Description

Overview:

Hudson Highland Group was spun out from its parent company TMPW Worldwide (TMPW) at the end of March 2003. It now trades as a separate company under the ticker HHGP. The distribution date for the tax free spin off was March 31, 2003.

As most of you are probably aware of TMPW owns the Monster.com business and is a leader in online job recruiting. Due to the different business lines of HHGP and TMPW management decided it was best if they were separated and operate as autonomous units.

HHGP basically consists of 2 business lines; eResourcing and Executive Search. eResourcing division primarily focuses on mid market executive search and temporary and contract business. Executive Search focuses on senior level searches for executives making more than $150,000 per year. The wide majority of HHGP’s revenue is derived from the eResourcing business. In 2002 $998 MM was in eResourcing vs. $67 MM in Executive Search.

Specialty staffing and permanent work is the largest contributor to eResourcing’s revenue. HHGP provides educated temp and permanent work for the finance, accounting, IT, healthcare markets, legal and scientific fields. HHGP’s operations are diversified across Europe, Asia and North America. 2002 revenues were 33% in Europe, 34% in Asia and 33% in North America. In 2002 permanent searches made up 50% of the gross margin, temp was 34% while executive search was 16%.


Current Valuation:

Price: $16.9
Shares Out.: 8.52
MV: $144.1

Cash: $40
Debt: $2.2
Net Debt: ($37.8)
EV: $106.2

Investment Thesis:

When HHGP was spun off it traded around $10 per share and has since quickly run up to the $16 range. While this has been quite a run I think the risk/reward is still excellent at current levels.

Looking at the Form 10 we can get a sense of the historical financials. Here is the general summary data:
2000 2001 2002
Revenue: $1,325 $1,288 $1,065
EBITDA: $85 $48.3 ($19.7)
NI: $34 $9 ($40)
FCF: $6.6 ($3.9) ($119.2)

It’s clear from the recent historicals that the business was not heading in the right direction. It important to point out that I have backed out several special charges that were taken relating to acquisitions and restructurings that were done in the past several years. Part of the decline in revenues is the economy and part I think was due to HHGP’s role within TMPW.

As with many spun off companies HHGP was not given the attention and appropriate treatment as part of TMPW. According to discussion with the CFO, HHGP was allocated more than its fair share of expenses and was not necessarily run to achieve profitability for its division. As a result, I feel the historical financials offer a more dire picture than is actually the case.

Due to the economy HHGP has stated that it expects to still burn cash and have negative EBITDA in 2003 but should turn positive in 2004. The good part about this is that HHGP also said a large part of the losses in 2003 are in Q1. These losses will still be part of TMPW not the new HHGP going forward due to the timing of the spin out. In addition, HHGP has $40 MM of cash and also will be getting $13.5 MM from TMPW over the course of 2003 to help with the new company’s start. This will greatly lessen the blow of this projected negative FCF year. I have not included this extra $13.5 MM of cash in the above EV calculation in the assumption that this cash will be used during the year. In addition, the Form 10 shows that HHGP will have about $80 MM in worldwide NOL’s.

In the past three years HHGP’s best EBITDA margin was 6.5% in 2000. Management has stated that they feel they should be able to reach a 7% EBITDA margin in a “normalized year”. Considering HHGP’s billion dollar run rate of revenue this is a very powerful statement. So if we assume in the next three years HHGP can reach a 7% EBITDA margin on say $1 BN of revenue that would be $70 MM in EBITDA. With $7 MM of “normalized” capex if we assume D&A and capex converge over time this would imply about $63 in pretax income and $38 MM in NI or FCF assuming a conservative 40% tax rate. A conservative 10x FCF multiple would imply roughly a $45 stock price three years out or roughly a 166% gain or 39% IRR over the three years. This proposed upside is especially conservative because I do not take into account that HHGP will probably not have to pay much taxes in its first year of profitability and as a result should generate more FCF initially than I have proposed in my “normalized” scenario.

While the upside scenario is attractive I feel there is a significant margin of safety at these levels as well. Currently HHGP has about $90 MM of tangible net working capital. With a current EV of around $106 MM, HHGP is trading very close to this level. This is especially appealing when considering that as stated above HHGP will receive $13.5 MM from its parent TMPW for its first year which will help mitigate the effect of the expected 2003 cash burn. Management has also publicly stated that it feels it will not have to draw down on its capital before its reaches FCF breakeven in 2004, implying that its current cash balance is enough to carry it through the current transition.

Management has also stated that they will receive 859,000 in options and restricted stock at $13.66. In addition, the CFO recently bought 5,000 shares at current prices. These measures should help to ensure that management is acting on our behalf.

Catalyst

Spin out and achieving “normalized” operating earnings in the next 2-3 years.