Description

A Play on Event-Driven Change in California & a Recovering Economy


Summary & Background

This is a fairly simply investment idea & business. RemedyTemp (REMX) is a temp-help agency, with 70% of its business concentrated in California. It follows an owned-store and franchisee model. Like those of most other companies in this industry REMX’s earnings have been depressed by the recession and the resultant increase in unemployment, which has boosted price competition and affected the company’s ability to pass-along cost increases. More so than other companies REMX has been hit by surging workers comp & unemployment insurance costs in California. Given a continuing pick-up in the economy, and the Gubernator’s recently enacted workers comp legislation, all of these negatives seem to be at their zenith & should abate over time. Meanwhile REMX has a solid balance sheet, with $3/sh in cash and $2/sh in tax assets. So, you’re paying $8 for a company with trailing peak earning power of $1.71. In the last upcycle this stock traded as high as $35 and had a P/E on peak EPS of 8-23 X.

The earnings of most cyclicals don’t oscillate around a single point, but rather zigzag upwards from one business cycle to the next. Assuming that the growth from peak earnings in the last cycle to those in the next cycle simply match the economy’s nominal growth rate (5%), then we would have $2.53/sh of earning power in 2007. A conservative 10X EPS multiple yields a $25 value, which equates to $30 of intrinsic value when combined with $5/sh of non-operating assets. Hence this provides a 57% margin of safety on today’s stock price of $13.

Absolute Valuation Statistics:
Stock Price = $13.00
Enterprise Value = $93.8m
Price/TTM sales = 0.26
P/E = -4
Price/Book = 1.7

Note, the above book value and EV numbers don’t reflect REMX’s $20m of tax assets.

Relative Valuation
The most comparable public competitors are Westaff (WSTF), Kelly Services (KELYA) and Labor Ready (LRW). WSTF is most alike but faces ‘going concern’ risk. So, here is a comparison of KELY, LRW & REMX:


Company Peak EPS Peak Multiple
Multiple using using CURRENT
Peak yr avg stock price
stock price

Kelly Services 10 13.5
Labor Ready 34 23.0
RemedyTemp 15.5 4.7


Industry Characteristics

·Few barriers to entry. >8K companies in the industry in the US. Top 15-16, of which REMX is one, a/c for 30% of revenue.
·Few key differentiating points between players – is an execution-based business.
·Notwithstanding the above, many companies in this industry generate very high returns on capital during good times & break-even in bad times, so on average throughout the cycle this is a decent business. I.e. REMX averaged a 28% pretax return on capital in the 4-years 1998-2001.
·Growing faster than GDP - temp workers as % of total workforce grown from 1.1% in 1990 to 1.7% in 2002. Being driven by increasing statutory costs & regulations, which make hiring and firing more difficult. In more regulated countries like England and Holland temps a/c for 3% and 4.5% of workforce respectively.
·Like REMX itself, many competitors have scaled back operations in this tough environment & some have actually exited REMX’s markets or gone out of business.


REMX Characteristics

·70% revenues from California
·70-20-5 revenue split between light industrial, clerical & specialty sectors
·Customer split: 25% of revenue from small companies (<$200-250K temp spend/year), 45% mid-size companies ($200K-5m), 30% large companies (>$5m)
·New management team, led by former COO Greg Palmer, took over in 2001. Focusing on moving REMX to higher margin revenue mix over next 3 years: smaller clients, more clerical & professional vs. light industrial, less California.


Management
·Paul Mikos, former CEO & the current son-in-law of founder Bob McDonough Sr., relinquished the CEO job in Jan 2001 to Greg Palmer, who had been COO from Jan 1998-2001. Prior to that Palmer was an executive at Olsten Corp for 13 years. So, Palmer has much industry experience. Mikos may have been pushed because he left fairly young (age 56). He is now non-executive Chairman.
·Palmer then changed the executive suite, bringing in a new CFO and Senior VP – Sales & Marketing.


Key Extra Points

1.) Workers Comp

·REMX workers comp costs surged from $11m (2.2% of rev) in 1999 to $33m (6.9%) in 2003. $12m of the 2003 number was catch-up for underreserving in prior years. REMX used to employ 1 actuary who did an annual calculation of WC liab. Now they have 3 actuaries who do it on a quarterly basis. They did this because like many companies they fell behind in following & incorporating WC rule changes in CA when they were made 2 years ago.
·WC got so bad in CA that they were accruing 4-5X for WC per $ of payroll relative to other states.
·History: 4 years ago CA passed legislation which made it easier for people to claim WC. They thought they were putting more protections in for workers, but costs spiraled out of control & yet patient outcomes didn’t keep pace. Examples of rule changes which led to the spiral in costs: (i) no limits on chiropractor visits for the rest of your life after an injury, (ii) in providing evidence as to whether someone is eligible for WC there is no independent review board, just the word of the patient’s doctor.
·Today CA WC costs lead the US and are 4X rest of the country. It is 2X the next highest state (TX).
·Meanwhile CA is 46th in terms of benefits to injured workers. Much of the money is going to clinics and lawyers.
·Arnold ran on a platform of cutting WC costs to the next highest level (i.e. 50% cut to TX level). Recently he said he wants to get to the national average (75% cut). Is hard to say how much of a benefit his recent legislative victory will be for employers. The way it will work is that now the legislation has been signed, more details will be provided over the next 2-3 months. Then an Independent Review Board will take 2-3 months to review the new rules & determine their impact on WC costs. Then REMX’s actuaries will use the IRB’s analysis to determine the impact on the company’s numbers. It should take 6 months before the benefits start flowing thru in the companies self-insurance WC numbers – will take longer for insurers to respond & cut their rates. In addition some aspects of the legislation apply to claims already incurred, so there may be a small decline in the WC liability on the books.
·WC should decline by a big chunk of the $12m top-up charge last year, and even more in future years as the benefits of the recent legislation flows through.

2.) Reliance Lawsuits

·Background: Reliance had been an insurer covering all of REMX’s workers comp claims for a flat premium till it went bankrupt leaving many claims unpaid. So REMX temp employees sued REMX clients & their workers comp insurers. REMX doesn’t want it clients dinged, and says that they are not responsible because that is the whole point of getting temps – the agency employing the temps & its insurer are responsible. Now that Reliance is broke, the California Insurance Guarantee Association (CIGA) is responsible since that is the state fund that Reliance & other insurers paid into just in case such an event occurred. CIGA claims it isn’t responsible & has joined the REMX employees in their suit.
·CIGA has been paying the Reliance claims. Now it doesn’t want to, so it’s going after REMX clients & their insurers. CIGA’s argument is that the law says that it is required to step in only as “insurer of last resort”, and that the clients’ insurers come in line before it.
·REMX’s argument is that CIGA is the insurer of last resort & that legislation was passed in CA in the late 1990’s allows that a business can contract away its workers comp liab for temp workers.
·REMX has lost 2 rounds of legal disputes on this so far, but they were not in a real court. Rather it got adverse rulings from a workers comp administrative judge and the CA workers comp review board, which is what one would expect. Now the case has gone to the CA Court of Appeals & will be heard in early June 2004.
·CIGA IS NOT MAKING ANY CLAIMS AGAINST REMX. Any loss would occur only because REMX has agreed to indemnify certain clients, and the company feels that its exposure is not what claims are paid (by the clients’ insurers) but “the impact of such claims, if any, on clients’ insurance costs”.

2004 Outlook

·REMX incurred an operating loss of $20m in 2003. This should be cut by $12m thanks to the removal of the one-time workers comp top-up in 2003.
·Meanwhile, unemployment insurance costs continue to rise due to empty state coffers & continuing high unemployment. But rates charged to companies like REMX should start to decline after 1 year as the economy picks up steam now.
·In addition REMX is investing in additional sales people as it drives its strategy of changing its sales mix to higher margin categories.
·I am projecting an EBIT loss of $10m in 2004, of which depreciation is $6-7m. Note, capex is projected to be $2.5m, so this means that cash losses are projected at $6m. This is not onerous for a company with $30m in cash & an unutilized $40m line of credit.


Risks

·This investment thesis is based on the idea that the decline in EBIT margins that REMX has experienced from 4-5% in 1998-2000 to –4% in 2003 is a cyclical, not secular event. There is nothing to indicate that the latter has occurred, but if it is then profits may not rise to my projected peak level of $2.53/sh by 2007. However, given the large margin of safety in this stock such an outcome still wouldn’t result in capital loss.

Catalyst

Improvement in earnings thanks to event-driven workers comp changes in California, and a recovering economy restoring demand for temps & pricing power to temp agencies.