You are sure to recognise Warren Dick (right) as a regular co-host and contributor on CNBC Africa. His real job, though an investment analyst at Trillian Asset Management, a boutique investment house. In this, his debut for Biznews.com, he takes a close look at a company that recently has attracted big investment by PSG, Sanlam and Coronation. Warren unpacks the inner working of Adcorp and explains why some of SA’s smartest money managers like the stock so much. After reading this considered piece, am already looking forward to Warren’s next contribution. – AH
By Warren Dick*
Labour broking and recruitment specialist Adcorp (JSE: ADR) presents an interesting dilemma for investors. The company has been quick to respond to changing circumstances in the domestic and international environments within which it operates. But while there has been a flurry of activity, nothing on the bottom line has convinced investors just yet that the value the company looks to unlock is a sure thing. So is it time to buy?
Adcorp was founded in 1975 as the country’s first recruitment agency and listed on the JSE in 1987. The group provides a full range of employment services which range from placing high level executives through to the placement and administration of contract workers (labour broking). The company places on average 80 000 contractors on any given day. This makes it the largest provider of staff in this category with a market share of over 10%.
Adcorp has generated healthy returns over the last 15 years (as can be seen from Figure 1 below) with return on equity (“ROE”) averaging 23.5% over the period. The variability in returns represents the cyclical nature of the labour market and is also reflective of the difficulty in asserting pricing power in an industry where the barriers to entry have traditionally been quite low.
The stagnant labour market in South Africa, for one, has been a motivating factor in the company’s international expansion. This has been borne out by the latest employment figures from StatsSA which notes that only 1 000 new formal, non-agricultural, private sector jobs were created in the third quarter of 2013. Private sector employment levels as a whole remains beneath those seen before the global financial crisis.
The second reason for the company’s acquisitive strategy relates to changes in the international recruitment industry which are now being felt in South Africa. As part of the company’s commentary in its most recent interim results, it noted, “A global trend which is starting to gain a strong foothold in the SA labour market is that of large employers appointing a master service provider (“MSP”) to administer and control contract workforces which, historically, tended to go largely unmanaged in many organisations. Large employers are aggregating recruitment requirements through a master vendor solution acting as the gatekeeper. There is far more sophistication in the procurement of skills.”
The third reason, and one which supports the second reason put forward above, are imminent changes to the legislation governing labour brokers in SA. This centres around proposed amendments to the Labour Relations Act (“LRA”) which is currently being considered by parliament. Some of the changes include laws making labour brokers jointly and severally liable for adherence to the LRA, as well as the principle of equal pay for work of equal value. Greater organisational rights will also be given to contract workers.
The company noted that these changes, “…..will be neutral to potentially positive for larger, sophisticated and compliant providers such as Adcorp.” It is the unintended consequences of the legislation that has got a number of investment managers excited about the company. PSG Asset Management believe the changes will lead to further consolidation in the industry, which in turn will mean that barriers to entry will be raised, which will ultimately lead to the company being able to extract pricing power. Since May PSG have owned approximately 5% of the company, while Sanlam Investment Management increased their stake to 12.44% as per SENS on 2 December. Coronation has got in on the act too and notified the market (on the 28th of November) that it now owns 11% of the company.
Consolidation has been happening in the industry for some time. The number of recruitment agencies in South Africa has fallen from 3400 in 2008, to 2800 in 2013. Another large player in the space, Kelly Group, has also indicated they want to “bulk up in the SA market”, ahead of proposed changes to labour legislation, “Companies will have to make key staff categories permanent and entirely outsource those that are not,” says Kelly CEO Gareth Tindall.
So the opportunity for the company to both grow income and increase margins has been presented on the basis of:
1. Being able to manage complexity (compliance with new legislation and the trend towards MSP’s internationally); and
2. Economies of scale (brought about by the ability to consolidate/pursue acquisitions).
This opportunity has seen the company invest heavily in back office systems and create shared service centres that will make it the lowest cost operator in the placement and administration of contract workers. Acquisitions in South Africa (Paracon), Australia (Paxus and Labour Solutions Australia) have been funded through a combination of debt and equity, and account for the large amounts represented in the cash flows from financing and investing activities (see Figure 2 above).
But as can be seen from the selected metrics I have chosen in Figure 3 below (which accounts for financial years 2010-2013), aggregate figures for revenue, operating profit, and profit attributable to owners of the parent have shown solid growth. But the dilutionary effect of paying for acquisitions through the issue of shares has not translated yet into any meaningful growth of earnings on a per share basis. And in order to fund the company’s growth, the dividend has been suspended.
This has left investors with the unenviable task of relying on future performance to justify the company’s current valuation. At the current price of R31.75 and using financial year 2013’s reported earnings per share of R2.21, this values the company on a price-earnings ratio of 14.3x. This is towards the upper end of its historical range.
Following the company’s interim results for the 1st half of financial year 2014 (to end-August) the company noted that ‘normalised’ EBITDA (that excludes the cost of share-based payments) was growing organically at 10% p.a. But the acquisition of Paxus in Australia has disappointed. This has seen the group’s overall EBITDA margins drop from 4.9% in the previous corresponding period, to 4.4% in the current period.
Much remains to be seen. The company needs to deliver on the objectives it set when it embarked on its current strategy, and this needs to be reflected in better margins, and stronger earnings growth on a per share basis in order to justify the large amount of capital that is being committed to the business. But this dilemma certainly seems to have the vote of the country best and brightest investment managers.
*Warren Dick is an analyst at Trillian Asset Management, and both he and the company do not currently hold any shares in Adcorp.
