SThree could defy recruitment downturn

Investors are clearly uneasy about the sector. Since January, recruitment giants PageGroup (PAGE) and Robert Walters (RWA) have lost around 40 per cent of their value. Right on cue, signs have started to emerge that the labour market is cooling. According to the Bureau of Labor Statistics, the United States added just 263,000 job openings last month, well below July’s increase of 537,000. The EU is experiencing a similar slowdown, while the number of UK vacancies has actually started to fall.

Recruiters can sense that change is in the air. Between July and September, PageGroup noted a “slight softening in client confidence” across most of its regions and a slowdown in hiring times, while Hays (HAS) identified a “modest reduction” in activity levels.

This is no normal downturn, however. Labour markets around the world remain tight, caused in part by increased economic inactivity, and wage inflation is still high. As a result, recruiters continued to achieve double-digit net fee growth in the third quarter of the year and certain areas of the jobs market look particularly sturdy. Enter: specialist staffer, SThree (STEM). 

STEM promises to flower 

SThree focuses on white-collar jobs in science, technology, engineering and finance. Tech is the big breadwinner, generating about half of net fee income, and there was some concern that the group would be caught up in Silicon Valley hiring freezes and layoffs. The historic correlation of its share price to the fortunes of tech giants such as Meta, Amazon and Microsoft means those concerns could well persist.

However, its client base actually spans a range of sectors, and the positions SThree fills look more robust than most. The drive to automate and digitise shows no sign of waning, for example, with a recent survey by consulting firm Gartner finding that “94 per cent of CEOs want to maintain or accelerate the already intense pace of digital transformation sparked by the pandemic”.

The desire for digital progress sits alongside well-established labour shortages. In the UK, for example, ‘professional scientific & technical activities’ are still reporting some of the highest vacancy levels, with 127,000 roles advertised between July and September.

SThree’s track record attests to its resilience. All recruiters took a battering during lockdown, but SThree held up better than many of its generalist peers, with operating profit falling by just 48 per cent in 2020, compared with 88 per cent at PageGroup and 71 per cent at Robert Walters. 

With the pandemic largely in the rearview mirror, momentum seems to be building even as we lurch into into a series of economic crises. In a September trading update, SThree said profit before tax for 2022 would be at least 7 per cent ahead of the market consensus of £71.2mn. This follows an upgrade in 2021, when full-year profits surpassed forecasts by 17 per cent. The recruiter’s contractor order book, which is up 24 per cent year on year, suggests 2023 will also be strong. 

Much ink has been spilt on the state of the UK labour market, and the chaotic state of the government. However, UK fees account for just 15 per cent of SThree’s revenue and – until 2021 – had been in decline for several years. They have now begun to climb again, but it’s more sensible to focus on the group’s bigger businesses in Germany, the United States and the Netherlands, where growth remains strong. According to Eurostat, the Netherlands has the highest job vacancy rate among EU member states, while Germany has the fifth-highest rate.

Unlike peers, SThree has also benefited from its lack of presence in China, where Covid lockdowns still weigh heavy on the labour market.

Cash conundrum 

The fact that SThree is weighted towards temporary placements – about three-quarters of its fees come from contract work – should also stand it in good stead, as permanent roles are often the first to go when times get tough. This is evident in a recent trading update from PageGroup, which noted that temporary recruitment is outperforming permanent “as clients looked for more flexibility in their resourcing and cost base, reflecting the current economic uncertainty”. Contracts should also provide better earnings visibility. 

This does come at a price, however. When recruiters find candidates for permanent roles, they typically receive a percentage of the agreed salary. When it comes to contractors, SThree has to pay the worker’s wages before the money – plus a fee – is received from the client. 

This has resulted in an extremely lumpy cash flow record. Adjusted free cash conversion – a measure of how well the group converts profit into cash for things like dividends, capital expenditure and share buybacks – has fallen from 178 per cent in 2020, to 40 per cent last year and just 4.6 per cent in the six months to May 2022. Until this latest drop, management targeted free cash conversion of at least 75 per cent. However, it has now abandoned this ambition, claiming it “no longer reflects the current business model”. 

The vertiginous decline in free cash flow has been attributed to a bigger contractor order book. This makes sense: cash conversion was highest during the pandemic when work was drying up. However, it is worth keeping an eye on how long the group takes to collect money from clients. Between 2018 and 2021 this remained stable at 44 days, but investors should look out for any big jumps in accrued income as the months drag on, as they could signify that SThree is struggling to collect cash from its clients.

For now, though, SThree is in a very comfortable position. As of May 2022, the recruiter has no debt beyond £31mn of lease liabilities and is sitting on a cash reserve of £48.4mn. 

Recession ready  

Another thing to watch out for is internal recruitment. SThree wants to keep growing its headcount but – as it knows better than most – the labour market is tight, and company churn is high at around 40 per cent. Wage inflation could impact the group’s already slim profit margins, therefore, and a shortage of experienced recruiters could hamper productivity in the longer term. On this score, PageGroup's admission that the majority of its latest recruits are non-experienced as the availability of experienced hires is “increasingly limited” is a worry.

Still, SThree’s weak spots become less concerning when you look at how much the shares cost. The recruiter has lost 39 per cent of its value over the past 12 months, and currently trades on a forward PE ratio of just 8.9, compared with a five-year average of 12.3. When it comes to recruiters, HSBC argues, the market is already close to recessionary multiples.

Meanwhile, analysts at Panmure Gordon have noted that SThree’s enterprise value to net fee income ratio sits at just 0.9 mtimes, compared with 2-2.5 times in the last period of cyclical recovery in 2010 and 2011.

SThree is not a risk free option. However, key qualities of its investment case seem to have been forgotten in the rush to ditch cyclical stocks, and its valuation is tempting. As the economic backdrop darkens, the recruiter could well surprise us.