Heidrick & Struggles International: Opportune Time To Buy

Summary

• Heidrick & Struggles has shown consistent growth in its revenues and operating margins.
• With its recent diversification into On-Demand talent services and HR consulting services, it should decrease its susceptibility to economic cyclicality.
• I see both organic growth in its core business and growth via acquisitions in its new business segments, though FY2023 is expected to be a challenging one.
• I find the company to be a good bargain at the current level from both an intrinsic valuation and a relative pricing perspective.

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Heidrick & Struggles International (NASDAQ:HSII) is human capital advisory firm providing retained executive search, on-demand talent services and leadership/cultural consulting to a variety of businesses. In such a reputation-based business, it boasts of a broad base of clientele, across several industry segments and geographies. Lately, the company is investing to diversify and grow its adjacent business segments. At the current price level, I find it to be very attractive from both an intrinsic valuation and a relative pricing standpoint.

A Strong Growth Story…

Barring the Covid induced dip, Heidrick & Struggles has shown consistent revenue growth for the past 10 years. Its revenues have grown at a 9.3% CAGR for the last 10 years, with the growth accelerating in the last 5 years. Even with strong FX headwinds in 2022 which affected its topline growth by 3.1%, its revenues increased by 7%. Simultaneously, HSII has increased its operating margins consistently from 4.4% to over 10% over the same 10-year period. It has been an efficient growth story with its revenues/FTE having gone up from ~$300K to ~$500K, while its EBIT/FTE increasing from ~$10K to ~$50K over this period.

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From a client and industry perspective, HSII is adequately diversified. Its top 10 clients only account for 6% of its revenues and no single client accounts for more than 1% of revenues. Furthermore, its client base is well spread across several industries, effectively mitigating its exposure to any specific industry group.

Diversification across industries (Author's analysis based on 10-K for FY2022)

Lately, HSII has diversified from its core business of retained executive search into adjacent segments of On-Demand talent services and leadership/cultural consulting. Though these segments are still small, accounting for about 18% of overall revenues, they are growing fast. While these nascent businesses are draining cash currently, both have seen a considerable improvement in operating margins over the course of last year.

Author's analysis based on 10-K for FY2022

Investment Thesis

HR services businesses are highly correlated to the general macroeconomic activity and exhibit similar cyclicality. I consider HSII to be in the same boat with bulk (82% currently) of its revenues coming from its core executive search business. Given the current economic slowdown, I expect HSII's topline to decline by ~10% in FY2023. This is in line with the company's Q1 2023 guidance. However, its diversification into adjacent On-Demand and Consulting business segments should soften some of these cyclical dips in the future as these segments tend to perform relatively better in tighter macroeconomic environments. Therefore, I expect HSII to keep growing its topline revenues at a moderately healthy pace of 7% for the subsequent 4 years. I consider this to be a fairly conservative assumption given its past CAGR and the growth in the upcoming segments being much higher.

Given its strong performance on the margins side, I assume it would get to a steady state of 10% EBIT margins. Its near-term margins, however, may be challenged given the decline predicted in its revenue base next year. In order to accelerate the growth of its On-Demand and Consulting segments, I reckon the company will invest more into these segments than in the past. HSII has indicated its increased rate of investment in R&D (to the tune of $25MM for FY 2023) to develop and expand its digital products. Simultaneously, I expect it to grow its On-Demand business through acquisitions. The recently announced acquisition of Atreus Group GmbH, a provider of interim executive management in Germany, is a precursor of things to come. It is important to note that these investment in R&D and acquisitions are relatively small given the scale of HSII's operations. Nevertheless, I have factored this increased rate of future capital investments in my valuation model.

Taking into account a relatively low beta, and low D/E ratio, I get the cost of capital for HSII as 9.5%.

Using these inputs, my valuation below results in an equity value of $954MM for the company or ~$45/share. This is about 50% higher than the current price of ~$30. I have already accounted for the cash bonuses of $414MM that the company has accrued over the last year to be paid to its consultants in H1 2023. With this bonus accounted for, I still find the company trading well below its intrinsic value currently.

FCFF Valuation Model ($ million)

DCF Valuation (Author's analysis)

Simulation Results

Results from the DCF model are highly dependent on the key assumptions outlined earlier. Revenue growth rate and the terminal operating margins are the key variables here. Monte Carlo simulations were run on the DCF model with these two inputs as variables, with their values being picked from distributions shown in the table below. A set of 10,000 random iterations were performed and the results from this simulation are shown in the figure below.

Input Variables for Simulation

Variable	Distribution	Baseline	Std. Dev.
Revenue growth rate	Normal	7%	1.08%
Terminal operating margin	Normal	10%	0.67%

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Frequency Plot of Intrinsic Valuation from Monte Carlo Simulation

Author's analysis

My range for intrinsic value lies in tight band from 20th percentile of $42.3 to the 80th percentile of $47.9. With HSII trading at $30.1 at close on 3/17/23, it lies at around the 1st percentile.

Relative Pricing

To analyze how HSII is trading vis-à-vis its peers, I selected a group of 22 public companies in the "HR and Employment services" sub-sector of the Industrials. I regressed the commonly used multiples against fundamental value drivers for each multiple. Based on these regression models, I calculated the predicted values of the multiples that HSII should be trading at, given its fundamentals (growth rate, margins, beta, payout ratio, ROC etc.). I selected the multiples where regressions R² was relatively high. As is seen from the table below, I found HSII to be undervalued currently on each of the 4 multiples. The range that I get using relative multiples is $32 - $49. Though this happens rarely, but in this case, HSII is current cheap relative to its intrinsic value and to its peer group as well.

Multiple	Predicted Value of Multiple	Equity Price/ share
EV/Sales NTM	0.8	$42
EV/Invested capital	2.1	$32
P/E NTM	13.7	$39
P/BV	2.5	$49

Click to enlarge

Risks

I see a couple of important risk factors here that are worth mentioning.

Macroeconomic headwinds - HSII's core business of executive search is highly dependent on the general macroeconomic environment in the developed economies. A slowdown in economic growth, as being currently experienced, is naturally a headwind for the company. The duration of this slowdown and the speed of recovery are uncertain here. Heidrick & Struggles is trying to minimize this risk via diversification. It is already well diversified geographically and by industry segments served. Now, it is accelerating its On-Demand and Consulting businesses, which would provide some level of immunity against these headwinds. On-Demand business, in particular, could be a vital cog in its wheel since the demand for fractional executive leaders can grow in harsher economic conditions.

Acquisitions - Heidrick & Struggles has grown in the past both organically and via acquisitions. Though these acquisitions have been relatively small, in my view, they have not really delivered much value. However, the company seeks to continue following this path. For example, it recently announced the acquisition of Atreus Group GmbH, a provider of interim executive management in Germany. Given their history, I would be wary that such acquisitions could be value destroying versus value additions, though again the impact may be small.

Conclusion

Based on my valuation, I find HSII to be cheap at a $30/share price relative to its intrinsic value and relative to its peer group, given its fundamentals. I consider this to be an opportune time to invest in this company if one can withstand some of the near-term gyrations of the stock.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.