Description

USG is cheap on current and extremely cheap on normal. It is a bet on reversion to mean in the cyclically depressed temporary work market in Europe. USG offers IRR potential of 35% to 80% in 3 years (2.5X to 5.5X upside). The business is of average quality, has debt and is cyclical. But downside is limited thanks to low capital intensity, flexible cost structure and high Free-cash-flow generation in trough and peak points in the cycle. It trades for about 10X trough earnings in 2013 and is uniquely cheap on normal. A very conservative base case implies USG trades for 4.5X normal in 2016, and mgmt case suggests USG trades for 2X normal that year.

Background

USG People is business services provider of temporary workers in Europe. The company operates through 12 brands in the Netherlands (45% of EBIT), Belgium (40%), France (10%) and other W.EU countries (5%, Germany, Italy, other). HQ is in the NL

USG provides two main types of temporary workers – “Generalist” and “Specialist & Professional”. Generalists are low skilled workers such as cleaners, secretaries, security guards and etc. They are supplied in volume and typically to large corporations. The Specialists & Pros are either blue collar workers with some level of certification (i.e. HVAC technician) or are white color temps (i.e. lawyers). The end customer is typically an SME seeking one to a few temporary works at a time. Specialists tend to be scarcer than generalists and require an element of value add in the form of sourcing, screening and interviewing candidates that fit the customer’s need. Generalists make up just over 40% of EBIT, Specialist & Pro over 55% and another 1-2% comes from placement of permanent employees.

Business Model

Revenues are a function of the number of hours supplied to the client, times the price per hour agreed upon. Historically on average of about 77% of revenues are used to pay temp salaries and benefits (recognized in cogs). Another 13% goes for staffer comps and deprecation takes another 2% off with IT, Rent and G&A an additional 5%. Net EBITA was 5.1% over the last cycle. USG’s revenues are highly cyclical as demand fluctuates with a multiplier to unemployment. While the costs are mostly variable, the low EBITA margins yield high operating leverage – during the last recession revs dropped by 28%, margins fell from 6.7% at the peak to 2.4% at trough and EBITA fell 73% in two years (2007-2009). As a temp staffing agency, USG is a people driven business. Return are therefore mathematically high as growth requires minimal capital deployment (ROITC >40%, ROIC in the teens with M&A).

Market

Let’s focus on the two main markets:

Netherlands: Over the last cycle the market expanded at ~5.5% cagr in value terms. About 3.5% came from volume and 2.5% from price. However the Generalist segment, which accounts for 60% of the market is mature and grew ~3% with barely over zero volume and 3% price increase (general inflation in the NL was 2.2% during the period). The Specialist segment, or 40% of the market, expanded around 6% on volume growth and 2% price inflation. It appears that demand for generalists was mature and possibly declining a bit (adj for population growth of 40bps), while demand for Specialists was expanding briskly.

Overall growth in Specialists comes from population growth, shift from blue color work to specialized work in the economy, and most importantly increased penetration of temp workers amongst white color / trained workers. Penetration is increasing as part of a larger trend by businesses to move costs from fixed to variable structures.

Going forward we assume the market will grow 3.5% over the cycle. Our market model implies 1.7% cagr in hours worked (0% for generalists and 4% for Specialists) with 1.8% cagr from price (IMF inflation estimate). The drivers of our model are based on 70bps/yr labor workforce expansion (past was 105bps), 10bps of higher penetration in total by 2016, and average number of hours per worker flat with previous cycle average. As such, we are currently around 30% below normal as of 2013. We expect 2016 or so to represent a normal year.

Belgium: over the last cycle the market expanded by ~5% with volume growing 2-3% and price growing around inflation. Volume growth was driven by population growth and increasing penetration of temps in the labor force as regulation eased and companies continued to move costs into variable structures. We assume the market will grow 3% cycle to cycle on population growth (80bps), 10bps of total increase in penetration from 2013 to 2016, plus general inflation of 180bps.

Competitive Advantages & Threats

USG operates in an industry with low barriers to entry and limited differentiation. During down turns in the market USG has no pricing power and competition is fierce. In up-cycles the company has more pricing power in the Specialty segment for workers in professions that are scarce at the time. Overall pricing power is low over the cycle. Thus USG’s margin profile is driven mostly by the business cycle and the position in which USG chooses to operate in (specialty/sme/high price, and generalist/enterprise/average price).

As it related to threats from technological change, so far the Internet has not replaced temporary worker agencies. Temporary work typically requires either large volume fulfillments (in Generalist), and/or quick delivery times (in the case of Specialists and Generalist). So far pure internet players have not penetrated the temp business. The existing players on the other hand have cut their physical branch footprint materially, while utilizing the internet as a recruiting tool that augments screen and interviewing in person by staffers (on behalf of clients).

Forward Scenarios

Assumptions for base case and upside scenario:

Valuation: USG historically traded for 8x fwd EBITDA and 13x fwd EPS excluding the recession (when it traded for 72x). Currently USG trades for 7X fwd EBITDA and 10.5x fwd EPS. The stock is just 25% above its all-time trough (of $5).

Catalyst