Description

CDI is trading near liquidation value with a call option on a management turnaround that could result in a double or more from current levels, with relatively low downside risk.  CDI is a collection of three businesses: a franchise staffing business (MRI), an engineering services business (GETS), and a temporary staffing business (PSS).  We believe that today you are buying the business at a reasonable value for MRI and at working capital for the PSS & GETS business.  

The company has $35M in net cash, generated positive FCF last year, and has underperformed for years.   The new CEO, Scott Freidheim came onboard late last year and when reading between the lines, we think he was brought in to clean up the business, set it in the right path and eventually prepare it for a sale.  Importantly, for the first time, these options are now on the table and an aggressive executive has been brought in to focus on creating shareholder value.  The stock recently traded off nearly 30% since reported Q4, when the new CEO and his team announced their intention next year to make the right steps for the business long-term, which will result in 2015 being a year of depressed EBITDA.   This makes sense considering management incentives award the CEO $15m of restricted stock (4.5yr vest) only if CDI’s stock price reach a minimum of $27.76 per share and $40m of stock awards only if the stock price reaches $41.64 per share versus the current stock price of $14.  Similarly, three other members of the new senior management will receive stock awards of $5M, $2M, and $2M respectively if the share price roughly doubles and $10M, $5M and $5M respectively if the share price roughly triples.  Management has an solid pedigree and is taking over a business that by all accounts has been managed very poorly.  We think a double from these levels is very realistic and achievable even if management merely does a mediocre job and the business fails to achieve margins and multiples consistent with peers.

The company is very unloved and for good reason - performance has been poor (the stock price was higher 25 years ago than it is today) and investor frustration and fatigue is very high. All that said, CDI generates a susbtantial revenue base ($1.1B) but earns very low EBITDA margins (sub 3.5%). We think the new management team is inhereting a business with a lot of options to create value through operating margin improvement, divesting non-core assets, and selective tuck-in acquisitions.

Historically, this business has been tightly controlled by its founder Walter Garrison, who is 88 years old. None of his heirs are interested in operating the business and are restricted by their trust structure from selling more than a small percentage holding each year (about 3% a year). We believe a sale of the company will eventually be the best way for his heirs, who are in their late 50s, to unlock the full value of their holding in the company in their lifetime. We believe there has been strong interest over the years to acquire pieces of or the entirety of the business but do not expect this to be the case in the near future.

What do they do?

CDI segments its business into three business units:  Management Recruiters International (MRI).  Global Engineering and Technology Solutions (GETS) and Professional Staffing Services (PSS).

MRI (5% of revenues) is a 50 year old global franchise business with 550 offices that provides permanent placement services and contract staffing.   CDI receives an initial franchise fee of $15,000 - $65,000 from a franchise owner.  Franchise owners will typically receive a 20-30% fee based on annual salary for each successful placement and CDI would collect a royalty fee of 7-9% of the franchise’s fee.  On average, CDI’s royalty fee is closer to 5-6% due to the potential for an owner to reduce the royalty fee based on a higher levels of revenue.  The MRI franchises recruit for a wide range of functions ranging from administrative and clerical positions to middle management positions.  Average salary of hires is $75,000 - $150,000.  MRI has it largest exposure to healthcare, financial services, technology and energy sector.  The primary service offered by the franchises are permanent placement and CDI has been pushing franchises to grow its contract staffing.  On the contract staffing, CDI generally handles all the collections/back office function and then distributes the portion owed to franchise owners.  Despite the margins being lower on the contract staffing business, the contract staffing would provide a more stable stream of revenue than permanent placement and will increase the overall revenues and profit dollars of the business.

• MRI generated $7.5m Pre-Corporate EBITDA in FY14 and we expect it will do $8m in FY15.  Applying 10x EBITDA multiple for this business gets us to a valuation of $80m.

• Given the nature of MRI and the revenue size compared to the overall business, there is very little working capital that is associated to MRI.  With a valuation of $80m for MRI and $153m of net working capital, we think the valuation is very compelling given that is the Company’s current enterprise value.

GETS (30% of revenues) is a project oriented engineering business. GETS helps its customers in the design and construction of various equipment and infrastructures such as chemical plants, tanks and terminal storage pumps, gas plants and turbines, aircraft airframes, engines and components, highway roads, bridges, naval ships etc.  GETS will be involved throughout the full development cycle starting from the up-front planning (feasibility studies, cost estimating) to the engineering and design and lastly the construction management and MRO.  Given the technical nature of the work, we view this business as a high value added service as all of the technicians are highly qualified mechanical/electrical/civil engineers, project managers, CAD drafters, architects, mechanical/piping designers, etc.  These projects can last from a couple weeks to several years.  In other words, this is the “E” in and typical E&C firm – we view this as the highest value, generally lowest risk part of the process – the vast majority of their work is cost plus with little of the fixed price risk typical E&Cs take on.  Oil, Gas, & Chemicals (OGC) represents 42% of the revenues, Aerospace (AIE) represents 22% of the revenues and federal, state municipalities and infrastructure represents 26% of the revenues.  This business is currently under earning due to some legacy fixed price contracts.

• OGC:  Given OGC represents about 40% of the revenues, we think it’s worth diving into what the GETS business does within OGC and how the decline in oil prices have impacted the business.  GETS has no upstream oil exposure.  The bulk (70%) of the business is downstream processing and chemicals – areas of strength include nitrogen-based chemicals (e.g. fertilizer) and chlorine.  This business has little / no energy exposure, despite the misnomer of the segment title.  The true energy exposure here is about 30% of the 40% (about 12% of total GETS revenues) and are mostly long-term midstream projects where the Company has yet to see and does not expect material negative impact here.    Even if this business were to come off, it would not be material to overall company performance.

• In other sectors, examples of engineering work CDI has done in aerospace includes the design of jet engines, high-end “thermal stress” analysis.  In government, examples include design for a new bridge in Pennsylvania, architectural engineering (designs for schools, correctional facilities, etc.)

PSS (65% of revenues) is a technical and professional staffing services business.  CDI provides customers with a temporary workforce and it is the client’s responsibility to supervise those employees.  This business is a more commoditized staffing business compared to GETS.  Hi-Tech represents 31% of the revenues, OGC represents 25% of the revenues and federal, state municipalities and infrastructure represents 32% of the revenues.  

• IBM:  It is important to call out that IBM’s revenues and their relationship with CDI given IBM represents 23% of PSS revenues ($168m revenues).  CDI has been doing business with IBM for over 30 years and they have been the main supplier in providing IT staffing services to IBM’s Global Technology Services and Global Business Services (collectively, “IBM Service”), which is IBM’s IT infrastructure and systems integration and consulting service business.  An example of a project is IBM was engaged by the state of Texas to build out its’ IT infrastructure.  IBM took on CDI’s workforce which acted as an extension to IBM’s team.  Because of the size of IBM’s contract, IBM typically employs 1,400 – 2,000 CDI employees.  CDI is paid based on number of hours worked and pricing will depend on the job category and skill level of the staff.  In December 2011, CDI renewed the contract for another three years, expiring in December 2014.  IBM’s services revenues been declining over the last three years as they’ve seen a reduction in their services business.

As a result, CDI’s IBM revenues have dropped by about 25% in FY 2014 from the peak in FY 2011.  CDI renewed the contract in December 2014 for another three years, expiring in December 2017 but management expects there will be continued weakness from IBM.  While we do realize this is a significant risk, the IBM business is a high volume business that generates the lowest gross margins for PSS.  We estimate that the IBM business generates ~8% gross margins and assuming a 20% decline in IBM revenues for FY15, we think that the net impact to the bottom line will be less impactful than the headline would suggest.

• OGC:  CDI’s largest clients in the PSS’ OGC business is TransCanada and Enbridge.  Similar to the GETS business, this business has no exposure to upstream.  CDI’s workforce provides support in maintenance work, inspection and testing pressures and leaks and fixing and reversing pipelines.  The downstream business is predominantly focused on chemical byproducts such as ammonia which is a key driver in in producing agriculture chemicals.  As a result, oil fluctuations have little impact on the business.

• It's worth noting that much of the business outside of high tech and their UK biz is engineering staffing, which tends to be slightly higher margin, longer duration work relative to most their temporary staffing peers.

How did we get to today?

CDI was founded in 1960 by Walter Garrison, a former engineer with Boeing and remained as CEO until 1997.  Walter is still a Board member and continues to own significant stake at 24% (including the Trust to his children).  Throughout its history, the Company has shown very little growth and very little shareholder value creation.  To put it in perspective, revenues are essentially flat from nearly two decades ago and the stock price is nearly at the same price as well.  Prior management had a history of making bad mistakes and employee morale has deteriorated to the point where employees are unmotivated.  A few examples that we’ve learned through diligence…

• MRI is an odd business in the portfolio but it is one that management never dedicated much support and focus in.  We’ve heard they were approached by buyers but management and the board decided not to explore the sale.  They decided to keep it but allocated no resources to support the franchise owners to the point where owners stopped using the MRI brand.  There was also significant management changes in MRI with the Company going through 5 different MRI presidents over the last decade.  

• PSS is predominantly a national account business but CDI used to have a $200m business serving regional and local accounts.  This business generated higher gross margins (mid-teens) than the national accounts business (single digit to low teens) but Paulette Eberhart, prior CEO from 2011-2014, decided to wind down this business and focus solely on national accounts.  

• Paulette Eberhart had decided to change the matrix of the sales organization such that the same sales team was selling into both GETS and PSS.  The issue here is that the customers are different in both of these businesses.  In GETS, the customer is going to be the head of engineering and he expects an engineer to call him about the solutions.  In PSS, the customer varies but is typically a finance, IT or HR staff.  Paulette eliminated costs which ended not being a very effective cost reduction initiative.  

• During the 2008 downturn, they crushed employee morale by slashing everyone’s salary so that they could have cash to purchase distressed businesses.  An acquisition made during that time was T K Engineering Associates which management did a horrible job of integrating and the Company lost over 60% of the revenues in that business within the first couple of years.

• Employees have been frustrated with the constant headcount reductions and poor decisions made by management.  They are tired and unmotivated given all the organizational and management changes and many have complained about prior management’s inability to stick with a business plan

Not only employees have been frustrated with management, but longtime shareholders have been displayed frustration with the lack of value creation.  Here is an excerpt from the Q1 2014 Conference call by Brad Evans, an analyst at Heartland Advisors (long time shareholders and currently second largest shareholder).  

“As I communicated to the Board at the annual meeting last year, in person, CDI has been a significant underperformer versus all the staffing companies within the publicly traded markets, without exception, if I'm not mistaken. So it's just it's been elusive for the Company to unlock shareholder value. And I think we can all agree that there's a lot of value here within the company, that it's just been difficult for us to deliver that value to shareholders.  And I think everybody here is frustrated and sees the opportunity, but the ability to deliver it has been, for lack of a better word, has been elusive.”

Who is the new management team?

Scott Freidheim (CEO) joined CDI in September 2014.  Scott began his career in investment banking and eventually joined Lehman Brothers in 1991.  While at Lehman, he held various senior leadership positions until Lehman’s bankruptcy in 2008.  After Lehman, Scott joined Sears as the President of Kenmore, Craftsman and Diehard division. Despite the many issues surrounding Sears, the Kenmore brand excelled under Scott’s leadership, growing market share from #3 to #1 and turning it from an unprofitable business to a profitable one.  Scott ended up leaving Sears in 2011 because he wanted a CEO role which would have been difficult to attain given Eddie Lampert had no plans to step down.  As a result, he became Vice Chairman of Post Acquisition Management of Investcorp’s Europe division where he was responsible for the private equity firm’s portfolio companies from an operating and strategy perspective.  With the CEO opportunity presenting itself in 2014, Scott left Investcorp with the goals of making us his mark as a CEO.  Scott has an impressive background and is a big believer of surrounding himself with star talent.  The first thing Scott did as CEO was bring in familiar faces, colleagues from Sears and Lehman.  Through our channel checks, we have heard Scott is a very intelligent and excellent at motivating the troops, which we think will do wonders for beaten down organization.  He’s extremely motivated and understands that this is a make or break situation for him.    

Michael Castleman (CFO and Corporate Development) joined CDI in October 2014.  Michael began his career in investment banking at Lehman Brothers.  He eventually became the co-founder of Lehman’s Venture Capital Partners where he generated an impressive IRR of 60%.  After Lehman, Scott hired him to become CFO of Kenmore, Craftsman and DieHard brands.  He eventually became President of the brand upon Scott’s departure.  Many colleagues that have worked with Michael have said that he’s intelligent and very analytical.  Besides his time at Sears, Michael doesn’t have a long history as an operator but we think Michael’s role as CFO and Corporate Development suits him well for his abilities.  The feedback that we’ve received is he’s a good dealmaker and investor and we think he will be helpful in thinking about capital allocation, driving costs and evaluating accretive acquisitions and divestitures.

Hugo Malan (President of Staffing for North America) joined CDI in October 2014.  Hugo began his career in various consultant and research roles including 5 years as a Principal at McKinsey.  He was also a senior executive at Lehman Brothers and Barclays.  He joined Sears in 2009 as the President of the Fitness, Sporting Goods and Toys division.  Through our diligence on Hugo, we’ve heard that he is extremely intelligent and was very highly regarded by Eddie Lampert.  The Fitness and Toys divisions were very big brands for Sears and his units were one of the few bright spots in the company.  Executives at Sears were impressed by his strategic initiatives which included creating a digital community around Sears Fitness to drive the brand awareness.  Between Scott, Michael and Hugo, we’ve heard that Hugo is likely the best operator of the group and we think he will act more as a COO to Scott.

David Arkless (President of International) joined CDI in October 2014.  David was the third upgrade that Scott made to the team.  Prior to CDI, David was with ManpowerGroup for over 20 years as a senior executive in strategic services, global account sales, global consulting and corporate and government affairs.  Of the new hires, David brings in the most industry expertise and will be in charge of running the International business which has been unprofitable.

What are management’s incentives?

Scott Freidheim

• Base salary:  $600,000

• Cash Bonus:  Up to 100% of base salary

• Stock options:  Option to purchase 50,000 shares of common with a term of 7 years and cliff vest on year 5

• Time Vested Deferred Stock (TVDS):  Granted 50,000 shares which will cliff vest in year 5

• Performance – Contingent Stock Units (PCSU):  Scott received 640,000 PCSU which will vest based on time-based vesting requirements and achieving certain stock value performance requirements by year 5 (September 2019)

• $15m if the minimum stock price of $27.76 per share (“Minimum Hurdle”) is achieved (which is double the stock price base of $13.88 per share)

• $40m if the maximum stock price of $41.64 per share (“Maximum Hurdle”) is achieved (triple the initial stock base).  Maximum payable bonus of $40m.

• If the stock price is in between the Minimum and Maximum Hurdle, Scott will receive $15m + $25M*((Price – Minimum Hurdle) / (Maximum Hurdle – Minimum Hurdle))

• I think it’s worth noting that Scott had a choice between a 4 year vesting and 5 year vesting. He chose a 5 year vesting given his level of commitment to trying to achieve the hurdles.  

Michael Castleman and Hugo Malan

• Base salary:  $400,000

• Cash bonus:  Up to 70% of base salary

• TVDS:  Michael received 59,844 shares of which 40% vests in year 2, 30% in year 3 and 30% in year 4 and Hugo received 63,331 shares with the same vesting schedule

• PCSU:  Each received 142,052 PCSU which will vest earned based on time-based vesting requirements and achieving certain stock value performance requirements by year 5 (September 2019).  Each will receive the following:

• $2m if the minimum stock price of $31.58 per share (“Minimum Hurdle”) is achieved (which is double the stock price base of $15.79 per share)

• $5m if the maximum stock price of $47.37 per share (“Maximum Hurdle”) is achieved (triple the initial stock base).  Maximum payable bonus of $5m.

• If the stock price is in between the Minimum and Maximum Hurdle, Michael and Hugo will each receive $2m + $3M*((Price – Minimum Hurdle) / (Maximum Hurdle – Minimum Hurdle))

• Insider Buying:  Michael purchased 5,000 shares on the open market on March 9, 2015 at an average price of $14.30.

David Arkless

• Base salary:  $400,000

• Cash bonus:  Up to 70% of base salary

• TVDS:  Granted 47,498 shares of which 40% vests in year 2, 30% in year 3 and 30% in year 4

• PCSU:  David received 603,362 PCSU which will be separated into two tranches.  

• Tranche I:  Up to 286,705 PCSUs will vest based on time-based vesting requirements and achieving certain stock value performance requirements by year 5 (September 2019).  

• $5m if the minimum stock price of $31.58 per share  is achieved (which is double the stock price base of $15.79 per share)

• $10m if the maximum stock price of $47.37 per share is achieved (triple the initial stock base).  Maximum payable bonus of $10m.

• If the stock price is in between the Minimum and Maximum Hurdle, David will receive $5m + $5M*((Price – Minimum Hurdle) / (Maximum Hurdle – Minimum Hurdle))

• Tranche II:  Up to 316,657 PCSUs will vest based on achieved levels of International Business Operating Profit (“IBOP”).  Today, the International business generates breakeven profits.

• $5m if the minimum IBOP of $10M (“Minimum Hurdle”) is achieved

• $10m if the maximum IBOP of $20M (“Maximum Hurdle”) is achieved.  Maximum payable bonus of $10m.

• If the IBOP is between the Minimum and Maximum Hurdle, David will receive $5m + $5M*((IBOP – Minimum Hurdle) / (Maximum Hurdle – Minimum Hurdle))

Currently, these are the only 4 executives that we know that have an incentive structure aligned to the stock price and business unit.  Scott has stated he plans to reorganize the rest of the management team’s compensation structure so that executives are paid based on the performance of their units.

Valuation:

Downside Case

With $153m of net working capital, we think our downside is somewhat limited in this situation.  Even if we assume a multiple of 7.5x for the MRI business, we get to an enterprise value of $213m which is a $12.60 stock price.  At the current valuation, we believe you’re not paying much for a turnaround of the stock and we don’t need management to be rock stars for this stock to do well.  

Base Case

We valued our based case on a sum of the parts analysis assuming a more normalized financial profile for the business.  Today, management is currently under earning versus its peers in GETS and PSS.  Within GETS, CDI’s competitors (JEC, ACM, CBI, CTG, FLR) are generating closer to 6.5% EBITDA margins and GETS is only at 3.5% ebitda margin today.  This is despite many of those peers having lower margin / higher risk construction contracts.  We think management can, at minimum, get this business to 5.5% margins.  A big part of this is the rolling off of one of the few fixed price contracts GETS has that has been a big drag recently on margin (a $1.9M loss in Q4 alone).  Within PSS, CDI’s competitors (MAN, CTG, RAND, KELY.A, HAS, KFRC) are generating 4.5% EBITDA margins and we think management should be able to bring this up closer to 3.5% ebitda margin, not far off from where they are today.  This margin will likely decline in 2015 as they invest in new sales resources, especially in the regional staffing business, but should trend towards the higher level over time.  We apply a 7x, 8x, and 10x multiple respectively, to GETS, PSS, and MRI, all of which are generally below peer multiples (GETS at 7.5x, PSS at 10x, MRI at 13x).

Upside Case

We think in an upside case that Scott and his team can easily hit their double stock price hurdle which would entail management executing and getting the Company merely seen in an average light (this performance in our view does not require top tier performance).  Even applying multiples below peers, we can arrive at a $31 price target (119% upside)

Comps:

Risks:

• We view the biggest risk here as senior management’s lack of experience in the staffing industry and ability to execute is a concern.  Management in general has more of a financial background than an operating background, and history is littered with smart financial people unsuccessfully turning around operating intensive businesses.

• Mitigants:  Scott may lack the industry experience but we think that he has formed a very good management team.  Everyone brings something to the table whether its financial/analytical savviness (Michael), industry expertise (David) or strategic thinking (Hugo), we think the team is very well balanced.  Scott also has significant relationships on Wall Street and we believe he will utilize this to his benefit to potentially improve the interests on CDI.  Lastly, at the current levels, we don’t need the team to hit it out of the ballpark.  We understand hitting the triple in particular is going to be very hard and potentially unrealistic and we are not underwriting that in an upside case.  But there is no doubt that management is very motivated, personally and financially, and we think they will find ways to create value for shareholders from these levels.

• Things could get worse before they get better.  Unlike some turnaround situations, the plan here is to invest more in growing the business / adding capabilities v. a situation of a fat company where costs need to be slashed.  Management is still new and it will probably take at least another 2-3 quarters before we start to see meaningful improvement from their initiatives.  They also continue to struggle with a few small fixed price contracts in GETS which hampered margins in Q4 and may continue to do so.

• Mitigants: They have already made this very clear, and this is likely reflected in the recent sharp move down in the stock and expectations for 2015.

• Decline in IBM business

• Mitigants:  30 year relationship with IBM, already has declined substantially and not a material portion of total company profits.

• OGC PSS & GETS has more exposure to energy than we realize

• Mitigants: Unless management is lying about having no upstream exposure and that the majority of downstream exposure is unrelated to oil feedstock, it’s tough to see a decline in midstream being enough to move the needle materially here

Catalyst

• Roll-off of fixed price GETS contracts that are losing money
• Management finalizing plan to turn around the business and presenting plan with clear financial goals to investors
• Any whiff of a turnaround potentially happening or any reason to be optimistic on the businesses prospects
• Potential divestures of MRI or other non-core assets
• Sale of the company