Description

SFN may not look cheap at first glance, trading at 23x 2006 EPS in a cyclical industry, but the company trades at under 1.0x current BV, has NOLs of approximately $400mm (worth $2 a share using a 10% discount rate), trades at a 2007 FCF Yield of 11.5% - 13% (depending on how you view the NOL) and trades at a TEV/EBITDA (ex- NOL) of under 4.5x 2007 EBITDA.  Furthermore, I believe that there is a reasonable chance that the company gets purchased by a strategic in the next 12 months.  The stock is hated on the Street with 0 buys, 5 holds and 2 sells.

The Business

Spherion is a temporary staffing company that primarily operates in two industry segments: Clerical and light industrial (75% of revenues) and IT and Professional (25% of revenues). 

The company has suffered through some attrition at its higher volume, lower margin businesses, showing negative organic growth in clerical and light industrial over the last 6 quarters offset by high single digit/ low double digit revenue growth in IT and professional services.  The good news is that at the end of this 2006, the company will have fully anniversaried the client attrition issues that had plagued the clerical division.  Last quarter, the company posted year over year increases in the clerical end market (light industrial was still weak) for the first time this fiscal year.  In addition, the company just pre-released Q4 revenues which were up 1% year over year, the first aggregate year over year increase in the last few quarters.  My estimates for 2007 incorporate a below market growth trend of approximately 3% for the light industrial/Clerical and market growth expectations of 9% for IT/Professional. 

Margin Expansion

The company has spent heavily in the last few years on infrastructure and recently announced a cost reduction program of $1mm which they expect to result in 5-6mm of savings in 2007.  The Company has historically targeted a conversion of 50% of incremental gross margin dollars to EBIT, but based on significant spending this year on systems and recruiters, the Company expects to convert over 60 of incremental gross margins to EBIT.  For the year, the company should generate a blended margin of 1.7%, which is much lower than those reported by its peers (most of whom have margins in the 3-5% range).  The company has a target of 3%, which they believe they should hit in a couple of years.  At a 3% margin, the company would be generating roughly 80mm in ebitda and free cash flow of 65mm (utilizing the NOLs).  I do not have a high degree of conviction that the Company will achieve this target, but I view this as a free option.

As an acquisition target, I believe that the synergy opportunity is 20-25mm for a prospective acquirer.  The company’s operating expenses are 1-1.5% too high relative to its peers. 

Value of NOL

Assuming a 10% discount rate and flat operating income, I believe the NOL is worth $110mm, or roughly $2 per share.  The NOL is comprised of Federal and State operating losses totaling $372mm.  The company also has 7mm of CAD operating losses and 30mm of overseas NOLs that the company will likely not utilize and have valuation allowances against.  If the company is sold, the NOL will have an $80 value to the acquirer as it will be subject to an annual limitation of use (I am assuming a $11 per share takeout price).  My understanding of the calculation for the limitation of use is the equity value of the company (sale price) multiplied by the federal funds rate.  In any event, the NOL is very valuable and the Street does not recognize this value.

Net Cash

As of the end of the third quarter, the company had 28mm of net cash.  I believe that the company generated roughly 10mm of cash in Q4, so the net cash position should be roughly $.70 per share.

2007 Earnings and Free Cash Flow

I expect the company will earn .50 cents per share in 2007 and base my expectations on 4% revenue growth and a 65% conversion of incremental gross margin to EBIT.  The .50 cents of EPS is higher than the street expectation of .43 cents and will translate into FCF of $1.00 (.50 cents + .37 cent tax benefit of NOL + .13 cent D&A to Capex pickup (D&A is 22mm and Capex is 14-16mm as per management guidance).

SOTP and BV

The company is trading at a cyclical trough valuation at .97x BV.  After the fourth quarter, the company will have BV of roughly $8.32 and by the end of this year, BV should increase to $8.82 (.91x BV). 

Of the company’s businesses, the IT/Professional business garners high comparable multiples while the clerical/light industrial is viewed as more of a commodity business.  MPS, a pure play comp in the IT/Professional space, trades at 10x LTM EBITDA.  Assuming an 8.5x multiple on the IT business values and a 6.5x the more commodity business, yields a break-up value of 500mm on my 2007 numbers (which does not include any synergy benefit to an acquirer which would increase EBITDA by 25-40%), plus 110mm of NOL value + 38mm of net cash = $11.50.  If you add the cash generation in 2007, you get a price target of roughly 12.50 ($1 of FCF less the utilization of the NOL for 1 year).

Insider purchases

Insiders have been purchasers of stock in the last six months at prices above the current quote.  In addition, a director recently purchased 1,000 shares at roughly the current quote.

Catalyst