Korn Ferry - 10-Q quarterly report FY

The number of shares outstanding of our common stock as of December 12, 2002 was 37,827,320.

The consolidated financial statements for the three and six months ended October 31, 2002 and 2001 include the accounts of Korn/Ferry International (“KFY”), all of its wholly and majority owned domestic and international subsidiaries (collectively, the “Company”). The consolidated financial statements are unaudited but include all adjustments, consisting of normal recurring accruals and any other adjustments, which management considers necessary for a fair presentation of the results for these periods. These financial statements have been prepared consistently with the accounting policies described in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2002 (“Annual Report”) and should be read together with the Annual Report.

In fiscal 2002, the Company determined that its investment in subsidiaries in Mexico should be accounted for using the equity method of accounting under accounting principles generally accepted in the United States (“GAAP”). Previously, the Company consolidated the accounts of its subsidiaries in Mexico, in which KFY believes it has effective control but owns less than 50% of the shareholder voting interest. While the Company believes that this presentation reflected the way in which these subsidiaries are managed and operate, the legal structure of these entities requires the use of the equity method of accounting under GAAP. This legal structure was established in 1977, which at that time, limited foreign investment. Accordingly, the accompanying consolidated financial statements for fiscal 2002 have been restated to comply with GAAP and reflect the operations of the Mexico subsidiaries under the equity method of accounting. The restatement to properly apply the equity method of accounting for the Mexico subsidiaries had no impact on net income, EPS or cash flow but did reduce previously reported revenue and expenses.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. As a result, actual results could differ from these estimates. The most significant areas that require management judgment are revenue recognition, deferred compensation and deferred income taxes.

Certain prior year amounts have been reclassified to conform with the current year presentation.

Effective as of May 1, 2002, the Company adopted Emerging Issues Task Force Issue No. 01-14 (“EITF No. 01-14”), “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred”. EITF No. 01-14 requires the classification of reimbursements received for “out-of-pocket” expenses as revenue and the related expenses incurred as expense on the statement of operations. Historically, the Company followed this practice for “out-of-pocket” expenses incurred by the Company and its consultants. Candidate “out-of-pocket” expenses, primarily travel, however, were netted in revenue as a reduction in the amounts billed to clients. The Company is the primary obligor and at risk for client reimbursement of the candidate “out-of-pocket” expenses and accordingly, prior period results reflect the reclassification of candidate “out-of-pocket” expenses previously netted in revenue to expense. Although revenue and expense increased as a result of the reclassification, there was no impact on operating profit, net income, EPS or cash flow.

Effective as of May 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. This statement replaces SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived assets to be Disposed Of”. The adoption of SFAS No. 144 did not have an impact on the Company’s financial statements for the three months and six months ended October 31, 2002.

In July 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. This statement requires that a liability for costs associated with an exit or disposal activity, including certain restructuring costs, be recognized and measured initially at fair value when the liability is incurred. Previously, these liabilities were recognized at the date an entity committed to a plan and measurement at fair value was not required. This statement is effective prospectively for exit and disposal activities initiated after December 31, 2002 with earlier application encouraged. The Company does not believe that the adoption of this statement will have a significant impact on the Company’s financial position or results of operations.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”. This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company does not believe that the adoption of this statement will have a significant impact on the Company’s financial position or results of operations.

Basic earnings (loss) per common share (“basic EPS”) was computed by dividing net loss attributed to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per common and common equivalent share (“diluted EPS”) reflects the potential dilution that would occur if the outstanding options or other contracts to issue common stock were exercised or converted and was computed by dividing the net loss attributed to common shareholders by the weighted average number of shares of common stock and dilutive common equivalent shares outstanding. Following is a reconciliation of the numerator (loss) and denominator (shares in thousands) used in the computation of basic and diluted EPS:

Assumed exercises or conversions have been excluded in computing the diluted earnings per share when there is a net loss for the period because their inclusion would reduce the loss per share or be anti-dilutive. If the assumed exercises or conversions had been used, the fully diluted shares outstanding for the three months and six months ended October 31, 2002 would have been 37,739 and 37,748, respectively.

Comprehensive income (loss) is comprised of net income (loss) and all changes to shareholders’ equity, except those changes resulting from investments by owners (changes in paid in capital) and distributions to owners (dividends).

Total comprehensive income (loss) is as follows:

Due to certain restructuring activities taken by the Company, as discussed in Note 4, the extended decline in the stock market and other factors, the Company believed that the loss in value related to certain equity securities was no longer temporary in nature and reclassified the loss of $2,962, net of a tax benefit of $2,145, included in other comprehensive income (loss) at April 30, 2001 to net income (loss) in the three months ended July 31, 2001 resulting in a pretax charge of $5,107. In addition, the Company recognized a holding loss on these securities of $1,157 arising in the three months ended July 31, 2001. The total pretax charge related to the recognized loss on this investment of $6,264 was included in the asset impairment charge for the three months ended July 31, 2001.

In the three months and six months ended October 31, 2002, the Company recognized unrealized holding losses related to this investment of $68 and $381, respectively, included in other income.

The accumulated other comprehensive loss of $11,723 at October 31, 2002 is comprised of foreign currency translation adjustments.

Based on deteriorating economic conditions encountered in the first quarter of fiscal 2002, the Company developed a series of business realignment initiatives announced in August 2001. The immediate goals of these initiatives were to reduce losses, preserve top employees and maintain high standards of client service. These initiatives resulted in a total charge against earnings in the first, second and fourth quarters of fiscal 2002 of $93.1 million. These charges reflect costs associated with a reduction in the work force of nearly 30%, or over 750 employees; consolidation of many of the back-office functions for Futurestep and Korn/Ferry; wind down of JobDirect operations and write-down of other related assets and goodwill.

In the first half of fiscal 2003, continued economic downturns contributed to the Company’s second quarter charge of $16.3 million and operating results include asset impairment and restructuring charges related to the following business segments in the second quarter of fiscal 2003:

The facilities restructuring charge in executive recruitment recognized in the three months ended October 31, 2002 of $7,972 relates primarily to lease termination costs, net of estimated sublease income, for excess space in eight executive recruitment offices due to the reduction in workforce and includes $1,042 related to unamortized leasehold improvements and $109 related to the write-off of facility related assets.

The facilities restructuring charge of $3,036 recognized in the three months ended October 31, 2002 relates to eight Futurestep offices that were closed as employees were co-located with executive recruitment in Europe and Asia/Pacific and includes $340 related to unamortized leasehold improvements and $689 related to the write-off of facility related assets.

The total restructuring charge for severance in the amount of $5,273 recognized in the three months ended October 31, 2002 includes severance for approximately 130 employees.

Operating results for the three months and six months ended October 31, 2001 include asset impairment and restructuring charges related to the following business segments:

The goodwill impairment charge recognized in the three and six months ended October 31, 2001 was based on an analysis of future undiscounted cash flows that indicated that goodwill was impaired. The charge represents the excess of the carrying value over fair value, based on a discounted cash flow method. The other asset impairment charge is primarily related to property and equipment and other investments. The restructuring charge for severance resulted from actions approved by senior management in response to a decline in revenue in the first half of fiscal 2002 that did not require board approval.

The facilities restructuring charge is comprised primarily of lease termination costs, net of estimated sublease income, for excess space and includes $2,013 related to the write-off of unamortized leasehold improvements for the three and six months ended October 31, 2001.

Included in accrued liabilities and other liabilities at October 31, 2002 is $3.6 million of severance costs and $16.4 million of facilities costs. The severance accrual includes amounts paid monthly and are expected to be paid in full by February 2004. The accrued liability for facilities costs primarily relates to lease payments, net of sublease income that will be paid over the next two to ten years. During the three months ended October 31, 2002, the Company paid $2.2 million of accrued severance costs and $1.7 million of accrued facilities costs. During the six months ended October 31, 2002, the company paid $3.7 million of accrued severance costs and $2.8 million of accrued facilities costs.

In June 2002, the Company issued 7.5% Convertible Subordinated Notes in an aggregate principal amount of $40.0 million, 10,000 shares of 7.5% Convertible Series A Preferred Stock at an aggregate purchase price of $10.0 million and warrants to purchase 272,727 shares of its Common Stock at an exercise price of $12.00. The warrants were recorded at fair value resulting in discounts on the Notes and Preferred Stock (together “the securities”) of $1.2 million and $0.3 million, respectively, that are amortized over the life of the securities.

The securities may be redeemed at the option of the purchasers after June 13, 2008, the sixth anniversary of the closing date, at a price equal to 101% of the issuance price plus all accrued interest and dividends. The securities are mandatorily redeemable if outstanding on June 13, 2010, at a price equal to 101% of the issuance price plus accrued interest and dividends. From the third to the sixth year, the securities are subject to optional redemption by the Company provided certain minimum price targets for our common stock are achieved.

Interest and dividends are payable semi-annually with 1% payable in cash and 6.5% payable in additional Notes and Preferred Stock for the first two year period from the date of issuance. Thereafter, interest and dividends are payable in either additional securities or cash at the option of the Company. The Company also incurred issuance costs of $4.3 million that have been deferred and will be amortized using the effective interest method over the life of securities as interest expense with respect to $3.4 million allocated to the Notes and as a charge against capital with respect to $0.9 million allocated to the Preferred Stock. The $0.9 million charge will be accreted to dividends over the life of the Preferred Stock.

The Company operates in two global business segments in the retained recruitment industry, executive recruitment and Futurestep. These segments are distinguished primarily by the method used to identify candidates and the candidates’ level of compensation. The executive recruitment business segment is managed by geographic regions. Futurestep’s worldwide operations are managed by an operating group comprised of a president of operations for North America and Asia and a president of operations for Europe. The regional leaders and this operating group report directly to the Chief Executive Officer of the Company.

A summary of the Company’s operations (excluding interest income and other income, and interest expense) by business segment follows:

In November 2002, the Company’s credit facility with Bank of America matured. The Company is currently considering replacing it.

We are the world’s leading recruitment firm with the broadest global presence in the recruitment industry. Our services include executive recruitment, middle-management recruitment (through Futurestep), strategic management assessment and executive coaching. Our clients are many of the world’s largest and most prestigious public and private companies, middle-market and emerging growth companies as well as government and not-for-profit organizations. As of April 30, 2002, over half of the executive recruitment searches we performed in fiscal 2002 were for board level, chief executive and other senior executive positions and our 3,908 clients included approximately 35% of the Fortune 500 companies. We have established strong client loyalty; more than 81% of the executive recruitment assignments we performed in fiscal 2002 were on behalf of clients for whom we had conducted multiple assignments over the last three fiscal years. As of October 31, 2002, we had 421 executive recruitment consultants and 75 Futurestep consultants based in 70 offices across 36 countries.

Based on deteriorating economic conditions in late fiscal 2001, we began developing a series of restructuring initiatives in the quarter ended July 31, 2001, to address our cost structure and to reposition the enterprise to gain market share and take full advantage of the eventual economic recovery. Our immediate goals were to reduce losses, preserve our top producers and maintain our high standards of client service. In August 2001, we announced these business realignment initiatives designed to reduce expenses in response to the current economic environment and to reposition our company to take advantage of the increase in the demand for recruitment services when the economy improves. In addition, we implemented additional business realignment initiatives in the fourth quarter of 2001 primarily to further downsize our operations in Europe and further streamline our Futurestep operations.

The total charge in fiscal 2002 related to these initiatives of $93.1 million resulted in charges against earnings in the first, second and fourth quarters of fiscal 2002 of $49.4 million, $34.8 million and $8.9 million, respectively. The charge reflects costs associated with a decision to reduce the workforce by approximately 30%, or over 750 employees; consolidate all back-office functions for Futurestep and Korn/Ferry; exit the college recruitment market and write-down related assets and goodwill.

In the first half of fiscal 2003, a continued decline in economic conditions contributed to the our fiscal second quarter charge of $16.3 million. Operating results include restructuring charges related to the following business segments in the second quarter of fiscal 2003:

In June 2002, we announced a change in our method of accounting for our ownership interests in our Mexico subsidiaries, which have been part of Korn/Ferry since 1977. Previously, based on our effective economic and management control of these subsidiaries, we had consolidated their operating results with a deduction for the other shareholders’ interest after tax. We now present our economic interests in the after tax operating results of the Mexico subsidiaries as a single line item, “equity in earnings of unconsolidated subsidiaries”, on our consolidated financial statements. This presentation reflects our less than 50% voting interest in the common stock of these entities. There was no impact on operating profit, net income, EPS or cash flow as a result of this change; however, revenue and expenses were reduced.

In November 2001, the Financial Accounting Standards Board (“FASB”) issued Topic No. D-13, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred” that requires presentation of reimbursements received for “out-of-pocket” expenses as revenue and the related expenses as expense in the statement of operations. This topic issued as Emerging Issues Task Force Issue No. 01-14 (EITF No. 01-14), is effective for reporting periods beginning after December 15, 2001 and requires prior period results to be reclassified to conform to the new presentation. We implemented this guidance effective May 1, 2002. Accordingly, prior year results reflect the reclassification of “out-of-pocket” expenses, primarily candidate travel expenses, previously reported as a reduction in revenue, to expense. There was no impact on operating profit, net income, EPS or cash flow as a result of the reclassification.

In the current quarter, we have presented our segment operating results to reflect our business segments without allocations of corporate overhead. This presentation represents how management internally evaluates the operating performance of our business segments and gives a more meaningful picture of our business units’ performance. Accordingly, prior year results have been reclassified to reflect segment operating results on the same basis.

The following discussion and analysis of our financial condition and operating results are based on our consolidated financial statements. Preparation of this Form 10-Q requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results may differ from those estimates and assumptions. In preparing our financial statements and accounting for the underlying transactions and balances, we apply our accounting policies as disclosed in our Notes to Consolidated Financial Statements. We consider the policies related to revenue recognition, deferred compensation and deferred income taxes as critical to an understanding of our financial statements because their application places the most significant demands on management’s judgment. Specific risks for these critical accounting policies are described in our Fiscal 2002 Annual Report on Form 10-K.

The following table summarizes the results of our operations for the three and six months ended October 31, 2002 and 2001 as a percentage of fee revenue:

The continued weakness in the global economy resulted in decreases in fee revenue in all of our business lines and geographic regions compared to the same period last year:

Executive recruitment fee revenue declined in all geographic regions in the three months ended October 31, 2002 compared to the same period last year. The decline is primarily due to the economic slowdowns in North America and Europe which contributed to a decline in executive recruitment fee revenue of $8.8 million, or 17%, in North America and $6.1 million, or 24%, in Europe as compared to the same period last year. Operating profit, excluding restructuring and asset impairment charges, decreased $2.4 million to $8.2 million in the current quarter as compared to $10.6 million in the same period last year. This decrease reflects a decrease in North America of $3.8 million to an operating profit of $7.7 million primarily due to the relatively smaller decrease in costs compared to fee revenue offset by an increase in Europe and Asia/Pacific of $1 million and $800,000, respectively, primarily attributable to the benefits of our fiscal 2002 cost savings initiatives.

Futurestep fee revenue declined $2.3 million, or 23%, in the three months ended October 31, 2002 as compared to the same period last year and reflects a decline in all geographic regions primarily attributed to the weakness in the global economy. As in executive recruitment, the lower cost structure resulting from our fiscal 2002 restructuring initiatives more than offset the decline in fee revenue resulting in a decrease in the operating loss of $2.2 million to $1.8 million for the current quarter.

The following tables summarize the results of our operations by business segment. The operating margin is calculated based on fee revenue.