7:59 cut – GATC

Gattaca (GATC) – FY Update

Gattaca are a Engineering and Technology recruiter with a 70% contract and 30% permanent split. There is an international business but nearly 90% of revenues are from the UK. After a number of years of poor organic and acquisition performance they have been restructuring.

Their low valuation has recently attracted stakebuilding from both Morson Group (a UK competitor) and HRnetGroup (a Singaporean company who have also been buying shares in Staffline), but they have also suffered from the attentions of the US DoJ for alleged sanctions-busting in a discontinued business. A cloud on the horizon is the (effective) changes to taxation of UK contractors (IR35) which may reduce their market in that area.

Today they provide a full-year update that looks very positive at first glance, with underlying profits before tax and underlying cash ahead of expectations [edit: it is pleasing to see them acknowledging the stated cash is flattered by year-end timing]. However the exceptional costs are higher than I expected (Equity Development had not estimated) and while they say that DoJ legal costs will reduce next year, the matter is clearly not over and the risk of large (and as a foreign company, capricious) fines remain. The statutory result looks to be a small loss: the last Equity Development note estimates underlying profit after tax of £7.63m and exceptional costs are £8.7m before amortisation / impairment of intangibles – ultimately it will come down to the tax treatment of these items.

It is notable that the closure of discontinued operations has resulted in a working capital unwind of £7m, significantly in excess of the related restructuring costs (ex DoJ). This supports my thesis that the business would release working capital in a downturn, giving downside protection. In particular, a reduction of contractors as a result of IR35 changes would resulting in a considerable working capital unwind, and in the short term permanent recruitment fees for those that convert may result in a one-off profitability jump.

It would be a serious mistake to rely solely on forward PE of under 6 for valuation. This is a very complicated situation with US DoJ legal action, IR35, one-off restructuring costs, Brexit, significant debt and a possible takeover battle. The recent volatility of the share price is hardly surprising and seems likely to continue. I am becoming less positive about the company but in the immediate short term I intend to stick with my holding.

[Edit: Equity Development have issued a new note today – you can find their full coverage of Gattaca here. They confirm that FY 2019 was ahead of their forecasts, but give no opinion on restructuring costs. They quantify the size of the cash timing issues likely to unwind in FY 2020. Concerningly they disclose a second DoJ investigation related to Huawei. Overall it is well worth a read, always remembering that they are paid by Gattica and so not independent].