Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Harvey Nash (HVN.L) – Recruiting Shareholders

with 11 comments

(This is the eighteenth installment in my series of case studies on the shares that have featured in my portfolio. To see the other seventeen articles, on Smurfit Kappa GroupBank of IrelandAIBRBSMarston’sFrance TelecomRyanairPetroNeftIrish Continental GroupIndependent News & MediaTotal ProduceAbbeyGlanbiaIrish Life & PermanentDatalexTrinity Mirror and Datong, click on the company names. I remain an investor in all of the above stocks, save for Marston’s and Glanbia)

 

One of the most interesting market sectors for me is recruitment. As with other professional services’ business models, it has some unusual characteristics – its principal assets walk out the door each evening, it has minimal capex requirements (a rented office, phone line and computer will suffice for most employees where tangible assets are concerned) and while its core business is, clearly, very cyclical, companies in the space can reduce volatility through measures such as diversification across different segments of the labour market or by adding recurring revenue offerings such as managed services (payroll etc.) to clients.

 

I’ve held two UK listed recruitment stocks in the past, namely Imprint (which is no longer quoted) and Harvey Nash. I sold out of the latter last year when its shares were trading above 70p. With the price now back in the low 50s, I figured that it was time to update the model and investigate whether or not I should be buying back into it.

 

To start, let’s look at Harvey Nash’s business model. To say it is a diversified one wouldn’t quite cover it – the group has 40 offices in Europe, North America and Asia. As slides 24 through 26 of this presentation show, just under half of its gross profits come from Europe, with 39% from the UK (which includes Asia!) and 12% coming from the US. Outside of geographic diversity, it is also quite diverse where sectoral exposure is concerned. Some 22% of gross profits come from executive search, 17% from permanent recruitment, 34% from contract & temporary, 19% from offshoring & outsourcing and 8% from managed services. The latter three are clearly ‘stickier’ than the first two, which are more reliant on one-off revenues. The group also operates across a wide range of industries. So, with different revenue streams across multiple industries in three continents, Harvey Nash doesn’t have anything like the degree of volatility a staffer focused on just one or two segments and/or markets would have.

 

Turning to its performance in recent years, I should mention that I don’t look at staffers’ revenues when analysing their performance, as this can be distorted significantly by mix effects due to the different treatment of monies received for placing permanent and temporary / contract candidates. So, skipping down to the more meaningful profit lines reveals a resilient performance over the past 5 years. Gross profits in the year ending 31 January 2012 were 63% higher than in the year ended 31 January 2007, while over the same period operating profits grew 33%. Harvey Nash’s operating profits for the 12 months to the end of January 2012 (€9m) were double those achieved at the low point of the cycle (the financial year ended 31/1/10). Despite the economic headwinds, the group has retained a prudent balance sheet policy, reporting net cash in each of the previous 5 years. Loyal investors have also been rewarded by a dividend that has increased by a total of 166% over the past 5 years.

 

In terms of returns metrics, there are some interesting takeaways from these. Between FY07 and FY09, ROCE and ROE were very stable, consistently standing at circa 17% and circa 11% respectively. Once the downturn hit, these unsurprisingly nosedived in tandem with profits, to reach troughs of 2.9% and 1.4% respectively in FY10. Over the past two years these have started to recover back towards cyclical highs, reaching 13.9% and 9.2% in the 12 months to the end of January. Given that these are still some way off pre-economic crisis highs, I think this is a good point in the cycle to be revisiting the story.

 

So, with Harvey Nash’s track record where earnings, dividends and returns are concerned out of the way, what has the company been saying recently? Obviously, conditions are far from optimal, but the company has nonetheless sustained its positive momentum. In its June trading update, management said it was ‘delighted’ with the group’s performance in Q1 of its financial year, with revenues +18% and underlying operating profits +10%. More recently, in an update provided in the middle of August ahead of the release of H1 numbers on September 28, the company said it expects to ‘confirm a robust performance’ in H1, guiding a 15% rise in revenues and 7%+ uplift in operating profits. Another development revealed in that update was the revelation that the company has swung into a modest (£13m) net debt position, having had net cash of £5.2m at the end of January. This reversal is due to: (i) a £2.2m one-off spend on a new consolidated facility for its London operation; (ii) the €1.8m cost of a business acquired in Belgium; and (iii) investment in working capital to support the temporary labour business. None of these factors give me any cause for concern as: (i) the London facility will trim costs by £0.8m per annum, so a less than 3 year payback; (ii) the Belgian business was acquired for less than 3x PBT, which again points to a likely short payback period; and (iii) Harvey Nash guides that working capital investment will “return to more normalised levels over the next 18 months”. Moreover, the £13m net debt compares with existing bank facilities of £41m, which gives me more comfort.

 

In terms of the valuation, based on consensus EPS forecasts and this evening’s closing price (51.75p), Harvey Nash trades on 7.5x forward earnings. This compares very favourably with its UK quoted peers – Hays (13.2x), Robert Walters (26.4x) and Michael Page International (24.8x).

 

One of the key problems with staffers is forecasting their likely performance, given the short-term visibility that is inherent to the permanent hiring business. In my own model, in which I’ve plugged in what to me look like conservative assumptions, I can get to a valuation above £1 (£1.056 to be precise), or about double where Harvey Nash is now. Is that an unrealistic valuation? Well, when you look at the multiples its peers trade on, I don’t think it is at all. Also, while past performance is by no means a guarantee of future returns, HVN’s shares traded as high as 97p in mid-2011. Moreover, if I simply plug in the £13m net debt reported in the recent statement into the DCF-based model and ignore the expected unwinding of this, it spits out an 81p price target, which is close to 60% above where the shares now trade. The key near-term risk is, obviously, the macro backdrop, but three things make me relaxed about this, namely: (i) Harvey Nash is cheap in both absolute and relative terms; (ii) if the outlook deteriorates, the investment in working capital is likely to unwind faster, which would see the balance sheet strengthen as the income statement softens; and (iii) based on where the shares are trading now, the stock offers a well covered dividend of 5.6%.

 

In summary, I view Harvey Nash as a case of strong track record+ diversified business model + attractive, well-covered dividend + inexpensive (both in absolute terms & relative to its peers) valuation. To this end, I have bought back into the stock today.

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Written by Philip O'Sullivan

September 3, 2012 at 4:25 pm

Posted in Sector Focus

Tagged with ,

11 Responses

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  1. Great analysis, Philip. Agree entirely with your conclusions, and wish you well with the investment.

    Steve Markus

    September 3, 2012 at 7:15 pm

  2. […] Switching to the support services sector, the venerable Paul Scott profiled UK staffer Staffline. You can read my profile of one of its peers, Harvey Nash, here. […]

  3. FWIW, I bought a teaspoon’s-worth in June this year. I topped up more heavily yesterday. Let’s hope great minds think alike. I was encouraged by the directorspeak. It’s on an EV/EBITDA < 3. I'd regard that as very cheap, unless I had some grave misgivings about the sustainability of those earnings. At that price level, it's trading at less than its historical average, and according to my calculations (of which you should be suspicious!) at less than half that of its peers.

    Best of luck to you!

    mcturra2000

    September 4, 2012 at 8:40 pm

    • Hi Mark – hopefully great minds and all that! The stock does seem to have its fans among the UK & Ireland value investor parish – so it’ll either be filet mignon or humble pie on the menu whenever we arrange a get-together!

      Philip O'Sullivan

      September 4, 2012 at 10:06 pm

      • Well, you’re article did wonders for the share price today. What else you got? — Whisper it in my ear —

        mcturra2000

        September 5, 2012 at 4:50 pm

  4. Great write up. Can I see your model, eg spreadsheet that gives you £1? Thanks, Peter

    Peter

    September 6, 2012 at 6:37 pm

    • Hi Peter, thanks for stopping by and commenting! I don’t post models up on this because from experience they lead to lengthy debates about ‘why do you have margins rising only 8bps this year, they were up 10bps in H1…’ and other nitpicking questions that ultimately have a marginal impact on the investment view but a far from marginal impact on my time!

      How I reached the £1+ level is as follows:

      I took operating cashflow (as reported), then took away 50% of capex which I assumed was maintenance (the balance being development as per new offices and so on) to produce free cash flow.

      This gave me £0.6m FCF for FY13 (depressed by the investment in working capital in particular), ~£6.4m for each of FY14 and FY15 and then for the terminal value I use a terminal growth rate of 2% (again, this is conservative because it should grow at the long-term nominal GDP growth rate, which would be higher if weighted across HVN’s markets) and discounted all of the cashflows back at a discount rate of 10%.

      This produced a PV of £72.4m. Adding in last year’s reported net cash of £5.2m* gets me to an equity value of £1.05 per share.

      *Now, the obvious question that arises is – “but isn’t the firm in a net debt position at the moment due to one-off items and investment in working capital”. Yes, that’s right – and that’s why I also gave the value for the equity value if you put that in, but I think that’s a bit harsh given that it’s not really a ‘normalised’ level of debt.

      ** I also cross-checked this valuation against the implied multiple the stock would trade on at that price – as this is well below what a lot of its peers are on I felt even more conviction in my ‘this is a conservative price target’ view.

      Philip O'Sullivan

      September 6, 2012 at 7:32 pm

  5. […] first things first, Philip O'Sullivan has a write-up on Harvey Nash which, while a stock I'm familiar with, apparently isn't one I've ever written about. I say […]

  6. Have you had a look at MatchTech (disclosure: I hold). I think it’s done a pretty good job of expanding and diversifying its reach through a tough employment market, though overall the business has treaded water in the recession. Still, that’s better than some and it’s maintained a big dividend payout, too. Entrepreneurial small cap. I need to look more deeply at the debt though, as I noticed it’s been creeping up steadily (from memory it used to be net cash!)

    Monevator (@Monevator)

    September 8, 2012 at 8:15 am

    • Hi Monevator – thanks for commenting. I have not come across MatchTech before but I will check it out – have 1 other stock that I want to profile first (in the media sector) before looking at other opportunities. Am 20% in cash at the moment so certainly open to good ideas 🙂

      Philip O'Sullivan

      September 8, 2012 at 8:25 am


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