Description

This is thesis to short HSII based on the devastating cyclical impact inflicted every few years when the job market heads downhill and the economy falls into recession.  This thesis is predicated on the belief that, for a variety of reasons, we are likely to be heading into a recessionary environment in the US (and, eventually, abroad), and that sectors that compose the majority of HSII’s business are likely to be hit hardest.  These conditions will eventually result in charges, margin compression, revenue declines, analyst revisions, loss of investor confidence, and panic selling.  Though the market is currently weary of cyclical risks here, analysts’ estimates are nowhere close to where they need to be to properly take into account cyclical risks.  This write-up will take the macro-thesis as a given: if you disagree with it, and aren't looking for any hedges in the event of a recession, this idea will likely be of little interest. 

HSII is an executive recruiting company focusing on high level, permanent placement staffing.  The company has two businesses: one is its permanent staffing business, which has historically generated earnings and FCF in favorable economic times, and suffered losses, margin compression, restructuring charges, and overall destruction in shareholder value in poor economic times.  Their 2nd business is a value destroying stock grant and buyback business, in which management awards themselves and employees options and stock grants throughout the cycle, exercises both at the peak of the cycle, and uses the minimal proceeds from the stock issuance and the cash flow generated from the business to buy back their own expensive shares on peak earnings, right before things go to hell.  HSII is not the only cyclical staffing company to do this, but shareholders still suffers from this choice.

Permanent placement business and cyclicality:
Permanent placement is a classically cyclical business that repeats itself in predictable patterns.  When competition for employees is high and jobs are plentiful, companies look towards executive placement companies to poach talent, fill new positions, and generally to help them get an edge in the talent war.  Good economic times also lead to candidates switching jobs frequently, resulting in more and more fees for the recruiters.  Avg. fees/search increases, margins expand on operating leverage and increased productivity, and companies add recruiters as business expands.  As the cycle nears an end, analysts and investors begin treating these as growth businesses and project recent growth into perpetuity.  They invent reasons why this time is different (global talent war, lucrative foreign markets, etc.).

Eventually, the economy slows down and the process works in reverse: companies hire less, have an easier time finding talent when they do hire (everyone has a talented friend whose been laid off), and have less use for the executive recruiters.  When this happens engagements decline, fees are pressured, margins tighten, operating leverage works in reverse, and companies take charges as they lay off employees and right-size their businesses.  HSII is particularly prone to be hit hard by the cycle given its sector exposure and aggressive share buybacks at these levels.

Despite the plain way in which this chain of events has occurred in the past, and will likely occur again, a series of misconceptions currently exist which will, one by one, will prove to be false over the next year or two as things deteriorate.

Misconception #1: Foreign exposure will make this time different
Analysts point to increased foreign exposure.  Really?

Geography    FY2000 % of rev    LTM % of rev
U.S.                    61                            51
Europe                30                            33
Asia/Pacific         6                             12
LATAM*           3                              4

Geography    FY2000 % of inc    LTM % of inc
U.S.                    61                            58
Europe                28                            22
Asia/Pacific          8                            16
LATAM*             3                             4

Although revenue and income is marginally more diversified than at the last peak, HSII still relies on the US for the bulk of its income.  This may actually be a good thing in an oncoming recession.  Lets see what happened to HSII’s revenue and income by market last time there was a recession.

Geography    Change in FY00-FY02 revenue
U.S.                                    -47%
Europe                                -29%
Asia/Pacific                        -39%
LATAM*                            -45%

*Estimates

The international markets fell apart on a revenue basis even nearly as much as the US did the last time around, and with explosive growth abroad and fates still linked at least in part to the US, I would not be surprised to see the same trends this time around. Looking at income by geo paints an even bleaker picture:


Geography    % of FY00 Op Inc    % of FY01 Op Inc    % of FY02 Op Inc
U.S.                        61                                83                            116
Europe                    28                                17                            -11
Asia/Pacific               8                                7                                5
LATAM*                 3                                -7                            -10

Note that the above is calculated before corporate expenses and restructuring charges.  This flies in the face of analyst estimates and common wisdom, which is that these markets will carry HSII in poor economic times.  Goldman, the most bearish of the I-banks, has modeled continued growth abroad.  The reason for the better relative performance in the U.S. is several fold:

1)    More layoffs and restructuring charges in the U.S., which protected core operating income even though the geography as a whole was unprofitable including charges
2)    Better scale In the US.  Divisions are large enough that you can layoff a couple people in an industry vertical and still be okay.  In some foreign markets, a given division may be comprised of only one or two people.  Lose those people, and you give up the segment
3)    The street expects growth to happen abroad.  Cutting staffing levels in poor economic times would hurt the story and make people realize that there actually isn’t any organic growth here.

It’s also worth noting that HSII’s sector exposure (34% financials, 19% consumer) is exposed to what will likely be the two weakest sectors in an oncoming recession.  These exposures—particularly the financials exposure—has grown noticeably since the last peak, meaning much of that growth may be tied to positions and companies that no longer exist.

Misconception #2: Restructuring charges are one-time charges

HSII has a history of taking charges, both in good and bad economic times.  When the charges occur as frequently as they do with HSII, and when they are specifically tied to a recurring, predictable event (hiring slowdowns), you have to consider them part of the ongoing business.  

    2000    2001    2002    2003    2004    2005    2006
Charges    12.2    55.2    48.5    29.4    .5    22.5    .4

One other point worth noting—which I don’t think the market has factored in—is that more charges are likely as the economy slows down.  I wouldn’t be surprised to see charges as soon as the next couple quarters as company lays off recruiters in the financial services vertical to right-size it for current demand.

Misconception #3:  These are long-term growth businesses.  Any slowdown will be a hiccup on a longer favorable growth pattern.

I’d argue that growth for a business as cyclical as this should be viewed over a full economic cycle.  Assuming we are at or close to a full cycle currently, HSII’s business has actually shrunk on a real basis.  Revenue CAGR from FY00 to LTM is a pathetic -0.1%.  Additionally, the executive recruiters face serious long-term pressure from the rise of social networks that allow people to maintain contacts more easily.  In a better-networked society, HSII (which, in many cases, is essentially a networker, connecting one person with another) becomes much less valuable.  

Despite nearly every analyst citing very serious cyclical concerns, no one has modeled anything close to a real cyclical downturn scenario, in which revenues drop 40%+ from their peak, margins collapse, and the companies take charges.  Below are analysts’ implied revenue CAGR based on FY09 estimates:

ML:  3.9%
GS: -0.2%
Davenport:  6.9%
Historical: -0.1%
FY00-FY02: -23%

Those estimates are bound to come down if we are in fact headed towards recession.  

Misconception #4:  Buybacks are shareholder friendly

HSII is part of a disturbing trend in which share buybacks serve to keep the share count constant as the company absorbs large option and share grants from selling management.  

Since the end of FY01, HSII has spent $149.1M on share buybacks.  In the same period, the fully diluted share count has risen by ~1.1M shares.

This is an outrageous fact, especially when you consider that HSII hasn’t really received any benefit from those additional shares (e.g. not issued for acquisition, capital expenditure, etc.). This is particularly outrageous considering that HSII is only a $600M company, and despite essentially buying back what should amount to roughly 1/4th of shares at today’s prices, the fully diluted share count has managed to go up.  Even the basic share count has only decreased by about 500k.  The company has a generous share grant package that continues to result in dilutive pressure and destroy shareholder value.  

The company continues to use its cash hoard by making acquisitions and conducting share buybacks at peak earnings, which is a recipe for continued value destruction.  Which brings me to the most common misconception of all.

Misconception #5:  HSII creates value for shareholders over a full economic cycle.

This past economic cycle has created virtually zero value for shareholders, as nearly all free cash flow (adjusting for extraordinary gains, most notably from HSII’s Google warrants) has gone into share buybacks to offset dilution from options and stock grants.  Calculating FCF is a bit of a mess and debatable depending on how you treat extraordinary gains, but the amount generated from the FY01 to the current quarter seems to roughly approximate all that was spent on buybacks keeping the share count down.  If all the FCF generated from each cycle continues to be used in this way, and if the value of stock really is ownership on the FCF stream generated by a business, can the stock be said to have any real value to shareholders the way it is currently run?  I realize this is a somewhat heady question, but I think it’s one investors will hopefully begin asking more of HSII and other management teams who essentially are using the company piggy-bank to buy back their own shares that they issued to management in the form of grants or stock options.

Misconception #6:  The risk of recession is already priced in; the stock has already fallen so much; the cash backstop provides a margin of safety.

The risk of recession is already priced in:  No, it’s not.  Analyst estimates are nowhere near recession scenarios; also, at least one analyst has erroneously looked at trough multiples based on current earnings, sales, and cash and concluded that we are already trading at recession multiples.  Though multiples are approaching (but not yet at) recession multiples, it is important to note that recession revenue, earnings, cash, etc. are likely to be much lower.  I think there is between 35%-55% downside remaining over the next year.  

The cash backstop provides a comfortable margin of safety: The buybacks and purchases of other companies at peak earnings are doing a great job eroding that cash balance.  Also, it’s worth noting that when the cycle last turned, both KFY and HSII experienced negative FCF of about $50M.   Overall, given HSII’s history of poor capital allocation, I don’t think we can give that cash full value.

Valuation  

I’ve attempted to find a trough price estimate based on a few different valuation methods.  I’ve used multiples from Fall of 2001 to estimate how bad things may get in a recession scenario.

Fall 2001 est. stats:
Cash:  $126M
Price:  $15
Mkt cap:  $270M
EV;  $144M

EV/ Peak EBIDTA multiple:  3

EV/Peak Sales:  .25

Recession Scenario:
*Cash:   $150M
Peak EBIDTA:  $88.5M
Peak Sales:     $600M
**Fully diluted shares:  18.3
Implied price on peak EBIDTA:  $22.70
Implied price on peak Sales:     $16.39
Downside:  35%-53%

*Current Cash of $218M + additional FCF of $32M – recession cash adjustment ($50M) – share buyback ($50M @ avg. of $30)
**19.1M currently – 1.6M share buyback + 800K additional share grants

Catalyst

Catalysts:
Buybacks, housing contagion spreads, unemployment increases, soft revenue/order bookings, more charges recorded, erosion of international segments, decreased analyst estimates, panic selling