TWST: What were some of the key takeaways for your group from the first-quarter earnings season?

Mr. McHugh: Broadly, the results have stayed pretty solid, although there is a lot of variance underlying the numbers. Certainly, trends in Europe have negatively impacted those companies with significant exposure to Europe, and some of the very strong growth rates in Asia have slowed down. That being said, the results across the group were generally positive, particularly for those companies focused on the U.S.

When it comes to employment-related names, those companies focused on high-end, white-collar professionals and temporary staffing are performing the best. When it comes to the consulting side of the list, the project nature of the sector always does produce some short-term volatility, but the sector broadly appears to be doing fairly well. The strongest area continues to be health care consulting.

TWST: When you look at each of those three segments — consulting, employer services and staffing — which one are you most bullish on?

Mr. McHugh: We come at it from a bottom-up perspective, so I don't have a sector preference amongst those three. I would say I am thematically focused on higher-end, white-collar, U.S.-focused businesses within the staffing side of my list. But in terms of one sector versus the other, I don't have a strong preference.

TWST: There is much headline noise about the economy recovering, but jobs still aren't coming back to some degree. Are you seeing that reflected with these staffing and consulting companies? What impact are job trends having on those companies at this point?

Mr. McHugh: One reason why I like the higher-end portion of the staffing sector is that there hasn't been a lot of volatility in what is an underlying strong set of demand for those professionals. If you look, even in the most recent BLS data, the majority of the employment growth in the last several months has come from white-collar professionals and the temporary staffing industry. While those two areas account for a relatively small percentage of a labor market, they are accounting for the bulk of the employment growth right now. And the trends have remained pretty steady over the last six to 12 months.

The volatility and the weakness in the overall employment numbers has more to do with government hiring activity and weakness in other employment areas, such as construction, retailers and leisure employment. So consulting, IT workers and accounting professionals remain in good demand. I think that while GDP growth may not be extremely high right now, profit margins are extremely high for most corporations, so there are discretionary budgets for those sorts of higher-end professional services. Therefore, demand is pretty good and the supply of those workers is actually somewhat limited, so finding people at the right skill sets to fulfill that demand is needed by corporations.

TWST: You mentioned health care consulting being strong. Something that you hear a lot is, like you said, that profit margins are high and companies have the budgets, that there still is a reluctance to spend. Within your group, where are you seeing the spending?

Mr. McHugh: Corporations are spending on IT projects and IT workers. The fastest-growing part of the temporary staffing industry is IT staffing, reflective of that trend. Secondarily after that, you have little niches that are in strong demand.

The strong growth in health care consulting is not driven by the fact that profit margins are very good, but rather the inverse — that profit margins are challenged, and there is a fundamental transformation in the health care industry being driven by health care reform legislation, the aging demographics and pressure on the financial arrangements with insurance. Those factors are causing hospitals to fundamentally transform the way they operate, and that's leading to a lot of demand for consultancies who can help hospitals become more efficient, improve their revenue cycle or transform their business model.

TWST: In what other niches or pockets of growth do you see spending?

Mr. McHugh: So other than IT and health care, I would say certainly the oil and gas industry is very strong, helped in part by the price of oil and an aging work force. For example, Dice Holdings (DHX) owns Rigzone, which is the leading industry portal and recruitment site for the oil and gas sector. Job postings for that business are growing at annualized pace of approximately 75% during the last several months, which reflects well on the demand for those types of workers.

We've also seen very strong growth over the last several years for the electronic discovery sector, which is a niche within the legal sector. I think the growth in that sector is being driven by an increase in litigation and regulation combined with the fact that the amount of data in the world continues to proliferate. So every new investigation or a piece of litigation requires an increasingly large amount of discovery work, especially electronically. Companies such as FTI Consulting (FCN), Huron Consulting (HURN) and Epiq Systems (EPIQ) are positioned to benefit from that trend.

Another area of strong growth would be cybersecurity and data analytics. Scrutiny of those issues is driving a lot of spending, both by the federal government, as well as increasingly by commercial clients. That's helping drive growth for companies like Corporate Executive Board (EXBD), Booz Allen (BAH) and Towers Watson (TW).

And then lastly, I would add that within the energy industry, energy efficiency is a quickly growing area. ICF International (IFCI) is seeing 50% growth in their commercial consulting operations because of that trend. Navigant Consulting (NCI) also competes for that type of work.

TWST: When you spoke to us in March, you said you expected M&A to pick up. What activity have you seen or do you see expect to see in the short-to-mid term on that front?

Mr. McHugh: More broadly, what I think you see in the last year is large-cap M&A has been choppy. The environment generally seems right for a lot of M&A when you consider the low interest rate environment, the strong balance sheets of companies and the lack of significant organic growth opportunity for many companies. But with that being said, we're seeing fits and starts in terms of the amount of M&A by large companies. Counterbalancing that, you've seen a general pickup in middle-market M&A activity during the last year, and there are some signs that is accelerating.

This year, we may see a circumstance that is very similar to 2010, when a lot of their market M&A activity was accelerated in 2010 because of concerns that tax rates were going to change in 2011. That concern is more pronounced now than it was even back in 2010. So I think there is a variety of small- and medium-sized companies, especially those backed by private equity firms who also face substantial increase in the taxes on carried interest profit next year, that are increasingly thinking about exits during the second half of this year.

TWST: What do valuations look like for your group at the moment? And when you consider valuation in combination with your mid- to long-term outlook for the sector, is this a good time to buy these stocks?

Mr. McHugh: We have to break it down certainly in terms of the different sectors, because of the cyclicality of the staffing and employment services names. For the consulting names, on average, the valuations have improved slightly from the recession levels. In most cases, they are not yet back up to the levels enjoyed prior to the last recession, but they are modestly improved from their recession levels. On average, the consulting companies that I cover are trading at a midteens p/e, which is above the low-teens level that they experienced in the recession, but not quite back up to that high-teens level they enjoyed prior to the recession.

In terms of the employment services names, it's usually best to look at multiples of revenue because of the cyclicality in profit margins. The p/e for staffing companies still have a lot of variance, but on average those companies are trading at midteens p/e. Staffing companies with the professional U.S. focus are trading for closer to 20 times or high-teens multiple, whereas the blue-collar staffing companies and those with a significant exposure to Europe are trading a little less than that group average. So in terms of the attractiveness from a valuation standpoint, the consulting companies I would argue are fairly attractive.

Many of the consulting companies have depressed profit margins, and their multiples are still recovering coming out of the cycle. You usually want to buy consulting companies when their multiples and margins are depressed, and I think we're still in that situation.

As it relates to the staffing companies, the best relative performance of staffing companies usually occurs in the first two years of an economic recovery. You did see substantial relative outperformance from this group in 2009 and 2010. The weak market conditions in the second half of 2011 though wiped out a lot of that relative outperformance. So if you look on a longer-term basis, while you are certainly not buying staffing stocks at recession-level lows, it does appear the group has got a pretty good risk/reward tradeoff over the next year or two. So we do think it's a good time to be looking at some of those stocks. Again, our preference is more U.S.-focused, professionally focused names within that group.

TWST: Would you give us your top picks for each of the segments you cover?

Mr. McHugh: On the staffing side, the two names I like are Robert Half (RHI) and On Assignment (ASGN). Robert Half is a very high-quality company and has been so for many years. The company, as it had done in the past, is growing faster than the overall industry and continues to perform well at the top line. The fact that they focus on the U.S. also makes us feel a little more confident that their growth can be sustained.

What we think is misunderstood about the story somewhat is the opportunity for continued leverage in the profit margins. The company’s enterprise-value-to-revenue multiple is roughly 0.9 times right now, whereas on average from 2004 and 2006, the average revenue multiple was 1.4 times. The difference there primarily relates to the fact that at this time last cycle the company had much better leverage of SG&A expenses than they have experienced thus far this cycle.

If you look at the company's gross margins relative to the prior cycle, the company has had far better gross margin trends than really any other staffing company out there. If we exclude the impact of lower-than-normal conversion fees, which still have not yet recovered from the cyclical perspective, the company's gross margin is essentially back to the prior peak level. The gross margin is the hardest thing for a staffing company to recover, because it is very dependent on pricing and competition. But Robert Half has already gotten basically back to its peak levels — again, excluding the conversion fees.

What happened though is that the SG&A leverage has been less than we have historically seen. The reason for that is that the company has made a one-time stepup in the infrastructure cost for their IT staffing business because they see substantial room for growth in that business during the next few years. We think that investment has now been made and will not continue to grow. Therefore, we think incremental leverage of those SG&A expenses should normalize over the next year or two as revenue growth continues. Stated another way, given the strength in the company's gross margin, we think the company can recover back to the company's prior peak margin during the next few years, which should provide for a significant earnings growth. That's why we like Robert Half.

On Assignment, following a recent merger, is now the second-largest IT staffing company in the U.S. We talked earlier about the strong growth trends for U.S.-focused IT staffing companies. So the company is very well positioned because of that. They've also seen a stabilization or even improving trends in the health care and life sciences portions of the business. So we think the company is pretty well positioned from an end-market perspective and has executed very well.

In terms of the valuation, if you adjust for some tax yields that have been created by recent acquisition activity, the valuation looks very attractive in our view. If you adjust out for the fee tax yields that have been created and for intangible amortization that flows through the income statement, the p/e is close to 12 times right now, whereas the Robert Half trades for 19 times and the peer group average is closer to the midteens. So the valuation looks attractive, the end market trends are strong, and we think the company can probably beat the estimates that are out there. So we like On Assignment, as well.

In the employment services space, the name I would recommend is Dice Holdings. I think that stock is attractive for a couple of reasons. Two-thirds of revenue is driven by IT employment trends in the U.S., which we think are strong and will remain strong. Another 10% to 15% is driven by the hiring activity in oil and gas sector, which we also think is very strong. The remaining 25% is driven by financial services employment, which is challenged. But the comparisons for that business will get easier during the second half of 2012, and the sequential trends over the last four to five months do suggest bottoming out in that sector.

We also think the company has set a relatively conservative guidance, as it always has done in the past, particularly as it relates to profit margins. We thus see opportunity for solid growth, better-than-expected margins and for the multiple to gradually move up. Right now, the stock is trading at a 17 times p/e and a free cash flow yield of 9%. We normally think about p/e multiples 20 to 25 times for this name.

On the consulting side of the list, the two names we recommend will be Towers Watson and Huron Consulting. Huron Consulting is primarily focused on health care consulting and electronic discovery, both of which we think have good growth trends during the next few years. The company delivered disappointing first-quarter results because of the timing of contingent fees in its health care consulting operation, but the underlying trends as exemplified by very high utilization rates for the company suggests that demand is strong for the company services. And we think that the end-market demand environment in the hospital sector will keep that demand at a high level for a while.

So the stock has pulled back on what we view as from short-term volatility and the timing of revenue because of the lumpy nature of contingencies. But we see a very strong underlying demand market for health care and e-discovery services, and we like that management team a lot, so we think that's a good chance to buy that stock.

On Towers Watson, we think it's a great franchise. The company has a history of steadily exceeding estimates. It trades for only 12 times earnings, which is at the low end of their long-term average p/e of 12 to 17 times. We think the company can continue to deliver solid growth, modestly improve their margins and perhaps get that multiple to expand. One recent development is that the company announced over of the weekend they are purchasing Extended Health, which is the leading provider of health care exchanges for retirees in the U.S. Health care exchanges are a dynamic area that the company is now expanding into it. The acquired business will be a relatively small part of the business to start, but it's got some significant growth potential and very strong profit margins and cash flow characteristics. So that should add a little bit to the company's growth going forward.

TWST: Thank you. (MES)

Note: Opinions and recommendations are as of 05/14/12.

Timothy McHugh, CFA

Partner & Analyst

William Blair & Company, L.L.C.

222 W. Adams St.

Chicago, IL 60606

(312) 236-1600

(800) 621-0687 — TOLL FREE