Description

Computer Horizons offers investors the opportunity to invest in a catalyst-driven, six to twelve month story that should result in significant price appreciation.

I believe Computer Horizons’ management attempted to plow through a self-serving, value destroying merger, and I believe they are about to pay the price while shareholders benefit. On Friday, Crescendo Partners a well-known and successful activist and value-oriented firm, along with well-respected and successful value-oriented investment firm Richard L. Scott Investments filed a 13D and Preliminary Contested Proxy Statement. The two firms have formed a group called the “Computer Horizons Full Value Committee”. The Proxy Statement and 13D are clear that the group intends to solicit proxies to vote against the proposed merger (which I will discuss later) and to call a special meeting to remove the current Board of Directors in order to pursue a sale of the Company or other “shareholder value maximizing” transaction.

The history of the Company is marred by insider trading allegations against a former CEO and a recent accounting restatement. However, the Company has some very interesting assets that I believe have value in excess of $4.50 per share up to over $6 per share.

The Company

Computer Horizons operates through three divisions:

IT Staffing: The IT staffing business is approximately $125-$130 million of revenue. The business operates at a 16-18% gross margin. CHRZ has provided IT staffing for 25+ years and has a Fortune 2000 customer base with solid exposure to the financial services sector.
IT Consulting: $55-$60 million of revenue, provides Web consulting, HIPAA compliance, near-shore/off-shore software solutions utilizing their facilities in Montreal and India. Gross Margins in the mid-20%’s.
Together, IT Staffing and IT Consulting make up the firm’s “Commercial” division.

Federal Government Services: $50 million of revenue. Provides high-end technology solutions and program management to Federal, State, and Local government agencies. Gross margins in excess of 40%.

Chimes: $25 million, the crown jewel of the business, Chimes utilizes proprietary, internally developed software to provide vendor management services (VMS) that assist customers in their procurement and management of their contingent labor. The segment is a recurring revenue and transaction fee based model (about 2% of a company’s contingent workforce spend). The division has a first mover advantage and a blue chip customer base (HP, Washington Mutual, United Healthcare, etc.). The segment has been growing in the 15-20%+ per year range and is on pace to do so again this year. It has a 90%+ gross margin and high fixed costs. The business passed the break-even threshold last year and management has stated that Chimes should operate at a 10% operating margin (post-corporate allocation) this fiscal year.

The Fight

A little background on the history of this Company is important, as I believe it helps in understanding the likelihood of success for the CHRZ Full Value Committee.

Two years ago, former CHRZ CEO John Cassese’s employment with the Company was terminated after charges of insider trading were brought against him and he was indicted. The Company then missed earnings badly, and competitor Aquent LLC attempted to take advantage of the beaten down share price. Aquent made a $5 cash bid to buy the Company after buying up about 5% of the shares. In order to help effectuate the transaction, Aquent nominated two representatives to serve on the Company’s Board of Directors and began a proxy fight to have their nominees elected. Eventually, Aquent won the proxy contest and two of its directors were elected to the Board. However, immediately after the election, CHRZ closed on a large acquisition of federal government services provider RGII, which chewed up over $1 per share of cash (the acquisition has actually been fairly successful). Additionally, CHRZ sued to have the results of the meeting set aside after having already sued Aquent for making false statements during the proxy fight. With a large source of financing gone and the prospect of additional lawyer fees ahead of it, Aquent gave up and resigned from the Board. However, they did not do so without incorporating some nice governance provisions into their settlement with CHRZ. As part of the settlement, CHRZ agreed to change the Company’s bylaws to allow for a call of a special meeting for any reason (including removal of all Board members) if holders of a beneficial interest in the common stock of 10% or more requested a meeting be held. This provision is coming in very handy now as the CHRZ Full Value Committee, with 10.3% of the shares, can call a meeting without any outside help.

After fighting off Aquent, the Company set about executing on its strategy of growing the Chimes and Federal Government business. In the first year after the fight, results were somewhat sideways and the Company continued to operate at low levels of profitability relative to the industry and past estimates made by management. The Company then announced an accounting error in October 2004 that resulted in significant write downs due to improperly understated consultant costs. At that point, it appeared animosity towards management began growing on each conference call. Rather than pursue what I believe would have been a shareholder maximizing transaction such as a sale of the Company, I believe management jumped at the chance to merge with the first company that came along and would allow them to keep their jobs. The Company announced its intention to merge with Analysts International, a company of similar size in terms of revenues. To add insult to injury CHRZ management negotiated what I believe to be an absolutely horrible deal for CHRZ shareholders. The CHRZ Full Value Committee does a good job of outlining the reasons the deal is poor, and I agree with all of them. Here is a summary of the argument:

- Despite being of similar size in terms of revenue, CHRZ having a far more liquid balance sheet and operating two business units (Chimes and Federal Government) that I believe to be of significantly more value than the staffing business that makes up the majority of ANLY’s business, CHRZ and ANLY negotiated a 50/50 merger of equals.

- ANLY’s management walks away with golden parachutes, and transaction costs (incl. parachute payouts) are expected to be $14 million; I believe these costs are far too high relative to the size of these companies.

- CHRZ had, on numerous occasions over the last two years, stated that the Company’s strategy was to transition away from and de-emphasize the staffing business to focus more on the high margin, value-added service offerings. The transaction with ANLY appears to do the exact opposite.

- Probably most importantly, it appears that CHRZ’s board did not pursue alternative strategic options to the merger with ANLY. In fact, nowhere in the very detailed S-4 does the Company discuss having contacted alternative merger partners, acquirers, or acquirers of individual business units. Crescendo takes a very constructive tone in their filing when they say “we believe the solicitation process was flawed” – I would have put it more bluntly; I believe the Board did not act on their fiduciary duty to maximize value for shareholders.

I encourage you to read the Company’s S-4 and the recent filing by Crescendo for more details on why this merger is a poor deal for CHRZ shareholders. I believe the merger and the details surrounding it show why it is problematic to invest on a passive basis in a company with limited shareholder ownership by management. However, this works to an activist shareholders advantage in a meaningful way.

Management owns very little stock in the Company and the shareholder base should be friendly. Here is a list of shareholders using the best information available to me:

CHRZ Full Value Committee 10.3%
Fidelity 9.75%
Royce 8.19%
Dimensional 6.26%
Tocqueville 4.86%
John Cassese (ex-CEO) 4% (approximately)
Longfellow 2.74%
NJ Div of Investment 2.18%
Lindvall 1.40%
SC Fundamental 1.28%
CALPERS 1.00%
Citizens Advisors 1.00%
Barclays 0.85%
Al Frank Asset Mgmt 0.82%
Pinnacle 0.7%
Kennedy Capital 0.7%
Total 56.0%

I think this list is favorable. The record date for the meeting related to the merger is June 24 (special meeting scheduled for August 12), and the CHRZ Full Value Committee owned about 6.7% of the stock on that date. In a special meeting called to remove directors the CHRZ Full Value Committee would vote all of its shares. Additionally, ex-CEO John Cassese still owns a significant amount of stock, and he actually came out aggressively against the Analysts International merger at the recent annual shareholder meeting:

http://www.dailyrecord.com/business/business1-comphor.htm

This is important in the context of this fight. Cassese was actually AGAINST the Aquent proposal from two years ago, and yet Aquent was able to win the proxy fight. At the time he owned 5.6% of the stock versus approximately 4% now. This is therefore almost a 10% swing away from current management’s prospective vote tally in favor of the CHRZ Full Value Committee. Owning virtually no stock and having made numerous promises during the last proxy fight that I believe were not met, missing earnings estimates for two years, proposing what I perceive to be a value destroying merger replete with large parachute payments, facing very professional shareholder activists and what appears to be a 10% swing in the vote the other direction, it is fair to say that the wind is definitively in the face of the incumbents. If either Royce or Fidelity support Crescendo I think this is over before it even starts. Additionally, I would expect ISS to support Crescendo given the tone of Crescendo’s argument, Crescendo and Richard Scott’s solid reputation, what I perceive to be overly generous proposed severance packages and the apparent lack of exploration of strategic alternatives by the current Board of Directors. The support of ISS may also make this a layup for the CHRZ Full Value Committee as many of these institutional shareholders are likely to listen to the ISS input.

It appears that the CHRZ Full Value Committee is planning on calling a special meeting to remove the current Board of Directors. As I mentioned, this is within their right as they now own over 10% of the stock. This meeting will likely be held after the vote on the ANLY merger. It is clear that the CHRZ Full Value Committee would immediately hire an investment banker to pursue a shareholder maximizing transaction or series of transactions if successful in removing all current directors. Here is the language from the PREC14A:

“We believe the Computer Horizons Board should retain an investment banking firm to assist in the review of all available strategic alternatives to maximize shareholder value including, but not limited to, selling the entire company by means of a merger, tender offer or otherwise to the highest bidder . . . or continuing to operate the Company and divesting or spinning-off its non-core assets”.


So What Is It Worth?

If you believe, as I do, that it is likely Crescendo will take over the Board, the next step in evaluating this opportunity is to determine what a sale or split up of the Company would yield in terms of value to shareholders. Crescendo should have a myriad of options here and could conceivably pursue a break-up of the company. Different buyers for different pieces of the business exist and a sum of the parts may be worth more than the whole. Obviously, a very large multinational IT services concern could also come in and trump everyone if they have the desire (think Accenture, IBM). Also, a small to mid-cap IT services business may propose an attractive stock deal (Ciber, Keane).

I do not believe CHRZ is an attractive business if it were to operate on a stand-alone basis (with or without ANLY), particularly with the current management team. However, CHRZ has significant strategic value to competitors that could take a great deal of cost out of the business. I have heard from a number of sources that CHRZ’s cost structure is very poor and that the Company is ripe for cost-cutting from the right party. The individual business units of CHRZ are profitable prior to corporate overhead allocation, and support a break-up value significantly in excess of the current price. Here is an overview of recent financial performance, by division:

$’s in Millions 2004 Q1 2004 Q1 2005

Commercial (IT Staffing and Corporate Consulting)
Revenues $191.1 $44.8 $48.7
Gross Profit $38.0 $9.7 $9.5
% Margin 19.9% 21.7% 19.5%
EBITDA $9.1 $3.3 $2.8
Op. Income $8.4 $3.1 $2.6
% Margin 4.4% 6.9% 5.3%
Corp. Allocation $15.6 $4.0 $4.1
Op. Inc. Post Corp. ($7.3) ($0.9) ($1.5)
% Margin -3.8% -2.1% -3.1%

Federal
Revenues $48.3 $9.6 $11.5
Gross Profit $22.2 $4.2 $5.4
% Margin 46.0% 43.8% 47.0%
EBITDA $7.2 $1.2 $1.5
Op Income $6.5 $1.0 $1.3
% Margin 13.5% 10.1% 11.5%
Corp. Allocation $1.8 $0.4 $0.4
Op. Inc. Post Corp. $4.7 $0.6 $0.9
% Margin 9.7% 6.1% 7.6%

Chimes
Revenues $23.1 $5.3 $6.4
Gross Profit $21.7 $5.0 $6.1
% Margin 93.9% 94.5% 95.1%
EBITDA $2.9 $0.4 $1.6
Op Income $1.4 $0.0 $1.2
% Margin 6.1% N/A 18.9%
Corp. Allocation $2.1 $0.5 $0.6
Op. Inc. Post Corp. ($0.6) ($0.4) $0.6
% Margin -2.6% -7.5% 9.4%

Commercial Valuation
I believe this business could sell to a strategic acquirer for about 20% of revenues. Analysts International is probably the best comp for this business, as they look very similar to this business unit inside CHRZ. ANLY disclosed in their proxy materials that they received a $4 per share cash bid from a third party. This bid was not solicited and an auction process would probably result in higher numbers. A $4 per share transaction price for ANLY would put it at 0.28x sales, approximately. Also, Comforce, a slightly larger publicly traded company with a similar business (larger mix of staffing) and lower gross margins trades at approximately 0.3x sales with no control premium. Finally, large pure-play staffing companies such as MAN and KELYA, with lower gross margins than CHRZ’s commercial business, trade for .27x and .21x, respectively, with no control premium attached. I discount these for CHRZ for a number of reasons, including conservativism and the fact that this piece of the business is not profitable on a stand-alone basis post-corporate overhead and would require synergies to justify (I will discuss the appeal of synergies to acquirers of CHRZ’s business lines later). Using a 0.15x to 0.25x sales range to value this business results in the following proceeds (Note: EBITDA is relevant here as capex for the company has been running at 1/3 of D&A):

Revenues $195 Million
Low Multiple 0.15x
High Multiple 0.25x
Low Value $29.25 Million
High Value $48.75 Million
Low Multiple of EBITDA (pre corporate) 3.6x
High Multiple of EBITDA (pre corporate) 6.1x

Federal Government Valuation

The Federal Government business generates 40%+ gross margins and mid-teen EBITDA margins, so it should trade at a decent premium to the Commercial business. In April PEC Solutions (PECS), a government consulting and IT Services business, was sold to Nortel for 1.6x Revenue and 8x Forward EBITDA. While PECS was larger than this piece of CHRZ’s business, it shows the type of multiples companies are willing to pay to gain a foothold in the federal government space. CHRZ has acquired the companies that make up this piece of the business over the last two years, and has paid about 0.91x revenue to acquire them with 20% of the consideration being in the form of short-term notes and earn-outs. I believe a conservative way to value this piece of the business is at 0.7x-0.85x revenue given the recent comparable transaction, the higher prices paid by CHRZ, and the value relative to divisional EBITDA:

Revenues $50.3 Million
Low Multiple 0.7x
High Multiple 0.85x
Low Value $35.21 Million
High Value $42.76 Million
Low Multiple of EBITDA (pre corporate) 4.7x
High Multiple of EBITDA (pre corporate) 5.7x

Chimes Valuation

Chimes is the most difficult piece of the business to value. It is growing at 15-20% with substantial leverage to the bottom line based on 90%+ gross margins. The business basically runs as a stand-alone unit within CHRZ. It is on a run-rate for about $6-7 million of EBITDA pre-corporate and should do better than that based on recent contract wins and pipeline (for more information see CHRZ’s Q1 and 2004 earnings reports). Many analysts who write on the sector believe there is a secular trend toward Vendor Management Software and Services and nothing in the Company’s results makes me think differently. Additionally, Chimes is one of the first companies to have entered the space and they are, if not THE leader in the industry, one of the leaders. This all leads me to believe that this business would see a double digit multiple of EBITDA in a change of control scenario. However, in the interest of being conservative, I assign a low value of 2x revenue, or 7-8x pre-corporate EBITDA to this business unit:

Revenues $24.0 Million
Low Multiple 2.0x
High Multiple 3.0x
Low Value $48.00 Million
High Value $72.00 Million
Low Multiple of EBITDA (pre corporate)* 7.4x
High Multiple of EBITDA (pre corporate)* 11.1x

* Using $6.5 million of EBITDA, should probably be higher

Balance Sheet

Computer Horizons balance sheet is liquid and holds significant value to an acquirer or in a liquidation should Crescendo decide to go the break-up route. The Company currently has about $30 million of cash on hand ($1 per share), net working capital of about $64 million (almost entirely cash and receivables, $2.06 per share, customers predominantly Fortune 500 and government, so receivables are money good) and tangible book value of $95.6 million, or $3.08 per share. The Company does have some contingent liabilities related to an earn-out in the acquisition of the federal government business and a SERP that are not on the balance sheet of about $15 million (once discounted). Given the high net cash and working capital position, I assign a value to the balance sheet of about $1 per share.

Break-up Value
$’s in Millions Low High

Commercial $29.25 $48.75
Federal $35.21 $42.76
Chimes $48.00 $72.00
Cash/Balance Sheet $31.00 $31.00
Total $143.5 $194.5
Sh’s Out 31.2 31.2
Total $4.60 $6.23
% Upside 27.8% 73.1%

A break-up is a real possibility here. Another potentially attractive alternative would be to sell the Commercial and Federal businesses while keeping Chimes as a stand-alone public company and attempting to garner a growth multiple. Finally, the Company has significant NOL’s that should shield any tax issues relating to asset sales above book (although commercial and federal using my numbers would be sold below or right around book). I feel as though I’ve been conservative enough on my low-end values to justify an entry into the stock at the current price of $3.60, and a $3.08 tangible book protects downside.

Another Angle

Another eventuality is a sale of the entire Company in a single transaction. While the numbers below do not look attractive on a stand-alone basis, I believe it is necessary to look at these numbers in the same way a potential acquirer would view the business. That is to say, what is the profitability of CHRZ once it is part of a larger entity? I have talked to an interested potential acquirer of the entire business, a man who has been in the business for multiple decades. He believes the following:

- There is real opportunity for a strategic acquirer to eliminate the vast majority of corporate overhead and a good amount of field overhead. His point was threefold.
o CHRZ is too small to be an independent publicly traded corporation and the costs of being public are high relative to the size of the business.
o CHRZ is known as having a “fat” organization, particularly on the SG&A line at the field level (non-corporate SG&A).
o It is unbelievable that Chimes’ margins are not well in excess of 20%. With 90%+ gross margins this should be a layup. Part of the reason for the poor profitability relative to a 90% gross margin is due to poor expense management by CHRZ. Another significant reason for this is customer implementation costs. For example, in the traditional model of selling software licenses, a vendor charges a large up-front perpetual license fee which more than offsets the customer implementation costs, and up-front margins on the sale are high. Under the recurring revenue Chimes model, a customer sucks up a fair amount of cost and resources up-front as they are implemented. However, the payoff is the high margin recurring revenue over the life of the customer, rather than up-front. This results in more back-end weighted profitability for individual customers under the Chimes model relative to companies selling software licenses. So as the Company matures, operating income should have significant room to move higher as a percentage of revenue. His point was, if Chimes were to stop implementing customers, operating margins would probably be well in excess of 30% and potentially in excess of 40%, while reasonable expense management should get it well above 20% even in its growth phases.

Here is a view of consolidated financials:

2003 2004 Q1 2004 Q1 2005

Revenues $245.2 $262.6 $59.7 $66.6
Gross Profit $72.0 $81.9 $18.9 $21.0
% Margin 29.4% 31.2% 31.7% 31.5%
Corporate Overhead $20.7 $19.5 $4.9 $5.1
Other SG&A $61.0 $67.3 $14.9 $16.2
Op Inc ($9.7) ($4.9) ($0.9) ($0.3)
EBITDA ($3.3) $1.6 $0.6 $1.1
EBITDA (pre-corporate) $17.4 $21.1 $5.5 $6.2
Op Inc (pre-corporate) $11.0 $14.6 $4.0 $4.8

Note: Results exclude one-time charges.

I have spent some time getting comfortable with the ability of a strategic acquirer to take out costs here. In addition to speaking with industry sources and the aforementioned acquirer, I attempted to back of the envelope the components of the Company’s corporate cost structure, compiled from other investors who have spoken with management and public filings. Note: These are estimates:

$’s in Millions
HQ Lease (expiring EOY ’05) $1.5
Exec/Admin Salaries $5.0
Sar-Ox & Other Public Acctg $2.3
Other Public Co Expense $2.7
IT $1.0
Exec Travel/Perks $1.0
Total $13.5

I believe strategic acquirers could likely wipe away much of this $13.5 million. Given that I cannot find the other $6.5 million of corporate cost, I assume an acquirer would have to take most of these on. However, I assume an acquirer could wipe away $5-$10 million of field SG&A primarily from the commercial business, although that may be conservative. Here is where that analysis gets me:

$’s in Millions
LTM EBITDA $2.1
Corporate Overhead Reduction (Low) $10.0
Corporate Overhead Reduction (High) $15.0
Field Overhead Reduction (Low) $5.0
Field Overhead Reduction (High) $10.0
LTM EBITDA Adjusted (Low) $17.1
LTM EBITDA Adjusted (High) $27.1

At a $5 takeout price, this leaves you with the following multiples:
Mkt Cap: $155 Million
Transaction Costs: $10 Million
Net Cash: $31 Million
TEV: $134 Million
Multiple of Low EBITDA: 7.9x
Multiple of High EBITDA: 4.9x

Something in the middle is probably right, so 6.0x-6.5x adjusted EBITDA on a takeout for a strategic acquirer at a $5 price. This sounds reasonable given the mix of businesses.

CONCLUSION

Crescendo Partners has a history of successful activism. They see what the market does not. It may sound like I am making a lot of on the come adjustments here. But I believe they are justified. Read the S-4 produced by management recently, specifically the rationale for the deal. Then tell me whether or not you believe this is a sophisticated, professional management team with a good handle on the business. It appears to me that they are not. But therein lies the opportunity. The market is not discounting the fact that a break-up of the Company would reveal that the sum of the parts is greater than the whole, that a solid management team from a larger strategic acquirer could make this a far more profitable operation, and that a sophisticated, successful shareholder activist is going to assure that shareholders benefit from one of these eventualities.

Catalyst

Catalyst

Vote-down of the proposed merger with Analysts International
Removal of current Board of Directors, to be replaced by Crescendo representatives
Followed by 1 of the following:
Sale of the Company
Split-up of the business with sales of individual business lines (break-up) followed by distribution of proceeds
Sale of staffing business and potentially sale of Federal government business followed by large dividend or tender offer