Citi Report: Third Quarter Results (Almost) All Good for Law Firms

There is an abundance of good news for the legal industry in the first nine months of 2014, whether compared with the first half of this year or with the first nine months of 2013. But the story is less about industry averages and more about the growing dispersion among the market segments we track, and even about dispersion within the segments. The Am Law 1-50 segment, particularly firms with strong transactional practices and more substantial global footprints, significantly outperformed the rest of the firms in our sample. So, at the nine-month mark, there are happy firms and worried firms.

Overall, demand momentum improved compared with the first half of 2014, which is impressive when you consider the strengthening demand dynamics in the third quarter of 2013. Though there was a slight slowing in revenue growth, while expense growth increased slightly compared with the first half, margin growth continued to be positive—a far cry from the margin compression most firms experienced in the years after 2008. The revenue slowing was largely a result of a lengthened collection cycle in the third quarter of 2014. Prospects for the full year appear bright when we consider the healthy growth in inventory (work that has been performed but not yet collected on) at the nine-month point. We’re sticking to our original 2014 forecast that the year will modestly exceed last year’s profit growth and that the Am Law 1-50 segment will outperform the other segments.

These results are based on a sample of 178 firms (79 Am Law 100 firms, 47 Second Hundred firms and 52 niche/boutique firms). Twenty-nine of these firms fit our definition of either “international” (less than 25 percent but more than 10 percent of lawyers based outside the United States), or “global” (at least 25 percent of lawyers based outside the United States). Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey. These reports, together with extensive discussions with law firm management conducted on an ongoing basis, provide a comprehensive overview of financial trends in the industry and insight into where it is headed.

Overall Results

Revenue was up 4.0 percent, down from 4.4 percent for the first half of the year. The slight decrease in revenue growth was due mostly to timing, as the collection cycle (how quickly cash is collected) lengthened by almost 1 percent.

There were encouraging developments regarding demand, the key revenue driver: gross demand (total hours worked by all timekeepers) and lawyer demand (total hours worked by all lawyers) were both up 1.6 percent. The good news is that we saw positive demand momentum for all segments, on average. The pickup in demand is notable in the face of a stronger third quarter of 2013. We attribute the positive demand dynamics to continued strength in the transactional area and continue to hear that litigation is soft.

Rate increases slowed slightly from the first half, but still came in at a robust 4.3 percent.

Lawyer productivity improved by 1 percent, as total attorney head count growth of 0.6 percent was less than the 1.6 percent increase in attorney hours logged. This is also the first time since 2011 that lawyer productivity increased through the first nine months of the year. But let’s be clear: Excess capacity still casts a long shadow over the landscape as average hours per lawyer of 1,651 (an annualized figure based on the first nine months of 2014) still lags the 2001-07 average of 1,723 hours by 72 hours.

Equity partner head count was up modestly at 0.4 percent, as firms continued to manage their number of equity partners very closely. As a result, attorney leverage increased by 0.2 percent.

Expenses rose 2.4 percent, up from 2.1 percent for the first half. The pickup in expense growth is attributable to an increase in overhead expenses (up 2.8 percent, compared with 2.3 percent for the first six months of 2014). The overhead increase, as we noted in last quarter’s article, is surprising in light of law firms’ focus on cost management and greater efficiency. Compensation expense remained steady at a 1.7 percent increase, despite some uptick in head count growth.

At the end of the second quarter, we reported that inventory was up 4.1 percent, the largest six-month increase since 2011. There was even better news at the end of the third quarter, as the inventory increase was 5.5 percent. This augurs well for full-year revenue growth.

Segment Analysis

In our articles on the first-quarter and first-half results, we indicated that a rising tide of positive economic indicators resulted in an increase in demand, but that not all segments or all firms within a segment were reaping the benefits. That continued to be the case during the nine-month period.

The Am Law 1-50’s growth rates outperformed the other segments in all the metrics that matter: revenue (4.8 percent), demand (2.4 percent), rates (4.9 percent) and productivity (1.7 percent). Equally impressive, the Am Law 1-50 improved its performance in demand despite the strong third quarter of 2013. This segment also posted a strong 6.5 percent increase in inventory (up from 4.8 percent at the for the first half), most of it unbilled time. This suggests full-year results will be strong.

The Am Law 51-100 saw a pickup in revenue growth, from 2.1 percent to 3.0 percent, but it still lagged the Am Law 1-50. Both demand and rate growth were positive, but in these areas too, the Am Law 51-100 firms also lagged their larger brethren. However, a solid 3.9 percent increase in inventory should bode reasonably well for fourth-quarter collections.

The brightest news for the Am Law Second Hundred was that demand went from -0.5 percent during the first half to a positive 0.5 percent for the nine months, while inventory increased by 4.6 percent for the nine months. That should help with fourth- quarter collections, which may push margin growth into positive territory (margins were flat through nine months).

Smaller firms lagged the other segments, with the lowest revenue growth (1.5 percent), shrinking profit margins (expenses up 2.6 percent, exceeding revenue growth), declining productivity (-0.3 percent) and only modest inventory growth (2.5 percent).

Looking at industry segments based on geographic reach, firms with the greatest international presence (those with more than 25 percent of their lawyers outside the U.S.) continued to outperform other segments. They had the highest growth in revenue (5.2 percent), demand (3.0 percent), rates (5.5 percent), productivity (2.8 percent) and inventory (7.0 percent).

It’s also important to look at what’s happening behind the averages for each segment, as we see very different results within each segment. If we were to measure profits per equity partner (PPEP) at the nine-month mark, we would see that 74 percent of Am Law 1-50 firms saw PPEP growth, while only 59 percent of firms in the Am Law 51-100 and Am Law Second Hundred did. For firms outside the Am Law 200, the contrast was even starker: Fifty-one percent of those firms saw a PPEP decline. We believe that this dispersion within industry segments is likely to continue.

As we enter 2014’s home stretch, law firms will have to navigate two high hurdles: the strong fourth quarter of 2013, which will be difficult to match, and the recent volatility in the equity markets, which may dampen M&A activity at year-end. Nonetheless, we are still projecting mid-single-digit growth for the industry as a whole, and we continue to believe that the Am Law 1-50 firms will significantly outperform the other industry segments. Partners at some of these firms will be cheering, while those at other firms will be shedding tears, as profit stratification will likely increase.