Korn Ferry, Monster, Heidrick & Struggles: Recession Risk Not Priced In

The more I study staffing stocks tied closely to the economic cycle, the more I continue to believe that the market--despite giving lip-service to cyclical concerns, has not realized how bad things really get for these companies when the economy heads downhill. The only analyst report I found that even took a cursory look at Korn Ferry (KFY) and Heidrick & Struggles International (HSII)'s financials prior to 2003 was Credit Suisse First Boston. And is it surprising, then, that they were also the only company I could find that had conveniently not included FY09 or FY10 revenue estimates?

Nearly every analyst cites cyclical concerns in these names, but none of the ones I could find actually models a true recession scenario. Even Goldman, which has probably been the most bearish of all analysts on the permanent staffing companies, does not model anything close to a recession scenario. Let's take a look at implied revenue growth estimates for KFY:

Analysts' compounded annual growth rate estimates (Merill Lynch, Goldman Sachs, & Davenport), were derived from their latest FY09 or FY10 revenue estimates. Note that these estimates are noticeably higher than the historical CAGR (CAGR from FY01 to FY08 Q2, a full economic cycle), and much higher than the revenue CAGR KFY experienced from the peak of the last economic cycle (a -28.4% (!) CAGR from FY01 to FY03).

Though KFY has more favorable industry exposure this time around, they'll still run into some serious trouble if we head into recession. Analyst estimates aren't just off base--they are nowhere in the ballpark.

How about HSII? Analysts have been much more critical of them, and in their latest quarter they've already shown a slowdown in bookings. Also, their industry exposure (34% financial, 19% consumer) is much more exposed to areas that are likely to see significant slowdowns). Surely, estimates are more in line with past recession scenarios, right?

Once again, not even close. Even Goldman, which has a sell rating on the stock and has stated they have serious cyclical concerns for HSII, does not price in anything like a recession scenario (they call for revenues to dip in FY08, with growth resuming in FY09). Lastly, let's take a look at growth story Monster Worldwide (MNST) which, many people do not realize, is actually a very cyclical stock.

Once again, all of the analysts are way above the mark. Not to pick again on Goldman, but I find it particularly funny that the analyst most seemingly concerned with cyclical issues here (Goldman), actually has the highest 2 year revenue CAGR estimate of any analyst I looked at. Even in the last recession, when MNST was a high profile growth story in North America, they saw their core MNST careers revenue drop by 12.1% annualized over 2 years.

I estimate that in a similar recession, MNST could see a 2 year revenue CAGR of -12.7%, to as high as -19% depending on assumptions. MNST's North America division, even in a more favorable economic backdrop, has struggled to grow, recording mostly single digit YoY revenue growth this year. This time around, with increased competition and a more mature market, I expect that North America will see revenue decreases in line with KFY and MNST (I model a -25% CAGR).

I assume flat growth internationally and in their ads business in a recession due to us being earlier in the maturation cycle in many of those markets. That said, if we were to go ahead and assume declines in those markets on par with what MNST experienced in the last recession (which I believe is somewhat probable, especially given the large % of international revenue from developed markets), we'd see a total revenue CAGR of -19%. If either recession scenario plays itself out, the stock would be absolutely crushed, as it was in the last recession.

What does it all mean?

Analysts and investors are forgetting how bad things get for these companies when the economy slows down. Comforted by seemingly low P/E multiples (on peak earnings), rosy management guidance, share buybacks, and other sleights of hand that will eventually be shown for what they are, I believe these three stocks will be some of the worst performing investments of the next 2-3 years (before they once again become become on of the best investments at the bottom of the cycle).

These companies will eventually post large revenue declines, huge charges, and margin compression; everyone will act surprised, despite the evidence of what happens in poor economic scenarios being right in front of them all along. If the economy does indeed head into a recession, all three stocks will suffer greatly.

Disclosure: Author is short KFY, HSII, and MNST. Author made best efforts to present data accurately, though mistakes may exist. Do your own DD. This should not be construed as advice to buy or sell shares.

Comments

[DaveinHackensack]

Here are a few reasons I think you shouldn't short HSII:

1) Your U.S. recession fears are baked into the stock prices in the sector already -- look at the one-year charts.

2) A recession next year is unlikely -- the Fed is ahead of the curve cutting rates, and the weaker dollar has American exports booming.

3) Even if there is a recession in the U.S., HSII gets 44% of its revenue from overseas (Europe and Asia).

4) HSII has $218 million in cash, no debt, and a market cap of only $619 million. You really want to short this company? They could launch a massive buyback if they wanted and squeeze you.

5) KFY just beat earnings and its share price went up 20%. What do you think will happen if HSII beats earnings?

[ResearchIntensiveInvesting]

Hi Dave,

Thanks for the comments. In response:

1) Though the stocks have already been hit hard, this is not much unlike the trend that occurred in 2000-2001; these stocks get marked down in 2 stages. The first (which has already occurs) happens when the market stops treating them a growth stories and begins to have more of a flattish outlook. The 2nd stage occurs when the businesses show clear signs of cylicality, and operating performance falls. Check my prior write-up on KFY why for I think there is still more room for these to fall.

2) This is a long debate, but I will say that the fed's impact has been negligible so far (LIBOR spreads have continued to increase, etc.), and that there are many arguments put forth by many smart people supporting serious recession risks.

3) I'm glad you brought this up. On an income basis, it gets ~ 61% from North America. Also, most of its international exposure is to multi-nationals, which have relatively greater exposure to the US than local companies (this is why in the last recession revenues and income abroad also dropped off a cliff, and will likely happen again this time around, though perhaps to a lesser extent).

4) The cash number is misleading. They have $112M in bonus payments due in Q1, and $15M they still have to pay for the Highland Partners acquisition, so lets say the current number is more like $150M. On top of that they are using most that money for buybacks, which are succeeding only to keep the share count basically flat, because of the generous share grants to employees. And they are also buying their stock on peak earnings, which in the long term I believe is destroying--not adding--shareholder value. Buybacks are not good when you are buying your own overvalued stock.

5) This will take some time to play out. But given HSII's sector concentration, I think its more likely than not that we'll see significant pressure in Q1 of next year, if not next quarter.

[Stocky]

Good Analysis. You should get short SFN, KFRC, CBR, SAPE, MPS, ANSR, RHI, BE and CDI as well. It is very easy to fire contractors without paying unemployment or issuing press releases. Check out what all these companies did in 2000-2001. Rising unemployement, jobless claims and continuing claims supports your thesis as well.

[DaveinHackensack]

Thanks for the response.

Regarding points 3 and 4:

3) By the same token, aren't many of HSII's domestic clients companies with international business that would lessen their exposure to a U.S. slowdown?

4) Does your Q1 cash estimate include the additional earnings HSII will retain in that quarter?

I'd wish you good luck, but since we're on opposite sides of a trade here, I'll just wish you Happy New Year.