce and also partially due to the use of outsourced labor by many government agencies to replace employees who are retiring. In our opinion, the recent positive trends in our operating results, which we believe have been enhanced by the streamlining of our operations and centralizing of certain support functions, have positioned Kforce well for the future.
There can be no assurance that customer demand or pricing in Kforce‚Äôs specialty staffing or government solutions sectors will continue to grow. In addition, Kforce has a number of competitors that are increasingly utilizing a lower-priced staffing preferred-vendor model (VOP/VMS). In addition, many clients are seeking ‚Äúoffshore‚ÄĚ solutions, which could negatively impact many of the Kforce business segments. Also, competition for skilled candidates, such as finance and accounting candidates, has increased. Each of these factors, among others, may impact the future growth and profitability of Kforce.
Kforce anticipates continued growth which may be organic and/or through acquisition of other entities that enhance or expand our existing businesses. We believe that we are positioned to acquire and integrate other businesses that are strategically beneficial.
The sections that follow this overview discuss and refer to critical accounting estimates and recent pronouncements, Kforce‚Äôs results of operations and important aspects of its liquidity and capital resources. Set forth below are what we believe to be important highlights of our operating results and our positioning for the future. Such highlights should be considered in the context of all of the discussions herein and in conjunction with the Financial Statements. We believe the following are the most significant highlights:
We achieved record net service revenues for the three months ended September 30, 2007 of $262.1 million with growth of 9.8% over the comparable period in 2006.
Our average billing rate increased 9.7% and 8.3% for the three and nine months ended September 30, 2007 over the comparable periods in 2006.
Search revenues increased 4.6% to $20.4 million for the three months ended September 30, 2007 from $19.5 million for the comparable period in 2006.
Gross profit margins increased 4.2% for the nine months ended September 30, 2007 to 36.0% as compared to 34.6% during the comparable period of 2006.
Income from operations increased to 7.4% of revenues for the third quarter of 2007 versus 6.6% for the third quarter of 2006. The increases are principally due to higher gross profit margins resulting from an increase in the spread between bill and pay rates as well as business mix.
Cash flows from operations were $41.8 million, which allowed for a reduction in outstanding borrowings under the Credit Facility of approximately $32.1 million during the nine months ended September 30, 2007.
We believe that the quality of accounts receivable, our primary operating asset, continues to be good, with an allowance for doubtful accounts and fallouts of 2.0% of gross trade accounts receivable.
CRITICAL ACCOUNTING ESTIMATES
The SEC has indicated that ‚Äúcritical accounting estimates‚ÄĚ may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and due to their material impact on financial condition or operating performance. For a discussion of our critical accounting estimates, see ‚ÄúItem 2. Management‚Äôs Discussion and Analysis of Financial Condition and Results of Operations ‚Äď Critical Accounting Estimates and Recent Pronouncements‚ÄĚ in our Annual Report on Form 10-K for the year ended December 31, 2006. The only significant change in our critical accounting policies and estimates is related to the adoption of FIN 48 effective January 1, 2007, which has been discussed in Note H ‚ÄúUncertain Income Tax Positions‚ÄĚ to the Unaudited Condensed Consolidated Financial Statements.
See Note A ‚ÄúRecently Issued Accounting Pronouncements‚ÄĚ to the Unaudited Condensed Consolidated Financial Statements for a discussion of recent accounting pronouncements.
RESULTS OF OPERATIONS
Kforce continued its trend of strong financial results in the third quarter of 2007. In comparison with the third quarter of 2006, Kforce experienced significant increases in revenues, gross profit and gross profit as a percentage of revenues; and a strong improvement in income before income taxes. Selling, general and administrative expenses as a percentage of revenues decreased slightly as compared to the third quarter of 2006, which is due mostly to an increase in net service revenues of 9.8% while maintaining a focus on operating expenses. This was partially offset by an increase in overall compensation and commission expense resulting from increases in associate headcount to increase capacity and leverage our business model over the comparable period in 2006. In addition, both the Flex and Search components of our revenues have shown growth throughout 2007 and 2006; however, it remains difficult to predict whether there will be continued steady growth in our Search business.
We believe the key components of our recent success were the initiatives undertaken during the last several years to restructure both our back office and field operations. The results of these efforts have increased operating efficiencies, thereby lowering our break-even level and enabling us to be more responsive to our clients. We believe our field operations model, which allows us to deliver our service offerings in a disciplined and consistent manner across all geographies and business lines, as well as our highly centralized back office operations, are competitive advantages and keys to our future growth and profitability. Also important to our future growth is our tested acquisition integration strategy. Having substantially completed the integration of four major acquisitions over the last three years, we believe that we have built a repeatable model that can allow us to integrate future acquisitions quickly, if we have the opportunity.
The acquisition of PCCI, effective January 31, 2006, and Bradson, effective October 1, 2006, which have been discussed in Note C ‚ÄúAcquisitions‚ÄĚ to the Unaudited Condensed Consolidated Financial Statements, continue to impact our financial results and business drivers. As a result of the integration, revenues and costs contributed by the acquisition of PCCI‚Äôs commercial business were merged into the Kforce‚Äôs Tech business segment, making it not possible to accurately estimate the impact of the acquired businesses on Kforce‚Äôs Tech revenues and margins. We have segregated the revenue and gross margin for government business contributed by the acquisition of PCCI and Bradson in the Government reporting segment. Exclusive of any impacts of the acquisitions, we believe that demand is increasing and gross profit is growing in all business segments. In addition, we believe that the acquisitions have provided a positive impact on Flex revenues for the Tech and Government segments. Search business and the FA and HLS segments were not materially affected by the acquisitions.
Results of Operations for each of the Three and Nine Months Ended September 30, 2007 and 2006.
Net service revenues. Net service revenues increased 9.8% and 11.3%, respectively, to $262.1 million and $774.3 million for the three and nine months ending September 30, 2007, respectively, as compared to $238.7 million and $695.4 million for the same periods in 2006. The increase was comprised of a $0.9 million and $5.9 million increase in Search fees and a $22.5 million and $73.0 million increase in Flex revenues for the three and nine months ended September 30, 2007,
Flexible Billings. Flex revenues in the FA segment decreased 15.5% and 9.1% for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The decrease in Flex revenues for FA for the three and nine months ended September 30, 2007 as compared to the comparable periods in 2006 was primarily due to the following: (i) the conclusion of project-specific business with a few significant customers that had both high volume and high bill rates, (ii) an increased focus on clients providing higher gross margins and (iii) a decline in mortgage related client needs due to the decline in the mortgage lending market, which now represents less than 1% of net service revenues. Tech, HLS and Government grew by 12.3%, 15.6% and 148.2%, respectively, for the three months ended September 30, 2007 compared to the same period in 2006. Tech, HLS and Government grew by 15.0%, 9.6% and 132.4%, respectively, for the nine months ended September 30, 2007 compared to the same period in 2006. The growth of Government was primarily related to the acquisition of Bradson.
The primary drivers of Flex billings are the number of hours and bill rate per hour. Essentially, the number of hours is a result of the number of assignments available requiring temporary staffing personnel. Continued economic growth and our focus on pricing and customer profitability contributed to the increase in the average bill rate per hour to $55.32 and $54.01, respectively, during the three and nine months ended September 30, 2007 from $50.43 and $49.88, respectively, compared to the same periods in 2006.
Total hours increased 0.6% to 4.3 million hours for the three months ended September 30, 2007 from 4.2 million hours for the same period in 2006. Total hours increased 2.8% to 12.9 million hours for the nine months ended September 30, 2007 from 12.6 million hours for the same period in 2006. Flex hours for the three and nine months ended September 30, 2007 and 2006 by segment.
Search Fees. Search fees are primarily driven by changes in both the average placement fee and number of placements. While total placements decreased 2.0% to 1,411 from 1,440, the average placement fee increased 6.7% to $14,438 from $13,531 for the three months ended September 30, 2007 as compared to the same period in 2006. Total placements increased 3.6% to 4,208 from 4,063 while the average placement fee also increased 7.2% to $14,228 from $13,279 for the nine months ended September 30, 2007 as compared to the same period in 2006. Search activity historically increases after economic conditions have shown sustained improvement and is strongest during the peak of an economic cycle, although there can be no assurance that this historical trend will be followed in the current cycle.
Gross Profit. Gross profit on Flex billings is determined by deducting the direct cost of services (primarily flexible personnel payroll wages, payroll taxes, payroll-related insurance, and subcontract costs) from net service revenues. Consistent with industry practices, gross profit dollars from search fees are equal to revenues, because there are generally no direct costs associated with such revenues. Gross profit increased 12.7% to $96.3 million and 16.0% to $278.8 million for the three and nine months ended September 30, 2007, respectively, from $85.4 million and $240.3 million for the same periods in 2006. Gross profit as a percentage of net service revenues increased to 36.7% and 36.0% for the three and nine months ended September 30, 2007, respectively, as compared to 35.8% and 34.6% for the same periods in 2006.
The increase in gross profit is primarily attributable to increases in volume for Search and Flex, an overall increase in the spread between bill rate and pay rate for flexible personnel (‚ÄúFlex Rate‚ÄĚ) and an increase in the average Search placement fee for the three and nine months ended September 30, 2007 as compared to the same periods in 2006. The increase in Flex gross profit for the three and nine months ended September 30, 2007, as compared to the three and nine months ended September 30, 2006, was $10.0 million and $32.6 million, respectively, resulting from a $0.4 million increase in volume and a $9.6 million increase in Flex Rate and a $6.0 million increase in volume and a $26.6 million increase in Flex Rate, respectively. The increase in Search gross profit of $0.9 million and $5.9 million for the three and nine months ended September 30, 2007, compared to the same periods in 2006, was comprised of a $0.4 million decrease in volume and a $1.3 million increase in rate and a $2.1 million increase in volume and a $3.8 million increase in rate for the three and nine months, respectively.
The increase in total gross profit percentage for the three and nine months ended September 30, 2007, as compared to the same periods in 2006 was primarily the result of increases in both Flex gross profit percentage and an increase in Search revenues. The increase in total gross profit percentage for Government for the three and nine months ended September 30, 2007, primarily relates to the acquisition of Bradson in October 2006. Flex gross profit, year over year, has seen continued overall improvement due to Kforce‚Äôs ability to manage bill rates over pay rates.
Selling, general and administrative expenses. Selling, general and administrative (‚ÄúSG&A‚ÄĚ) expenses increased to $73.1 million and $213.9 million, for the three and nine months ended September 30, 2007, respectively, as compared to $66.9 million and $190.6 million for the same periods in 2006.
SG&A expenses as a percentage of net service revenues remained relatively flat at 27.9% for the three months ended September 30, 2007 as compared to 28.0% in the comparable period in 2006, which was primarily attributable to (i) an increase in compensation and benefits, (ii) a decrease in commissions and (iii) decreases in other expenses such as lease, travel and professional fees as a percentage of revenue as a result of a focus on cost containment. The increase in compensation and benefits as a percentage of net service revenues is a result of increased bonuses reflecting our guiding principle related to pay-for-performance compensation plans, increased expenses driven by the implementation of additional incentive plans, increased headcount as well as increases in health insurance costs. The decrease in commissions as a percentage of net service revenues is primarily related to a significant increase in net service revenues in the Government segment as a percentage of Kforce‚Äôs overall net service revenues, which are non-commissionable sales. SG&A expenses as a percentage of net service revenues increased to 27.6% for the nine months ended September 30, 2007 as compared to 27.4% in the comparable period in 2006, which was primarily attributable to an increase in compensation costs. Total commissions, compensation, payroll taxes, and benefits costs were $61.3 million and $175.8 million, which represented 83.8% and 82.2% of total SG&A for the three and nine months ended September 30, 2007, respectively, and $53.6 million and $149.8 million representing 80.2% and 78.6% of total SG&A for the same periods in 2006, respectively. Commissions and related payroll taxes and benefit costs are variable costs driven primarily by revenue and gross profit levels, and associate productivity. Therefore, as gross profit levels increase, compensation levels are also generally anticipated to increase.
Depreciation and amortization. Depreciation and amortization increased 37.4% and 35.9% to $3.8 million and $10.8 million for the three and nine months ended September 30, 2007, respectively, compared to $2.8 million and $7.9 million for the same periods in 2006, respectively. The increase in expense for the periods ended September 30, 2007 as compared to the same periods in 2006 was primarily due to amortization of intangible assets related to the PCCI and Bradson acquisitions during 2006, depreciation of computer hardware and other furniture and equipment under capital leases, the commencement of amortization related to the new back office computer software which went live in August 2007, and an overall increase in leasehold improvements and other capital expenditures as the business continues to grow.
Kforce implemented additional back office software modules, which we believe will enhance the efficiency and productivity of our sales and delivery activities such as our order, time entry, billing and cash receipt processes as well as improve customer service. The additional back office software modules went live during August 2007. As of September 30, 2007, Kforce has capitalized costs of approximately $10.7 million related to this implementation. Based upon the estimated useful life of the software, Kforce believes that this will lead to an increase in software amortization of approximately $0.5 million per quarter as well as maintenance costs, which are expensed as incurred. Kforce does not expect to capitalize or incur any significant costs subsequent to September 30, 2007 related to the back office software modules.
Other expense, net. Other expense, net increased 30.1% and 44.5% to $1.1 million and $3.9 million for the three and nine months ended September 30, 2007, respectively, from $0.8 million and $2.7 million for the same periods in 2006. The increase of $0.3 million and $1.2 million, respectively, was primarily due to an increase in interest expense resulting from increases in debt balances related to the acquisitions of PCCI and Bradson. As a result of Kforce‚Äôs continued emphasis on paying down outstanding debt during 2007, corresponding decreases in interest expense have been realized during 2007.
Income before taxes. Income before taxes for the three and nine months ended September 30, 2007, increased to $18.2 million and $50.3 million, respectively, as compared to $14.9 million and $39.1 million for the same periods in 2006, as a result of the factors discussed above.
Income tax expense. For the three and nine months ended September 30, 2007, Kforce has recorded total income tax expense of $7.2 million and $19.9 million, respectively, compared to total income tax expense of $6.1 million and $15.8 million for the same periods in 2006. Income tax expense as a percentage of income before taxes for the three and nine months ended September 30, 2007 was 39.5% as compared to the comparable periods in 2006 of 40.7% and 40.5%, respectively.
Net income. Net income increased to $11.0 million and $30.4 million for the three and nine months ended September 30, 2007, respectively, as compared to $8.8 million and $23.3 million for the same periods in 2006, primarily as a result of the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have financed our operations through cash generated by operating activities and cash available under our revolving credit facility. As highlighted in the Statements of Cash Flows, Kforce‚Äôs liquidity and available capital resources are impacted by four key components: existing cash and equivalents, operating activities, investing activities and financing activities.
Cash and Equivalents
Cash and equivalents totaled $1.1 million and $0.8 million at September 30, 2007 and 2006, respectively. Kforce generated $41.8 million of cash from operating activities, used $12.1 million of cash in investing activities and used $30.2 million in financing activities, during the nine months ended September 30, 2007. For the nine months ended September 30, 2006, Kforce generated $23.6 million of cash from operating activities, used $71.4 million of cash in investing activities and generated $11.5 million in financing activities.
During the nine months ended September 30, 2007, cash flow provided by operations was approximately $41.8 million, resulting primarily from net income of $30.4 million, an increase in accounts payable and other accrued liabilities of $7.4 million, an increase in accrued payroll costs of $13.2 million, deferred income tax expense of $5.9 million, and depreciation and amortization of $10.8 million, offset primarily by an increase in trade receivables of $33.2 million.
Kforce‚Äôs gross accounts receivable were $169.9 million at September 30, 2007, which was a $32.7 million increase from $137.2 million at December 31, 2006. The majority of this increase is due to increased revenues.
At September 30, 2007, Kforce had $86.9 million in positive working capital, which includes $1.1 million of cash and cash equivalents. Our current ratio (current assets divided by current liabilities) was 1.93 at September 30, 2007. If we continue to experience significant revenue growth, we may need to finance these increases. Currently, we believe adequate capacity exists for this purpose under the Credit Facility as described below.
During the nine months ended September 30, 2006, cash flow provided by operations was approximately $23.6 million, resulting primarily from net income of $23.3 million, adjusted for non-cash items of $19.5 million and net cash used by changes in working capital of $19.2 million.
During the nine months ended September 30, 2007, cash flow used in investing activities was $12.1 million. The primary driver for the use of cash in investing activities was capital expenditures which totaled $9.7 million and premiums paid for Kforce owned life insurance related to deferred compensation plans which totaled $2.9 million. These capital expenditures were primarily for new software development, field office growth and computer equipment refreshes. We believe we have sufficient cash and borrowing capacity to fund these and such other capital expenditures as are necessary to operate our business.
During the nine months ended September 30, 2006, cash flow used in investing activities was $71.4 million. This was primarily composed of acquisitions of businesses, net of cash received, of $64.6 million, capital expenditures of $4.0 million and premiums paid for Kforce owned life insurance related to deferred compensation plans of $2.9 million.
During the nine months ended September 30, 2007, cash flow used in financing activities was $30.2 million, resulting primarily from $32.1 million in net payments to our Credit Facility. In addition, Kforce received proceeds of $4.1 million from the exercise of stock options and repaid certain capital expenditure financing totaling $3.2 million.
During the nine months ended September 30, 2006, cash flow provided by financing activities was $11.5 million. This resulted primarily from $3.3 million of net borrowings on our Credit Facility, proceeds from the exercise of stock options of $9.6 million, excess tax benefit attributable to stock options and restricted stock of $4.1 million and repurchase of common stock and repayment of capital expenditure financing totaling $5.5 million.
On October 2, 2006, Kforce entered into a Second Amended and Restated Credit Agreement, with a syndicate led by Bank of America, N.A. (the ‚ÄúCredit Facility‚ÄĚ). Kforce‚Äôs maximum borrowings under the Credit Facility are limited to $140 million, including a revolving loan tranche of up to $125 million (the ‚ÄúRevolving Loan Amount‚ÄĚ) and a $15 million sub-limit for letters of credit. An additional revolving loan tranche (the ‚ÄúAdditional Availability Amount‚ÄĚ) allowed up to $25 million before its retirement in April 2007. Borrowings under the Credit Facility are limited to 85% of eligible accounts receivable less certain minimum availability reserves. Outstanding borrowings under the Revolving Loan Amount, which is now retired, bore interest at a rate of LIBOR plus 1.25% or Prime, and outstanding borrowings under the Additional Availability Amount bore interest at a rate of LIBOR plus 3% or Prime plus 1.25%. Letters of credit issued under the Credit Facility require Kforce to pay a fronting fee equal to 0.125% of the amount of each letter of credit issued, plus 1.25% per annum of the total letters of credit outstanding. To the extent that Kforce has unused availability under the Credit Facility, an unused line fee is required to be paid equal to 0.25% of the average unused balance on a monthly basis. Borrowings under the Credit Facility are secured by substantially all of the assets of Kforce. Under the Credit Facility, Kforce is required to meet certain minimum availability and fixed charge coverage ratio requirements. The Credit Facility expires on November 3, 2011.
On April 2, 2007, Kforce retired the Additional Availability Amount, thereby reducing the interest rate on outstanding debt to 6.6%.
On June 23, 2005, the Board of Directors increased its authorization for open market repurchases of common stock by $20 million to $135 million. At September 30, 2007, and October 31, 2007 Kforce repurchased approximately 20.7 million shares for $120.2 million under this plan. No shares have been repurchased during 2007. Therefore, approximately $14.8 million was available under the current board authorization as of September 30, 2007 and October 31, 2007. Additional stock repurchases could have a material impact on cash flow requirements for the next twelve months.
In addition to the $54.3 million and $63.1 million outstanding, the amounts available under the Credit Facility as of September 30, 2007 and October 31, 2007 were $68.3 million and $60.7 million, respectively.