Introduction
My previous “tick-tock” article had a very narrow focus examining whether there a case for buying at a price depressed by the fear of an imminent suspension in the hope of a bounce once suspension (or the threat of it) was lifted. I concluded that, for me, the answer was no. This article is more general, looking at the history of the company, how it got to this point, what is likely to happen next and their short and long term future.
History
Great!
The company was established in 1986 and changed their name to Staffline in 2009 to reflect their main focus on temporary staff provision and management. They then branched out into supporting various government employability-related initiatives, branding this as PeoplePlus in 2015.
Growing organically supported by a long term trend of increasing use of agency workers; by winning government employability contracts; and by acquisition, they reached a market capitalisation of £450m in November 2015.
Acquisitions were largely funded by strong cashflows and temporary recourse to debt, limiting the amount of share issuance and supporting a share price rise from lows of 25p in 2009 to a peak of over £16 in November 2015.
Not so great
In their FY 2017 results they reported a positive trading outlook and said they were on track to be in a net cash position in 2018. They also reported successful completion of their so-called “Burst the Billion” strategic target on revenues of £957.8m, claiming this was justified on a run rate basis. The CEO of 9 years, Andy Hogath stepped down to a NED position with the FD taking his place and an insider becoming FD.
A week later the outgoing CEO sold two thirds of his shares for £10m.
In H1 2018 profits were lower due to the cancellation of the government “Work Programme” on the PeoplePlus side. Due to further acquisitions (and working capital movements), debt was up to £36.9. Despite the claimed run-rate going into the period, and the acquisitions, revenue was £481.0m.
After a final push, they reported in their January 2019 trading update that FY 2018 revenues had finally exceeded their 2017 £1bn target. Profits were said to be inline with reduced expectations, prior to exceptional costs of £20m related to the closure of the government “Work Programme“. Complete full-year results would be issued admirably quickly on 30th January as usual.
Bad
On 30th January the market was treated to not one but three announcements:
- 07:00 results are delayed
- 15:30 shares suspended pending an announcement
- 18:14 possible accounting issue – shares remain suspended.
Then on 12th March that they reported that one of the issues was with National Minimum Wage compliance, that they had previously been aware of an issue and were in discussions with HMRC. They had planned a provision of £4.4m in the accounts but following legal advice had increased this by a further £3.5m, that the results would be lower than expected by this latter amount, but that business was on track with good cashflow. At the same time they reported a couple of contract wins. The suspension was lifted and the shares recovered half of their losses from the 30th January.
Nothing more was heard about the delayed results until 30th April when they confirmed that discussions with HMRC and advisers were ongoing.
Worse
On 17th May they issued a profits warning blaming Brexit uncertainty resulting in companies moving Staffline-managed EU workers to direct permanent employment contracts (which apparently doesn’t result in Staffline getting a percentage of their first year’s salary) and customers worrying that they haven’t published their results yet. The latter seems unlikely, however I can see how being party to illegally underpaying workers (albeit due to customer imposed working practices) would affect their standing in the industry and the worst may still be to come in terms of publicity.
Following the profit warning, EBITDA was forecast to be £23-28m vs around £45m for FY 2017. They have significant debt with some covenants are based in EBITDA and it was clear that they would breach and a waiver would be required. A subsequent broker’s note reportedly cut FY 2019 EPS by 46% and increased year-end debt.
To make matters worse, they confirmed that they were still working with the HMRC on the minimum wage issue and could not produce their FY 2018 results until this was resolved and an audit carried out. At that point AIM rule 19 meant they had about 3 weeks until the shares were suspended (again). Not surprisingly this caused the share price to progressively drift down.
Terrible!
It wasn’t until Monday 17th June that they announced agreement with the HMRC and it wasn’t pretty. Costs were far higher than previously announced – perhaps HMRC felt they were in a strong negotiating position under the circumstances and/or wanted to make an example of them.
They confirmed that they are in breach of their debt covenants and in negotiations with lenders. The cancellation of the dividend was confirmed and large emergency fund raise announced.
What went wrong?
Straightforwardly put, they foolishly overstretched themselves trying to meet a silly revenue target despite government policy headwinds, and then were unlucky enough to be hit by a historical legal issue in an area of increasing political focus (minimum wage), followed by headwinds caused mainly by political mismanagement of immigration policy.
You may have guessed that I don’t like revenue targets. The reason is that they can drive margins lower and debt higher, often increasing risk and ultimately impacting what I really care about: value and earnings per share.
What will happen next?
Fund raising price and dilution
It is possible that a firm price has already been agreed with institutions over the weekend. If not (as most commentary suggests) then further falls in the share price would reduce the placing price and increase the amount of dilution, with the threat of this adding further pressure to the share price. If a placing price has already been agreed this is likely to be at a 50%+ discount to Friday’s price and be subject to a material adverse change clause which could be triggered by a share price fall below a certain level.
At this stage, any institution wanting to be involved in the placing is likely to have been taken inside. This can depress the share price the big potential buyers cannot buy, leaving shorters and private investors to set the price. Informed commentary suggests this was the main cause of FireAngel’s fall from 28p to 19p immediately before their rescue fund raising.
Open offer take-up
There is a further open offer for £7m which will be at the same price as the placing. Until recently it was very common for fund raisings in general, and emergency fund raisings in particular, to exclude private shareholders entirely. Therefore this is to be welcomed. However it does create further uncertainty about the level of dilution.
If the entire £7m were to be raised then this would place the company in a usefully stronger position, but the dilution would be higher.
Timing
The level of dilution is such that the fund raising will require agreement from shareholders and therefore cannot take place before July. However, terms are likely to be published much sooner, possibly imminently.
Audit
Based on Monday’s and earlier RNS statements, the only matter remaining before the results can be issued is now the audit. It seems likely the results date was chosen because it is the penultimate possible date to avoid suspension rather than based on the length of time to do an audit plus a reasonable contingency. For this reason alone there remains a risk of them missing the suspension deadline.
However what would concern me most is whether the auditors are going to be happy to sign them off as a going concern. Following criticism of the auditors of Carillion (amongst others), there is pressure to be more cautious in this area. This could, at best, delay accounts. It seems reasonable to believe that commitments to the placing from institutions be sufficient to placate the auditors, but this not an area I know much about. At worst it could result in a suspension, large intangibles write-offs to fire-sale values and further problems with lenders and customer confidence.
Future
If / when the fund raising is concluded, results published and any suspension lifted, what are the future prospects and valuation of the group?
This principally depends on three things: The price of the fund raise (and therefore the level of dilution), how much the business has been affected by bad publicity, and the political environment. The first point was briefly covered above and will be again in my conclusion.
Publicity effects
The implication that business turned down partly due to customer concerns over the initial delay to the annual report and not further due to subsequent (then unexpected) delays does not seem credible. One explanation is that a single large customer cited this as a concern.
News coverage to date has been (from a shareholder’s perspective) mercifully limited, even in the business pages, however the announcement of the fund raising details will be another opportunity for coverage, as would any HMRC publicity statement. This may be read by customers, suppliers and agency staff, further affecting the business.
Politics
Nobody should now be left in any doubt that the company is heavily politically exposed.
Their PeoplePlus unit supports specific political policies that are subject to future change such as employability programmes and in particular apprenticeships. They contract with government departments who are likely to take a dim view of involvement in underpaying workers. Although they declare no customer above 10% of revenues, this is likely to refer to different arms / regions of the government and most would consider they have an exceptionally high customer concentration and a power imbalance between customer and supplier. An example of the risks this entails are the £15m+ exceptional costs in to 2018 due to the closure of the government “Work Programme”. However, in exchange for this margins are relatively high.
Their Staffline business provides agency staff, the majority of which are some combination of: an EU migrant, on a zero hours contract, being paid minimum wage. Brexit is the epitomy of political risk and the impact is already being felt. Zero hour contracts are under increasing pressure from all sides and some kind of legislation seems likely. Minimum wage rules are being increasingly strictly applied and enforcement more draconian as they have learnt to their cost. As wages pass through Staffline, margins are low.
Valuation
Statutory profit figures are likely to be complicated for some time and the eventual number of shares and level of debt is not yet known. For this reason I will be focusing on earnings before interest and enterprise value (EV).
The last update gives a range of £23-28m underlying EBIT (aka underlying operating profit) for 2019. I have run this through a model and, assuming no further loss of business (highly uncertain at this stage), this seems realistic. Adding back underlying amortisation and depreciation of £4.6m (double the H1 figure), gives a central EBITDA value of £30m compared to £43.5m last year. Given the level of ongoing capitalised investment required on systems, I prefer EBIT which, based on 2017, is likely to be close to EBITDA + capex.
For 2020 EBIT of £39m is forecast. However this forecast relies on growing revenues in both Staffline (staff provision) and especially PeoplePlus divisions and it is difficult to see where this will come from. The trend for agency staff seems to have peaked, no acquisitions seem viable (though one has already been made), and in PeoplePlus clouds (and possible reorganisation costs) are gathering over apprenticeships. Using my model the forecast would be for £30-35m EBIT.
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On the positive side, as the leading supplier of “casual” workers, Staffline may ultimately benefit from increased regulation as smaller competitors (and employers) do not have (and cannot cost-effectively develop) the digital and other systems to manage the complexity. As well as out-competing them, this should give Staffline a steady supply of very cheap acquisition targets.
Conclusion
Before I give my conclusion, I’d like to remind readers that when I say that I am / am not buying / selling, you need to remember that a) my research / judgement might well be wrong, b) even if statistically my judgement makes sense, unknown / random factors mean that it won’t always pay off, and c) at best the statement only applies to me, i.e. in the context of my personal situation, portfolio and risk profile. Not only should you do your own research, but you should also consider how your situation might vary from others and how this should affect your decisions. I am not giving advice, merely stating my opinion.
Overall, I would be happy valuing the business enterprise value at 5x stabilised EBIT which I estimate to be £162m. This compares to an EV of around £114m at 105p based on brokers’ estimates of 2019 year-end debt (pre-raise).
On this valuation I calculate that a placing price of 72p would, after dilution, provide a 100% upside the institutions involved. This should be a sufficient margin to encourage bids.
Existing holders / buyers in the market before the price is confirmed gain rights to buy an allocation of shares at the placing price. The ratio of rights to existing holdings increases as the placing price decreases which provides some protection against dilution from institutions at a lower than expected placing prices.
Accordingly I have recently purchased a very small position and will be monitoring the situation this morning very closely with a view to adding. A significant further delay to the fund raising would indicate more serious problems that would make me reconsider.
LeoInvestorUK's blog 
Very good analysis.
Have you considered that given low visibility at this time of the year and the combination of negative publicity (as result of forced capital raise/HMRC settlement), cyclical risks and some degree of operating leverage – the underlying EBITDA for the year could come out at £20m or lower. It is possible given the fluid political and company-specific situation.
If that indeed turns out to be the case, even if they successfully raise money now, the could still be 3x levered (or higher) on the new and potentially lower earnings number. If there is a reasonable risk of this happening I would not be comfortable owning the shares.
Ultimately, the temp recruitment business is at the mercy of its customers and the margins are unbelievably thin.
The current management do not exactly fill me with confidence and they have absolutely no skin in the game.
We have no visibility and Brexit is a clear and obvious risk to their entire recruitment business unit – overwhelming majority of workers are from Eastern Europe and there may be material disruption coming from this event. I haven’t heard the management address this threat.
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Thanks for your comment. You raise several important points, so my reply is quite long!
I’m interested what you mean by “low visibility at this time of year”. Shareholders can expect an H1 update in 3 weeks and (assuming the FY 2018 results are out by then), unaudited H1 results at the end of July. Commentary suggests (company and calendar) Q1 is the quiet patch during which there is little visibility for the rest of the year, thus the sudden large downturn in expectations following April / early May’s trading. Generally, the summer is said to be a busy period and although actual delivery in parts of PeoplePlus will be quiet over the summer holidays, they are probably getting people signing up and gaining visibility. While there is a Q4 weighting in the lead up to Christmas, I think there is enough visibility well before then for any major shortfall to be evident, at which point they would be obliged to warn. After H1 results the next scheduled trading update is in the first week of January.
Negative publicity I certainly covered. It is a big risk, but from a customer perspective other (smaller) suppliers are likely to have just as bad or worse systems and they probably quite value not being on the hook themselves for HMRC fines etc. The worker will be choosing the end employer and so has no choice in using Staffline. However this is similar to the situation with renting a house where the customer is primarily choosing the house and so has no choice over the agent – this naturally led to a severe market failure and in turn recent legislation to protect the customer. Again, I think the biggest risks are political.
I cannot remember specifically considering cyclical risks and choosing to leaving them out of the article. When I think about it now the answers seem obvious, so maybe I did, or maybe I’m now making up any story to cover up my omission (which human minds are very good at): Temporary worker provision’s market share of employment should increase as employers are less likely to want to commit to permanent staff on their own payroll. This is likely to still be a net negative, but Staffline should benefit from the withdrawal / cheap acquisition of weaker / sub-scale players. PeopleSoft should in principal be counter cyclical as to some extent government spending should naturally rise in this area as unemployment increases (“automatic stabilisers”), however governments are very prone to pro-cyclical spending when it comes to discretionary spend. I think there is a general risk that after such a long time of employment expansion it is difficult to remember what it was like last time employment was falling and Staffline is probably sufficiently different now that reports from 10 years are of limited help.
I did perform a sensitivity analysis and what surprised me was how insensitive the valuation was to higher debt from larger one-off costs. What it is very sensitive to is of course normalised earnings. Either of these things could, as you say result in a breach of their EBITDA covenant even after the fund raise. I will be a lot happier if they raise the full £7m in the open offer, which of course means that a) the share needs to not be suspended b) the placing needs to be at some discount c) the price needs to hold up during the extended offer period, almost certainly including the H1 update and possibly the full H1 results. EBITDA covenants are 2.5x tested at the end of each calendar quarter on the last 12 months rolling EBITDA. June’s will certainly be missed. If there is any further downturn (and they are still a quoted company) then I will try to model quarterly EBITDA. Regardless, I think lenders would be willing to look through to more normalised EBITDA in the short term.
I specifically considered the risk of a historic earnings overstatement. Given the amount of cash paid out in dividends and acquisitions, and the lack of tangible assets to under-depreciate, it is difficult to see how this could be the case barring the (newly familiar) hidden overdraft and trade debtors scenario.
Margins do look thin on the staff provision side, but of course this is because wages pass through the company’s books. Some of the best businesses work by making a small cut of large amounts of money in transit (e.g. Mastercard). They take no pricing or supply / demand imbalance risks on this money (unlike, say a consultancy company employing full-time staff and selling them on hourly contracts). There are some risks in proportion to the turnover (as we have seen), but overall I think it is a nice business model. If you were to measure margins on just the charges to the customer then they would be very high and we might even say obscenely and/or unsustainably so.
I don’t think any of the candidates for the next prime minister has suggested a change in status for working EU immigrants in the foreseeable future. This risk is what message the EU workers are getting.
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Thanks for such a thoughtful reply. I respect the time and effort it took you to address these points and to write it up.
I generally don’t disagree with anything you have written. I don’t have any exposure to Staffline – although it is a stock I am watching. This relates only to how I view it personally – I just feel that the management do not have too much visibility into the fourth quarter and so there may be a further disappointment down the line, after the capital is raised (which I hope they do).
Furthermore, the outlook for next year also remains unclear for me – the outcome funnel for next year’s earnings/ cashflow seems too broad for my liking with such balance sheet risk. Just my opinion.
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