Exponent, Inc. (EXPO) Earnings Call Transcript & Summary

All right. Good afternoon. I'm Josh Chan, business services analyst here at UBS. Our next presentation is from Exponent. They are a $5 billion market cap provider of scientific consulting services. Exponent advisers businesses on accident failures and new product development and other complex topics. With us from the company today are Dr. Catherine Corrigan, CEO; and Rich Schlenker, CFO. I think Catherine will give a brief overview of the company to kind of level set us, and then we can go into fireside chat. If anybody has any questions, feel free to send them into the iPad here, and I'll pass them along as well. So with that, I will turn it to Catherine.

Yes. Thank you, Josh, and thanks, everybody, for taking the time. As Josh said, we are premium engineering and scientific consulting organization. What we do is really help clients with some of their most pressing problems related to their products and their processes throughout the product life cycle. We serve clients across a wide variety of industries from consumer products to transportation, utilities, oil and gas, chemicals, life sciences, and others. The theme that really unites the work that we do is that it is driven by concerns around safety, around health and around the environment and also it's really driven quite a bit by innovation. The complexities around product development and regulatory frameworks all the way to litigation and product recalls are some of the things that really drive the marketplace for our services. We're a global organization. We are probably about 85% or 90% of the business is domestic, but we're also in the U.K. and Europe as well as in Asia. We operate out of about 30 offices around the United States. We've got about 1,000 consultants. Most of those consultants have PhDs or doctorates in their field of study. So we like to think of our services as academic depth at the speed of commerce in a lot of ways. And so -- that's just a very high-level intro that we can dive into whatever folks are interested in learning more about.

Yes, that sounds great. So I guess given just the breadth of the business, how would you -- what would you consider to be your addressable market? Is the growth primarily comprised of convincing customers to hire you as opposed to doing it internally? How do you think about marketing growth?

Yes. I think it's good to give a little background about how we think about our services. And one way that we classify them is that we've got reactive services and we've got proactive services. And historically, Exponent actually started as a company called Failure Analysis Associates, 55 years ago. There were a handful of Stanford faculty and researchers, who saw an opportunity to do failure analysis work in engineering, and that expanded over time. We got into the health and environmental consulting business a few decades later. And then as the portfolio has grown today, about half the business is still that reactive component. And the other half is what we call our proactive business. So this is regulatory consulting. This is product development-related consulting. It's risk-related consulting. But we think about growth being driven by -- across the business by the fact that society is constantly increasing its expectations around safety and around health and the environment. When you have an automated vehicle, that makes a decision and gets into a crash and creates an injury. There is a much higher expectation of the safety level of that vehicle than there is of a human driver, right? So as technology gets more complex, the safety critical technologies become areas that are critically important to the reputation of our clients and also are being watched very, very heavily by the regulators. So when we think about the marketplace for our services, those are the things that drive it, right? It's an industry in transformation. I think automotive, I think it's safety critical. It's -- highly complicated and it has a fast innovation cycle. These are the kinds of things that drive that market. But the market is constantly changing. So trying to put a -- what's the addressable market is a tough question to put a number on. But it's really about the fact, if you believe that society is increasing its expectations around safety and health and all of those things. And if you think the complexity is growing, which clearly it is, if you think about artificial intelligence, now making the decisions, it provides just a host of opportunities for us to continue to evolve our services and serve our clients.

Sure. Sure. So I guess, how does Exponent stack up against others who could provide maybe a similar type of service? How much does the Exponent umbrella bring in business just by itself?

Yes, yes. Well, a lot of the -- on the reactive side of our business, our experts are really well known in that client community. A lot of that client community is legal. It's industries outside counsel or it can be the in-house counsel for those entities. And our people are giving toxic conferences, they're active in their technical communities and professional organizations. They're acted in standards making organizations. And so they are -- it's their job to become famous and be sought out by clients for their most urgent sort of technical challenges. And so it's very rare for us to win work based on a traditional process of an RFP being sent out and us sort of competing with a number of other entities that look like us. It doesn't happen that way. The work is one based on our relationships and our activity in those technical communities. And yes -- and so that at least gives a little bit of a flavor for how the work comes in.

Sure. Okay. So you've mentioned that the business benefits from increasing complexity, which is hard to quantify. I guess you have to decide how many people to hire in the next year. So how do you go about doing that while it being kind of difficult to kind of quantify how your business could grow?

Yes, yes. Well, we have a very detailed planning process that we go through on an annual basis with all of our business units. So we organize ourselves internally by technical discipline. We have 17 of those that we group. So it's our mechanical engineers, our environmental scientists, our polymer scientists. And each one of those business units is looking out at the marketplace at what is coming around the corner for our clients? What are the challenges that they're going to be meeting? What are the new regulatory requirements? What are the product development issues? And there we're having to make some forecasts about what that's going to look like in each one of those business units puts together a hiring plan that is very strategic. It's not just, oh, we need to hire 200 people across the business. It's we need them very specifically to have certain credentials in certain niches where we anticipate a lot of activity. A great example right now is around batteries and vehicle electrification. This is a big opportunity for Exponent. We're already working in this area. It's complicated, safety critical, heavily regulated, right? It checks all of the boxes. So we have a very robust hiring plan around folks who have done their PhDs in battery technology, whether that's material scientists, chemists, mechanical engineers, thermal scientists, right? So it's a very strategic kind of discipline by discipline, market-by-market assessment that we're making in order to develop those hiring plans.

Sure. It sounds like it's like a roll-up of what people see on the ground and in the industries that they serve.

Well, our consultants are the sales force, right? So they are out constantly engaging with that client base, engaging at those conferences, looking for those new clients and they're in conversation with them around what are you seeing, what are the challenges that you're facing, what's coming around the bend. And this gets back to why the relationships are so important. We've got to be able to kind of have that advanced intelligence around what we think the client community is going to need.

Okay. Are the consultants forecast usually right? Or do you like haircut it? Or do you add more? Or how do you use?

I think Rich would be great to answer that one.

Yes. Look, we are sitting back in with our officers is sort of even in the middle of the year, really looking out over a 3- to 5-year period of time and really where they see the market going, where the drivers are because this is all about staying ahead of the curve, evolving with the technology that we've got coming through. So we've got to start with that basis of seeing where this is traveling, where are we going in EV, where are we going in medical devices and life sciences, where are we going in wearable technologies and sensors, all of that driving to coming back to sitting down with these practices or disciplined areas and looking at it. I would say they are optimistic about the things, which is great. We want optimism. We want people looking out at the market. We know the probability of execution on their part usually fits in to that. And you balance it by how much you're pushing on that if the market is that big, that why aren't we moving faster to get that hiring and we're not only doing that at planning time in the fourth quarter of the year. We're doing it through the year. This is -- energy storage is huge. Why aren't we making more progress? What are the barriers that you're running into is that the way we're going to market in our recruiting. Is it compensation? Is it what do we need to do to attract that talent? But at the same time, you are also looking at other areas where maybe your utilization is a little bit lower. And you're asking those questions about where do we need to be on that right balance of talent is the inflow of business has something changed? Or is it developing a little bit slower from the business development standpoint? And that clearly is a tone that is -- we need to make sure we're a little bit more conservative on where we are on the hiring and staff management and things. So it's all -- it's not -- we're not turning on a dime here. We're really driving the ship to the right -- on the right course over the long term.

Okay. Yes. That makes sense. So what is kind of the constraint on growth, if you will? So could you theoretically grow faster just by hiring more people? Or what does the market afford you that? How do you think about how fast to grow?

Yes, yes. Well, the way we think about growth going forward really is a -- it's a pretty simple algorithm, right? If you're increasing headcount on a net basis, maybe 4%, 5% to 8% or 9% annually, something in that range, we're at the higher end of that range, even a little ahead of it in Q1. And then, in pricing, this year, I think we've guided to realize about 4.5% to 5.5% in pricing, that's higher than usual. Normally more in the, say, 2%, 3%, 4% range. And then you can also gain maybe another 0.5 point a year in improving utilization. When you stack all of those up, you're in a high single to low double-digit growth of the top line on average over time. And that affords us the ability to have our consultants doing the work that brings in the billable hours, but also all of the other things that they're doing to invest in the future of the business. So the hiring of the teams, the mentoring of the staff, we have a very development-oriented culture. When we bring in a consultant at the junior level, the expectation is that they're going to become a principle in our company eventually. Now they don't all get there, right? Many of them will peel off kind of at that mid-level, maybe they realize the sales part of consulting isn't for them. We try to filter for those characteristics that would make them that way, but they might go into industry, they might go into a potential client organization. So it's not the worst thing. But very development oriented, and they need to be doing that recruiting, they need to be out at those conferences, right? And so we're able to -- in that high single to low double-digit growth range, and looking at utilizations that can rise from low 70s now up into that mid-70s over time provides the right kind of balance for that organic growth model. In theory, can you being hire at 20% a year. And the challenge is can you then build the relationships fast enough to grow the business? So you have to kind of calibrate those at the right level. I can't just turn my recruiting dial, and my business development dial and have them instantaneously adjust to that higher level because you're doing all that with the same bunch of people.

Right. So this is high single and low double-digit range what you feel is a sustainable pace kind of going forward?

Yes. And can you surge from that? Well, some years be a little less than that. But on average, over time, that's really the way we think about it.

Okay. All right. Could you talk about what could happen in a recessionary type of scenario? I mean, I don't suppose litigations are very economic sensitive, but product development might be. So just kind of talk through what factors you might encounter?

Yes. I mean it might be helpful to get a little historical perspective from past recessions, like '08, '09 time frame. Rich, do you want to talk through that?

Sure. So I think what we've seen over time in the early 2000s, then into 2008, '09 was we saw ourselves have double-digit growth in 7 and 8. That -- but still had flat revenues in 2009. That included 2 good clients of ours, GM and Chrysler going bankrupt in 2009. So without that, we probably would have been in the low single-digit growth, mid low to mid-single-digit growth had that not occurred. But it gives you a sense of in that environment, what we ended up seeing is on the reactor side, so the litigation work that was ongoing. Clients -- plaintiffs' bar is still an active entity. Litigations are being filed. Activities are continuing on. But clients do manage a budget a little bit tighter and tighten up the belt, but they need to continue that process. No one is letting them off the hook in that environment. On the proactive side, what we saw happen was our regulatory consultants -- consulting continued at a pretty steady pace, but it varied by client. Certain clients pulled back in-house and really tried to do as much as they could in their registering their chemical or their medical device or such with their regulatory consulting team. And others actually with hiring freezes on and early retirement programs ended up happen to reach out and use more outside resources. So net-net, we saw that continue to grow in 9, 10 and 11 on through there. When we looked at our product development support work that we were doing, again, our clients tightened their belt, but they were still innovating. The consumer electronics firms were still needed to innovate and bring out a new product each year during that time frame. The medical device firms were not going to back up with an aging population in their evolution of their products that they were bringing to market. So those areas, we continue to see a little bit tighter revenues, but continuing the majority of the revenues moving forward.

And that seems to be the -- look, today, we're in a sort of uncertain environment. And we've -- it's very much like Rich was saying, a client-by-client sort of activity. The litigation and failure analysis business is as robust as ever, continuing to grow. That's both domestic as well as international disputes. In fact, on the international front, there's a significant growth opportunity, we believe, for us in disputes. The legal frameworks are evolving in the EU. The IT litigation is increasing. It's highly complex. It checks a number of those boxes. And we're seeing, for example, a client that is experiencing a lot of layoffs right now. They may say, "Okay, look, we've got to reconfigure our team, we're going to come back to you next quarter with that work that we thought we were going to do this quarter." So it's not a scenario of, hey, we're canceling that program as much as it is, hey, we're we've got to wait a quarter or 2, get ourselves reorganized and we're going to come back and do it because, look, we've made a strategic decision as a company to be going after the kind of work that has got to have it, not nice to have it, right? And that, I think, supports the fact that we've been not immune from economic cycles by any stretch, but I think we tend to do fairly well in comparison during those kinds of times.

Sure. Yes, yes, you definitely do. I do have a question from the audience. What is -- from your revenue exposure, what end industry and what geographies are your main exposure?

Yes, yes. Do you want to hop on that?

Yes. So in -- the consumer products area is an area that we have about 25% of our business with a significant amount of that coming from the consumer electronics industry. So this evolution, a good -- a big part of that balance being on the more proactive side. So helping clients in the product development cycle that they're going through. The broader chemicals industry, both in the agricultural chemicals, industrial chemicals and others is a mid-teens percentage of our business, a balance there of reactive and proactive work. So there's lots of questions about the exposure people have had the chemicals and litigation and health and environmental issues related to that, but there's a lot in the regulatory environment, both here in the U.S. as well as in Europe as well as around the world that we support clients in doing the appropriate health and environmental studies and go through the regulatory process on that. In the 10% to 12% range, we've got what we do in transportation, which is mainly in the automotive area. Historically been dominated by reactive work for us and moving into the more proactive areas, those clients move into EV and automated vehicles, and the development cycles are getting shortened significantly by the disruptors that have joined that industry that's big. Utilities or energy overall fits in that 10% to 12%, with the largest part being in the energy in the utility sector and about 4% of our business overall being in oil and gas. We also do about 10% of our business in the life sciences arena.

Great. Thanks for the color there.

Yes, you had asked about geography as well on that. So probably between 85% and 90% of the revenue is coming from our domestic operations in the U.S. There are about 25 offices we have around the country. And then our U.K. and EU operation, a lot of that is in this chemical regulatory area. So we're quite well known over there for that. We've also got that in the U.S. We're building our presence around engineering in Europe. That is something that we see as a significant growth opportunity, both in the litigation and sort of recall areas as well as around proactive work, things like electrification and batteries, both in consumer products as well as in the transportation industry there. And then our operations in Asia are probably 3% of the business something like that. Those folks are working primarily for U.S. clients who are manufacturing over in Asia. So a lot of that is driven by consumer electronics.

Yes. That's good color. So on your bill rates, I guess, pre-COVID, it usually goes up in like the low single-digit type range and it's been higher now. So what's the expectation on bill rates going forward?

Yes. I think we're -- everything will depend on where the economy goes and such. But even if you look back historical regardless of that, our bill rate realized rate increase is somewhere in the 2% to 4% range. The -- our existing staff come January 1, the rate increases we realized on those employees, it tends to be in the 6% to 7% range on average normally. It's that we have turnover in the middle and we hire in at the associate level that, that blended realized rate ends up in the 3% range. It should be noted that our pricing the way that we go about that is we set an individual bill rate for each individual in our company based on their technical area, their experience in the industry and clients that they're serving. And we look at that marketplace. We set that specific rate come January 1, and they billed all clients at the same rate regardless of it what industry it's for, if it's a new client or a very old client or on a very large job or a small job, there is a consistent rate each individual charges. So that's nonnegotiable for us. We will work with clients around the scope of the work and the deliverables. But -- and what the mix of the team can be for them, but we won't discount the rates.

Do you get -- do you have a sense on what the elasticity of demand may be relative to your rate? So for example, if you were to take a more aggressive stance on pricing, what kind of impact would that have on the demand.

Yes. I mean, well, we very intentionally look to position ourselves to win the most challenging and complex work that is the most urgent for the client, right? We are intentionally at that sort of premium service level and so -- where I like to have them is where they're feeling a little bit of pain on the price, but they're also saying how much they love us. And so they're really getting the value. With us, it's about making that conversation, not about rates, but about the value that we're going to be able to deliver in the way that they're going to be able to make the decisions that they need to make in their business. Once we've given them this foundation, whether that's a decision to settle a litigation or to defend themselves all the way to the mat, whether that's on a regulatory type of challenge, whether they're going to be able to get that product through the framework or not, these are really big, important decisions. And so I hope that we're kind of right at that point where we want to be. There are always going to be some areas that are -- we're trying not to be competing on price, but there are certainly areas where clients are going to be concerned about that, right? We don't get a blank check for what we do. And so that's part of this process that we go through each year in engaging with our business units and understanding what's the feedback you're getting from your clients? What is the -- what are the competitor firms charging for this? And how do we position ourselves there? And so -- but we -- if we think we have an ability to raise prices for a particular individual, we might go up 25% in 1 year because that person is just on this hockey stick part of their growth curve, and there's such a demand for that individual that we will go ahead and we will drive that to where we think makes sense.

Okay. The clients are paying you good money, but you're also solving a big problem for them. So it's okay.

That's what we're aiming for. Yes, yes, I mean, look, we could be a much larger entity with higher revenues, but much lower margins if we decided to go after a more commodity level of work, whether that's regulatory, whether that's more insurance-related litigation as opposed to product liability litigation. There's a big market of kind of lower-level consulting in these arenas. But from a strategic standpoint, we are looking to -- we like the margin profile of the business. We think our shareholders like that as well. And it also allows us to hire the best and the brightest. These are people who want to come in, they want to make a career solving really, really hard challenges. They've just come out of MIT or Stanford or Caltech or Michigan or Berkeley. And they've gotten their PhD and they want to use that doing some really impactful work, right? And so the whole value proposition is about doing the kinds of things that nobody else can do.

Yes. This kind of does my next question. You mentioned the consultants. So could you talk a little bit about how the consultants are compensated? What kind of structures common?

Yes. Do you want to start that off?

Yes. So each employee consultant in our firm is that almost all of them are full-time employees. That's very important. This isn't a Rolodex model or a set of professors that work part time for us. This is their full-time job. We've hired most of them as an associate to grow up to be principal or partner if we were in a private firm, that's what we are established. So they all have base salaries to be competitive in the marketplace, especially on drawing them in. And then we have a bonus pool for the entire company that is 1/3 of pretax pre-bonus profit. So we take 1/3 of that. That creates the bonus pool in the firm for everybody from the receptionist through the CEO. It's been this way for 20-plus years. It's been that same percentage. So we've been able to make that work for shareholders and for the employees. We distribute our bonuses based on merit. So very much on that annual year's performance and what we do. We evaluate our people on multidimensions, not only their financial metrics, which are very important, but professional growth and leadership and teaming and things of that type as well. For our principles, which is about 180 of our employees, they receive their bonus in a split between cash and restricted stock units. So we take the top quartile of our principles, and we pay them 60% of their bonus in cash and 40% in RSUs. The first grant of RSUs, that RSU grant is actually vested but not deliverable for 4 years. So they are an owner of the firm for 4 years. We actually then match that with a matching grant that is another 40%. That is -- comes -- isn't out of our bonus pool. That's out of our sort of equity pool. And as such, that cliff vest 4 years out. So not ratably a clip vest 4 years out. So then we take our next quartile of principles. They're in a program of 70 30 30 and the remaining half of our principal during a program of 80 20 20. So every one of our principles is aligned on ownership because the grants are clipped vest and aren't deliverable for 4 years. It's an integration of their last 4 years' performance that creates what is in the RSU program and hold. So they have a long-term interest in the firm's performance, the stock's performance and it creates some retention for those people as well. So that's how we run that overall program.

And I think it's important to highlight as well that for particularly that top layer of high-performing principles, I mean the scale of the bonus part of their compensation is considerable, right, as a percentage. So it's not unusual for a bonus to be equivalent to their base salary, and then they're going to get another 40% sort of on top of that. So it can become a significant ownership stake and it scales with the really high performers.

Yes. Thanks for the color there. Maybe shifting to some of the nearer-term topics. I guess could you talk about utilization and how long it takes usually for utilization to get back to where you like it to be compared to maybe where we were in Q1?

Yes. I -- look, I think that we've guided that our utilization this year will be between 70% and 72%. Over the last 12 years, that utilization is ranged between 70% and 75%. It was up at that peak -- at the high end of that range there in 2021 when sort of we had been controlled headcount growth during the early part of the pandemic. And really then business came back in strong and utilization popped up. That came down a little bit in '22. It's coming down a little further here in '21. I would view that it will be a gradual growth on up from that. I think that where we've guided is that we expect that our margins will be 28% to 28.5% here in that utilization range. That margin is higher than where we were in 2019. We were at 27.4% then. And I think it's creating a good base for us to be able to from outside of 2023 to see an improvement in our margins, while we're growing the organization in that high single to low double-digit top line growth, we can get a little bit higher growth on average out of the bottom line.

Okay. So I guess reading between the lines, it does sound like that 2023 might be a temporary kind of margin bottom and maybe it can kind of improve from there, assuming you get the utilization improvement that you target.

Yes, that's correct.

Yes, I mean the utilization is by far the strongest driver of that -- of the bottom line

Okay. All right. And then, I guess, longer term, how do you think about margin improvement cadence? How much can margins improve each year?

Yes. So I would expect that a 1% improvement in utilization will deliver about 50 basis point improvement in EBITDA margin as a percentage of our net revenues. We -- if we're gradually improving that utilization, maybe 0.5% a year on average, you're going to get 25 basis points out of that, and you might get a little bit of leverage, 10 to 20 basis points out of leveraging G&A and other ops that allows you on average improved margin sort of 30 to 50 basis points as you look out over a 5-year period of time, let's say, from 2024 on.

Great. Maybe kind of bigger picture again. Any new practice areas that Exponent is not in now that you would find would be interesting in the coming years? So -- and if you were to kind of expand into those, does it -- is it mostly organic type of expansion that you expect?

Yes. Well, one area that's great to highlight there is the pharmaceutical arena. This is an area that's been less than 1% of our revenue over the course of time, and that work has been more on the sort of engineering and manufacturing side. But we see a great deal of opportunity in this industry as it is transforming. I mean you think about going from a volume-based to a value-based business, the companies in that industry are looking to find novel data sources to demonstrate the value of their therapies. They're looking at using sensors and electronics to better understand the patient journey. At the same time, we've got the electronics industry moving more towards medical device with all of their new innovation. And so it's a natural fit for us to be able to sort of be that independent third party, bring that technology over into the life sciences arena. We've got lots of use cases. We did them -- it's publicly known, we've done a significant amount of work with the Department of Defense, Army and Navy deploying wearables during COVID, so that they could understand the readiness and the health implications for the armed forces. We were doing contact tracing using electronic wearables, proximity monitoring, physiologic monitoring. We developed all of the data architecture and the privacy issues and the data management for that. So we're very well positioned and think that pharma in the next 5 to 10 years, it shouldn't be 1% of our revenue. Maybe it's 10% of our revenues even as the rest of the company keeps growing. So I think that's a great example. We see Europe as an opportunity. We're well established there on the chemical regulatory side, but not as much on the engineering side. And so that's a place where right now, we're growing at brick by brick. But if there were an opportunity to seed it with a tuck-in acquisition, it's certainly something that we would consider. We can accelerate that growth path, at least in theory. In practice, acquisitions in professional services can be challenging. There can be situations where we'll look at an opportunity, but there's a piece of it that's really more low end in commodity, and we kind of struggle to think about the way to integrate that and do we really want that. We struggle with founders who are looking for their exit strategy, but bear the connection to the market. And so the folks that are going to be left aren't going to be able to bring the value. So it's challenging, but I think we certainly could accelerate growth through that kind of mechanism.

Okay. And maybe I'll ask you one question, Catherine. So if in 5 years, you look back and you've done a good job, what would have happened to Exponent between now and then?

Yes. It's funny because I just crossed my first 5-year milestones. You're now asking me for the next 5-year milestone as CEO, although I've been with the company in my whole career. I think it's about executing on the promise of the opportunity that we have because, I believe, the opportunity is very large. We're very intentional and methodical about how we grow it and how we do it. We're very intentional about being high end in our services, which again allows us to bring in incredible talent. But I want the business to deliver for all those stakeholders. I want our employees to be incredibly engaged and excited about what they're doing and who they're doing it with. I want to be able to say that we've grown the work that we're doing and the value that we're delivering to clients across industries. And I want to see that we've delivered value for our stakeholders, right? But I mean, I think the promise is there, and it's my job to make sure that the company is executing on that promise.

Great. That's a good note to end on. And with that, please join me in thanking Catherine and Rich for being here, and we're -- you guys are here.

Great.

Thank you.

Thanks, Josh. Thanks, everybody.

Thank you.