Description

We believe we have found a particularly well managed (operationally speaking) company, one that has dramatically outperformed most of its peers during an industry depression, with no net debt, and yet surprisingly it still trades in today’s market at a very reasonable 10x currently depressed earnings and at about 6x what we think they can earn when their business turns up. Therefore we think the stock could easily double or triple from here.

More detail: RCM Technologies, Inc. (ticker RCMT) is a well managed and profitable IT-related company, with basically no net debt, trading at about 10x depressed current fully-taxed EPS. This company has remained profitable throughout the entire IT meltdown. RCMT is well positioned to take advantage of an uptick in the economy, yet if the economy is just flat and RCMT’s earnings are merely flat, RCMT is still undervalued based on its current results. Given management’s propensity to manage RCMT to remain solidly profitable even in tough business environments, we think the risk of permanent capital loss in the stock is low, and the upside is fairly high. The stock is currently trading at $6.40, and with a little help from an economic turnaround, the stock could trade at $15+ in a couple of years. If you are nervous about the market like we are, then you might consider owning this stock and hedging out the market risk by shorting perhaps the Russell 2000 or something with a similar small or mid cap weighting (we’re not experts at hedging so don’t ask questions about what we recommend!) – the point is that RCMT is one of the few cheap stocks remaining, and we can hardly envision a scenario in which it doesn’t outperform the market over a two year period. We believe that that hedged position ought to perform meaningfully better than T-Bills.

RCMT is a professional services company involved in three business lines – IT consulting and project staffing (about 50-60% of revenues recently), engineering services (about 30-40% of revenues), and commercial services (around 10% of revenues). These businesses provide a mix of project-based consulting services and staffing services. They do work in a variety of industries including aerospace, banking/finance, government, healthcare, insurance, manufacturing, pharmaceuticals, telecom, and utilities. RCMT has 37 offices in 12 states in the US and Canada. The company has been targeting specific areas of strength in the economy and specific industries where regulatory changes are driving demand for services (such as pharmaceuticals where FDA regulations for compliance relative to electronic records has caused firms to spend money on IT). They’ve worked to develop new services targeting specific future opportunities – for example they are developing a new service around “global data synchronization”, which is helping clients deal with new global standards for UPC codes.

We are not aware of any particular competitive advantage that RCMT has within any of its three business lines, but we believe that RCMT has been exceptionally well managed throughout the down-phase of the last business cycle. RCMT has remained profitable and has held both its gross margin and operating margin relatively constant since 2000, even though its revenue has declined by roughly 30% from 2000 levels – which is pretty amazing. The revenue decline has been the result of the general decline in the IT area since the tech bubble began bursting in 2000 and the end of the dot com era.

In Q2 2000, RCMT was doing about $76 mm per quarter in revenues, which declined to about the $50 mm per quarter level by Q4 2001. From Q4 2001 through Q3 2003 RCMT has done about $45 mm to $50 mm per quarter of revenues (net of subcontracting revenue which is discussed further below). Thus the company’s revenues have been fairly stable for the last two years. During this period when RCMT’s revenues declined from $76 mm to around $45 to $50 mm per quarter, RCMT’s management has been able to maintain gross margins in the 26% to 28% range and EBITA margins in the 7% to 9% range (except as noted below). Management did this by running a lean operation and being extremely focused on costs, in order to maintain a respectable level of profitability even in a difficult market environment. As revenues came down, they closed offices in order to reduce the fixed cost component of their cost of service to maintain gross margins, and additionally reduced SG&A from around a $14 mm quarterly rate to currently just over $8 mm per quarter, which has allowed them to maintain operating margins. During the entire IT-meltdown, this IT based company has remained profitable and cash flow positive. From mid-2000 through today the company has reduced its debt from about $57 mm to about $3 mm presently (through cash from operations as well as reductions in working capital as revenues declined, as well as from some income tax refunds). Given the changes in the economic environment, especially in the IT area, RCMT made changes to its strategy to market its IT services more to non-IT companies such as pharmaceutical companies and governments (as opposed to tech, telecom and internet customers). They have also experienced growth in their engineering business especially in the utility and power generation area.

Note that in the last four quarters, Q4 2002 through Q3 2002, gross revenues (which for accounting purposes include pass-through subcontract revenues on which they make virtually no profit) have increased a little while gross margins and operating margins have been below the 26-28% and 7-9% levels discussed above. In Q4 2002 and Q1 2003, gross margins were around 21-23% and operating margins were around 4.5%. In Q2 2003 and Q3 2003, they brought operating margins back up to 5.2%. These apparent declines are due to some developments in the engineering business – in particular they have one large engineering project in Canada on which RCMT has subcontracted out some construction work, which has distorted the margins in these last few quarters. Essentially this subcontracting work is a pass through item which RCMT makes essentially no margin on. So, you have to adjust for that by netting out the subcontracting revenues, to arrive at true net revenues – and on that basis, gross margin would have been around 360 basis points higher in the last few quarters, and operating margin would have been around 6% -- just below the 7-9% operating margin range this business has been doing for the last two years. The drop from the 7-9% range, down to 6%, is mainly attributable to some general margin pressure in the engineering business. Importantly, the IT business which represents the bulk of their revenues and gross profit, has generated relatively consistent margins, including over these last couple of quarters.

The company believes it can increase operating margins back to historical levels of 9%+ with a little help from the economy. Revenues and operating margins – net of the distorting effect of the subcontracting revenue -- have increased in each of the last three quarters, suggesting an improvement is underway and the company is on its way to getting the margins back up.

Given the cost cutting the company has done over the last few years and the current cost structure of the company, incremental revenues will have a high incremental impact on the bottom line. Management noted in the November earnings conference call that the corporate infrastructure could handle a doubling of revenue before they would have to add material overhead costs, and the field infrastructure could handle a 50-75% increase in revenues – suggesting that there is big operating leverage here. If the economy really is close to turning, RCMT is well positioned to take advantage of an uptick in IT services as well as engineering and temporary staffing, and RCMT has indicated that they are seeing some improvements in their business. If the economy doesn’t turn, RCMT has shown that it is capable of keeping revenues relatively stable in a tough environment, and maintaining respectable levels of profitability in a tough environment.

Unlike 90%+ of all other US stocks today, RCMT’s stock price does not appear to factor in any premium for a business upturn (and in fact, is underpriced even given a flat to somewhat recessionary economy). We are aware of only one sell-side analyst that follows this company – Bill Sutherland at Boenning & Scattergood – who has done a reasonably good job of describing the company in two recent reports, and he also points out and provides detail on the fact that most comparable stocks trade at much higher multiples to current and forecasted earnings. . Boenning & Scattergood’s phone number is 800-883-1212 if you want to get the reports. (Understand, of course, that we have no relationship with this analyst, nor do we express any opinion about his forecasts or recommendations – we are just pointing this out if you want to get some more information and read another person’s opinion.)

RCMT has about 11.4 mm diluted shares times a $6.40 stock price, for a $73 mm market capitalization. (This share count is our estimated total, proforma for a transaction that is in progress pursuant to which the company is swapping shares to employees in exchange for options.) At 9/30/03 the company had about $7.3 mm in debt and $4.8 mm in cash, for an enterprise value of about $75 mm. (Note that we are excluding from our calculation of enterprise value $8.3 mm of restricted cash that RCMT has deposited in lieu of bond with the Superior Court of New Jersey, so that they can appeal a lawsuit they lost. RCMT has accrued a liability for $7.8 mm for the judgment on this lawsuit, which RCMT believes it can reduce on appeal. This lawsuit has nothing to do with the quality of their work or with customers, but instead concerns a dispute with two former officers. If RCMT is successful on appeal, some material portion of the restricted cash could become unrestricted. However, the appeal will not be heard for about a year.)

Over the last four quarters RCMT has done EBITA of $10.0 mm, and last quarter RCMT did $2.9 mm EBITA or an annual pace of $11.6 mm. The fourth quarter is generally weaker seasonally, but the company has indicated that they are planning for about the same level of operating income in Q4 as in Q3, so $11 to $12 mm of annualized EBITA seems like a reasonable estimate for what the company is currently doing. $11 to $12 mm of annualized EBITA works out to around $0.60-$0.65 of fully diluted EPS. (Note we are talking about EBITA here – we hate EBITDA measures and wish somebody would declare them illegal!) At an $11.5 mm annual EBITA pace, the company is trading at about 6.5x a depressed level of EBITA, which is too low for such a well managed company. The company is currently on a roughly $183 mm annual net revenue pace, for an EV/Sales ratio of 40%. And at a $0.62 annual EPS pace the company is trading at about 10 times fully taxed current EPS.

What should RCMT trade at? Well, given that the company is earning around $0.62 cents annualized EPS right now, in a depressed environment, and given the excellent execution by management, we think a fair PE right now would be at least 14, which suggest a more fair price for the stock would be around $9. In an economic recovery, if you assume that revenues rise say 30% (in total, not per year) over a 2-3 year period to $230 mm, and apply a more normalized 8% operating margin (roughly what RCMT did from mid-2000 through late 2002), that would bring annual EPS to roughly $1.00. At a PE of 15-20 times such growing EPS level, for a company with no debt, the stock should trade at $15-$20.

Although RCMT stock is up for the year in 2003, there are a couple of reasons why we think the stock has not been fairly priced by the market, particularly when other economically sensitive businesses have already priced in an overall economic recovery. Management tends to be extremely conservative, and while they have been hinting in their press releases that they are seeing signs of improvement in demand, they tend to downplay the positives they do see. For example, in the early November conference call to discuss Q3 earnings, management noted that Q4 would be a challenging quarter based on revenue, and that their revenue would be down for two reasons – the winding down of the engineering subcontract revenues on a specific project (which they generate no gross profit on anyway) and because of general seasonality which results in fewer billing days in Q4 and less consulting and staffing activity around the holidays. They noted however, that even with revenues likely to be down and with less billing days in the quarter, they are planning for about flat operating income in Q4 versus Q3. The analysts on the call honed in on these comments by management about Q4 revenue being down from Q3 levels as if it were a negative issue. Management could have just as easily said: despite the fact that we expect revenues to be down in Q4 due to seasonal issues and the wind-down of the subcontract work, we expect flat operating profit which is actually a very good accomplishment in this seasonally weak quarter (or something like that with a more positive tone to it). It’s also a small cap stock, not overly liquid. And management is perhaps too conservative financially (they could have easily used their balance sheet to buy back stock earlier this year when it was super-cheap, but chose not to) – we find this to be a drawback but not a major one.

The only truly bad rap on this management team is that they made multiple dumb acquisitions a few years ago near the peak of the IT market. Without question they flushed a lot of value down the drain, and we won’t attempt to defend that in any way. We’ve “mentally” gotten over that issue though by focusing on what we think is important going forward: (a) we believe from their words and actions that they’ve learned their lessons regarding acquisitions, and that while they still talk about being interested in acquisitions, we think they are being extremely cautious and (b) their operating execution of the last few years appears to be nothing short of outstanding.

Some investors may find it more compelling to go long a cheap IT services company like RCMT and short a more expensive one. There are a number of higher priced IT services company (mostly bigger than RCMT) whose share prices appear to discount a full recovery in the economy. For example, CDI is a company that is about 4 times bigger than RCMT, and is in both the IT services and engineering services markets, and is trading at 27 times 2003 expected earnings. There are likely other more expensive IT services companies that could be shorted, but we haven’t focused on this because pairs trading is not our cup of tea.

In summary, RCMT is a fairly simple company whose stock is trading at a cheap multiple of depressed earnings. Management has a history of being extremely cost focused and managing the business to continually remain profitable even in the toughest business environments. RCMT has a clean balance sheet. Risk of permanent capital loss appears low given the company’s ability to remain profitable and cash flow positive even in the difficult environment for IT businesses of the last 2-3 years. An improving economy would be a catalyst that could generate material improvement in revenues and profits. Even without a material improvement in the economy, RCMT remains a cheap, well-run company based on the company’s current fundamentals. The stock should be priced 40% higher right now just based on current depressed results, and in an economic recovery could double or triple.

Catalyst

1) Fundamentally cheap, well run-company.
2) Big operating leverage with improvement in economy.