Description

I recommend the short sale of Resources Connection at current prices. Factors important to my recommendation are the overvaluation of the company, the downturn in fundamentals I expect one to two quarters from now, and the catalyst of the very next (March) or subsequent (June) earnings conference calls, where the company should predict slowing growth (and an implied earnings miss). Please note that RECN has a May fiscal year-end, and reports earning off the typical calendar cycle.

Resources Connection is an international professional services firm that provides experienced accounting and finance, risk management and internal audit, information technology, human resources and supply chain management professionals to clients on a project basis.


I APOLOGIZE IN ADVANCE FOR THE POOR FORMATTING OF NUMBERS ......


THESIS
A very substantial portion of RECN’s recent growth revolves around the requirements of Section 404 of the Sarbanes-Oxley Act, which requires extensive implementation of accounting processes and procedures and associated documentation by public companies. The deadline for this work was December 31, 2004 for most public companies with a market cap in excess of $75 million. Most of this work is one-time in nature, and should lead to a drop-off in demand for accounting services in 2005 (analagous to the decline in IT services demand in 2001 related to Y2K remediation).

As an example, I spoke with the CEO of one RECN client who estimate he spent $1 million on RECN in 2004 (100% for Sarbox), with $0 to follow in 2005.


A reversal in 2005 of the heavy Sarbox demand would have a particularly negative impact on RECN for several reasons:


1) RECN’s client base is made up of smaller companies than the clients of large accounting firms. These smaller clients were more prone to a steep ramp-up in 2003-04 in external accounting services because their (smaller) accounting departments do not have the resources to conduct Sarbox implementations.

RECN says that it focuses on middle market companies, and the data supports this … In FY04, RECN generated $328 million in revenue from 1,600 clients, or an average of $205,000 per client. RECN says that half the Fortune 100 were clients making up 11.1% of FY04 revenues. Each Fortune 100 client generated $730,000 in FY04 revenue, implying a very superficial relationship.


2) RECN had substantial recent margin improvement because of Sarbox demand.

Quarter ended

11/04 8/04 5/04 2/04 11/03 8/03 5/03 2/03 11/02 8/02

Change in Comp Q in Associate billing rate (revenue driver)

11.1% 8.5% 6.9% 10.0% 10.0% 7.5% 7.9% 5.8% 2.9% 3.0%

Change in Comp Q in Associate compensation rate (cost driver)

7.2% 8.3% 17.0% 15.5% 14.9% 8.2% 8.1% 8.0% 5.3% 5.8%

Difference (margin driver)

3.9% 0.2% -10.1% -5.5% -4.9% -0.7% -0.2% -2.2% -2.4% 2.8%


Note that the data for the May quarters is imperfect because it is calculated from annual data, but the message is clear ... Through the May 2004 quarter, the billing rate for associates grew slower than the cost of compensating associates. However, this relationship has inverted in the last two quarters, resulting in unsustainably high profit margins in the two latest quarters. A likely explanation is that the huge demand to get the Sarbox work done by the deadline has resulted in the combination of price hikes (higher billing rates) and higher associate utilization (slower hourly compensation growth).


3) High valuation

RECN trades at 29x LTM EPS ($1.75 per share) and an EV/EBITDA = 15x

($ million)
Market value $1,260
Less: Cash (98)
EV $1,162

LTM EBITDA $77


4) Higher valuation when accounting for stock-based compensation

RECN trades at 35x LTMEPS ($1.43) pro forma for stock compensation expenses.

This is particularly significant for a company whose major cost is employee compensation, and whose high-flying stock must serve as an attractive component of this compensation.


TARGET PRICE

RECN management has publicly expressed target EBITDA margins under normal operating conditions of 15%, based on 40% Gross Margin (US business) and 25% SG&A. While the latest quarter had EBITDA margins of 19.7% for the reasons discussed above, 15% fits in the middle of the performance range shown below:

11/04 8/04 5/04 2/04 11/03 8/03 5/03 2/03 11/02 8/02

EBITDA Margin
19.7% 17.6% 17.8% 12.2% 11.0% 10.5% 12.2% 10.0% 11.5% 9.7%


I consider three performance scenarios for the next twelve months:

A generous scenario with annualized 2Q05 results and management target margins (15% EBITDA) provides EPS of $1.87 per share. A 20x P/E (with revenue likely to decline going forward) gives a target price of $37.

A middle scenario with LTM performance provides EPS of $1.75 per share. A 20x P/E (with minimal forward growth) gives a target price of $35.

A conservative scenario takes LTM revenue but applies management target margins, resulting in EPS of $1.51 and a target price of $30.

Conservative Middle Generous
LTM Rev with Actual LTM Annlzd Q2 Rev with
Mgmt Target Margins Performance Mgmt Target Margins


Revenue
$447,204 $447,204 $548,108
Direct cost
268,322 270,180 328,865
Gross profit
178,882 177,024 219,243
SG&A
111,801 99,952 137,027
Amort
1,644 1,840 1,644
Depr
2,172 2,197 2,268
Op Inc
63,265 73,035 78,304
Interest inc
1,033 1,033 1,644
Pretax
64,298 74,068 79,948
Taxes
26,362 30,368 32,779
NI
37,935 43,700 47,169

FD EPS $ 1.51 $ 1.75 $ 1.87


TIMING

My short-term trigger was the earnings conference call conducted by Manpower Inc (MAN) on February 1. On that call, MAN surprised the market with the disappointing performance of its Jefferson Wells division, which conducts significant Sarbox work, and matches up well with a large part of RECN’s business. Manpower management conceded that clients were beginning to reduce Sarbox work, and expects an 8% sequential decline from the December to March quarters in Jackson Wells revenue (in contrast to analyst expectations of sequential growth) and a decline in recent high margins. I believe the warning bell is ringing for all Sarbox service providers, and would expect RECN to reduce expectations during the March or June earnings conference calls.

As an aside, I would note that some clients continue to generate last-minute Sarbox demand past year-end 2004 because their deadline is the 10-K filing date (March 15 for most companies), but most companies, which have planned ahead, are not in this situation.


BACKGROUND (from the 10K)

Resources Connection is an international professional services firm that provides experienced accounting and finance, risk management and internal audit, information technology, human resources and supply chain management professionals to clients on a project basis. It assists its clients with discrete projects requiring specialized expertise in accounting and finance, such as mergers and acquisitions due diligence, financial analyses (e.g., product costing and margin analyses), corporate reorganizations and tax-related projects. In addition, it provides human resources management services, such as compensation program design and implementation, information technology services, such as transitions of management information systems, and internal audit services, such as documenting internal controls. It also assists its clients with periodic needs such as budgeting and forecasting, audit preparation, public reporting and with their compliance efforts under the Sarbanes-Oxley Act of 2002.

The company operated as a division of Deloitte & Touche from its inception in June 1996 until January 1997. From January 1997 until April 1999, it operated as a subsidiary of Deloitte & Touche. In April 1999, the company completed a management-led buyout. Prior to the management-led buyout, the company was unable to provide certain accounting services to audit clients of Deloitte & Touche due to regulatory constraints applicable to the company as a part of a Big Four accounting firm. Subsequent to the management-led buyout, RECN was able to expand the scope of services it provides to its clients. The Company is an independent company, which is no longer affiliated with Deloitte & Touche.

RECN went public in December 2000.


FINANCIAL EXHIBIT – RECENT QUARTERLY PERFORMANCE TO PROVIDE CONTEXT
($000)

11/04 8/04 5/04 2/04 11/03 8/03 5/03 2/03 11/02 8/02
# Weeks
13 13 13 13 13 13 14 13 13 13

Revenue
$137,027 $115,401 $107,018 $87,758 $74,016 $59,541 $59,048 $49,237 $50,209$43,528
Direct cost
81,851 69,934 64,042 54,353 45,420 36,055 35,285 30,153 29,909 26,301
Gross profit
55,176 45,467 42,976 33,405 28,596 23,486 23,763 19,084 20,300 17,227
SG&A
28,170 25,181 23,877 22,724 20,471 17,229 16,534 14,170 14,526 13,018
Amort
411 411 504 514 392 306 200 298 126 31
Depr
567 543 580 507 433 387 335 328 312 315
Op Inc
26,028 19,332 18,015 9,660 7,300 5,564 6,694 4,288 5,336 ,863
Interest inc
411 304 171 147 103 172 238 231 270 338
Pretax
26,439 19,636 18,186 9,807 7,403 5,736 6,932 4,519 5,606 ,201
Taxes
10,840 8,051 7,456 4,021 2,998 2,323 2,843 1,853 2,298 ,722
NI
15,599 11,585 10,730 5,786 4,405 3,413 4,089 2,666 3,308 2,479

FD EPS
$0.62 $0.46 $0.43 $0.24 $0.19 $0.15 $0.18 $0.12 $0.15 $0.11
Rolling 12M
$1.75 $1.32 $1.01 $0.76 $0.64 $0.60 $0.56

FD EPS (pro forma for stock compensation)
$0.55 $0.36 $0.37 $0.15 $0.13 $0.09 $0.07 $0.02 $0.07 $0.03
Rolling 12M
$1.43 $1.01 $0.74 $0.44 $0.31 $0.25 $0.19

EOQ # Associates
2,645 2,370 2,086 1,980 1,665 1,468 1,056 1,181 1,221 1,044
EOQ # Offices
62 65 64 66 66 63 55 55 52 47
Billing rate Comp change
11.1% 8.5% 6.9% 10.0% 10.0% 7.5% 7.9% 5.8% 2.9% 3.0%
Associate hourly cost Comp change
7.2% 8.3% 17.0% 15.5% 14.9% 8.2% 8.1% 8.0% 5.3% 5.8%
Difference
3.9% 0.2% -10.1% -5.5% -4.9% -0.7% -0.2% -2.2% -2.4% -2.8%

Gross Margin
40.3% 39.4% 40.2% 38.1% 38.6% 39.4% 40.2% 38.8% 40.4% 39.6%
Seq Q change
0.9% -0.8% 2.1% -0.6% -0.8% -0.8% 1.5% -1.7% 0.9%
Comp Q change
1.6% 0.0% -0.1% -0.7% -1.8% -0.1%

EBITDA
27,006 20,286 19,099 10,681 8,125 6,257 7,229 4,914 5,774 4,209
Rolling 12M
77,072 58,191 44,162 32,292 26,525 24,174 22,126

EBITDA Margin
19.7% 17.6% 17.8% 12.2% 11.0% 10.5% 12.2% 10.0% 11.5% 9.7%
Seq Q change
2.1% -0.3% 5.7% 1.2% 0.5% -1.7% 2.3% -1.5% 1.8%
Comp Q change
8.7% 7.1% 5.6% 2.2% -0.5% 0.8%



HISTORICAL ANNUAL PERFORMANCE TO PROVIDE LONG-TERM FINANCIAL PERSPECTIVE
(I apologize in advance if the formatting renders this information unusable)

6ME11/04 6ME11/03 2004 2003 2002 2001 2000

Revenue
$252,428 $133,557 $328,333 $202,022 $181,677 $191,496 $127,459
Direct cost of services
151,785 81,475 199,870 121,648 108,715 112,555 74,668
Gross profit
100,643 52,082 128,463 80,374 72,962 78,941 52,791
Selling, general and administrative expenses
53,351 37,700 84,301 58,248 50,688 49,964 34,648
Amortization of intangible assets
822 698 1,716 655 125 2,273 2,231
Depreciation expense
1,110 820 1,907 1,290 1,180 866 285
Income from operations
45,360 12,864 40,539 20,181 20,969 25,838 15,627
Interest income
715 275 593 1077 1183 633 0
Interest expense
0 0 0 0 0 3,629 4,717
Pretax income
46,075 13,139 41,132 21,258 22,152 22,842 10,910
Taxes
18,891 5,321 16,798 8,716 8,861 9,137 4,364
Net income
27,184 7,818 24,334 12,542 13,291 13,705 6,546


FD EPS
$1.09 $0.33 $1.00 $0.55 $0.58 $0.71 $0.42
FD shares
25,044 23,618 24,390 22,869 22,862 19,421 15,714

# Offices EOP
62 64 55 47 44 35
EOP # associates
2,645 1,665 2,086 1,175 1,060 1,283 1,056

EBITDA
$47,292 $14,382 $44,162 $22,126 $22,274 $28,977 $18,143
Acquisitions
(1,923)(30,777) (31,027) (8,803)(1,683) (225) (271)
PP&E Capex
(1,643) (453) (3,180) (675) (1,980) (1,755) (3,021)
EBITDA - PP&E Capex
45,649 13,929 40,982 21,451 20,294 27,222 15,122

Cash
$98,460 $69,839 $68,078 $55,745 $34,503 $4,490
WC less cash
25,909 26,689 12,099 11,390 8,462 3,174

LTD
0 0 0 0 0 41,771
Equity
213,756 180,334 133,531 113,471 86,032 17,185


DISCLOSURE
I currently have a short position in RECN, and may increase or decrease the size of the position at any time without notice.

Catalyst

The very next (March) or subsequent (June) earnings conference calls, where the company should predict slowing growth. (see TIMING section in the write-up)