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Legal industry results halfway through 2017 reinforce our belief that full-year results will feature margin compression, low-single-digit growth in revenue and profits and continued dispersion and volatility in performance. While revenue growth was higher than in any first half of the last three years, the expense increase, due in large part to the rise in associate salaries implemented in mid to late 2016, was slightly higher than revenue growth, a reversal of the trend in the prior three comparable periods. On a positive note, lawyer demand growth and rate increases were each somewhat stronger than in any of the last three years at the halfway mark. Demand dispersion (the range of increases to declines in a given period) and volatility (an up period followed by a down period or vice versa) continue to plague the industry at levels similar to what we’ve seen in the post-2010 years.

These results are based on a sample of 186 firms (83 Am Law 100 firms, 51 Second Hundred firms and 52 niche/boutique firms). Thirty-three 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 the Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey and produce the Law Firm Leaders Confidence Index semiannually. 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 grew 4.9 percent at the six-month point, flat from the first quarter. As in the past six years, billing rate increases, at 3.8 percent, remained the single largest driver of revenue growth. While total demand (i.e., all timekeeper hours) rose a modest 0.4 percent, lawyer demand, the more valuable hours, was up a relatively robust 1.6 percent, the biggest rise in the last four years at the halfway point, thus also contributing to revenue growth. Improvement in the collection cycle of 1.1 percent also helped increase revenue.

Expenses increased by 5.1 percent due to the combined impact of increased associate compensation and lawyer head count growth of 1.9 percent, which drove lawyer compensation expense up a whopping 7.5 percent, compared to 3.0 percent at the six-month point of 2016. We’ve also heard anecdotally that the rise in associate salaries caused some compression at the more senior end, against counsel, causing some firms to increase counsel salaries. In contrast, operating expenses were up 3.3 percent. Anecdotally, we hear that technology, and particularly cybersecurity-related expense, is a big contributor to this increase. The good news regarding associate salary increases in the second half of the year is that the incremental impact will lessen, as the increases were put in place at the start of July for many firms or soon thereafter for others.

The 1.9 percent growth in total lawyers combined with a 0.2 percent decline in the equity partner ranks drove lawyer leverage higher, but also placed downward pressure on average hours per lawyer, which fell 0.3 percent. This continued a trend evident in each of the prior three comparable periods, resulting in an oversupply of lawyers. While firms tell us that it’s become increasingly more difficult to match hiring decisions to demand levels in this volatile market, they also recognize that the consequence of too many lawyers chasing too little work is continued pressure on realization.

Looking toward full-year revenue results, inventory growth of 3.8 percent is a tick below last year’s figure at six months and well below the two comparable periods prior to 2016. This suggests some softness in second-half collections is likely, barring a flurry of new activity during those periods.

Behind these averages, we continued to see high levels of dispersion and volatility. Forty-four percent of firms saw lawyer demand decline during the first six months of 2016, a figure within the range seen in the last three comparable periods. We also saw volatility in lawyer demand performance, defined as alternating periods of demand growth and decline. To measure volatility in demand performance, we looked at the 134 firms that reported nine-month results in 2015, 2016 and 2017. Approximately 46 percent of these firms either saw demand increase in 2016 and decrease in 2017, or vice versa. The dispersion and volatility results underscore the challenges firms face in a slow-growth, hypercompetitive market where one firm’s success is likely to come at the expense of another.

Grouping the firms based on revenue size, Am Law 1-50 firms saw both the greatest revenue growth (6.2 percent) and expense increase (6.4 percent). Rate growth of 4.0 percent (the highest of any segment), relatively robust total demand growth of 1.5 percent and an improved collection cycle were primary drivers of revenue growth. Further good news for this segment is that, even with strong collections, inventory grew by 4.6 percent, the second highest of any segment, positioning Am Law 1-50 firms for a strong third quarter. Only Am Law 51-100 firms saw revenue growth (4.6 percent) outpace expense growth (3.6 percent). Am Law 51-100 firms saw the second-strongest growth in revenue, driven by rate growth (2.7 percent) and improvement in the collection cycle as total demand declined by 1.1 percent. In our last article, we wrote about the wide difference in experience between firms based on revenue size, and particularly the challenges Second Hundred firms were facing in growing the top line. Second Hundred firms saw modest revenue growth of 1.6 percent and an expense increase of 2.0 percent. Niche/boutique firms had the lowest revenue growth (0.2 percent) and the second highest expense increase (4.6 percent). Total demand, however, was up a robust 2.8 percent, the highest of any segment. This group of firms, which includes a number of firms who do a significant amount of contingency work, saw a significant lengthening of the collection cycle, accounting for its tepid revenue growth.

Looking at the firms by geographic reach, international firms saw the strongest revenue growth (6.1 percent) and, with an expense increase of 5.8 percent, was the only segment to show margin improvement. The revenue increase was driven primarily by a rate increase of 3.9 percent, as total demand was up only 0.2 percent and the collection cycle was essentially flat. A change in demand mix also contributed to revenue growth (total demand was up only 0.2 percent but lawyer demand was up a healthy 2.7 percent, the highest of any segment). Looking ahead, international firms also saw the highest growth in inventory (5.8 percent), which should help collection efforts in the second half of the year. Global firms exhibited some weakness as their 5.6 percent revenue growth was propped up by the largest improvement in the collection cycle, while inventory growth was the most modest at 2.2 percent. The more U.S.-centric firms lagged in revenue growth, primarily due to tepid demand dynamics, while suffering from higher expense growth thus compressing margins. Inventory levels for these two segments suggest collections will track at or slightly above those of the first half.

At the halfway mark of 2017, the mix of variables impacting full-year results point to the kind of year the industry has produced in the post-2010 environment. We stand by our forecast published in the 2017 Citi Hildebrandt Client Advisory: modest demand growth coupled with continued dispersion and volatility resulting in low-single-digit revenue and profit growth. Absent a material uptick in demand and/or a monumental cash collection effort in the fourth quarter, 2017 should look a fair bit like 2016 on the profits front. Even though revenue growth may exceed that of 2016, the bigger increase in expenses will keep the brakes on profit growth.