KFY

Business Context and Reporting Period

Korn/Ferry International filed its Form 10-Q for the quarterly period ended October 31, 2006. The Company is a global provider of talent management solutions, operating primarily through two segments: Executive Recruitment and Futurestep (middle-management and outsourced recruitment). The reporting period includes the impact of the acquisition of the Lominger Entities on August 8, 2006, and the adoption of SFAS No. 123(R) regarding stock-based compensation effective May 1, 2006.

Key Financial Metrics

Operating Margins: Operating income margin was 14% of fee revenue for both the three and six-month periods. Net income margin was 9% of fee revenue for both periods.

Material Changes vs. Prior Period

• Revenue Growth: Fee revenue increased 24% year-over-year for both the quarter and the six-month period. This was driven by a 14% increase in the number of engagements billed and higher average fees, alongside the contribution of the Lominger acquisition ($3.4 million in fee revenue for the quarter).
• Expense Increases: Compensation and benefits expenses rose 26% for the quarter and 30% for the six months. This increase was attributed to hiring new consultants (18% increase in headcount), performance increases, and the adoption of SFAS 123(R), which added approximately $1.4 million in stock-based compensation expense for the quarter.
• Profitability: Operating income increased 17% for the quarter and 13% for the six months. However, operating margins for Executive Recruitment declined slightly (from 22% to 20%) due to the new stock-based compensation accounting standard.
• Cash Flow: Net cash used in operating activities was $13.7 million for the six months ended October 31, 2006, an improvement from $21.1 million used in the prior year period. Investing activities consumed $33.7 million, primarily due to the $21.2 million cash paid for the Lominger acquisition.

Guidance, Outlook, and Risks

Management Commentary: Management's strategic focus for fiscal 2007 is on increasing market share and cross-selling multi-product strategies. The Company noted strong performance across all geographic regions, with North America showing the largest dollar increase in fee revenue. The acquisition of Lominger is expected to enhance leadership development solutions.

Capital Allocation: The Company repurchased $25.9 million of common stock during the six-month period under approved buyback programs. As of October 31, 2006, approximately $32.6 million remained available under the repurchase programs.

Risks and Contingencies:

• Accounting Changes: The adoption of SFAS 123(R) reduced reported net income and EPS compared to prior accounting methods (APB 25).
• Market Risks: The Company is exposed to foreign currency exchange fluctuations. A 15% strengthening of the U.S. dollar against major currencies would result in an estimated exchange loss of $1.6 million.
• Debt Obligations: The Company has $45.3 million in 7.5% Convertible Subordinated Notes and $11.4 million in Convertible Preferred Stock, mandatorily redeemable in June 2010 if outstanding.

Investor Verification Checklist

• Stock-Based Compensation Impact: Verify the specific impact of SFAS 123(R) on future quarters, as it significantly increased compensation expenses and reduced margins compared to the prior year.
• Acquisition Integration: Monitor the integration and revenue contribution of the Lominger Entities, which contributed $3.4 million in fee revenue in the first quarter post-acquisition.
• Headcount vs. Revenue: Assess the efficiency of the 18% increase in consultant headcount against the 24% revenue growth to ensure margin sustainability.
• Cash Position: Review the $201.3 million cash balance against the $25.9 million stock buyback and $21.2 million acquisition spend to evaluate liquidity for future growth or debt service.
• Convertible Securities: Note the mandatory redemption date of June 13, 2010, for the $56.7 million aggregate of convertible notes and preferred stock.