Expense growth may have outpaced revenue growth for the law firm industry during the first quarter, but there was plenty of good news about how 2018 began.

Demand growth surged in the industry in the fourth quarter of 2017 and much of this work was still in inventory as the year ended. In fact, 2018 began with the strongest inventory growth figures that we’ve published since 2007. Further, demand growth continued into the first quarter of 2018, adding to those strong inventory levels. However, collections slowed, suggesting that first quarter revenue growth could have been stronger, and perhaps outpaced expense growth.

The good news is that the continued demand growth and slowing of collections has led to a further accumulation of inventory through the first three months of the year, setting the industry up for a strong second quarter. That said, though the start of the year is promising, it is not equally promising for all firms. We continue to see broad dispersion in firm results. As has been the case for the past two years, large firms fared better than the rest of the industry in the first three months of 2018.

These results are based on a sample of 179 firms (80 Am Law 100 firms, 47 Second Hundred firms and 52 niche/boutique 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). Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and the Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey and semiannually produce the Law Firm Leaders Confidence Index. These reports, together with extensive discussions with law firm leaders, provide a comprehensive overview of current financial trends in the industry as well as forward-looking insight.

Revenue growth of 4.2 percent in the first quarter of 2018 was driven by demand growth of 1.3 percent and lawyer billing rate growth of 4.8 percent. In the case of the demand growth, this was the strongest result we’ve published since the first quarter of 2016, and in the case of lawyer billing rates this was the strongest result we’ve published since the first quarter of 2008. The collection cycle, however, lengthened by 3.1 percent during the first quarter, working counter to revenue growth, but contributing to inventory growth. In fact, inventory levels continued to accumulate during the quarter and on average are up 7.3 percent at quarter-end–the highest level we’ve seen since the first quarter of 2008.

Expense growth of 4.8 percent exceeded revenue growth. It should be noted that following a year in which the dollar weakened, both expense growth and revenue growth would have been lifted by the foreign exchange effects of firms with foreign offices.

Broadly, lawyer compensation expense growth of 5.9 percent contributed more to the overall expense increase than operating expense growth of 3.8 percent. This was, at least in part, due to the growth in lawyer head count of 1.8 percent. As has been the case in recent years, this growth does not extend to the equity partnership and we actually find that the size of the average partnership declined by 0.3 percent during the first quarter, as the industry continues to carefully manage equity partner head count. As a result of both the growth in the industry and the slight decline in equity partners, we find lawyer leverage increasing 2.9 percent. The good news is that the average firm was able to grow leverage without sacrificing average lawyer productivity.

Behind these averages, we continue to see high levels of dispersion and volatility. Forty-seven percent of firms saw demand decline during the first quarter of 2018. We also saw volatility in demand performance, defined as alternating periods of demand growth and decline. To measure volatility in demand performance, we looked at the 130 firms that reported first-quarter results in 2016, 2017, and 2018. Approximately 42 percent of these firms either saw demand increase in the first quarter of 2017 and decrease in the first quarter of 2018, or vice versa. Further, 27 percent of firms saw demand decline in both periods. Whereas the majority of firms would have enjoyed consecutive periods of positive results in the high-growth market that preceded the recession, that result has now become the exception (31 percent of firms), while for the remainder of firms the best case scenario has been a more jagged path towards growth.

Looking at the results by revenue size, we find that the Am Law 1-50 firms fared the best among the segments in the first quarter. They were the only segment that saw demand increase (2.6 percent) and the only segment to see an improvement in lawyer productivity (0.2 percent). They also saw the second-greatest growth in revenue (5.3 percent) and the greatest growth in lawyer billing rates (5.0 percent).

On the other hand, the Am Law 1-50 firms saw the greatest expense growth (6.5 percent) and, along with other Am Law segments, saw expense growth outpace revenue growth. Am Law 1-50 firms saw the greatest growth in lawyer FTE (2.9 percent) and this drove lawyer compensation expense higher, which in turn helps to explain their comparatively high expense growth. Inventory growth at these firms (10 percent) positions them well for the rest of the year.

Other firms saw greater revenue growth (5.5 percent) than the Am Law 1-50 firms, driven in large part by relatively strong rate growth (4.5 percent), but this was the only segment to accelerate collections (-2.3 percent) and they head into the second quarter with the second-lowest growth in inventory (3.1 percent). The Am Law 51-100 and Second Hundred firms saw comparatively lower levels of revenue growth (2.3 percent and 1.8 percent, respectively). These firms saw demand decline and did not achieve the levels of rate growth that the largest and smallest firms in our sample saw. Though they both saw the collection cycle lengthen, the Am Law 51-100 and Second Hundred firms saw inventory levels grow at similar paces to other firms.

Looking at firms by geographic reach, global firms outperformed the other segments in terms of revenue growth (8.0 percent), demand growth (2.4 percent), and lawyer billing rate growth (6.1 percent). Global firms also saw material growth in inventory (8.9 percent), despite seeing the smallest lengthening among the segments in their collection cycle (0.9 percent). Global firms also saw the greatest increase in expenses among the segments (9.8 percent).

All segments except national firms saw expense growth outpace revenue growth. International firms saw the lowest increase in revenue (2.9 percent) despite seeing the second-highest increase in demand (2.1 percent). This is largely due to the slowing of their collections (8.1 percent) and, as a result, these firms enter the second quarter with 11.2 percent growth in their inventory. National firms saw 3.8 percent growth in revenue. They saw demand increase 1 percent but it was coupled with the lowest billing rate increase among the segments (3.6 percent). These firms bring a 4.9 percent inventory increase into the second quarter. Regional firms saw revenue increase 3.2 percent. While these firms saw billing rates increase at 4.9 percent, they struggled to add to demand and saw just 0.1 percent growth. These firms bring a 5.5 percent increase in inventory into the second quarter.

Though revenue growth trailed expense growth, this masks the strong economics during the first three months of the year. Demand and billing rate growth through the first quarter have been the strongest that we’ve published in years. The revenue tailwind provided by 2017’s strong year-end inventory levels has yet to catch in the sails of 2018, as collections slowed and inventory levels continued to accumulate, setting up the industry for a strong second quarter.

As firms focus on collections, we would expect to see stronger revenue results as we move through the rest of the year. While we would expect average industry revenue and PPEP growth levels to be in the mid-single-digits, wide dispersion in the results suggests that larger firms will see a better year than others in the market, and within any given segment, some firms will grow at the expense of others, driving further market consolidation.

David Altuna is a client advisor within Citi Private Bank’s Law Firm Group and Gretta Rusanow is Head of Advisory Services. Senior Client Advisor John Wilmouth contributed to the article.

The views expressed herein are for informational purposes only and are those of the author and do not necessarily reflect the views of Citigroup Inc. All opinions are subject to change without notice.