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MHH > SEC Filings for MHH > Form 10-K on 22-Mar-2013All Recent SEC Filings

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Form 10-K for MASTECH HOLDINGS, INC.


22-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We are a domestic provider of IT and specialized healthcare staffing services to mostly large and medium-sized organizations. From July 1986 until our September 30, 2008 spin-off, we conducted our business as subsidiaries of iGATE. We do not sell, lease or otherwise market any computer software or hardware, and 100% of our revenues are derived from the sale of information technology and specialized healthcare staffing services.

On January 2, 2010, we acquired Curastat, Inc., an Arizona-based provider of specialized healthcare staffing services. This acquisition furthers our growth and service offering diversification strategies by providing an entry point into the specialized healthcare staffing space. Since the acquisition, we have expanded these operations geographically and added to our portfolio of service offerings. This acquisition is more fully discussed in Note 2, "Acquisition", to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.

On January 11, 2010, the Company sold its brokerage operations service offerings (operated under the name Global Financial Services of Nevada), as more fully discussed in Note 18, "Divestiture of our Brokerage Operations Service Offerings" to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.

Economic Trends and Outlook

Generally, our business outlook is highly correlated to 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 last 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. During 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 and 2012, activity levels have continued to trend up in most technologies and sales channels. As we enter 2013, we are encouraged by the recent strengthening of the domestic job market.

In addition to tracking general U.S. economic conditions, a large portion of our revenues are generated from a limited number of clients (see Item 1A, the Risk Factor entitled "Our revenues are highly concentrated and the loss of a significant client would adversely affect our business and revenues"). Accordingly, our trends and outlook are additionally impacted by the prospects and well-being of these specific clients. By way of illustration, during the second half of 2006, while general U.S. economic conditions were positive, we experienced a decline in billable headcount and negative sequential quarterly revenue growth due to client-specific conditions at two of our larger clients. This "account concentration" factor may result in our results of operations deviating 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 IT sales channel, many large users of IT staffing services are employing Managed Service Providers ("MSP") 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.

Recent Developments

On October 23, 2012, the Company's Board of Directors approved the extension of the Company's existing share repurchase program through December 22, 2014, and increased the number of shares subject to the program by 250,000 shares. This program was set to expire on December 22, 2012.


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On November 29, 2012, the Company announced the declaration of a special one-time cash dividend of $2.00 per share of common stock, payable on December 21, 2012. This $6.7 million dividend was funded by a combination of cash balances on hand and borrowings under the Company's credit facility with PNC Bank, N.A.

Results of Operations

Below is a tabular presentation of revenues and gross profit margins by sales channel for the periods discussed:

                    Revenues & Gross Margin by Sales Channel

                             (Amounts in millions)



                                               Years Ended December 31,
            Revenues                        2012         2011         2010
            Wholesale IT Channel           $  64.0      $  57.7      $  46.2
            Retail IT Channel                 26.5         22.3         19.6
            Specialized Healthcare            11.0          8.8          5.7
            Permanent Placements / Fees*       0.3          0.6          0.3

            Total Revenues                 $ 101.8      $  89.4      $  71.8

            Gross Margin
            Wholesale IT Channel              18.3 %       18.8 %       19.0 %
            Retail IT Channel                 19.5 %       20.4 %       20.9 %
            Specialized Healthcare            18.1 %       18.4 %       16.3 %
            Permanent Placements / Fees*     100.0 %      100.0 %      100.0 %

            Total Gross Margin %              18.9 %       19.6 %       19.6 %

* Permanent Placement / Fees are generated from clients within all three of our existing sales channels.

In order to minimize the impact of the industry trends mentioned above on our operating margins, the Company will need to continue to lower its operating cost structure as a percentage of revenues through innovation and greater efficiencies. Investments in our global recruitment centers, aimed at improving operational effectiveness, and costs rationalization efforts throughout our entire organization, are examples of past actions that have resulted in lower operating costs.

Below is a tabular presentation of operating expenses by sales, operations and general and administrative categories for the periods discussed:

Selling, General & Administrative ("S,G&A") Expense Details

(Amounts in millions)

                                                Years Ended December 31,
                                              2012           2011       2010
             Sales and Marketing            $     4.7       $  5.3     $  4.3
             Operations (HR & Recruiting)         5.6          4.9        3.9
             General & Administrative             5.4          5.5        4.8

             Total S,G&A Expenses           $    15.7       $ 15.7     $ 13.0


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2012 Compared to 2011

Revenues

Revenues for the year ended December 31, 2012 totaled $101.8 million, compared to $89.4 million for the year ended December 31, 2011. This 14% increase was due to higher demand for both the Company's IT and healthcare staffing services during 2012. Billable IT consultant headcount at December 31, 2012 totaled 632-consultants compared to 555-consultants one-year earlier. Billable hour increases in our therapy, per diem surgical nursing and travel nursing service offerings were responsible for the revenue growth in our healthcare staffing segment.

Revenues from our wholesale IT channel increased 11% in 2012 compared to 2011. Higher revenue levels from staffing clients (up 28%) were driven by strong demand for our IT services. Revenue from our integrator clients were largely flat in 2012, compared to 2011, as lower levels of ERP assignments in 2012 impacted our overall growth rate with these clients. Retail IT channel revenues increased by 19% in 2012 compared to a year earlier. Essentially all of this growth came from higher demand at many of our MSP clients. Revenues from direct end-user clients were impacted by the late 2011 closure of several under-performing branch operations. Healthcare staffing revenues totaled $11.0 million in 2012, and represented a 25% increase over the previous year. This improvement largely reflected growth in our core service offerings. Permanent placement / fee revenues declined in 2012 by approximately $300,000 from 2011. This decline was largely due to several branch closures in late 2011, which were areas of high permanent placement opportunities.

In 2012, we had three clients that represented more than 10% of total revenues (IBM = 11.8%; TEK Systems = 10.7%; and Kaiser Permanente = 10.5%). In 2011 we had two clients that represented more than 10% of revenues (IBM= 14.8% and TEK Systems 10.8%). Our top ten clients represented 54% of total revenues in 2012 compared to 57% of total revenues in 2011.

Gross Margin

Gross profit increased to $19.2 million in 2012 compared to $17.5 million in 2011. This improvement in gross profit was due to our revenue growth in 2012. Gross profit as a percentage of revenue was 18.9% in 2012 compared to 19.6% in 2011. The 70 basis point decline in gross margin reflected lower levels of permanent placement / fee revenues and various levels of margin compression in all three of our sales channels.

Wholesale IT channel gross margins decreased by 50 basis points in 2012 compared to 2011. This performance reflected a lower level of ERP assignments at integrator clients and lower margins at our staffing clients. In our retail IT channel, gross margins declined by 90 basis points from 2011 levels. This decline largely reflected a shift of revenues toward MSP clients and away from direct end-user clients. This shift in revenues was largely due to the closure of several under-performing branch operations in late 2011. Healthcare gross margins were 30 basis points lower in 2012 compared to 2011 and was related to the revenue mix of this segment's various service offerings.

Selling, General and Administrative ("S,G&A") Expenses

S,G&A expenses in 2012 totaled $15.7 million and represented 15.4% of revenues, compared to $15.7 million or 17.5% of revenues in 2011. Excluding severance expenses in 2012 and 2011 of $120,000 and $407,000, respectively, S,G&A expenses would have represented 15.3% of revenues in 2012 compared to 17.1% in 2011.

Below is a variance analysis by expense category related to S,G&A expense in 2012 compared to 2011:

Sales expense decreased by $0.6 million and reflected savings associated with the realignment of our sales leadership structure and the late 2011 closure of several branch operations.


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Recruiting expenses increased by $0.7 million due to staff increases of $0.3 million; higher commission and bonus expense of $0.1 million; and higher activity-base expenses of $0.4 million (H1-B processing fees, job board access fees and background check expenses); partially off-set by lower facility costs of $0.1 million, which reflects our new office lease arrangement in New Delhi, India.

General and administrative expenses decreased by $0.1 million. Higher severance expense in 2011 related to the elimination of several executive positions was responsible for $0.3 million of this decline. Bad debt expense in 2012 of $0.1 million, compared to a $0.1 million credit expense in 2011, was largely responsible for the balance of the variance in general and administrative expenses.

Other Income / (Expense) Components

In 2012, other income / (expense) consisted of net interest expense of $68,000 and foreign exchange gains of $36,000. In 2011, other income / (expense) consisted of $38,000 of net interest expense, foreign exchange losses of $26,000 and a $5,000 loss related to the closure of a joint venture. Higher net interest expense in 2012 was due to higher unused credit line fees on our expanded credit facility and higher amortization of loan origination costs incurred in August 2011. Net foreign exchange gains and losses in 2012 and 2011 reflect exchange rate variations between the Indian rupee and the U.S. dollar.

Income Tax Expense

Income tax expense for 2012 was $1.3 million and represented an effective tax rate on pre-tax income of 38.6% compared to $679,000 for 2011, which represented an effective tax rate on pre-tax income of 37.9%. The higher effective tax rate in 2012 was largely due to a higher aggregate state income tax rate.

2011 Compared to 2010

Revenues

Revenues for the year ended December 31, 2011 totaled $89.4 million, compared to $71.8 million for the year ended December 31, 2010. This 24% increase largely reflected higher demand for the Company's IT staffing services and the geographical expansion of our healthcare staffing business. Billable IT consultant headcount at December 31, 2011 increased by approximately 22% to 555-consultants, compared to 456-consultants at December 31, 2010.

Revenues from our wholesale IT channel increased by approximately 25% in 2011 compared to 2010. Higher revenue levels from both staffing clients (up 27%) and integrator clients (up 24%) were driven by stronger demand for IT services. Retail IT channel revenues increased by 14% in 2011 compared to a year earlier. Much of this increase came from higher demand at many of our MSP clients. Revenue increases from direct end-user clients were modest in 2011 and reflected the closure of several under-performing branch operations during the second half of the year. Healthcare staffing revenues totaled $8.8 million in 2011, a 54% increase over the previous year. This improvement reflected the geographic expansion in which we market our services, as well as entry into several new service offerings. Permanent placement / fee revenues increased to approximately $600,000 in 2011, from approximately $300,000 in 2010, due to higher demand.

IBM and TEK Systems represented 14.8% and 10.8% of 2011 revenues, respectively. During 2010, the same two clients represented 19.1% and 10.3% of total revenues, respectively. Our top ten clients represented approximately 57% of total revenues in both 2011 and 2010.

Gross Margin

Gross profit increased to $17.5 million in 2011 compared to $14.1 million in 2010. The improvement in gross profit largely tracked our revenue growth in 2011. Gross profit as a percentage of revenue was flat at 19.6% during 2011 when compared to a year earlier. Lower IT gross margins in both sales channels during 2011 were largely offset by higher permanent placement / fee revenues and gross margin expansion in our healthcare staffing business.


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Wholesale IT channel gross margins decreased by 20 basis points in 2011 compared to 2010. This performance reflected a lower level of ERP assignments at integrator clients and slightly lower margins at our staffing clients. In our retail IT channel, gross margins declined by 50 basis points from 2010 levels. This decline largely reflected a shift of revenues toward MSP clients and away from direct end-user clients. This shift in revenues was impacted by the closure of several under-performing branch operations during the year. Healthcare gross margins totaled 18.4% in 2011 compared to 16.3% in 2010. This improvement reflected a revenue shift towards the Company's higher valued service offerings.

Selling, General and Administrative ("S,G&A") Expenses

S,G&A expenses in 2011 totaled $15.7 million, or 17.5% of revenues, compared to $13.0 million or 18.1% of revenues in 2010. Excluding severance expenses included in 2011 of approximately $400,000, S,G&A expenses would have represented 17.1% of revenues. The increase in S,G&A expenses in 2011 was largely due to investments in our sales and recruitment organizations and higher variable expense components of our operating cost structure. These variable expenses tend to track revenue and profitability levels and include expense categories such as commissions, bonuses, H1-B processing fees, job board access fees and business travel.

Below is a variance analysis by expense category related to the $2.7 million increase in S,G&A expense in 2011 compared to 2010:

Sales expense increased by $1.0 million and reflected staff increases of $0.3 million; higher commission and bonus expense of $0.5 million; and $0.2 million in additional business travel and facility costs.

Recruiting expenses increased by $1.0 million due to staff increases of $0.5 million; higher commission and bonus expense of $0.2 million; higher H1-B processing and job board access fees of $0.2 million; and increases in business travel of approximately $0.1 million.

General and administrative expenses increased by $0.7 million. Severance expense related to the elimination of several executive positions was responsible for $0.4 million of this increase. Higher bonus and business travel expenses largely accounted for the balance of the increase in 2011.

Other Income / (Expense) Components

In 2011, other income / (expense) consisted of net interest expense of $38,000, foreign exchange losses of $26,000 and a $5,000 loss related to the closure of a joint venture. In 2010, other income / (expense) consisted of $22,000 of net interest expense and $4,000 in foreign exchange losses. Higher net interest expense in 2011 was due to higher unused credit line fees on our expanded credit facility and the amortization of loan origination costs incurred during 2011. The increase in foreign exchange losses reflected a significant weakening of the Indian rupee, relative to the U.S. dollar, during the fourth quarter of 2011.

Income Tax Expense

Income tax expense for 2011 was $679,000, representing an effective tax rate on pre-tax income of 37.9%, compared to $375,000 for 2010, which represented an effective tax rate on pre-tax income of 36.1%. The higher effective tax rate in 2011 was due to a higher aggregate state income tax rate, compared to 2010, and a favorable accrual adjustment in 2010, related to our 2009 federal income tax return.

Liquidity and Capital Resources

Financial Condition and Liquidity

At December 31, 2012, we had $2.0 million of outstanding debt, net of cash balances on hand, and approximately $12.5 million of borrowing capacity under our existing credit facility. This financial position


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reflects returning $9.2 million of capital to our shareholders during 2012 in the form of share repurchases ($2.5 million) and cash dividends ($6.7 million). The cash dividend was declared by our Board of Directors as a one-time special dividend and we do not anticipate adopting a recurring dividend program at this time.

Historically, we have funded our business needs with cash generated from operating activities. In the staffing services industry, investment in operating working capital levels (defined as current assets minus cash and cash equivalents and current liabilities, excluding short-term borrowings) is a significant use of cash. Controlling our operating working capital levels by closely managing our accounts receivable balance is an important element of cash preservation. Our accounts receivable "days sales outstanding" ("DSO's") measurement was 47 days at December 31, 2012 and 2011. We believe that effectively managing our DSO's has been an important factor in maximizing our cash flows in recent years.

Cash provided by operating activities, our cash and cash equivalents balances on hand at December 31, 2012 and current availability under our credit facility are expected to be adequate to fund our business needs over the next 12 months. Below is a tabular presentation of cash flow activities for the periods discussed:

                                            Years Ended December 31,
               Cash Flows Activities     2012          2011         2010
                                              (Amounts in millions)
               Operating activities    $    1.0       $   0.4      $   0.4
               Investing activities        (0.2 )        (0.3 )       (1.3 )
               Financing activities        (5.9 )        (0.7 )        0.1

Operating Activities

Cash provided by operating activities for the years ended December 31, 2012, 2011 and 2010 totaled $1.0 million, $0.4 million and $0.4 million, respectively. Factors contributing to cash flows during the 2012 period included net income of $2.1 million and non-cash charges of $0.7 million, offset by an increase in operating working capital of $1.8 million. In 2011, cash flows from operating activities included net income of $1.1 million and non-cash charges of $0.3 million, offset by an increase in operating working capital of $1.0 million. In 2010, cash flows from operating activities included net income of $0.7 million, non-cash charges of $0.5 million and an offsetting increase in operating working capital of $0.8 million. The increases in operating working capital during 2012, 2011 and 2010 were in support of higher activity levels and revenue expansion.

We would expect operating working capital levels to increase should revenue growth continue in 2013. Similar to previous years, such an increase would have a negative impact on cash generated from operating activities. We believe that DSO's are likely to remain in the 47 to 50-day range during 2013.

Investing Activities

Cash used in investing activities for the years ended December 31, 2012, 2011 and 2010 totaled approximately $0.2 million, $0.3 million and $1.3 million, respectively. In 2012 and 2011, capital expenditures and long-term facility lease deposits accounted for all uses of cash in investing activities. In 2010, the acquisition of Curastat, Inc. accounted for $1.1 million and capital expenditures and facility lease deposits approximated $0.2 million.

We believe that investments in capital expenditures and facility lease deposits should approximate $0.3 million in 2013.

Financing Activities

In 2012, cash used in financing activities totaled $5.9 million and included $6.7 million of dividend payments on common stock, $2.5 million of purchases under the Company's share repurchase program, partially offset by $2.6 million of borrowings under our revolving loan facility and $0.7 million of proceeds related to


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stock option exercises. In 2011, cash used in financing activities totaled $0.7 million and principally related to share repurchases and deferred financing costs incurred in connection with our amended credit facility with PNC Bank. In 2010, financing activities largely consisted of net proceeds from stock option exercises.

Contractual Obligations and Off-Balance Sheet Arrangements

We have financial commitments related to existing operating leases, primarily
for office space that we occupy, and borrowings under our existing credit
facility. Our commitments are as follows:



                                                       Payments due by period
                                                       (Amounts in thousands)
                                     Less than      1 - 3      3 - 5       More than
 Contractual obligations              1 year        years      years        5 years        Total
 Operating Leases                   $       766     $  774     $  102     $         0     $ 1,642
 Borrowings under credit facility         2,610          0          0               0       2,610

We do not have any off-balance sheet arrangements.

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, seek to ensure that billing rates 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 patterns. Accordingly, we typically have lower utilization rates and higher benefit costs during the fourth quarter.

Foreign Currency Exchange

The Company is exposed to foreign currency risks as a result of its Indian-based global recruitment centers. During 2012, the Company's expenditures in Indian rupees, in support of these operations, increased significantly due to staff expansion and a new office lease in New Delhi which is denominated in Indian rupees. To mitigate and manage the risk of fluctuations in foreign currency exchange rates, the Company entered into foreign currency forward contracts in 2012 as a hedge to such exposures.

Critical Accounting Policies

Certain accounting policies are particularly important to the portrayal of our financial position, results of operations and cash flows and require the application of significant judgment by management, and as a result, are subject to an inherent degree of uncertainty. In applying these policies, our management uses judgment to determine the appropriate assumptions to be used in the determination of certain estimates. These estimates are based on our historical experience, terms of existing contracts, observances of industry trends and other available information from outside sources, as appropriate. The following explains our most critical accounting policies. See the Notes to the Consolidated Financial Statements, contained in Item 8, of this annual report on Form 10-K for a complete description of our significant accounting policies.


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Revenue Recognition

The Company recognizes revenue on time-and-material contracts as services are performed and expenses are incurred. Time-and-material contracts typically bill at an agreed upon hourly rate, plus out-of-pocket expense reimbursement. Out-of-pocket expense reimbursement amounts vary by assignment, but on average represent approximately 2% to 3% of total revenues. Revenue is earned when the Company's consultants are working on projects. Revenue recognition is negatively impacted by holidays and consultant vacation and sick days.

In certain situations related to client direct hire assignments, where the Company's fee is contingent upon the hired resource's continued employment with the client, revenue recognition is deferred until such employment conditions are satisfied.

Accounts Receivable and Allowance for Uncollectible Accounts

The Company extends credit to clients based upon management's assessment of . . .

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