Based on our read of the results for the first half of 2012, we’re now concerned that this year the legal industry may be unable to match 2011′s low single-digit profit growth. There are three reasons for our concern: demand growth slowed during the second quarter from an already tepid first-quarter level; inventory as of June 30 had grown little from the prior year, not a good omen for future collections; and signs that realization will decline again in 2012, squeezing profit margins even further.

Though revenue growth gained momentum and expense growth slowed during the second quarter, expenses still continued to grow at a faster pace than revenue. Head count growth slowed during the second quarter, but it was not enough to counter the impact of slowed demand growth. As a result, productivity declines accelerated, driving billable hours down even further than the historically low numbers we’ve seen postrecession.

Revenue growth of 2.7 percent was an improvement on the first quarter, driven by a moderate increase in rates and a shortening of the collection cycle, as firms focused on converting accounts receivable and unbilled time into cash. This was the opposite of what we saw during the first half of 2011, when the collection cycle had actually lengthened. The most notable acceleration in revenue growth during the second quarter occurred among the Second Hundred, and to a more modest extent, Am Law 1–50 firms. Demand growth was less of a driver of revenue growth, with disappointing results for all segments. Across the industry, demand grew just 0.3 percent during the first half, a considerable slowdown from the 1.5 percent growth we reported for the first quarter.

The Am Law 1–50 and non–Am Law 200 firms saw demand decline, and for The Am Law 1–50, the second quarter saw an acceleration of the decline experienced during the first quarter. Though the Am Law 51–100 and Second Hundred firms saw demand growth for the first half of this year, it slowed from the first quarter to the second quarter.

These results are based on a sample of 176 firms (79 Am Law 100 firms, 47 Second Hundred firms, and 50 additional firms). 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.

Rate increases continued to grow at a similar rate to 2011, and more than in the prior two years, but still lag historical averages.

Expense growth slowed from the first quarter, but, at an increase of 4.1 percent for the first half of 2012 compared to the same period in 2011, expenses continue to grow at a materially greater rate than we’ve seen in recent years, exceeding revenue growth. While head count growth accounts for some of the increase (the growth in compensation expenses was 2 percent), the increase in total expenses was driven more by growth in overhead expenses (5.5 percent). We continue to hear firms talk about pressure to upgrade technology, as well as an uptick in health insurance costs. Looking at firms by Am Law 200 designation, expense growth slowed during the second quarter for all segments of the market. Most notable was the decline in compensation expenses experienced by Am Law 1–50 firms, which  did not pay spring bonuses this year.

Head count increased a modest 1.1 percent for the industry during the first half of 2012, having slowed during the second quarter for all Am Law 200 segments, and actually declining for non–Am Law 200 firms. Equity partner head count continued to increase only slightly, driven by modest increases among the two Am Law 100 segments. These changes in head count also resulted in a more modest increase in leverage than we saw during the first quarter.
 
With head count growth outpacing demand growth, we saw the relatively flat growth in productivity of the first quarter become a decline of 0.8 percent across the industry by the middle of the year. The biggest driver of this decline was the Am Law 1–50 firms, which saw the 0.5 percent decline in productivity they experienced during the first quarter accelerate to a 1.5 percent decline for the first half of 2012, when compared to the same period in 2011.

With billable hours well below historical levels for all segments, we see the continuing trend of firms feeling pressure to discount their fees. We have already seen declining realization during the first half of 2012, as reported to us in the Law Firm Leaders Survey we conducted in July of the managing partners of 57 Am Law 100 and Second Hundred firms. In response to the question, “How has realization changed in the first six months of 2012 [compared to] the same period in 2011?,” 55 percent indicated a decline—more than in either of the prior two years’ survey results.

Looking ahead, a weak increase in inventory (1.8 percent growth in mid-2012, compared to 6.3 percent growth seen in mid-2011) does not augur well for third-quarter collections. With weak demand growth and the continuation of expense growth, it is likely that expenses will continue to grow at a faster pace than revenue, squeezing margins and making it tricky to achieve even low single-digit profit growth.

Dan DiPietro and Gretta Rusanow are chairman and senior client adviser, respectively, at Citi Private Bank’s Law Firm Group.