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MASTECH HOLDINGS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion in conjunction with our audited consolidated financial statements and accompanying notes for year ended December 31, 2013, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission ("SEC") on March 21, 2014. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements about future events, future performance, plans, strategies, expectations, prospects, competitive environment and regulations. Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words, "may", "will", "expect", "anticipate", "believe", "estimate", "plan", "intend" or the negative of these terms or similar expressions in this quarterly report on Form 10-Q. We have based these forward-looking statements on our current views with respect to future events and financial performance. Our actual financial performance could differ materially from those projected in the forward-looking statements due to the inherent uncertainty of estimates, forecasts and projections and our financial performance may be better or worse than anticipated. Given these uncertainties, you should not put undue reliance on any forward-looking statements. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed under "Risk Factors", "Forward-Looking Statements" and elsewhere in our 2013 Annual Report on Form 10-K. Forward-looking statements represent our estimates and assumptions only as of the date that they were made. We do not undertake any duty to update forward-looking statements and the estimates and assumptions associated with them, after the date of this quarterly report on Form 10-Q, except to the extent required by applicable securities laws. Website Access to SEC Reports: The Company's website is www.mastech.com. The Company's 2013 Annual Report on Form 10-K, current reports on Form 8-K and all other reports filed with the SEC, are available free of charge on the Investor Relations page. The website is updated as soon as reasonably practical after such reports are filed electronically with the SEC. Recent Developments On July 11, 2014, the Company entered into a Second Amended and Restated Loan Agreement (the "Loan Agreement") with PNC Bank, N.A. ("Bank"), replacing its previous Bank credit facility that was set to expire on August 31, 2014. This new facility expires in three years and provides for up to $20 million of credit, subject to a borrowing base and commitment reductions and mandatory prepayments, as described in the Loan Agreement filed as Exhibit 10.1 to the Company's current report on Form 8-K, filed with the SEC on July 17, 2014. The credit facility includes sub-facilities in aggregate amounts not to exceed (i) $1 million for letters of credit and (ii) $5 million for certain permitted acquisitions. Revolving credit loans made for the purpose of financing permitted acquisitions will be converted into term loans with five year maturities and the credit facility will be reduced by an amount equal to each such converted term loan. The credit facility also includes an accordion feature which may be exercised by the Company to increase the loan commitment by an aggregate amount of up to $10 million, subject to Bank approval. Critical Accounting Policies and Estimates: The Company's significant accounting policies and critical accounting estimates are described in Note 1 "Summary of Significant Accounting Policies" of the Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies" in our Annual Report on Form 10-K for the year ended December 31, 2013. There were no material changes to these critical accounting policies during the six months ended June 30, 2014. Overview: We are a domestic provider of IT staffing services to mostly large and medium-sized organizations. From July 1986 until our September 2008 spin-off, we conducted our business as subsidiaries of iGATE Corporation. We do not sell, lease or otherwise market computer software or hardware, and 100% of our revenue is derived from the sale of staffing services. Our IT staffing business combines technical expertise with business process experience to deliver a broad range of services within business intelligence / data warehousing; web services; enterprise resource planning & customer resource management; and e-Business solutions. We provide our services across various industry verticals including: automotive; consumer products; education; financial services; government; healthcare; manufacturing; retail; technology; telecommunications; transportation; and utilities. We have one operating segment. Thus, no segment related disclosures are presented. We do, however, track and evaluate our revenues and gross profits by three distinct sales channels: wholesale IT; retail IT; and permanent placements / fees. Our wholesale IT channel consists of system integrators and other IT staffing firms with a need to supplement their abilities to attract highly-qualified temporary technical computer personnel. Our retail IT channel focuses on clients that are end-users of IT staffing services. Within the retail channel are end-user clients that have retained a third party to provide vendor management services, 17 -------------------------------------------------------------------------------- Table of Contents commonly known in the industry as Managed Service Providers ("MSP"). Permanent placement / fee revenues are incidental revenues derived as by-product opportunities of conducting our core contract staffing business. Economic Trends and Outlook: Generally, our business outlook is highly correlated with general U.S. economic conditions. During periods of increasing employment and economic expansion, demand for our services tends to increase. Conversely, during periods of contracting employment and / or a slowing domestic economy, demand for our services tends to decline. As the economy slowed during the second half of 2007 and recessionary conditions emerged in 2008 and during much of 2009, we experienced less demand for our staffing services. During the second half of 2009, we began to see signs of market stabilization and a modest pick-up in activity levels within certain sales channels and technologies. In 2010, market conditions continued to strengthen over the course of the year and activity levels within most of our sales channels progressively improved. In 2011, 2012 and 2013, activity levels continued to trend up in most technologies and sales channels. During the first six months of 2014, activity levels have stabilized and remain consistent with the second half of 2013. In addition to tracking general U.S. economic conditions, a large portion of our revenues are generated from a limited number of clients. Accordingly, our trends and outlook are impacted by the prospects and well-being of these specific clients. This "account concentration" factor may cause our results of operations to deviate from the prevailing U.S. economic trends from time to time. In recent years, a larger portion of our revenues have come from our wholesale IT sales channel, which consists largely of strategic relationships with systems integrators and other staffing organizations. This channel tends to carry lower gross margins, but provides higher volume opportunities. This trend in our business mix has impacted overall gross margins during the past several years, and if this trend continues, will likely impact future gross margins as well. Within our retail sales channel, many larger users of IT staffing services are employing MSP's to manage their contractor spending in an effort to drive down overall costs. This trend towards utilizing the MSP model has resulted in lower gross margins in the retail IT channel over the last two years and it is likely that our gross margins will be pressured in future periods should this trend continue. Results of Continuing Operations for the Three Months Ended June 30, 2014 as Compared to the Three Months Ended June 30, 2013: Revenues: Revenues for the three months ended June 30, 2014 totaled $27.7 million, compared to $26.1 million for the corresponding three month period in 2013. This 6% year-over-year revenue increase, reflected higher demand for the Company's services and the corresponding increase in billable consultants on assignment during the 2014 period. Billable consultant headcount at June 30, 2014 totaled 734 consultants compared to 716 consultants, one-year earlier. Additionally, our average bill rate was slightly lower in the 2014 period compared to 2013. During the three-months ended June 30, 2014, our billable consultant headcount declined by approximately 4% sequentially and reflected an early project termination which impacted our consultant-base by 30-consultants during the quarter. Below is a tabular presentation of revenues by sales channel for the three months ended June 30, 2014 and 2013, respectively: Three Months Ended Three Months Ended Revenues (Amounts in millions) June 30, 2014 June 30, 2013 Wholesale IT Channel $ 21.6 $ 19.9 Retail IT Channel 6.0 6.1 Permanent Placements / Fees 0.1 0.1 Total revenues $ 27.7 $ 26.1 Revenues from our wholesale IT channel increased approximately 9% in the three month period ended June 30, 2014 compared to the corresponding 2013 period. Higher revenue levels from both staffing clients (up 9%) and integrator clients (up 8%) were driven by stronger demand for IT services. An early project termination at one of our integrator partners negatively impacted revenues during the 2014 period. Retail IT channel revenues were down approximately 2% during the three months ended June 30, 2014, compared to the period one-year earlier. The decline reflected lower revenues from direct end-user clients. Permanent placement / fee revenues were approximately $0.1 million in both the 2014 and 2013 three month periods ended June 30. For the three months ended June 30, 2014, the Company had two clients that exceeded 10% of total revenues (Accenture = 11.0% and CGI = 10.1%). For the three months ended June 30, 2013, the Company had one client that exceeded 10% of total revenues (Accenture =11.2%). The Company's top ten clients represented approximately 58% and 56% of total revenues for the three months ended June 30, 2014 and 2013, respectively. 18 -------------------------------------------------------------------------------- Table of Contents Gross Margin: Gross profits in the second quarter of 2014 totaled $5.1 million, or approximately $0.1 million higher than the second quarter of 2013. Gross profit as a percentage of revenue totaled 18.5% for the three month period ending June 30, 2014, which was 50-basis points below our gross margin performance one year earlier. The continued shift of revenues towards the wholesale channel and consultant compensation increases were responsible for this variance. Below is a tabular presentation of gross margin by sales channel for the three months ended June 30, 2014 and 2013, respectively: Three Months Ended Three Months Ended Gross Margin June 30, 2014 June 30, 2013 Wholesale IT Channel 17.3 % 18.3 % Retail IT Channel 21.6 20.8 Permanent Placements / Fees 100.0 100.0 Total gross margin 18.5 % 19.0 % Wholesale IT channel gross margins decreased by 100 basis points for the three months ended June 30, 2014 compared to the 2013 period. The decline reflected both lower margins on new assignments with our integrator clients and consultant compensation increases on existing assignments that have out-paced bill rate increases. Retail IT gross margins were up 80 basis points during the three months ended June 30, 2014 compared to the corresponding 2013 period as margins on MSP assignments continued to strengthen over the last twelve months. Additionally, the Company elected not to pursue new business opportunities with a low-margin MSP client in mid-2013. Selling, General and Administrative ("SG&A") Expenses: SG&A expenses for the three months ended June 30, 2014 totaled $3.7 million or 13.3% of revenues, compared to $3.8 million or 14.4% of revenues for the three months ended June 30, 2013. Fluctuations within SG&A expense components during the 2014 period, compared to a year earlier, included the following: • Sales expense was essentially flat in the 2014 period compared to 2013. Higher salary expense related to our new business development efforts was offset by lower bonus expense. • Recruiting expense in the 2014 period was down $0.1 million compared to 2013. A slight decline in domestic staff and lower bonus expense were largely responsible for the decrease. • General and administrative expense was flat in 2014 compared to 2013. Higher corporate related expenses were offset by lower bonus expense. Other Income / (Expense) Components: Other income / (expense) for the three months ended June 30, 2014 consisted of interest expense of ($23,000) and foreign exchange gains of $37,000. For the three months ended June 30, 2013, other income / (expense) consisted of interest expense of ($29,000) and foreign exchange gains of $34,000. Income Tax Expense: Income tax expense for the three months ended June 30, 2014 totaled $540,000, representing an effective tax rate on pre-tax income of 37.7%, compared to $458,000 for the three months ended June 30, 2013, which represented a 37.4% effective tax rate on pre-tax income. A slightly higher aggregate state tax rate in the 2014 period was responsible for the higher effective tax rate. Results of Continuing Operations for the Six Months Ended June 30, 2014 as Compared to the Six Months Ended June 30, 2013: Revenues: Revenues for the six months ended June 30, 2014 totaled $56.3 million, compared to $50.1 million for the corresponding six month period in 2013. This 12% year-over-year revenue increase reflected higher demand for our services and the corresponding increase in billable consultants on assignment during the 2014 period. Additionally, our average bill rate for the six months of 2014 was essentially flat compared to one year earlier. 19 -------------------------------------------------------------------------------- Table of Contents Below is a tabular presentation of revenues by sales channel for the six months ended June 30, 2014 and 2013, respectively: Six Months Ended Six Months Ended Revenues (Amounts in millions) June 30, 2014 June 30, 2013 Wholesale IT Channel $ 44.5 $ 37.8 Retail IT Channel 11.7 12.2 Permanent Placements / Fees 0.1 0.1 Total revenues $ 56.3 $ 50.1 Revenues from our wholesale IT channel increased approximately 18% in the six month period ended June 30, 2014 compared to the corresponding 2013 period. Higher revenue levels from both staffing clients (up 12%) and integrator clients (up 22%) were driven by stronger demand for IT services. An early project termination at one of our integrator partners during the second quarter of 2014 negatively impacted our six month 2014 revenue growth rate. Retail IT channel revenues were down approximately 4% during the six months ended June 30, 2014 compared to the period one-year earlier. The decline reflected lower revenues from direct end-user clients. Permanent placement / fee revenues were approximately $0.1 million in both the 2014 and 2013 six month periods ended June 30. For the six months ended June 30, 2014, the Company had one client that exceeded 10% of total revenues (Accenture = 10.7%). For the six months ended June 30, 2013, the Company had two clients that exceeded 10% of total revenues (IBM = 10.4% and Accenture =10.2%). The Company's top ten clients represented approximately 60% and 57% of total revenues for the six months ended June 30, 2014 and 2013, respectively. Gross Margin: Gross profits in the six months ended June 30, 2014 totaled $10.3 million, or approximately $1.0 million higher than the corresponding period of 2013. Gross profit as a percentage of revenue totaled 18.3% for the six month period ending June 30, 2014, which was 30-basis points below our gross margin performance one-year earlier. Below is a tabular presentation of gross margin by sales channel for the six months ended June 30, 2014 and 2013, respectively: Six Months Ended Six Months Ended Gross Margin June 30, 2014 June 30, 2013 Wholesale IT Channel 17.2 % 18.0 % Retail IT Channel 21.7 20.2 Permanent Placements / Fees 100.0 100.0 Total gross margin 18.3 % 18.6 % Wholesale IT channel gross margins decreased by 80 basis points for the six months ended June 30, 2014 compared to the 2013 period. The decline reflected lower margins on new assignments with our integrator clients and consultant compensation increases on existing assignments that have out-paced bill rate increases. Retail IT gross margins were up 150 basis points during the six months ended June 30, 2014 compared to the corresponding 2013 period as margins on MSP assignments continued to strengthen over the last twelve months. Additionally, the Company elected not to pursue new business opportunities with a low-margin MSP client in mid-2013. Selling, General and Administrative ("SG&A") Expenses: SG&A expenses for the six months ended June 30, 2014 totaled $7.5 million or 13.3% of revenues, compared to $7.2 million or 14.4% of revenues for the six months ended June 30, 2013. Fluctuations within SG&A expense components during the 2014 period, compared to a year earlier, included the following: • Sales expense increased in the 2014 period by $0.2 million compared to 2013. Higher salary expense, related to our new business development efforts, and higher marketing expenditures were largely responsible for this increase. • Recruiting expense in the 2014 period was down $0.1 million compared to 2013. A slight decline in domestic and offshore staff were largely responsible for the decline. 20 -------------------------------------------------------------------------------- Table of Contents • General and administrative expense was up $0.2 million in the 2014 period compared to 2013. Higher travel and other corporate related expenses were partially offset by lower bonus expense. Other Income / (Expense) Components: Other income / (expense) for the six months ended June 30, 2014 consisted of interest expense of ($46,000) and foreign exchange gains of $68,000. For the six months ended June 30, 2013, Other income / (expense) consisted of interest expense of ($54,000) and foreign exchange gains of $46,000. Income Tax Expense: Income tax expense for the six months ended June 30, 2014 totaled $1.1 million, representing an effective tax rate on pre-tax income of 37.8%, compared to $784,000 for the six months ended June 30, 2013, which represented a 37.5% effective tax rate on pre-tax income. A slightly higher aggregate state tax rate in the 2014 period was responsible for the higher effective tax rate. Liquidity and Capital Resources: Financial Conditions and Liquidity: At June 30, 2014, the Company had cash balances on hand of $1.2 million, no outstanding debt and approximately $16.0 million of borrowing capacity under our existing credit facility. Historically, we have funded our business needs with cash generated from operating activities. Controlling our operating working capital levels by closely managing our accounts receivable balance is an important element of cash generation. At June 30, 2014, our accounts receivable "days sales outstanding" ("DSO's") measurement improved to 50-days from 56-days a quarter ago. This improvement in DSO's favorably impacted cash flows during the three months ended June 30, 2014 by approximately $1.8 million. Cash provided by operating activities, cash balances on hand and current availability under our existing credit facility will be adequate to fund our business needs over the next twelve months. Cash flows provided by (used in) operating activities: Cash provided by (used in) operating activities for the six months ended June 30, 2014 totaled $0.9 million compared to cash used of ($1.0 million) during the six months ended June 30, 2013. Elements of cash flows in the 2014 period were net income of $1.8 million, non-cash charges of $0.2 million, and an offsetting increase in operating working capital levels of ($1.1 million). During the six months ended June 30, 2013, elements of cash flows were net income of $1.3 million, non-cash charges of $0.2 million, and an offsetting increase in operating working capital levels of ($2.5 million). The operating working capital increases in both 2014 and 2013 reflected higher account receivable balances in support of our revenue growth. Discontinued operations for the six months ended June 30, 2014 provided $28,000 of cash, compared to $191,000 in the 2013 period. Cash flows used in investing activities: Cash used in investing activities for the six months ended June 30, 2014 totaled $156,000 compared to $62,000 for the six months ended a year earlier. In both 2014 and 2013, capital expenditures accounted for essentially all of our cash needs. The increase in the 2014 period compared to 2013 reflected expenditures made related to our new Pittsburgh, PA office facility. Cash flows provided by (used in) financing activities: Cash provided by financing activities for the six months ended June 30, 2014 totaled $93,000 and largely consisted of proceeds and excess tax benefits related to the exercise of stock options / vesting of restricted shares, partially offset by the repurchase of common stock of ($272,000). Cash provided by financing activities for the six months ended June 30, 2013 totaled $867,000 and largely related to proceeds from short-term borrowings. Contractual Obligations and Off-Balance Sheet Arrangements: The Company rents certain office space and equipment under non-cancelable leases which provides for future minimum rental payments. Except for an office lease executed on April 2, 2014 as described in Note 3 "Commitments and Contingencies", total lease commitments have not materially changed from the amounts disclosed in the Company's 2013 Annual Report on Form 10-K. We do not have any off-balance sheet arrangements. 21 -------------------------------------------------------------------------------- Table of Contents Inflation: We do not believe that inflation had a significant impact on our results of operations for the periods presented. On an ongoing basis, we attempt to minimize any effects of inflation on our operating results by controlling operating costs and, whenever possible, seeking to insure that billing rates are adjusted periodically to reflect increases in costs due to inflation. Seasonality: Our operations are generally not affected by seasonal fluctuations. However, our consultants' billable hours are affected by national holidays and vacation policies. Accordingly, we generally have lower utilization rates and higher benefit costs during the fourth quarter. Additionally, assignment completions tend to be higher near the end of the calendar year, which largely impacts our revenue and gross profit performance during the subsequent quarter. Recently Issued Accounting Standards: In April 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The main objective of this update is to change the criteria for reporting discontinued operations and enhancing convergence of the FASB's and the International Accounting Standard Board's (IASB) reporting requirements for discontinued operations. The amendments in this Update affect an entity that has either of the following: 1) A component of an entity that either is disposed of or meets the criteria in paragraph 205-20-45-1E to be classified as held for sale. 2) A business or nonprofit activity that, on acquisition, meets the criteria in paragraph 205-20-45-1E to be classified as held for sale. The amendments in this Update improve the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity's operations and financial results. Under current U.S. GAAP, many disposals, some of which may be routine in nature and not a change in an entity's strategy, are reported in discontinued operations. The amendments in this Update require expanded disclosures for discontinued operations. The Board concluded that those disclosures should provide users of financial statements with more information about the assets, liabilities, revenues, and expenses of discontinued operations. The amendments in this Update also require an entity to disclose the pretax profit or loss (or change in net assets for a not-for-profit entity) of an individually significant component of an entity that does not qualify for discontinued operations reporting. The Board concluded that this disclosure should provide users with information about the financial effects of significant disposals that do not qualify for discontinued operations reporting. The amendments in this Update include several changes to the Accounting Standards Codification to improve the organization and readability of Subtopic 205-20 and Subtopic 360-10, Property, Plant, and Equipment-Overall. For example, the disclosures required by Subtopic 205-20 are organized by the nature of the discontinued operation. Additionally, flowcharts were added to Subtopics 205-20 and 360-10 to help stakeholders implement the disclosure requirements. A public business entity and a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market should apply the amendments in this Update prospectively to both of the following: 1) All disposals (or classifications as held for sale) of components of an entity that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. 2) All businesses or nonprofit activities that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. An entity should not apply the amendments in this Update to a component of an entity, or a business or nonprofit activity, that is classified as held for sale before the effective date even if the component of an entity, or business or nonprofit activity, is disposed of after the effective date. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. 22 -------------------------------------------------------------------------------- Table of Contents The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements. In June 2014, the Financial Accounting Standards Board (FASB) issued Update 2014-12, Compensation-Stock Compensation (Topic 718) Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. Generally, share-based payment awards require a specific performance target to be achieved in order for employees to become eligible to vest in the awards. Also, an award with a performance target generally requires an employee to render service until the performance target is achieved. In some cases, however, the terms of an award may provide that the performance target could be achieved after an employee completes the requisite service period. That is, the employee would be eligible to vest in the award regardless of whether the employee is rendering service on the date the performance target is achieved. This Update is intended to resolve the diverse accounting treatment of those awards in practice. The amendments in this Update apply to all reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. As indicated in the definition of vest, the stated vesting period (which includes the period in which the performance target could be achieved) may differ from the requisite service period. For all entities, the amendments in this Update are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements. |