Results from the first nine months of 2012 are in, and it appears increasingly likely that the legal industry will fall short of 2011′s low single-digit profit growth.

Not only did third-quarter revenue and demand growth slow from the first half of the year, demand actually posted a slight decline (-0.1 percent) compared to the third quarter of 2011, which marked the beginning of the current prolonged period of soft demand. Although expense growth also slowed during the third quarter of 2012, it continued to outpace revenue growth; in fact, the gap between the two widened, putting a further squeeze on profit margins.

These results are based on a sample of 182 firms (80 Am Law 100 firms, 51 Second Hundred firms, and 51 additional firms). Ten of these firms (nine Am Law 1–50 firms and one Am Law 51–100 firm) fit our definition of global firms: greater than 25 percent of total lawyers (as measured on a full-time-equivalent basis) 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.

Aside from the decrease in demand, another primary reason for the drop in revenue growth in the third quarter was a slowdown in the collection cycle. Much of this had to do with timing. While the second quarter of 2012 benefited from the conversion to cash of inventory—work that has been performed but not yet collected on—that was built up during the first quarter, there wasn’t enough of an inventory buildup in the second quarter to benefit third-quarter collections.  On a positive note, there was a buildup in third-quarter inventory, so we might see a rebound in revenue growth in the fourth quarter. This seesaw pattern of inventory growth and collections, however, particularly on top of increasingly weak demand, does not bode well for consistency in the foreseeable future.

Through the first nine months of 2012, larger firms generally underperformed the rest of the industry, and those with the greatest global presence fared the worst. Am Law 1–50 firms, for instance, saw nine-month revenue growth of only 1.1 percent, while the global firms saw a drop of -3.0 percent (as compared to a 1.7 percent increase industry wide). Both segments were hit proportionately harder by the slowdown in collections. Furthermore, they had larger decreases in demand than the industry average, as did the non–Am Law 200 firms in our sample, which had the largest percentage drop in demand of all the segments.  However, when we compared the third quarter with the first half results, we noted that the Am Law 1-50 (particularly the global firms) was the only segment that fared better in terms of demand.  It will be worth watching whether this momentum is sustainable.

Rate increases continued at about the same pace as last year, but are still running at approximately one-half the level of historical averages.

Expense growth slowed to 3.7 percent, down from 4.1 percent in the first half, primarily because of a slowdown in overhead expense increases, from 5.5 percent to 4.8 percent. We continue to hear firms talk about pressure to upgrade technology, as well as a rise in health insurance costs. Compensation expenses, on the other hand, continued to increase at a more modest 2.0 percent, the same as in the first half. The compensation expense increase reflected a steady 1.1 percent head count growth, also the same as in the first half.  The fact that compensation expense increased at a faster rate than head count growth may reflect a demographic shift to a more senior mix of lawyers.

While overall head count is still growing, however modestly, firms continue to carefully manage equity partner growth. After a 0.3 percent increase in 2011, equity partner head count has edged up at only a slightly greater pace (0.4 percent) through the third quarter of 2012. This result was driven by Am Law 100 firms, which increased equity partner head count by 0.9 percent, while Am Law Second Hundred and smaller firms reduced the number of their equity partners.

With demand down yet head count growing, productivity continued to deteriorate, down 1.2 percent in the third quarter, from a decline of 0.8 percent in the first half. As we’ve noted before, there was already a roughly 100-hour gap in productivity coming into 2012, so this drop only exacerbates the problem.

This growing productivity gap feeds the pressure to discount fees. Last year, industry realization was approximately 87 percent, and all indications are that it will likely be even lower this year. Given continued pricing pressure and the slowdown in demand, many firms are focusing on improving efficiency as a way of increasing both productivity and profitability. While some firms are contemplating moves to cheaper locations, others are looking at ways to be more efficient in the use of existing space. The biggest push, however, is in finding ways to more efficiently manage their alternative fee arrangements, which law firm managing partners we’ve surveyed say are expected to become an increasingly greater percentage of revenue in the years ahead.

For fiscal year 2012, despite the likelihood that the conversion of third-quarter inventory to cash will help bolster revenue, continued growth in expenses will probably result in the second year in a row that margins will be squeezed. Furthermore, continued weak demand and the seesaw pattern of inventory and collections suggest there will also be no running start to 2013.
 
Dan DiPietro is chairman of Citi Private Bank’s Law Firm Group. John Wilmouth and Gretta Rusanow are senior client advisers in the group.