Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.
First, an introduction, preaching the benefits of small cap activism:
The activism that makes the papers tends toward large companies such as Hess, Apple and Microsoft. There's definitely money to be made by selectively following activists there (my last article was about Air Products!), but the best opportunities are at small cap companies. There's a few reasons for this:
1) Well-known activists targeting large companies will bump up stock prices 5 to 10% within seconds of the campaign announcement. This erases much of the value available to investors entering in later. Small companies targeted by lesser-known activists generally won't have such large stock price bumps.
2) Smaller companies are subject to less market oversight, so activists introduce accountability that wasn't present before. In contrast, large companies, well covered by sell-side analysts, have less waste when an activist enters.
3) Smaller companies are more likely to be sold, a key way we profit from activist pressure.
With that introduction out of the way, I'll introduce the subject of this article: RCM Technologies (RCMT), not just a small-cap, but a micro-cap. The market is not appreciating that a large activist is closely monitoring the company, and the company may sell itself to avoid a proxy fight if it cannot bring its stock price up by the end of the year. Either way, I expect the stock to outperform over the next three to five months.
RCM is a provider of business and technology solutions (an IT staffing company). Its stock closed on Friday at $5.95, with a market capitalization of $74 million.
The activist shareholder in this situation is technically Michael O'Connell's IRS Partners No. 19, L.P. However, if you look at the 13D's filed, you'll see that the investment is being directed by Legion Partners, led by Bradley Vizi and Christopher Kiper. While IRS and Legion have little in the way of an activist track record, Vizi and Kiper themselves have an impressive activist background, having each spent three years at Shamrock Capital before founding Legion in 2010. These guys are not new to activism, and will likely work hard to secure a victory at their first public activist target at Legion Partners.
On January 19, 2012, IRS/Legion filed a 13D reporting its original stake in RCM, at 5.1%. IRS/Legion gradually increased its stake throughout the year, reaching 12.4% on January 2, 2013, when IRS/Legion finally "went activist," nominating Roger Ballou and Bradley Vizi to the board. Ballou was CEO of CDI Corp. (CDI) from 2001 to January 2011. (In 2010, CDI, a close competitor of RCM, made an unsolicited bid for RCM. More on that later.)
IRS/Legion also hired top activist law firm Olshan Frome Wolosky and submitted proposals to declassify the board, elect directors by a majority vote in uncontested elections, and that the board adopt a policy that the chairman be independent. Currently, CEO Leon Kopyt serves as chairman. The 2012 annual meeting was held on June 14, so we would normally expect the 2013 annual meeting to be held near then as well.
On January 31, RCM adopted a poison pill with a 15% trigger. In March, IRS/Legion increased its stake to 13.0%. On May 15, with no word yet of an annual meeting date, Legion, now a 13.4% holder, put out a press release calling on the company to promptly schedule the annual meeting. The company did not respond publicly, but on May 28, it added a qualified offer provision to its poison pill. On June 12, the company appointed director Robert Kerr as lead independent director. We haven't heard anything since from either side.
Under Nevada law, RCM has 18 months from the last meeting to hold its annual meeting, and then a court can compel a meeting. That means that if no meeting is held by December 14, IRS/Legion will force one to be held in the following couple of months. However, I doubt we'll get to that point, as that would incur the ire of proxy advisers and shareholders, and most likely the meeting will be scheduled for early December.
A few things point to a sale announcement being in the works:
1) Annual meeting has been indefinitely delayed. This often hints that the company is working on a sale or other major action.
2) May 28 amendment to poison pill to add qualified offer provision. The qualified offer provision is not all that meaningful in practice, but in theory it implies that the company is open to a fair offer, and is not "not for sale."
3) June 12 appointment of Robert Kerr as lead independent director. Kerr is a former M&A consultant so he may have been given the lead role in order to handle a strategic review.
Here's a few counterpoints:
1) The lead independent director appointment and the qualified offer provision are corporate governance improvements that might have been taken to make RCM look better in the upcoming proxy fight, meaning that the company is expecting to hold the meeting and not expecting to avoid the proxy fight by selling itself.
2) RCM has a classified board, so even if IRS/Legion is successful in winning the two board seats it wants, it still wouldn't be enough for a majority on the five-seat board. The company may thus just not feel much pressure.
3) IRS/Legion hasn't publicly asked for the company to be sold.
4) One month ago, on August 20, a director purchased shares on the open market. My understanding is that this would be difficult to do in the middle of a sale process. To me, this all but rules out a quick sale, although I don't think it means much for the prospects of a sale in several months. Anyone with some legal expertise have any input here?
The most likely buyer is probably CDI Corp., as CDI tried to buy RCM back in June 2010 for $5.20 per share in cash. (RCM paid a $1 special dividend at the end of 2012, so add a dollar to the current stock price of $5.95 if you want to compare the offer to today's price.) However, private equity or another strategic buyer could certainly be interested as well.
If the company does not sell, its (only slightly) improved corporate governance is a little encouraging. IRS/Legion Partners has a big stake in the company and will likely continue to be a positive force if there is no sale.
Proxy fight analysis:
RCM's ownership is very favorable to IRS/Legion. IRS/Legion holds 13.4% of shares, and Dimensional Fund Advisors and Heartland Advisors are the next two biggest holders, each owning about 9% of shares. Heartland has some activism history (including having forced the sale of Analysts International (ANLY) a month ago), and Dimensional is known as a dissident-friendly holder as well (see this [really cool] study).
One point that IRS/Legion could have improved upon is their nominees. I doubt that ISS and Glass Lewis will support Ballou, given his role in trying to take over RCM just three years ago. ISS and Glass Lewis may view him as too conflicted to serve on the board. I expect ISS and Glass Lewis will support Vizi, however, given Legion's significant stake in the company.
I'll leave the proxy fight analysis at this basic overview for now, but if this proxy fight progresses and anyone wants to hear more, I'd be happy to take a deeper dive.
Recent Analysts International sale:
On August 28, Analysts International announced an agreement to be acquired by American CyberSystems for $6.45 per share, a 61% premium to its last closing price, of $4.01. Analysts had previously been under pressure from Heartland Advisors, which argued that the company should sell itself because it was too small to be public, with a $16 million market cap. Check out Heartland's "supporting statement" at the bottom of its December 10, 2012 13D. RCM is of course a bit bigger than Analysts, but at a $74 million market cap, you could make all these same arguments for RCM.
The 14D9 filed by Analysts notes that there were multiple strategic bidders for the company (see page 14). Analyst's adviser, Cherry Tree, received eight non-binding indications of interest after contacting 81 strategic and financial buyers. The two finalists were American CyberSystems and another strategic buyer. Per the 14D9 (page 15):
Between August 2, 2013 and August 6, 2013 Cherry Tree had price discussions with the two highest bidders-ACS and another strategic bidder. ACS had offered between $6.00 to $6.25 per share with a financing contingency, and the other bidder had offered $6.00 per share without such a condition. ... On August 5, 2013 the other bidder raised its proposal to $6.12 per share, again without the requirement of a financing contingency.
Analysts then agreed to exclusivity with ACS. What this story means, though, is that there is a strategic bidder interested in acquiring an IT staffing company, and that bidder was shut out of buying Analysts just a month and a half ago (assuming that bidder was not in fact RCM itself). Obviously RCM and Analysts are different companies, but if you're looking to buy a small IT staffing company, well, there aren't too many.
Comparables and valuation:
The 14D9 filed by Analysts also provides a few very useful comparables (see page 30). Cherry Tree calculated median Enterprise Value/LTM Revenue for public IT staffing companies (eight, including RCM) as 0.32x, and median EV/LTM EBITDA as 8.9x. RCM's current EV is $60 million. Revenue is $155.5 million and LTM EBITDA is $7.3 million, making for in-line ratios of 0.39x and 8.2x. Let's focus on EBITDA multiples for the following analysis because the 25th percentile to 75th percentile ranges are tighter (0.13x to 0.52x for EV/Revenue, and 6.8x to 11.7x for EV/EBITDA), so the EBITDA multiples are likely more meaningful.
But RCM's last year was relatively weak, and it's showed a lot of growth in the past two quarters, on both the EBITDA and earnings fronts. RCM said in its last earnings release:
As the board and management team continue to execute on RCM's strategic plan and achieve progressively positive results, we are cautiously optimistic that our overall results for the two remaining quarters of fiscal 2013 will exceed the comparative two quarters of fiscal 2012. Based on our current internal metrics we expect that we will enjoy a marked increase in performance in fiscal 2014 as compared to fiscal 2013.
EBITDA in the last four quarters was (most recent first): $2.4m, $1.8m, $1.7m, $1.5m. So let's lay out three growth scenarios. In the low growth case, RCM's EBITDA over the next two quarters adds up to $3.6 million, for a total of $7.8 million on the year. If RCM's EBITDA over the next two quarters adds up to $4.2 million (matches the last two quarters), we have $8.4 million on the year. If RCM's EBITDA over the next quarters adds up to $4.8 million (matches Q2), we'll get $9 million on the year.
Thus, after Q4 earnings are reported, adding in $14m of net cash (and keeping us at 12.4 million shares outstanding) the company should trade at:
Low case ($7.8 million annual EBITDA):
8.2x current RCM multiple: $6.29 (that's (8.2*7.8+14)/12.4)
8.9x average IT staffing multiple: $6.73
Medium case ($8.4m):
8.2x multiple: $6.68
8.9x multiple: $7.16
High case ($9.0m):
8.2x multiple: $7.08
8.9x multiple: $7.59
Of course, let's remember this article is based on a sale possibility! Cherry Tree also calculated transaction multiples for IT staffing companies (eight deals) at 0.37x EV/LTM Revenue and 14.3x EV/LTM EBITDA. That 14.3x multiple would give RCM a sticker price of $10-$11.50 in our three above cases. (I didn't add in Analysts' EV/EBITDA transaction multiple of 24.5x to my median calculations; I just kept Cherry Tree's numbers.) The EV/EBITDA ratio for CDI's unsolicited bid in 2010 was 10.5x, by the way, but of course RCM rejected that offer.
Earnings and P/E:
The company's earnings appear to be growing strongly. RCM made $0.12/share in Q2, handily beating the only estimate (of $0.06), and it made $0.08 in Q1. The company's earnings don't appear to be significantly seasonal, so it seems reasonable, given the company's comments on its outlook, to expect that earnings stay near or above these levels in the coming quarters.
At annual earnings of $0.40, P/E would be 15. If we add in the seven other IT staffing companies in the Cherry Tree analysis (and eliminate one with negative earnings), we have P/E's of 12 Harvey Nash Group PLC (LON:HVN), 14 Mastech Holdings, Inc. (MHH), 18 (RCMT itself), 18 CDI, 18 Computer Task Group Inc. (CTG), 25 Kforce, Inc. (KFRC), and 65 InterQuest Group (LON:ITQ), for a median of 18.
With a P/E of 18 and earnings of $0.40, RCM would be worth $7.20.
RCM stock is somewhat illiquid, trading an average of 11k shares each day over the last month. If you buy, know what you're doing!
RCM appears to be slightly undervalued based on comparables analysis. Add in that it is being pressured by an activist with a large stake, and has a 9% shareholder that recently successfully pressed for a sale at a competitor, and this is an excellent situation to buy into. The company is undoubtedly monitoring costs in order to be able to present the best possible numbers in front of its upcoming annual meeting, so buying in before Q3 earnings can capitalize on this incentive.