Saturday, November 17, 2007

Shorting Staffing Stocks Part 1: KFY

My apology for the delay in updates. I hope to do a much better job updating more regularly in the future.

With the recent market turmoil in the financials, I have closed out many of my short positions in the space: most notably ABK and MBI, and have been looking to other, more overvalued sectors to hedge my long positions.

The staffing sector has already taken a hit, but if history is any indication, there could be a lot more room to fall. If you believe we are at the onset of a recession that will eventually manifest itself in a considerably weaker jobs market, then several staffing companies look particularly attractive as a way to profit off the upcoming job market turmoil.

Market Overview:
Not all staffing companies are created equal. There are two primary different types of staffing companies:

1) Permanent search: these companies typically hired on a fee basis to find and screen employees for permanent hire on behalf of other companies. They are typically paid a non-recurring fee based on their success in finding a suitable applicant.
2) Temporary Staffing companies: these companies find and screen employees for temporary jobs, which can range anywhere from weeks to months. The temporary business model is different than the permanent placement model, in that staffing companies usually employ the worker themselves, paying them an hourly rate and billing out the employee at a higher rate to another company. These companies make their money on the spread between what they pay the employees and what they bill them out at.

Staffing is a cyclical industry. When economic times are good, companies do more hiring. Not only do they do more hiring, but they usually have a more difficult time finding quality employees, since unemployment rates are low and demand for qualified employees may outstrip supply. Permanent staffing companies are in particular demand when economic times are good--companies like Korn Ferry are often retained to help companies poach talent from other companies because the supply for qualified employees is so low. In bustling economic times, companies are generally also willing to pay more for these kind of services then in poor economic times. Temporary staffing is cyclical but not as much: in good economic times they benefit from increased staffing needs, but they also tend to hold up moderately well in poor economic times as companies shy away from full-time hires and look more to temporary employees to complete a specific task or project.

In bad economic times, the permanent staffing companies in particular face difficulties. Not only do companies hire less, but the supply/demand dynamic shifts strongly in favor of companies hiring. There are more likely to be more qualified workers, making it easier for the company to hire themselves, or to justify lower fees to the permanent staffing company. This can often result in both lower absolute number of permanent hires, plus lower fees/placement.

Why Korn Ferry
Korn Ferry specializes in high level permanent placement. Their earnings have historically been cyclically tied to trends in hiring and unemployment rate, and there is no reason to believe that this will not continue into the future. In addition to the aforementioned negative impact of a poor hiring environment, staffing companies like Korn Ferry further suffer due to their high fixed cost based on recruiters. Productivity/recruiter usually suffers, making relatively small moves in revenue devastating to the bottom line.

Though apparently reasonably valued, Korn Ferry is trading at peak earnings. A quick glance at the companies stock price between 1999-now will give you a good look at the sort of downside potential inherent when the hiring environment turns. Korn Ferry is a slightly different company than they were previously: they have more international exposure, a stronger balance sheet (becoming less so with share buybacks), and a more favorable cost structure than at the last turn in the cycle. SG&A expenses as a percent of total sales are much less than they were in past cycles, making the risk of big losses as the cycle turns less likely. Let's take a look at KFY in 2001 (peak earnings form last cycle) v. KFY's lastest FY ending April 2007.

FY2001 FY2007
Revenue 651.6 689.2
Gross Profit 231.6 196.8
SG&A 149.7 105.3
D&A 26.9 9.3
EBIT 55.0 82.2

Revenue 100% 100%
GM % 35.5% 28.6%
SG&A % 23.0% 15.3%
D&A % 4.1% 1.3%
EBIT % 8.4% 11.9%

I focus on EBIT rather than Net income to remove the affect of Interest Income and one time gains/losses, and focus on the profitability of the underlying business. Though KFY's SG&A expenses are down, their GM % is also down, mostly likely from increasing competitive pressures in the staffing business. If you adjust for differences in D&A, EBIT margins are only 70 basis points (.7%) from their prior peak. Not too impressive of a structural improvement in the business.

Despite talks of cyclical fears in KFY, analysts are still projecting healthy YoY increases in profits and revenue for the foreseeable future, which I think will be unlikely to materialize. Permanent staffing is, and always will be economically cyclical, and although KFY has made strides in reducing its fixed cost structure and global footprint, subsequent downturns are still inevitable. So, assuming we are once again at peak earnings, what is the downside as KFY transitions to trough earnings over the next couple years? Let's compare FY2001 with FY2003:

FY2000 FY2003 Change
Revenue 651.6 338.5 -48%
Gross Profit 231.6 92.2 -60%
SG&A 149.7 73.1 -51%
D&A 26.9 16.2 -40%
EBIT 55.0 2.9 -95%

Revenue 100% 100% 0%
GM % 35.5% 27.2% -23%
SG&A % 23.0% 21.6% -6%
D&A % 4.1% 4.8% 16%
EBIT % 8.4% 0.9% -90%

Not very pretty, is it? So, assuming we are once again at a cyclical peak, what does the future hold? This time, I'm going to use Last twelve month financials and see what trough earnings might come out to, assuming similar declines:

LTM FY2010 (?)
724.3 434.6
209.0 96.1
112.6 78.2
9.3 9.0
87.1 8.9

100.0% 100.0%
28.9% 22.1%
15.5% 18.0%
1.3% 2.1%
12.0% 2.0%

The above assumes a relatively conservative 40% drop in revenues from peak revenues, a 23% gross margin decline (consistent with that experienced in the last downturn), SG&A expenses rising to 18% (keep in mind company become much more lean during last downturn, and they are unlikely to be able to cut expenses again as much this time around). Under this model, EBIT would drop considerably. On a net income basis, it is likely the company would be flat to slightly positive or negative, depending on interest income and write-downs.

In times of trough earnings, it seems most reasonable to value KFY on a EV/Sales basis given the depressed state of earnings. In the past economic cycle, KFY traded at several points in trough periods at .5 EV/sales ratio. Assuming the same valuation on our hypothetical projection of trough earnings, KFY's enterprise value would be approximately $220M. If recent corporate activities are any indication, KFY is likely to buy its stock on the way down, eroding some the value of its cash. If we assume a 25% erosion to current Cash & ST investments of about $245M, that would leave KFY with a a TEV of $220M+ $200M of Cash and equivalents, yielding a market cap of $420M. With a market cap of $832M currently, that gives us an upside of about 50% in two years on our short.

If you think our economy is headed down the drain, this is a relatively low risk trade. KFY's international exposure in emerging economies is still small, and though their international exposure may lessen the blow some, a huge chunk of their business is still US based. In poor economic times with rising unemployment, it's tough to see KFY's stock performing well, even if it holds up better than expected, given all the negative macro fears and dearth of catalyst likely to be present.

Disclosure: Author is short KFY. Not a recommendation to buy or sell shares. Do your own due diligence.

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