(Illustration via iStock)

The strong start for the legal industry we reported on three months ago continued in the second quarter of 2014. While demand growth slowed slightly, rates grew at modestly higher levels compared with the first three months of the year. And although expense growth picked up, revenue gains remained higher, suggesting full-year profit margin growth.

While the industry is well ahead of where it was this time last year, there are headwinds. Demand growth accelerated in the second half of 2013, so the year-over-year comparisons in the second half will be more challenging. That said, we still forecast 2014 to be a better year than 2013.

During the six-month period, performance varied widely across industry segments. Am Law 1-50 firms outperformed all other segments in revenue, demand and rate growth, just as they did in the first quarter, although their growth in these metrics slowed from the first quarter of 2014. Global and international firms continued to outperform U.S.-centric firms. Firms with strong transactional practices have fared very well, while litigation has lagged.

These results are based on a sample of 174 firms (81 Am Law 100 firms, 44 Second Hundred firms and 49 additional firms). Thirty 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.

At the halfway point in 2014, revenue was up 4.4 percent, slightly more than the 4.3 percent for the first quarter. There was also little movement in two of the key revenue drivers, as overall demand growth (for all timekeepers) slowed slightly to 0.9 percent from 1.0 percent in the first quarter, and rate increases stayed level at 4.4 percent. The slight increase in revenue from the first quarter was due mostly to timing, as accounts-receivable turnover quickened. The slowdown in demand was a result of better demand performance during the second quarter of 2013. It’s this pickup in demand that continued into the second half of last year and will present the primary hurdle to performance for the remainder of this year.

The pace of expense growth, on the other hand, did pick up, rising 2.1 percent through six months, compared with only 1.6 percent for the first quarter. Looking at the two components of expense reveals that the driver of this increase was overhead. Growth in attorney compensation expense remained constant quarter to quarter at 1.7 percent, but overhead growth jumped from 1.6 percent to 2.3 percent. Although the overhead increase of 1.6 percent for the first quarter is low and the 2.3 percent increase for six months is only slightly higher than for the same period last year, the focus of law firms on cost management and greater efficiency makes this acceleration in overhead growth worth noting.

Total attorney head count was up slightly at 0.4 percent, which was outpaced by a 1.3 percent increase in attorney hours logged, thus driving higher lawyer productivity. This is also the first time since 2011 that lawyer productivity increased through the first half of the year.

Equity partner head count was up marginally at 0.1 percent as firms continued to manage the number of their equity partners very closely. As a result, attorney leverage increased by 0.5 percent.

At the end of the second quarter, inventory was up 4.1 percent, the largest six-month increase since 2011. This augurs well for second-half revenue growth.

In our article on the first-quarter results, we indicated that a rising tide of positive economic indicators and increased demand for legal services was not lifting all boats. That continued to be the case after six months, as the Am Law 1-50 once again outperformed the other segments in several key metrics, including revenue (5.9 percent), demand (1.9 percent) and rates (4.8 percent). These firms were also more modest in terms of lawyer head count growth, with only a 0.2 percent increase. Furthermore, this segment was the only one to reduce equity partner head count, a 0.6 percent drop. As a result, the Am Law 1-50 posted a 2.0 percent improvement in lawyer productivity. By contrast, the Am Law 51-100 posted only a 0.3 percent increase in productivity, and the Am Law Second Hundred and smaller, non-Am Law 200 firms experienced drops.

Despite the strong showing, the Am Law 1-50 did experience a slowdown from the first quarter in most of these metrics. For example, the six-month revenue growth of 5.9 percent was slightly down from first quarter’s 6.2 percent. Part of the reason for this slowdown is that the first quarter hurdle for the Am Law 1-50 was the lowest among all segments because of an underperformance in the first quarter of 2013. The Am Law 1-50 also saw expense growth accelerate from 1.5 percent to 2.1 percent, slowing profit margin growth. Nevertheless, a strong 4.8 percent increase in inventory—most of it unbilled time—should bode well for the third quarter.

The Am Law 51-100 also saw a slowdown in revenue growth—from 3.5 percent to 2.1 percent—but the issue for this segment seemed to be one of timing. Both demand and rate growth improved from the first quarter, but collections slowed. As with the Am Law 1-50, however, a solid 4.0 percent increase in inventory should bode well for the third quarter.

The reasons for the improvement in the Am Law Second Hundred and smaller firms, however, weren’t necessarily indicators of sustained success. The Am Law Second Hundred saw six-month revenue growth of 2.7 percent, faster than the anemic first- quarter growth of 0.9 percent and better than what the Am Law 51-100 experienced. Demand, however, was actually down more than in the first quarter, and rate growth slowed. Inventory was up only 2.5 percent heading into the third quarter.

The smaller firms actually had a 0.5 percent drop in six-month revenue, though this was an improvement from the 1.9 percent drop in the first quarter. Like the Am Law Second Hundred, these smaller firms saw a greater drop in demand than in the first quarter, and although rate increases increased slightly, the primary reason for the improved revenue result was strong collections. This left inventory up only 0.5 percent heading into the second half of the year.

Firms with a greater international presence continued to outperform other segments. They saw a slowdown in the growth of certain key metrics, but compared with U.S.-centric firms, they continued to have stronger demand growth and higher rate increases. The most global among this group had the highest productivity and the greatest inventory increases entering the third quarter.

As we enter the second half of the year, we are mindful that the hurdles will be more challenging. Nonetheless, we are still projecting mid-single-digit growth for the industry as a whole. We do anticipate, however, that the Am Law 1-50 firms will significantly outperform the other industry segments.

John Wilmouth is senior client adviser of Citi Private Bank’s Law Firm Group. Chairman Dan DiPietro, senior client adviser Gretta Rusanow and lead analyst Andrew Godwin contributed to the article.

This document is for informational purposes only. All opinions are subject to change without notice. Opinions expressed herein may differ from the opinions expressed by other businesses of Citigroup Inc., are not intended to be a forecast of future events or a guarantee of future results. Although information in this document has been obtained from sources believed to be reliable, Citigroup Inc. and its affiliates do not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use.