- KFRC could benefit from both short-term and long-term trends in the US tech temp employment market.
- KFRC has an impressive financial profile.
- COVID-related businesses continue to hamper the progression of the gross profit margins, and increased tech unionization is a long-term risk.
- I do much more than just articles at The Lead-Lag Report: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »
It’s now over a year since the advent of the pandemic, and while some industries in the US economy have returned to pre-pandemic levels, the broad US employment market is still some way from the pre-pandemic norm of over 7 million job openings. However, as pointed out in The Lead-Lag Report last month, the most recent job-openings number was quite encouraging and reiterated the ongoing progress in the employment market terrain.
If you’d like to tap into the ongoing employment market recovery and are looking out for suitable equity options, you may consider looking at Kforce Inc. (NASDAQ:KFRC) - a professional staffing services firm that offers employment solutions both on a temporary and permanent basis. According to SIA, KFRC is one of 15 large publicly-traded specialty staffing firms. Unlike some of its listed peers that have exposure to other global employment markets, KFRC is very much an American-centric business with 100% of its revenue coming from the domestic market.
Temporary employment services leading the recovery
Data from the non-farm payroll release shows that temporary employment continues to ramp up at a faster pace than permanent employment. I suppose this is to be expected, as businesses are still dealing with the aftermath of the pandemic and an uncertain economic outlook. Considering the wobbly outlook, it would be prudent to not make any definitive large-scale permanent employment-related decisions and rather move ahead with some flexibility in the employment cost base until things become clearer. Now, why should this matter to KFRC, you ask? Well, temporary-based placement has accounted for ~97% of KFRC's topline over the past three years (Source: Annual Report), so the current economic and business conditions are ideal for a temp staffing firm of this ilk.
A key aspect that differentiates KFRC from its peers is its focus on the tech landscape; the company focuses mainly on clients involved in tech areas such as systems/applications architecture and development, data management, business and artificial intelligence, machine learning, network architecture and security. As you can see from the chart below, around 10 years back, they had ~50% exposure to the tech space, an elevated figure in its own right, but this has since grown over the years and currently makes up for ~75% of the business making this very much a tech-oriented staffing play.
Some of you may not appreciate the increased concentration within the revenue mix, but the management feels this is a particularly lucrative area whose prospects will only grow. Digital transformation has been rampant across businesses for a few years now, but the pandemic accelerated this even further with several companies increasing their technological investments. In addition to that, there also has been a spurt in regulatory costs and employment laws have become more complex. This has necessitated the need for tech companies to seek alternative and flexible modes of employment to help bring down the overall cost of employment. Companies such as KFRC are at the vanguard of providing services to facilitate this. All in all, it’s worth noting that tech staffing spending - projected to be $32 billion in 2021 - has almost doubled over the last 10 years (Source: SIA).
Also do note that the average bill rates (estimated to be $80) in the technology temp employment space are substantially higher than what it is in other markets such as industrial staffing or administrative staffing or even finance and accounts staffing. Revenue visibility too is greater as the average project duration is much longer at 10 months vs. say less than six months in other areas (for instance finance and accounts is 3-4 months) (Source: KFRC).
All in all, KFRC’s tech service offering is currently very instrumental in driving a sequential pickup in operations. As per the latest results, the billing per day in their tech business came in at 6% sequential growth in Q4-20, up from 2% sequential growth in Q3-20. Most of the increase is down to a pick-up in volumes (consultants on assignments have grown by 15% since June-20), highlighting the underlying demand for their services. The management also highlighted that this “meaningful acceleration” continued into Q1-21.
Impressive financial profile
I’ve also been quite impressed by KFRC’s overall financial profile as there's much to admire, be it on the balance sheet, the income statement or the cash flow statement. I mentioned previously how KFRC has moved from being a somewhat diversified play with exposure to a number of end-markets to a more tech-focused staffing player. This increased concentration has been abetted by large-scale divestitures. Between 2012-2019 the company divested ~320m of revenue from businesses in its non-core offerings. Normally, one would see a significant drop off in the growth rates on account of this revenue attrition, but it’s a testament to the management’s focus on the tech and F&A (finance and accounts) space that group revenues have actually grown despite the divestment hindrance.
Unlike most growth companies that are inundated with debt, KFRC’s position is well managed with net debt of only $18.9m (representing a minuscule net debt/EBITDA of 0.22x). This is a significant improvement from levels of $120m seen only three years ago. During this same period, the free cash flow has grown by more than 4x from $16.6m in FY17 to $71.2m in FY20. As an equity investor, you also want to see if a company has been able to generate ample returns on its equity base. Even here, KFRC delivers, the company generated an elevated ROE of 32.2% recently, and has been delivering ROEs averaging 28.8% over the last five years, much higher than the 8.3% sector median levels.
Having laid out the bullish case, I’d also like to touch upon a few risks related to the KFRC story.
GPM weakness could linger
A dominant theme over recent quarters has been the weakness with the temp gross profit margins. For instance, in the recently-concluded Q4, the temp gross profit fell by 20bps q-o-q and 40bps y-o-y. The main reason for this is the increased share of COVID-19 related revenue from their finance and accounting business, which is an inherently low-margin business. In Q4, KFRC generated about $28m of revenue from their support of government-sponsored activities related to COVID-19, in Q1 this impact will linger and they expect to generate COVID-19 related revenue to the tune of $22.5m-$27.5m.
Risk of tech unionization
The other risk is more longer-term and I brought this up in The Lead-Lag Report. In general, unionization may be in decline across the US, but we’ve seen recent trends of tech employees at blue-chip companies setting out their own unions with other tech companies now expected to follow suit. If this trend carries on, it could tilt the ball in favor of the labor force and make it challenging for tech staffing agencies such as KFRC, by way of potentially higher employment and regulatory costs.
Investors looking to exploit the near-term recovery in the labor market and the long-term secular trends in the tech employment market may consider looking at KFRC that has deep expertise in these areas and also has a very resilient financial profile. Risks include a likely continuation of GM weakness and the brimming threat of tech employee unionization.
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