Here is my report after meeting Directors of STAF yesterday, for their results presentation lunch.

I attended the private client brokers lunch for Staffline Group (STAF), hosted on 3 Sept 2012 at Buchanan's offices in Cheapside (thank you to them for their hospitality). This report gives my thoughts on that meeting. There were 3 Directors present: Andy Hogarth (CEO), Tim Jackson (FD), and Diane Martyn (Non-Exec - with a lot of senior experience in the recruitment sector).

Disclaimer: I am a shareholder in STAF, and indeed bought a few more shares after the meeting, as I came away feeling positive about the company. In my opinion this share is very good value, but this report constitutes purely my opinions, and is not financial advice. So as always, please do your own research.

First off, the market cap? At 226p a share, it's £52m mkt cap (per DigitalLook).

A bit about the business. Staffline is a recruitment and outsourcing company, providing blue collar workers to primarily the UK food, manufacturing & distribution markets. So it's a low margin, competitive market, with many players - mgt told us there are about 17,000 employment agencies in the UK.

The best way to view STAF is as 2 complementary divisions - the main employment agency business, and the recently entered welfare to work (a key policy of the Coalition to get benefits claimants back into work).

Firstly their main business, which has a network of branches across the UK, some of which are in secondary retail locations. However, interestingly 85% of their revenue is now from their "Onsite" model, where STAF situate one of their staff at the client's premises, and work for that client - hence no rent & rates, no need for multiple staff cover for H&S reasons, etc. Sounds a great idea, but it is being copied by competitors. This division is trading well, and the interims today indicated that profit rose 23% - but this seems to have been obscured by initial losses in the other division (of £400k, vs a one-off £400k profit last year (on the termination of the old Labour Govt work programme contract), so an £800k adverse swing for H1 results this year).

The relatively new welfare to work division (Eos) is potentially very interesting. This is where a lot of the growth could come from, and it seems to me that the Stock Market has not yet grasped how significant this part of the business could become over the next few years. Hence I believe there is an opportunity to buy these shares cheaply (on a PER of just 7) at the moment, before the profit growth (expected from 2013) from Eos kicks in.

At this stage, Eos is loss-making (£400k in H1), and consuming working capital, because fees are payable (by Govt) on a results basis - so the onus is on Eos to get people into work (proper, paid jobs, not work experience unpaid jobs) and crucially to keep them in work for 6 months, which then triggers a significant fee from the Govt.

We talked at length about this part of the business, and my distinct impression was that STAF approach this work positively, and do not seem a spivvy operator like some companies in this field which have attracted negative publicity.

They emphasised that they try to be "squeaky-clean about everything", in order to rise to the top in this sector. As with any investment, you're investing essentially in a management team. I was very impressed with STAF's Directors - all questions were answered immediately with a straight answer. Politicians could learn a thing or two from this approach - it instils confidence in their honesty & competence, unlike the evasive & spin-driven "answers" that you hear from politicians & their ilk.

So what you get here is a tell-it-like-it-is management team, a big box ticked there. They are also ambitious, part way through a rapid growth plan. They seem alive to opportunities too, such as the Eos deal, which could potentially look like a very smart move once the programme has really ramped up. It just has the feel of a group which is ahead of the curve.

There are significant barriers to entry with the welfare to work contracts, as they are awarded 5-yearly, and the nature of the cashflows is that costs are up-front, with payment by results later (typically 3-months to 6-months). So that limits how many companies are able to compete with Eos, and has frightened off many people in the sector.

There is a significant H2 bias to trading, so STAF are on track to make around £10m profit (before amortisation) this year, flat vs last year - that could be the reason that the shares dropped 5% on the results, perhaps investors were expecting another year of out-performance?

However, any such disappointment is misplaced in my view, since the growth lined up for 2013 is significant, at around 20%, so expect about £12m profit in 2013. There should then hopefully be continued growth from the welfare to work programme, and the core business. So quite why the market is pricing this as a value share on a PER of 7, is a mystery. It clearly has growth characteristics, and deserves a higher PER in my opinion. I'm valuing it on a PER of 12 times 2013 earnings, which implies a price nearer 450p (about double the current share price).

Moreover, it pays a sensible dividend, with a current year forecast yield around 3.1%, which isn't bad for a growth company. The CEO explained (rightly) that the cash is better used making bolt-on acquisitions at low cost, and of course it will be working capital hungry for the next few years due to the deferred payment nature of the welfare to work contract.

Another type of welfare to work contract via the EU has also been undertaken by STAF, but has not taken off, as Local Authorities are failing to refer people to the programme. Management are confident that can be restructured in due course, but it has been a drag on profits in 2012.

Net debt rose to £8.4m, but that's partly because last year's net cash of £2.4m was heavily flattered by short term cash balances of £8.2m at Eos (recent acquisition). The debt looks fine as it's under 1 year's profit, and mgt confirmed that there are no issues there. They also have a large, blue chip, ungeared debtor book. So if needed, they could move to invoice discounting, but don't need to. But it does mean there's potentially £30-40m in headroom on working capital if needed. They have a very strict 30-day payment terms requirement, and won't deal with bad payers - a good approach.

Mgt own 15%, which in my view is about right - not too much to be overly dominant, but enough skin in the game to make them highly motivated.
Their salaries also look about right, and not the excessive rewards you see all too often at Listed companies.

On the downside, STAF has always been cheap, slipping as low as a PER of 3 during the financial crisis. I'm not quite sure why this should be the case, although smaller recruitment companies generally are all cheap at the moment. Again, quite why that should be, when larger recruitment companies are typically on double the rating, is a mystery. In my view it's an opportunity, and STAF is certainly my favourite sector pick, as it offers good management, sound finances, good growth prospects, and a low PER, plus a reasonable divi in the meantime.

It also reminds me a bit of Judges Capital - i.e. that it's a consolidator in a very fragmented sector, and is able to buy small agencies at low prices, and fund those acquisitions largely through earn-outs. So a low-risk model for continued growth, although most acquisitions have been quite small.

I've no idea what the share price will do in the short term, however I believe that with a 12 month+ view, this share has excellent upside potential, mainly because of the growth anticipated from the welfare to work programme. That's not in the price, hence why I think it's good value.

Any views?

Regards, Paul
Twitter: @paulypilot

Nice report, Paul. My main concern with Staffline, and I am also a shareholder and have been for the last couple of years, is with the Welfare to Work contracts. Anecdotally there seems to be significant difficulty experienced with placing people in longer term work - I can't put names to those having difficulty, but did you get any feelings as to the confidence of management when it comes to succeeding in that area?

Other than that, I agree with your thoughts on the company. They just get on with the job and deliver, and a strategy of buying and topping up on the dips has so far been very successful for me.

Thanks for the report,
Steve.

Hi Steve,

You asked;

"My main concern with Staffline, and I am also a shareholder and have been for the last couple of years, is with the Welfare to Work contracts. Anecdotally there seems to be significant difficulty experienced with placing people in longer term work - I can't put names to those having difficulty, but did you get any feelings as to the confidence of management when it comes to succeeding in that area?"

Yes, we discussed the newish Welfare to Work area in some detail.

Management seem very confident about it. They said that 76% of placements stayed in their first job for at least 3 months, which triggers the first outcome payment. Others are put into a second job, which still pays out fees from the Govt.

Mgt struck me as genuinely passionate about welfare to work, saying that they invested money in training people (e.g. to drive a forklift truck, or food hygiene courses) for specific job opportunities - which of course they generate through their other business. So the two divisions are complementary.

Most of the jobs are Min Wage, but at least it gets people back into the workforce.

The main thing they do is reinstate peoples' confidence, through proper support. Once someone is back in the habit of getting up each day to go to work, they get into a virtuous circle of rising confidence, motivation, etc.
They said that most placees DO want to work, but initially lack of confidence is the big issue.

So it all sounds very positive. Would be good to get some third party corroboration of all this, but from what STAF told us, they are putting people into proper jobs, and this programme has a lot of mileage.

This is the bit I think the market has overlooked, and it's potentially pretty lucrative - could well become highly material to results within a couple of years - which is why I think the shares are cheap, as a PER of 7 doesn't price in any growth really.

Regards, Paul.

Hi Steve,

You asked;

"My main concern with Staffline, and I am also a shareholder and have been for the last couple of years, is with the Welfare to Work contracts. Anecdotally there seems to be significant difficulty experienced with placing people in longer term work - I can't put names to those having difficulty, but did you get any feelings as to the confidence of management when it comes to succeeding in that area?"

Yes, we discussed the newish Welfare to Work area in some detail.

Management seem very confident about it. They said that 76% of placements stayed in their first job for at least 3 months, which triggers the first outcome payment. Others are put into a second job, which still pays out fees from the Govt.

Mgt struck me as genuinely passionate about welfare to work, saying that they invested money in training people (e.g. to drive a forklift truck, or food hygiene courses) for specific job opportunities - which of course they generate through their other business. So the two divisions are complementary.

Most of the jobs are Min Wage, but at least it gets people back into the workforce.

The main thing they do is reinstate peoples' confidence, through proper support. Once someone is back in the habit of getting up each day to go to work, they get into a virtuous circle of rising confidence, motivation, etc.
They said that most placees DO want to work, but initially lack of confidence is the big issue.

So it all sounds very positive. Would be good to get some third party corroboration of all this, but from what STAF told us, they are putting people into proper jobs, and this programme has a lot of mileage.

This is the bit I think the market has overlooked, and it's potentially pretty lucrative - could well become highly material to results within a couple of years - which is why I think the shares are cheap, as a PER of 7 doesn't price in any growth really.

Regards, Paul.

In my view it's an opportunity, and STAF is certainly my favourite sector pick, as it offers good management, sound finances, good growth prospects, and a low PER, plus a reasonable divi in the meantime.

As you say there is certainly a marked difference between the valuation of the large recruitment firms; such as Hays, Michael Page, Sthree and Robert Walters and the minnows such as Staffline. However I don't think the valuation of Staffline is much different from Harvey Nash, Hydrogen, Networkers, Matchtech or Empressario. The whole small cap recruitment sector is depressed; presumably on macro economic concerns.

I keep a spreadsheet of the key metrics. Comparing the minnows on various bases shows:-

P/E

EMR       6.1
STAF      6.3
HVN       6.5
MTEC      8.9
NWKI      9.0
HYDG      9.0

EV/EBITDA

EMR       2.7
HVN       2.9
STAF      5.3
HYDG      5.6
NWKI      6.4
MTEC      7.0

Yield

MTEC      7.7%
HVN       5.1%
HYDG      4.4%
STAF      3.3%
NWKI      2.6%
EMR       1.4%

tNAV/Mkt Cap

MTEC       51%
HYDG       46%
NWKI       41%
HVN        40%
STAF        8%
EMR         8%

On that basis I'd favour Harvey Nash (if I was buying any, which at the moment I'm not). It's also got geographical diversity in Northern Europe. MTEC is the yield play, which I've held before. EMR is cheap but more of a recovery play and it's broker is Shore. However if you believe the forecasts, which show EPS growth of 54% over the next 2 years, then its a steal. It's also more geographically diversified. The main plus for STAF is the welfare to work, but I'm not convinced personally. The balance sheet is also weak. When the recovery comes working capital will suck up cash in all of them, so it's best to start with as much as possible.

Of course should the recovery come then it'll probably be a matter of a rising tide lifting all boats..............

My main concerns would be:-

1) Acquisitions through earn-outs has led to many problems as the cashflows differ hugely from the normal trading that has led to them. There has been many examples of companies getting tripped up here. Hopefully STAF have that covered from all angles and possibilities.

2) Eon - welfare to work. I have a rule that I will not invest in anything that relies on some form of contract or scheme run by the Government. This isn't a party political issue, but as party politics does involve changes to philosophy/strategy then it can't be ruled out that changes in the game-rules or even a complete switch-off of the scheme are only at the swish of a ministerial pen. Think of EAGA with their warmfront, think of Patientline who were stiffed by the NHS trusts refusing to buy into their services after the government insisted they do so and both have suffered enormously. Think of G4S and the Olympics debacle - they take on a contract at a ridiculously cheap price (as they have to in order to win the tender) and then find they can't supply the service at the price tendered. Branson is using the same argument to try hold onto the West Coast Rail franchise. Point of this waffle - don't trust or rely on the government.

3) I remember the fiasco that was Imprint. If that hasn't put me off recruitment, I don't know what would:-)

Cheers
jb

Hi Stemis,

Useful sector analysis, many thanks.

There is a very interesting scatter chart on the Liberum Capital house note on STAF (published yesterday) which I've seen but there is no link to it, which plots PE against 2013 forecast EPS growth, and STAF comes out the clear winner, against sector comparables.

That's what interests me about STAF - it's priced on a PER of 7, as a value share. Yet it has some pretty serious growth in the pipeline due to the Welfare to Work contracts. Those contracts are already up & running, being scaled up, and going well. Hence when the deferred fees start kicking in from 2013 onwards, I suspect the market might well reappraise the rating, and possibly price it more as a growth company. That's my main angle on it really.

Regards, Paul.

I use recruitment companies as little as possible, but still find myself working with them on pretty much a daily basis. I regard them all as being involved in the soft end of the human trafficking business, but I guess everyone has to make a living somehow.