Kelly Services: Acquisition Target, Variant Perception On Implied Growth And Risks

| About: Kelly Services, (KELYA)

Summary

Kelly Services' overwhelmingly positive metrics relative to its industry group.

Positive and negative indicators of a possible acquisition. Including a look at an amazingly strong balance sheet.

How earnings composition has materially changed, and what it means for the stock.

Implied growth rate, and a possible variant perception. Why this stock is priced for demise, and maybe shouldn't be.

Why I'm still cautious. Insider selling, short-term volatility and more.

Kelly Services (NASDAQ:KELYA)(NASDAQ:KELYB) is an ancient (founded in 1946) staffing company. It has a very wide range of industries serviced on a global platform. Its main business is, however, still staffing in the Americas. I won't waste more of our mutual time describing Kelly Services in-depth. There are several write-ups that are probably better on that subject than I could hope to produce.

Central takeaway: Kelly Services has a more-than-fair chance of being acquired, and optionality on growth in its OCG business segment. Several risks are, however, present.

Overview:

So what stats does Kelly Services boast? Well, it's currently selling at $750 million, currently has $70+ million FCF, therefore, selling at a meager 10 P/FCF. It also has several other advantages; the strongest being its solid balance sheet.

Currently, the company has a current ratio of 1.5, having $400 million more in current assets than liabilities (a fair bit being bound capital, unfortunately).

In addition, the company has $360 million in other assets, around $142 million being in available for sale investments. All in all, if the pension liabilities are discounted correctly, Kelly has an aggressively estimated $160 million EV (refer to appendix B for calculations, assumes that deferred taxes of $200 million can cancel out $50.4 million of current tax liabilities, and includes working capital - so way too aggressive assumptions to be of use.)

Now, I'm a scared guy by nature - so I always assume something is wrong with my calculations - and I'm definitely not going to flaunt a stock based on my fancy matching of liabilities and assets. With a purely normal approach we still get $485.4 million worth of net cash. (Appendix C).With a large margin of safety (this approach yielding a $256.6 million EV).

Now, and this is very important: These above calculations are including working capital - inflating the aggressive figure by about $400 million. These figures I will only use when talking about an acquisition from a larger staffing company - as they would be de facto deferred expenses normally required to start a new operation - as such, it would make sense for a project NPV of a company's financial department to include them. For our leverage adjusted metrics, look below.

To be safe, we're going to assume EV at $550 million in the continuing examples. Here, we take the calculations included in appendix B, but simply add on working capital of $400 million. This would lead to a $550 million EV.

If you furthermore ignore the $200 million for covering insurance in other assets (that means not removing the corresponding liabilities), the $197 million deferred taxes removing the $50 million tax liability, the $142 million held in investments for sale, and the $94 million held for sale in the APAC venture - you end up with net cash of $60 million - giving us a $670 million EV.

When looking at personal investments, one should consider this $550/670 million EV the relevant metric - the accompanying calculations will be supplied in Appendix E.

For classical stats, Kelly has 12 P/E and is selling at a discount to book (0.8). Graham classically said that an 8.5 P/E for a no-growth company was fair. Considering the current alternatives (negative yield debt and all), I think it's fair to say that Kelly is not exactly priced for massive growth.

So what are the opportunities/potential catalysts?

Opportunity one, Acquisition: With the cost of debt being as it is, acquisitions are flowing out faster and faster in the staffing industry. Duff & Phelps say that staffing acquisitions are occurring at levels not seen since 2007, with massive double-digit increases YoY (Q1-15 v Q1-16, at 38% growth being an example). Kelly Services would be a pretty decent acquisition target for several reasons:

It's cheap, relatively speaking: I'll let the picture speak for itself, before I expound. Data is from Yahoo sector comparison.

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With $850 million of tangible book (around half being working capital), Kelly's price at $700 million would be an incredibly easy way to bolster a company's otherwise leveraged balance sheet. It carries almost no debt, seeing as it is net cash positive, in an industry that is highly levered. Furthermore, the magic word synergy, could easily come into play - with a growing OCG department and a globally diversified business.

Furthermore, Kelly has a long and sustained track record - and to quote one of my favorite Paul Graham essays:

"Companies doing acquisitions are not looking for bargains. A company big enough to acquire startups will be big enough to be fairly conservative, and within the company the people in charge of acquisitions will be among the more conservative, because they are likely to be business school types who joined the company late. They would rather overpay for a safe choice. So it is easier to sell an established startup, even at a large premium, than an early-stage one."

Although not a start-up acquisition, the mind-set still applies. With that in mind, Kelly Services is about as safe as you can get.

If one is still skeptical about the relative cheapness of Kelly Services, look at the short introduction to a quantitative comparison between TrueBlue (NYSE:TBI) and KELYA in Appendix A at the end of the article.

Opportunity two, Organic Growth:

Kelly Services is really standing at a growth gap. It's been here several times before, but never this way. With that said, management is not expecting excessive growth in 2017. The reason this time may be different (a bad phrase to use, I know) is earnings composition.

If you aren't the optimistic type (and you'd be foolish to invest based on hope, in my humble opinion) this graph doesn't look too good. Kelly Services has obviously (especially, if you look back to 2003-2005, pre this graph) been at this supply capacity before, and has rarely - if ever - broken through. That's probably why it is priced for demise. Let me just shortly expound on that.

Implied growth?

If we use a reverse-DCF (thanks James Montier) and set the discount rate to a somewhat conservative 11%, what % growth YoY for the next 10 years will give us our current MC and EV? The discount rate assumptions are as such.

The equity risk premium is on the high-end for this interest rate environment, and our industry premium at 3% is due to the inherent lack of moats that most commercial companies suffer from.

What about our starting cash flows? Again, with the goal of being conservative, let's assume that normal staffing activities (excluding OCG) mean revert to normal GP/NP ratios. So it's clear we have to adjust if they're out-of-whack. Luckily, 1% net is somewhat in the middle of the historical values. Assuming that to hold true in all normal staffing activities (that is to say, excluding OCG revenue) we are looking at 1% of $4,908 million worth of revenue, which gives us expected earnings of $49 million on average. So we have a stable $49 million as our base. Furthermore, we have OCG. OCG has not behaved normally/with a stable NP - so let's start by making conservative expectations. OCG had two amazing quarters in 2015 Q3-Q4 - with earnings (adjusted for corporate overhead) being almost 35% of total earnings, normally hanging around 15%).

For our conservative approach, let's say that these amazing quarters never return. They simply happened once and that's all. Furthermore, revenue doesn't grow faster than other staffing growth (although it has consistently grown YoY quite fast).

Net profit ratios also remain at 2.6%, as it had been in 2013 and 2014. With all this, we have steady-state cash flows of 700 * 0.026 = $18.6 million. We are assuming that the continued cash flows of OCG will be $11 million lower than they were last year, and only $2 million higher than they were in 2014 - when the first two quarters only had 80% of the revenue from the first two quarters of 2016.

so $50+18 million, giving us a normalized starting cash flow - with rather conservative assumptions of no margin expansion and no OCG growth - at $68 million. Since we need to add SG&A and taxes to the OCG - let's stick it at $11 million from OCG - $61 million resulting. For our reverse-DCF, we have an implied 2% growth after year 10 in perpetuity - for inflation.

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With a discount rate of 11%, and an implied 10Y CAGR growth of 3% - KELYA would be fairly priced. For the implied price to hit Enterprise Value ($550 million), implied growth would have to be -1.5 % growth - every year for the next 10 years. That's at the $550 million EV. For the $160 million and $250 million we would need -20% and -12% CAGR 10Y growth - respectively (Appendix D).

(EV is a hardcoded number, just to compare).

So with that being the consensus view, let's continue to the next catalyst(s).

There are two ways to achieve organic growth:

1. OCG growth:

One is through the obvious OCG growth. If OCG manages to grow more than 3% YoY, there is hope ahead - and a lot would indicate that OCG can expand its margins from our assumed 2.6%. Just last year, OCG had a 4.1% net ratio - contributing $29 million to GP. Furthermore, if we deduct our corporate overhead from our earnings (in effect, adding the real cost of earning the money), this is the resulting OCG earnings trend:

However, with the recent discussions of NAFTA and the hate towards outsourcing - I don't think investors should rely solely on OCG growth.

2. Mean reverting Americas:

Americas staffing segment has been showing weakness and decline from its 2012 heights of $90 million earnings contribution (and that's adjusted for corporate overhead). Here is Kelly's earnings composition over the last six years. I'll let the pictures speak for themselves.

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(Legend tables: "forøg" = Increase, "Formindsk" = Decrease, "Samlet" = Total)

To not become too long-winded, and that may be a discussion for a whole other article, there is a distinct chance that KELYA could lever up and revert its Americas earnings to pre-2013 levels of ~$75 million. This would give us, with the new OCG assumed at ~$15 million, a $100 million NI - giving us a P/E of 7.

The third catalyst could be selling of divisions, as Kelly recently did with parts of its APAC operations. This could be one of the cases where you simply keep the value drivers and earn good returns on the underperforming APAC and EMEA divisions.

Risks:

The reason I'm not entirely 100% bullish on Kelly is for several reasons.

1) It could make bad acquisitions with debt; very tempting when you have a ton of cash and no debt.

2) Margins could become even more compressed. Our "so-called" conservative OCG assumptions could be proven entirely too optimistic.

3) OCG could be destroyed by political initiatives against outsourcing.

4) I'm worried that OCG will strongly underperform compared to the 2015 results in Q3-Q4 - which could disappoint investors and cause short-term volatility.

5) The biggest one, and the reason my Kelly position is downright small until I gain clarity, is because of the low insider holding at 4.6%, combined with the recent material selling of stock from insiders. Insider selling this last month definitely got me worried. If this last risk was not present, I would view Kelly Services as a superbly safe investment.

With all that said, Kelly is still a pretty safe company - with a strong balance sheet, at an affordable price, and free optionality in both growth and as an acquisition target. $19 per share is a decent price, but I'm waiting for any short-term movements before adding substantially to my position. The material insider selling has, however, got me convinced that I should not expect an acquisition this year.

On a scale from 1-10, this is one of my 5/10 ideas. Certainly not a free home run, but a conservative investment based on a sustainable business that has proven its position through the years - and now with an asymmetric risk-reward on several aspects. I'm holding this for at least 2-3 years, unless a major catalyst plays out, the stock jumps excessively or I'm worried the fundamentals have changed. In the best-case scenario, with OCG priced for growth and mean-reverting Americas - a P/E of 16-18 at $90 million NI would be justified, giving us a share price above $35+. This is, however, in a perfect scenario - and you should never invest based on best-case scenarios.

Appendix A:

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Appendix B:

It is assumed that Kelly Services has been auditing its statements correctly and is recognizing AR to AP and pension liabilities "correctly", that is to say, in accordance with GAAP.

We will be assuming the normal definition of EV; it being the real cost of taking over the company.

EV = MC - Net cash

Net cash = Cash and cash equivalents - All liabilities

For Cash (and/or liquid sellable securities):

$33.3 million cash

$142.3 million held in investments available for sale

$94 million equity held for sale from APAC

$197 million in deferred taxes (which we are not counting in the EV calculation, but to nullify the $50.3 million tax liability - so we are practically counting $200 million in deferred taxes as worth only $50 million).

Pension and retirement liability money held in other assets

Also a surplus of $390 million in A/R, after expenses connected to A/R. Explained: A/P, payroll and insurance - together boasting $690 million that are related to the current A/R. subtracting them from A/R leaves us at $389.8 million that will be received within the next 70 days (average DSO) - early enough for us to consider them cash. This leaves at a surplus of $389.8 million.

So we have 33.3 + 142.3 + 94 + 390 in things that could be cash within three months = $659.6 million. This is not including the $200 million in deferred taxes and not including the pension money - since these will be used to cancel out matching liabilities more easily.

Our liabilities are as follows:

$26.9 million in debt

The A/P, insurance and payroll we have already subtracted.

$50 million in liabilities on held for sale.

Pension and retirement liabilities held in other assets not counted in assets above.

Taxes of $50 million we are canceling out with $200 million in deferred taxes.

This gives us 26.9 + 50 = $76.9 million

A normal EV approach =

Net cash = 659.6 - 76.9 = $582 million.

EV = 742 - 582 = $160 million EV.

And that is without counting the excess $150 million deferred taxes we left out.

Appendix C:

Liquid Assets:

Current assets (cash, A/R and held for sale investments) - prepaid expenses = 1,254 - 48 = $1,206 million

Current assets + available for sale investments (In other assets) + money market funds: 1,206 + 142 + 3.7 = $1,352.8 million

1,352 - Current liabilities = 1,352 - 816 = $536 million
536 - non-current liabilities (excluding pension and retirement, as they should be the excess $200 million in other assets) = 536 - 50.6 = $485.4 million

MC - net cash = 742 - 485.4 = $256.6 million EV.

And then we have $197 million deferred taxes and $50 million deferred expenses we haven't yet included.

Appendix D:

Worth $278 million at -12% growth YoY next 10 years


Worth $170 million at -20% growth YoY next 10 years

Appendix E:

Worth $670 million at 1.55% growth next 10 years YoY.

Worth $500 million at -2.5% growth next 10 years YoY.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KELYA, KELYB over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The position will be initiated once I have liquidated a speculation fully, to acquire funds and maintain portfolio structure (cash-wise). It is more than likely that I will initiate a position within 72 hours, and almost certainly within the next two weeks. Albeit a small one, as described above. The article is written as if I already hold a position, cause I might as well be - having already put the funds aside to buy up.