Description

Healthcare Locums (HLO LN): £1.70

Thesis

Healthcare Locums ("HLO") presents an opportunity to purchase a uniquely positioned, noncyclical business for <7x 2010 earnings with sustainable earnings growth of >30% organically per year and >200% incremental return on invested capital.  At first glance, HLO appears to be a general staffing company, similar to Adecco or Randstad.  In reality, HLO has a very specialized niche within healthcare recruiting where the firm focuses exclusively on placing doctors, social workers and health professionals.  Due to poor communication following a historical non-cash change in accounting policy, the shares aggressively sold-off by >30% in just over one week.  We believe that the City/Street misunderstands the accounting change, the quality of the business, the sustainability of the growth, and the aptitude of the second largest owner, the CEO.  Excluding the CEO, the top five shareholders have all been adding to their positions following the dramatic decline.  The CEO remains in a quiet period indefinitely.  We suspect the Company is being aggressively pursed by one or more potential acquirers.

In addition to first mover advantages including scale and brand equity, HLO has created a unique moat with high barriers to entry from its interdependency with the NHS.  CEO Kate Bleasdale owns nearly 10% of the shares and has an impressive track record of value creation within the space.  At HLO, she has proven out the business model from its formation in 2003.  The Company is now in the early stages of a virtuous cycle as indicated by >30% sustainable earnings growth against minimal incremental capital invested, while the healthcare placement industry grows by 8-10%.  Industry growth could accelerate driven by budgetary pressure at the NHS and an increasing demand abroad (more than doubled in 2009 and in 2008).  The NHS can save 25-30% per doctor by employing HLO versus hiring full-time doctors in-house.  In effect, we believe we are buying a business that will sustainably grow earnings by at least 30% per annum in any economic condition behind the best manager in the space for less than 9x current year earnings.

Description

HLO is a specialist healthcare recruitment business focused on higher margin disciplines, including doctors (33% of sales), social workers (27% of sales - think adoption and fostering, child protection, mental health, elderly care, etc.) and allied healthcare professionals (40% of sales - think nurses, specialty technicians and other healthcare practitioners).  This means that they source and place permanent (7% of sales, but growing by >50% per annum) and temporary healthcare professionals into hospitals and social service facilities.  The largest direct customer is the NHS ~40% of revenues (99% of Doctors, 30% of allied health professionals and 0% of social care).  Indirectly, the UK government accounts for ~60% of total sales.  Nearly 100% of sales are within the UK.  The US business currently accounts for just GBP3.2mm of sales, but that is 10x higher than 2007. 

Aside from domestic brand equity, HLO has created a very strong niche by uniquely sourcing supply (the bottleneck in the industry).  >70% of HLO's Doctor placements are sourced from overseas (US, Australia, New Zealand and the Middle East).  These trained professionals are sourced through a series of small offices in local countries, and then efficiently processed and documented through established relationships with the British immigration services.  This is typically a six month process.  Due to burdensome bureaucracy in the US, the Visa process requires four years on average.  HLO began its placement services for the US five years ago.  In 2009, the Company generated £3.2mm from the US.  In 2010, HLO will generate >£6mm.  The demand for nurses in the US is extensive, creating an enormous opportunity for HLO over the next five years (1.6mm additional nurses required by 2014). HLO is the ONLY player in the UK with this immigration-driven business model.  They are the largest player by a significant factor with really no ceiling to market share gains given just 13% market share in staffing doctors, 14% in allied healthcare professionals and 10% in qualified social workers. 

Long Merits

• Valuation: Despite 2009 ROIC of 38% and >30% sustainable earnings growth, Healthcare Locums trades at <7x 2010 and 5x 2011 P/E. The shares trade at just 6.2x and 4.4x 2010 and 2011 P/FCFS.
• Clear Market Dislocation: The accounting correction was non-cash, only impacts 2008 and 2009 historical figures and actually ENHANCES cash earnings. Staffing-sector focused analysts value HLO using peer average industry multiples from the low-growth, cyclical, mid-single digit ROIC peers. This is largely the result of misunderstanding a) the consequences of UK government budgetary cuts, and b) the virtuous cycle that HLO has created, resulting in above-industry average growth and 200% incremental ROIC.
• o Accounting: The accounting change impacted just 4% of sales in 2009 and will have a positive cash impact. Permanent placements accounted for 4.3% of sales in 2009, 2% in 2008 and almost 0% in 2007. In 2009, this figure doubled again to 4%. Similar to Robert Walters, Michael Page, Randstad, Manpower and Robert Half, Healthcare Locums recognized permanent placement revenue upon the candidate signing the contract (and receives a cash payment/deposit) as opposed to when the candidate starts. While this is common practice in the industry, International placements began to grow at a very rapid pace and the management team decided, completely independent of the auditor, to change the policy to recognize the revenue when the candidate begins the job. The reason this change happened now is quite simple. Even now, this is a very small portion of the overall business. However, as it becomes significant to the Company, the need for provisioning could increase as many placements into the US, for example, take many months and sometimes years to get fully processed through immigration and training. While they have not experienced a single defector, Management kept provisioned 5% of sales regardless. Now, management has decided to take an even more conservative stance and will only recognize revenue when the candidate begins his job. Hays, SThree and Adecco also prescribe to this more conservative method of accounting. The reality is that there is no impact to 2010 financials as revenue differed in 2008 and 2009 will be recognized this year. Additionally, the Company will receive a cash tax refund for excess taxes paid in the previous two years as lower accrual income begets lower cash taxes. Unfortunately, the Company delayed their filing one day and elected to engage in one-on-ones instead of hosting a broader analyst call. The CEO admitted this was a PR blunder and has been traveling throughout the UK (and now the US) to set the record straight. Again, for any concerned on the accounting issues, we suggest you just follow the cash...
• o Customer Concentration: 30% of people in the UK are employed by the government. The NHS spends >£100bn per year and total healthcare expenditures are over £200bn. Total healthcare liabilities are >£1.5tn. The UK has the third worst demographic trends in the world (after Japan and Germany) with increasing demand growth as baby boomers are now entering their "golden years." These facts are well-flagged. The world knows that the UK is in for a very difficult position (except maybe the debt and currency markets) and the answers are clear: significant spending cuts, increasing debt issuances and increasing debt monetization. While some analysts appear to believe that HLO will face pressure from the government, the exact opposite is true. 60% of NHS spending goes to wages. The NHS saves 25-30% per employee when relying on HLO versus hiring internally. With over 240,000 registered doctors at an average salary of nearly £90,000, over 400,000 registered nurses with an average salary of £22,000 and hundreds of thousands of other social care employees, the savings potential is in the several billions. Both political parties are fully aware of this potential and maintain very strong relationships with HLO management.
• o Business Model: As a result of HLO's established reputation, scale and systems, the firm has created a virtuous cycle. HLO has access to the best prospects (doctors, nurses, etc.) from inside and outside the UK. Hence, the best clients (hospitals, social services, etc.) give the best opportunities (and most profitable) to HLO, who is best-positioned to fill them. Additionally, as the Company gets bigger, they can assist the NHS by taking on larger contracts. This is the virtuous cycle that enables and underpins continued market share growth.
• Management Quality: Kate Bleasdale owns nearly 10% of HLO with over 20 years of experience in working within healthcare staffing. Kate originally started Match Group, a general healthcare placement service, in 1986. She started the business with nothing except for a small office and a phone, which she financed with £7,000 from family. Match had turnover of over £120mm in 2000 when it was purchased by HG Capital of £70mm. Kate remained at the helm until 2002 where she grew sales to GBP185mm and net profits to GBP12mm. She left unceremoniously and litigiously following the new owner's decision that the firm would IPO at a better price with a man at the helm (obviously hearsay, but confirmed by settlement). Kate then launched HLO in 2003. The Company went public in 2005, which now has 75% higher turnover than her predecessor company (and several hundred basis points of higher margins). Kate would sell HLO at the right price, but she does not believe that the current valuation reflects the growth and quality of the business.
• Business Quality: This appears to be a very strong business with high barriers to entry reflected by 40% ROIC (and rapidly accreting) and >15% operating margins. While the initial recruit may not intend to create value for his fellow recruits, he does so because the aggregation of demand results in greater supply (hospitals use the service more and more), and hence greater demand, and greater supply, etc. These network effects have created a positive feedback loop that would require significant time and money to attempt to replicate. This barrier is also reinforced by HLO's strong relationships with the NHS and hospitals, schools in nearly every corner of the English-speaking world and with immigration services. Given low double-digit market share, it appears that the growth rate should continue to be very high driven by current undersupply in the market, significant demand growth driven by UK budgetary constraints and the virtuous cycle created by HLO management.
• Takeout Candidate: Many general staffing companies are aggressively looking for acquisition candidates in order to grow (especially Adecco). HLO appears to be an ideal target given the highly visible growth potential of the company at a single digit multiple of current year earnings and a balance sheet that will carry no debt by year-end 2010. When we asked the CEO and CFO if they were personally buying shares last week, the response was that they were unable to do so because they are currently restricted. Further, we asked about why they were restricted, they explained that the management team is unable to share the reason why. With only a few possibilities underlying the restriction, we expect that the Company may already be in takeover discussions. The only issue with that, as we see it, is that a 40-50% premium would be a crime given that we see 200-300% upside over the next few years.

Long Risks

• Customer concentration: NHS accounts for 40% and UK government for 60% of top-line sales.
• o Because procurement is largely executed at the local level, no single customer actually accounts for more than 2% of sales.
• High ROIC and margins could erode over time as competition enters this lucrative market.
• o We believe margin expansion will occur as HCL has avoided commodity services, fill-rates are rising (suggesting increasing client satisfaction and pricing power) and the inherent operating leverage in the business (minimum additional capital or G&A required to grow).

Catalysts

• Roadshow, quarterly earnings, new/better research coverage, takeout

Catalyst