Whitney Kukulka - Investor Relations, Director at The Blueshirt Group, LLC Catherine Corrigan - President and Chief Executive Officer Rich Schlenker - Executive Vice President, Chief Financial Officer and Corporate Secretary.

Tim McHugh - William Blair & Company Tobey Sommer - SunTrust Mike Reid - Cantor Fitzgerald Marc Riddick - Sidoti.

Good day everyone and welcome to Exponent's second quarter 2018 conference call. Today's conference is being recorded. And at this time, I would like to turn the conference over to Whitney Kukulka. Please go ahead..

Thank you operator. Good afternoon, ladies and gentlemen. Thank you for joining us on Exponent's second quarter 2018 financial results conference call. Please note that this call will be simultaneously webcast on the Investor Relations section of the company's corporate website at www.exponent.com/investors.

This conference call is the property of Exponent and any taping or other reproduction is expressly prohibited without prior written consent. Joining me on the call today are Catherine Corrigan, President and Chief Executive Officer, Rich Schlenker, Executive Vice President and Chief Financial Officer and Paul Johnston, Executive Chairman,.

Before we start, I would like to remind you that the following discussion contains forward-looking statements, including, but not limited to, Exponent's market opportunities and future financial results that involve risks and uncertainties that may cause actual results to differ materially from those discussed here.

Additional information that could cause actual results to differ from forward-looking statements can be found in Exponent's periodic SEC filings, including those factors discussed under the caption Factors Affecting Operating Results and Market Price Stock in Exponent's most recent Form 10-K.

The forward-looking statements and risks in this conference call are based on current expectations as of today and Exponent assumes no obligation to update or revise them, whether as a result of new developments or otherwise. And now, I will turn the call over to Catherine Corrigan, Chief Executive Officer.

Catherine?.

Thank you and good afternoon everyone. Following my discussion of the results for the second quarter, Rich will provide a more detailed review of our financial performance and business outlook. Paul is also here for the question-and-answer portion of the call.

As you know, we announced the CEO succession plan in December and since then, I have had the wonderful opportunity to meet many of you on the road. I joined Paul and Rich on our two previous earnings calls and I am very much honored to be addressing all of you today as Exponent's Chief Executive Officer and President.

Exponent delivered high single-digit revenue growth in the quarter and continued to expand margins, contributing to a strong first half of 2018. Total revenues in the second quarter grew 9% to $95.6 million as compared to the same period one year ago. Revenues before reimbursements increased 7% to $90 million.

EBITDA increased 10% to $26 million and net income was $18.4 million or $0.34 per diluted share.

Exponent's results reflect continuing demand for our expertise and services, supported by positive market trends across several industries, practices and geographies and consistent with the expected step down in the ongoing large human factors project in the second quarter.

We are raising our EBITDA margin guidance for the full-year following another quarter of better than expected profitability.

In line with our previous expectations, the large project in the consumer products industry represented approximately 4% of net revenues during the quarter, down from close to 8% in the first quarter and 5% in the second quarter of 2017.

We now anticipate this project will contribute approximately 5% of net revenues in the third quarter and will continue but at a lower level in the fourth quarter. We are encouraged by the increased demand for our human factors services from clients in the virtual reality, automated vehicle and consumer products industries.

Our teams are advising clients as they strive to optimize the performance of their technologically complex products and also the experience of their users.

As the need to better understand the interactivity between sophisticated products and their users grows, we continue to position Exponent as a leader in this area and to differentiate our offerings. We believe these capabilities are a source of strength and future opportunity for Exponent.

Exponent's engineering and other scientific segment represented approximately 80% of the company's second quarter and first half net revenues. Net revenues in this segment grew 8% in the second quarter and 11% in the first half, as compared to last year.

For the second quarter, this segment had noteworthy performances in its human factors, material sciences, thermal sciences, mechanical engineering and construction consulting practices. The company experienced strong demand for advice related to the reliability of components and system level designs of consumer products.

Demand continued for battery technology assessments for the transportation, medical device and consumer electronics industry. Exponent's environmental and health segment represented approximately 20% of the company's second quarter and first half net revenues.

Net revenues in this segment grew 3% in the second quarter and 7% year-to-date, as compared to last year. Exponent's chemical regulation and food safety practice continued its strong growth, focusing on the safety of agricultural chemicals in the Americas, Europe and Asia.

Additionally, May of 2018 included another deadline for regulatory submittals for the safety of chemicals in Europe. Consultants from this segment also continued to support the large human factors project. We continued to grow our global presence by recruiting top experts and identifying new opportunities to expand our proactive and reactive services.

Additionally, we are augmenting our current go-to-market strategies as we form interdisciplinary industry teams to expand our key services. There are significant growth opportunities for us in this type of proactive industrial work.

Going to market with an industry focus will encourage cross-selling that will help broaden our reach within existing client relationships. Over my 21 years with the firm, I have always known that I was part of a unique organization.

I am thrilled to lead Exponent as we engage with clients to find solutions to their most challenging issues in an increasingly technologically complex environment. Before I turn the call over to Rich, I want to take a moment to thank Paul for his tremendous leadership over the last nine years.

He led Exponent through a challenging economic environment and delivered impressive financial results during his tenure as CEO. I appreciate the Board's confidence in me as the next CEO of this great firm and I look forward to working with our stakeholders in the years to come.

Rich?.

Thanks Catherine. Let me start of by saying that all comparisons will be on a year-over-year basis unless otherwise specified. For the second quarter of 2018, total revenues were up 8.9% to $95.6 million. Revenues before reimbursements or net revenues, as I will refer to them from here on, were up 7% to $90 million.

Net income for the second quarter increased 33.6% to $18.4 million as compared to $13.8 million. As a reminder, our net income also benefited from the new tax legislation, which reduced our consolidated tax rate. I will provide more details on this tax rate shortly.

Earnings per diluted share were $0.34 in the second quarter as compared to $0.26 a year ago. Stockholders approved a two-for-one stock split on May 31. In accordance with generally accepted accounting principles, all common shares and per common share amounts have been adjusted on a retroactive basis to reflect the stock split.

As of June 29, Exponent had approximately 52 million shares of common stock outstanding. EBITDA for the quarter increased 9.5% to $26 million as compared to $23.7 million a year ago. As Catherine noted, the large human factors project decelerated from the first to the second quarter and was approximately 4% of net revenues.

We expect this project will increase to approximately 5% of net revenues in the third quarter but will be down approximately three percentage points from the 8% we earned in the third quarter last year. Although we do not have a commitment for the fourth quarter, we do expect this project to continue but at a lower level.

For the first half of 2018, total revenues increased 11.7% to $192.1 million and net revenues increased 9.8% to $180.7 million. Net income was $38.8 million in the first half of 2018, as compared to $30.4 million. Earnings per diluted share were $0.72 in the first half of 2018, as compared to $0.56.

In 2016, Exponent adopted a new accounting standard for the classification of tax adjustments associated with share-based awards. The tax benefit realized in the first half of 2018 was $4.1 million or $0.08 per diluted share as compared to $6.1 million or $0.11 per diluted share in the same period last year.

For the first half of 2018, EBITDA increased 16.5% to $49.4 million. For the quarter, billable hours increased 4.5% to 324,000. For the first half of the year, billable hours increased 7.8% to 653,000. The second quarter's utilization was 74.7% as compared to 77.0% for the same period last year.

For the first half of the year, utilization was 75.8%, up slightly from 75.6% for the same period last year. As a reminder, we have seasonality in our business related to sequential increases from quarter to quarter in holidays and vacations.

For the third quarter, we expect a three percentage point decline in utilization from the second quarter due to an average of three additional holiday and vacation days taken. The fourth quarter's utilization will decline an additional three percentage points.

For the full year 2018, we expect utilization to be down by approximately one to 1.5 percentage points from last year's 74.7%. Technical full-time equivalent employees in the quarter were 834, up 7.8% from last year. For the remainder of 2018, we expect quarterly sequential headcount growth to be approximately 1%.

The realized rate increase was approximately 2.5% in the second quarter. For the remainder of 2018, we expect the year-over-year realized rate increase of approximately 2% to 3%. For the quarter, EBITDA margin increased 67 basis points to 28.9% of net revenue. For the first half, EBITDA margin increased 158 basis points to 27.4%.

For the full year 2018, the EBITDA margin is expected to decline 25 to 50 basis points from the 26.5% in 2017. This is primarily related to the lower utilization. For the quarter, compensation expense after adjusting for gains and losses and deferred compensation increased by 7.7%.

Included in total compensation expense is a gain in deferred compensation of $1 million, flat with year-over-year. As a reminder, again, gains and losses and deferred compensation are offset in miscellaneous income and have no impact on the bottom line. Stock-based compensation expense was $3.7 million in the quarter as compared to $3.5 million.

We continue to expect stock-based compensation to be $3.5 million to $3.8 million in each of the remaining quarters in 2018. Other operating expenses increased approximately 4% to $7.6 million in the second quarter. Included in other operating expenses is depreciation expense of $1.6 million.

For the remainder of 2018, other operating expenses are expected to be in the range of $7.8 million to $8.2 million per quarter. G&A expenses were $4.5 million in the quarter, down 10.5%. G&A expenses were higher in the first half of 2017 due to our managers' meeting.

For the remainder of 2018, G&A expenses are expected to be in the range of $4.8 million to $5.2 million per quarter, which includes a principals' meeting at the end of September. I will expand on our year-to-date tax rates and our expectations for the remainder of 2018.

Exponent's consolidated tax rate was 26.1% in the quarter compared to 38.3% due to the new tax legislation. For the first half of the year, inclusive of the tax benefit for share-based awards, Exponent's consolidated tax rate was 18.2% as compared to 23.6% for the same period last year.

For comparative purposes, excluding the tax benefit for share-based awards, Exponent's tax rate decreased to 26.7% in the first half of 2018, as compared to 38.8% in the same period last year, due to the new tax legislation.

We expect our consolidated tax rate to be approximately 26% to 27% during the remainder of the year and our full year tax rate to be approximately 22% to 23% which is 10 points lower than it would have been as a result of the new tax legislation. This lower tax rate will generate an additional $8 million to $9 million of net income.

Moving to our cash flows. Operating cash flow were $24.2 million for the quarter. Capital expenditures were $2.1 million. We distributed $6.7 million to shareholders through dividend payments in the second quarter and $13.5 million so far this year. Today, we announced a quarterly dividend payment of $0.13 for the third quarter of 2018.

We ended the quarter with $193.3 million of cash and short-term investments. For the full year 2018, we are reiterating our revenue growth and increasing our margin expectations.

Our outlook reflects positive momentum in the business as well as the expected lower year-over-year revenues from the ongoing human factors project in the second half of 2018. We expect revenues before reimbursements to grow in the mid to high single digits and EBITDA margin to decline by approximately 25 to 50 basis points as compared to 2017.

I will now turn the call back to Catherine for closing remarks..

Thanks rich. The market drivers for our business remains strong as society insists upon safer, healthier and more sustainable products and processes. As these grow in complexity, assuring reliability and reducing risk become more formidable tasks.

Exponent's interdisciplinary engineering and scientific advice is more valuable than ever as industry faces these tough challenges. Exponent holds a unique market position and we will continue to leverage our experience and superior reputation in reactive services to drive growth in our proactive services around the world.

We remain confident in the sustainability of the model and our focus remains the same, position Exponent for long-term success by providing unparalleled scientific advice, delivering strong financial results and creating value for our stakeholders. Thank you for joining today's call. Operator, we are ready for questions..

[Operator Instructions]. We will for first to Tim McHugh with William Blair & Company. Please go ahead..

Thanks. Just one number one quickly, I guess. I had missed the utilization.

Can you repeat that, Rich?.

Yes. The utilization for the quarter was 74.7% as compared to 77.0% in the same quarter last year bringing the half year to 75.8% which is up slightly from the 75.6% that we did in the first half in 2017..

Okay. Thanks.

And then on the large project, I know you had talked about it stepping down in 3Q in kind of a general trend, but it seems like it probably was at the lower end of what you said last quarter and probably the lower end of I guess what I would have thought for the second half of the year? Is there any color you can provide on that as well as the visibility on the fourth quarter? I know you said you don't have a contract or maybe that's not the right term, but I guess would you have expected to have a commitment I think is the term you used at this point and any just additional color on what we can think about post third quarter in terms of the expected contribution?.

Sure, Tim. So we do have a specific projection regarding the third quarter. So we expect that to be at about 5%. You are right that we don't have a commitment for the fourth quarter. However, the visibility that we do have is that the project will continue. We do expect it to go down from that 5% level, but we don't know exactly how much.

And in terms of 2019, we don't know that yet either. What I can say though, the good news is that with respect to this client and this type of work, there is some degree of a portfolio of projects in this area and this type of work for this client is going to continue.

The client is very pleased with the work product, pleased with the capabilities that we have as we delivered that product. So we fully expect that we would be engaging with them next year on this type of work.

This type of work with this client isn't going away, but how much is on one project versus another project simply isn't clear to us at this point..

Okay. That's helpful. And maybe a follow-up Catherine, on the industry focus comments, I know that's part of your strategy there.

Can you talk about how quickly you want to go after that and how you balance that with the cost? Is this an added layer of like specialization you are thinking about having within the consultant base? And is that a near-term cost you have to get leverage of overtime? Or can you just elaborate on tactically how you are going to pursue that industry focus within the consulting ranks?.

Yes. Sure. So, it's an augmentation to our existing go-to-market strategy, right. I mean, the way that we sell our business is through the consultants and they are the ones that are sitting across the table from those clients. That sort of fundamental hasn't changed.

What we are doing with these industry teams is developing a more focused degree of attention with respect to the clients themselves, with respect to the issues that they are facing and with respect to the development of the capabilities and the offerings that we have that can really address those issues for industry in a targeted way.

So it's really not a situation where we have to kind of add another layer of, let's say, business development staff in order to do that. We certainly have our existing BD staff engaged in this process, but we don't have really an additional layer that's going on there.

In terms of the speed with which we roll this out, it's kind of like going to the gym. It's something that takes time to implement and you don't see the results immediately. But what I can say is that this client relationship management approach, it's first of all geared toward our proactive work.

Our leading team that is using this right now is our consumer electronics team and that's a proactive industry area where we are seeing the fastest growth. So while it's difficult to parse out precisely what the effect is of the augmentation of our approach to the market, we are certainly feeling like we are seeing positive results from that.

I am out in the client community engaging with these clients and I am talking with them and I am getting feedback from the teams and I do believe that we are seeing positive results from the clients' perspective to what we are doing now..

Okay. Great. That's helpful. Thank you..

You are welcome..

Thank you. We will move now to Tobey Sommer with SunTrust. Please go ahead..

Thanks. A follow-up on the augmented sales approach.

What's the impact of the industry teams been so far on growth? And what do you think the impact may be over sort of in longer stretch, two, three years because I understand you are in some part of the roll-out phase now?.

Yes. We absolutely are in the roll-out phase now. And this frankly will be a continuously evolving process, right. As we look out at the marketplace, as we look out at who the players are, we are constantly innovating what the offerings are and which clients are in a position to really need those offerings is something that changes over time, right.

So I would say it's a continuously evolving process. I don't have a specific quantitative projection to give you in terms of what I think the impact will be. I do think that this is something that will evolve over the course of years.

This is not something where I am going to come back next quarter and say, hey, we have gotten a certain percentage of growth out of this. But again, I would reiterate that the feel from being out and pounding the pavement with the clients like I have been doing is that they are responding to this in a way that's very positive.

So I am very pleased with that..

Okay.

Is it really associated change in the way that you are compensating people to incentivize team and collaborative behavior that may be different than it has been in the past?.

Well, we are of course always looking at the way that we credit folks and the way that we compensate them relates to that. We have a system whereby we recognize a variety of things that go into ultimately making decisions about compensation.

We very much recognize referrals of work, for example, as a way of encouraging a cross-selling type of environment. So we do continue to look at that. But we feel like the system that we have in place ultimately is one that is going to work well with this new approach..

Okay.

Do you feel that the frequency of sizable proactive projects may be changing? And if so, what factors do you ascribe to driving the change?.

It's difficult to predict. There are opportunities, I believe, out there in a number of segments, a number of sectors where I think we could conceivably see that type of work. But again as we build that business out, there is a portfolio of projects that goes from some relatively small engagements as we just get to know a client.

Typically, the larger engagements tend to happen with those clients that we have had longstanding relationships with. So there is a mix and I think it's very difficult to say. I think in terms of how we are recruiting and how we are building the business out, that we are in a position to be able to execute on those types of engagements.

But it's very difficult to say what the frequency will be going forward..

Okay.

Are there any end-markets that are as opposed to projects that may oscillate up and down with demand? Any end markets that are soft or frankly showing negative growth? Or most of your industry focus is growing?.

So I would use, for example, oil and gas. That's a place where we are not currently seeing increases in demand for our services. We are continuing to put out our thought leadership. We are continuing to position our folks as experts in that domain.

I think the hope is that with the increasing price of oil and the change in that environment that there may be more open doors to discussion around the types of work that we do. So we are engaging with clients in that way and having those discussions. But I think that's an example of an area that is not a high growth area.

And industrial chemicals would be another example of that. The agricultural chemical side is growing very well. We are seeing lots of demand there. On the industrial side, I think that we may be starting to pickup a little bit, but over the last short period of time that's been relatively stagnant for us..

Okay. And last question from me and I will get back in the queue. It's kind of a longer-term one. You talked about, I guess, your headcount up around 8% and you are looking for 1% sequential increases.

How do you think about the theoretical kind of upper bound of how quickly you could grow headcount within the firm? Whether that kind of bottleneck and gating factor would be ability to recruit, availability of talent? Where is the upper bound at which you think Exponent could increase its headcount on a year-over-year basis?.

Yes. I think we talk about sort of 4% to 8% as kind of the operating range that we work within. Our hiring process is an intensive one in terms of the types of people that we hire. These are PhD level, MD level folks that search can take months.

And so it's an activity that we are constantly engaged in and something we do for the long term because these are folks who are really coming to us to build a career. But I think really that 4% to 8% is kind of our reasonable operating range that we think about for increasing our headcount..

Okay. Thank you very much..

You are welcome..

Thank you. Our next question will come from Joseph Foresi with Cantor Fitzgerald. Please go ahead, sir..

Hello. This is Mike Reid, on for Joe. Thanks for taking our question.

I just wanted to ask, as the EBITDA margins expanded and then in comparison to the decline in utilization, was that expansion just due to the lack of the management meeting or were there other drivers there?.

Yes, Michael. The managers' meeting clearly was a contribution to that. We also, starting at the sort of compensation line, I think what you can see there is that even though the utilization came down, compensation grew just slightly ahead of that.

So we didn't lose as much on that margin as we would have and the reason for that is that we are still getting a pretty good leverage out of our more junior staff that we are bringing in. That 8% headcount growth while we are having a pretty good year in senior recruiting, it's still a small percentage of the total headcount that we are bringing in.

So between the associates we are bringing in and in some of the areas we have also added some billable staff that might be a technician in the battery area or a research assistant in the human factors area to support those operations and we have been getting very good utilization and good effective multiples out of those people.

So while the utilization dropped, we didn't have the impact to that gross margin that you would have expected with that same drop.

And then in line with that, we have been able to continue to leverage the infrastructure that we have that you see at least for the quarter that the other operating expenses, which are rent and technical materials and computer systems and things, with a 4% year-over-year growth with that 7% revenue we got leverage in that area as well..

Okay. Thanks.

And then looking at the balance sheet, if that cash balance continues to get higher and higher, would you consider accelerating the capital allocation actions to start moving back towards the target cash balance?.

We are definitely committed to continuing to work on bringing that down over time. I wouldn't say that we would make any sudden rash move, but we clearly continue our commitment to grow our dividends. We have been growing that faster than we have been growing earnings.

At least for the near term, I see that continuing and we have clearly got strong earnings growth this year that should drive good dividend growth in the future.

But in addition to that, on our stock repurchase program, we are committed to, while we haven't done much at all here in the first half, we still are committed to the position that we will repurchase in a year at least what we are putting out in our stock plans and then be very opportunistic on pullbacks and the stock and being in the market strong and a little bit lighter on real increases that go on there.

Just try and do this over the long term instead of trying to do anything in the short term..

Okay. And then lastly, what percentage of the overall revenues has the human factors become.

And then what percentage of projects would you consider multi-discipline?.

Yes. So on the human factors side, our revenues in that area, what we should be clear about is, we have a human factors practice that is still a small part of our business. It's, call it, in the 6% of our business in size where it's that group of professionals.

In the case of these user studies, we are able to leverage the other scientists in the organization because in those roles we can have leadership and a core team that's in that human factors area with a supplement of people who are very strong in data analytics and scientific data collection methods.

So that's how we are able to get a broader leverage out of that team as we are building it out. As far as the number of projects or percentage of our projects that's multi-disciplinary, that number is a little bit hard to or at lease we don't have that exact number.

But what I would say is as projects get larger, they almost certainly are multi-disciplinary in nature. And many of our very small projects can be singular in nature. Just the request from the client is something that's in the $5,000 to $25,000 range.

We do thousands of projects in that range that might have one or two disciplines in them, but beyond that size they tend to leverage multiple disciplines in a single project..

Okay. Thanks guys..

Thank you. Our next question will come from Marc Riddick with Sidoti. Please go ahead..

Hi. Good afternoon..

Hi Marc..

Hi..

I wanted to follow up. You touched on some of the other things already, but also in your prepared remarks you mentioned of virtual reality.

I was wondering if you can sort of put a little more context around that and maybe what you are seeing so far this year in that area that gives you confidence? And then as a side note then, maybe if you can give a similar type of update around where you are with vehicles, be it working with the companies or maybe the regulation around that? Thank you..

Sure. So with respect to virtual reality, this relates back to the last question with regard to human factors. The work in virtual reality relates to, again, that interface between the human and the machine. So there are health and safety issues, there are user experience issues. We also have issues around the electronics, the laser systems, the optics.

So from the standpoint of multi-disciplinary work, which we were just talking about, that's a very good example.

And so we are working across multiple players in that industry and are very much, I believe, in a leadership position to do that because of the interdisciplinary approach that we have with the expertise in human factors as well as the electronics.

With regard to vehicles, there is work that is proactive in the automated vehicle space as well as very much the more traditional portfolio of work that we have had over the years with regard to recall actions, with regard to defect investigations and with regard to product liability litigation.

Those are areas that continue to be prominent in our portfolio and we believe it will continue to be that way going forward..

Okay. And then one last follow-up from me. I was wondering if you could give us an update. I know you have talked in the past about the user research center and the experience labs and I was wondering if you can give a bit of an update as to sort of how that's coming along and how you see that being utilized? Thank you..

Yes. And that actually relates back to the discussion about virtual reality. That's one of the areas where we are utilizing the space and the infrastructure that we have invested in at our Phoenix facility. But there are a broad range of products actually that we evaluate in that facility. They can be consumer electronics. They can be appliances.

They can be vehicles. So there is a broad range. And again, this is the strength of our human factors expertise that is driving that area. And so this contributes certainly to the consumer electronics sector growth that we have been seeing over the course of time.

There is strong demand and we have positioned ourselves with respect to our talent base quite well, I believe, to execute on those opportunities..

Okay. Then I just remembered one last follow-up. I promise this is the last one.

We talked about the CapEx around Boston earlier and I was wondering if there were any other areas, be it regionally or internationally, what have you, that you are looking at, that you would like to expand some cash and doing something similar to what you are doing in Boston? Thank you..

So look, we are expanding. This is a unique situation in the Boston area where we have acquired some land and are building a facility there. Boston is really one of the centers of our activities on the East Coast. It's a very multi-disciplinary office.

It's not only around a great set of clients, but a number of great universities as well to attract talent. And we made a decision to construct our only our second sort of own facility here in Menlo Park. We have had this facility since before the company went public, so back in 1989 and we did add a warehouse to that portfolio a couple of years back.

But really this Natick situation is unique. On the other hand, we are definitely expanding what we are doing in other locations. Those include the fact that we are building up on operations in the London area. Again, we started off very small and really controlled as far as what we need to do from an investment standpoint.

These are really consultants that we are bringing in. And as you bring in senior consultants, sure, there is a little slower ramp-up time than there might be for more junior people that you are bringing in to the organization. So part of that can be the investment. We also have done a number of projects, as you are aware, in the international disputes.

We have run that out of Hong Kong and supporting that from the U.S. We identified that Singapore is clearly an important place for us there and we have just put our first employee there.

Again, I don't know that that's going to be a huge operation, but it is examples of where we have now got places to grow in both Singapore, Hong Kong and Shanghai in Asia. We are continuing to expand our footprint in Europe as well and the U.K..

Okay. Great. Thank you very much..

Thank you, ladies and gentlemen. With that being our final question, that will conclude Exponent's second quarter 2018 earnings conference call. We do thank you for your participation and you may now disconnect..