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Cyclical staffers split the City

The recruiters are extremely cyclical; the problem is that observers disagree on where we are in the cycle.
August 28, 2014

Recruiters are highly cyclical. When the economic cycle is on the up, companies hire staff and people have the confidence to switch jobs. When the economic cycle turns down, everything grinds to a halt. Adding to the cyclicality is the fact that a recruiter's capital is its people. In lean times, a manufacturer might just mothball machinery. But a recruiter can't mothball its consultants. It has to keep paying them and in the process suffer a serious dip in profitability. Or lay them off and risk losing its pool of talent and client relationships.

Consider Hays (HAS), the UK market leader. In its 2008 fiscal year, the UK business made an operating profit of £137m. Four years later that had swung to a £6.5m operating loss as the economic downturn hit job market confidence. At that point Hays had cut deep into its operations in a damage limitation exercise. The group had reduced its UK office network to 110, which was less than half the peak level of 235 in 2009. The number of UK consultants had dropped to 1,934, down almost 40 per cent from the 2008 headcount. It was a similar story at other recruiters. Michael Page's (MPI) UK operating profit shrank by more than 70 per cent between 2007 and 2012, while Robert Walters (RWA) saw its UK profits decline by over 90 per cent during that period.

Things are much rosier now. The UK unemployment rate dropped to 6.4 per cent in the three months to end June - that's the lowest level for nearly six years. Economists at financial information provider Markit believe there is a "high probability" that unemployment will fall below 6 per cent by the end of the year.

With lean cost bases following several years of cost-cutting, the recruiters are enjoying a sharp uplift in profits. Hays reported an almost 20-fold increase in its UK operating profits to £9.9m in its first-half results as 93 per cent of its net fee income - a key metric for recruiters that is made up of placement fees for permanent jobs and a margin earned on temporary jobs - dropped straight through to operating profit. Robert Walters said at its first-half results that the UK was seeing a "broad-based recovery in most disciplines". It added that it was "well positioned to further leverage our operational gearing as confidence levels improve and candidate shortages become more widespread and acute".

But if everything is moving in the right direction why then are the recruiters' share prices flat-lining or even reversing? Well first and foremost, these stocks had a stellar run in 2013. Many of them rose by more than 50 per cent as investors priced in the hoped-for recovery. By the start of this year, many of the larger recruiters were commanding price earnings multiples in the region of 30 times. That kind of rating left limited scope for expansion. So when a jobs recovery came good this year, it justified last year's re-rating rather than providing fuel for the shares to push higher.

Another factor is that although there has been much better news on the UK job market recently, recruiters are still facing headwinds elsewhere. Gone are the days when recruiters were a pure-play on the UK economy. As the UK market has matured, the recruiters have exported their model overseas to markets such as North America and Asia where there is still a vast pool of untapped in-house recruitment. That global diversification means that they are exposed to some markets where the job market remains challenging. The resource-led slow down in Australia has been a particular headache for many of them, while continental Europe has also proved slow off the blocks. Michael Page said at its recent results presentation that France and Germany were still seeing difficult trading conditions in the permanent, higher-salary segment. However, there was better news on Australia, where Page says there are signs that the market is now stabilising.

That global presence also exposes the recruiters to currency headwinds - a major issue not just for recruiters, but any UK company with overseas operations given the recent strength of sterling. Page reported a solid 8 per cent increase in group gross profit to £264m, but currency wiped off £19m of that taking the reported growth down to less than 1 per cent.

CompanyTickerPrice (p)YTD price change2013 price changeMarket value (£m)Forward dividend yield*Forward price-earnings multiple*Last IC view
HAYSHAS130-2%50%17902.1%19.1Buy
HARVEY NASHHVN1032%57%753.4%11.0Buy
MATCHTECHMTEC5781%141%1453.5%15.3Buy
MICHAEL PAGEMPI448-8%16%14302.5%25.8Buy
ROBERT WALTERSRWA3200%60%2471.8%30.3Hold
STAFFLINESTAF94572%84%2551.3%16.2Hold
STHREESTHR343-5%8%4214.1%21.2Hold
MEAN AVERAGE2.7%19.9
FTSE ALL SHARE0%17%
 * Based on consensus forecasts from Thomson One Analytics

So where do the recruiters go from here? The bull case scenario is that the job market recovery in markets such as the UK continues to gather pace and that lagging economies such as France and Australia catch up. Candidate and client confidence continues to grow and the permanent job segment - always slower to pick up that the temporary segment because it requires more conviction to take on permanent employees - gathers momentum. Earnings growth gathers pace by enough to offset currency headwinds, upgrades filter through and share prices get another leg up. (See the Broker's View section where the analyst at Credit Suisse takes this line.)

But then there is the bear case. Some City analysts believe that this is not the middle of the cycle but the top of it. A recent research note from Bank of America Merrill Lynch warned that the market is "at risk of complacency", and that "earnings growth will be insufficient to drive further upside". They argue that the rate of improvement in economic lead indicators has slowed and that we may be closer to the top of the market than people think. They point out that the previous four cycles lasted on average 59 months from trough to peak. The current cycle is 32 weeks from its most recent trough in the last quarter of 2011. But if you measure from the deeper trough of the post financial crisis in 2008/2009, then this cycle has already lasted 67 months. Noting that "the cyclical nature of staffing means that many investors have one eye always on the exit", the analysts at Merrill say the recruiters' bull run is over.

FAVOURITES:

Hays was a tip of the year (Buy, 128p, 2 January 2014) for the recovery potential in its UK business. The shares initially did well, hitting 158p in April but have pulled back since along with many of the other recruiters. We stick with our buy call as we believe the UK turnaround is not priced in. We also like Matchtech (MTEC) for its niche position in specialist engineering roles where there is an acute skills shortage. We turned buyer of Matchtech at 350p in April 2013 and the shares are up 67 per cent so far. We also recently turned buyer of Michael Page (Buy, 438p, 13 August) as we felt the recent pull back in its shares had opened up a buying opportunity. And we have a buy on technology recruiter Harvey Nash (HVN), which is the cheapest stock in our table on earnings multiples.

OUTSIDERS:

We have no outright sells at present. The most expensively rated stock in our table is Robert Walters on a forward price earnings multiple of 30 times. So although the group is trading well, we rate the shares a hold.

IC VIEW:

The recruiters' huge cyclicality makes them an intriguing prospect for anyone wanting to make a big bet on where the economy goes from here. Looking at the spread of our recommendations (four buys, three holds), we would have to say that we have taken a glass half-full view of the sector primarily due to the fact that profits are still well below pre-crisis levels and thus have plenty of room to recover further. But while a rising tide floated all recruiters' boats in 2013, this year it pays to be more selective. If you are feeling bullish on the macro and want to take a punt on the sector then look for those stocks that have pulled back enough to present a decent buying opportunity.