Shares in recruitment specialist Staffline (LON:STAF) crumbled today by in excess of 50% as a trading update revealed that projected profits for this year were set to miss expectations. The warning didn’t sound too bad on paper, but the share price had a huge reaction, suggesting that more factors may be at play:
The share price gradually fell in the first hour and as of yet shows no real sign of recovery. In truth there have been red flags for investors for some time. In January the shares were suspended from trading without much warning as it emerged that accounting regularities may have impacted profits, and stayed suspended for over a month.
The restoration of trading saw the a new allegation of non-compliance with regulations and a £3.5m exceptional cost booked to deal with it. Since then confidence in the share has been lacking – after all, an accounting oversight was a precursor to the demise of Conviviality. Broker notes have been supportive, and allege that the third-party disclosure may have had ulterior motives.
The share price has tumbled from a high of over 1300p last year to 400p today, so the valuation of the company is worth a third of what it was then. Given the nature of its business – many recurring revenues it might be a little surprising, but we must look at the warning in more detail.
Stockopedia rates this share highly – before the accounting issues it was on a rating of 93, and even today it still is at 83, so this may have been on the watchlists of some.
The warning comes in a morning RNS update. This is hard to digest with few numbers. Here we start:
The ongoing Brexit uncertainty is impacting the UK labour market and led to a number of customers transferring a significant volume of their temporary workforce into permanent employment to mitigate the risk of that labour market tightening. Typically, this reaction to uncertainty tends to reverse over time, but we expect it will continue to impact temporary worker demand throughout the current year.
A proportion of these “temp to perm” transfers have occurred in the higher margin driving sector, resulting in an overall margin dilution. In addition, we are seeing further challenges in the higher margin automotive sector and associated supply chain where reductions in demand have been greater than expected.
It seems that in response to the poor conditions, companies are simply employing their temps. This could make sense as the commissions paid to agencies such as Staffline is often large.
There are some oddities:
There has also been a slowdown in new contract momentum in the current financial year, which the Company largely attributes to the impact of the delay in publication of the 2018 Full Year results.
I would have thought this was an accounting, not operational issue.
Future trading prospects:
The Group experiences seasonality in its trading and typically earns only approximately 15% of its earnings in the first quarter of the financial year. The April performance is therefore a key initial indicator as to the full year turn out, and with visibility of that trading, and as a consequence of the broad range of factors highlighted above, the Board now expects the Group to deliver adjusted EBIT in the range of £23 million to £28 million for the financial year ending 31 December 2019.
There is no mention of what the previous expectation was, but the broker notes on Research Tree imply earnings of over £40m, so a large profit miss.
It is clear why Stockopedia liked Staffline, here is a look at its main results:
This seems like a large tick of growth, with revenues projected to break the £1bn barrier. Not all of this has been organic, and there have been some large acquisitions along the way. This being said, it previously has been a good performance, given the fact that it is also apparent that margins are wafer thin here – approximately 2%. This is rather surprising for recruitment given the fees charged, but consistent for the industry as a whole. Another large giant Robert Walters has margins of around 4%.
The margins may be a turn-off for some but there are quite a few other aspects to like about the business: it is cash generative, and converts that cash into profits reasonably well. Capex charges are also low, as we can expect from this type of business. We also have a progressive, and well-covered dividend which if maintained would see a very good yield.
These problems are overshadowed though by the delay to the 2018 accounts. Without these we don’t really have the full picture and much has changed in the past year, even taking away the biggest news of the share suspension.
The acquisitive nature has led to a build up of many intangibles on the balance sheet – by 2017 £115m of the £263.5m were made up of goodwill and other intangibles. We can deduce from the RNS that there were at least four acquisitions in the past year: Endeavour Group, Learndirect, Grafton Ireland and Passionate About People all came under management.
We also tell that these items are expensive. Net debt at year end was projected at £63m, which is a sharp increase from 2017. Even worse, this debt is projected to increase further as further acquisitions are made, and the reduction in profits could lead to further trouble in future as profits could be declining. On the flip side, the company has refinanced its debt and has £150m available, so there is still headroom.
Things could get worse before they get any better here. EBIT shows no improvement on last year, and it may be the case that in a declining market there will have to be some kind of impairment on the intangible assets. In common with most businesses in this sector, there is not a great deal of asset backing and most of the value made up of customer contracts. Price pressures may see these be worth less in terms of future cash flows.
The dividend might not be safe here at these levels. The increased level of debt may put pressure on to reducing the levels of it to keep in onside (assuming that profits show a decrease in future).
The bigger factor is the uncertainty surrounding the future. The delay in the accounts and still open issues with HMRC do open the door to thinking if there may be similar issues in the future.
Because of these issues, I do think it trades at quite a large discount to fair value. Very large depreciation costs mask the cash generation, and having large amounts of intangibles is not necessarily a problem if these underlying businesses continue to operate as planned. This has been the case so far, but the latest trading update seems to pullback on this somewhat. Even allowing for a large debt I see a discount, so buying this share becomes a bet on whether Staffline can ride out the current storm and not fall foul of the lenders.
Not a share for me though, and comparatively others in the same industry such as Robert Walters appear in better shape. 2/5