RANJF - Adecco: Margin Is In Focus Now

2023-03-17 05:51:59 ET

Summary

• Adecco reported 4Q22 organic growth of 5%, beating expectations and narrowing the organic growth gap to Randstad.
• Company's EBITA margins are still significantly lower than Randstad, and there are concerns about the company's leverage ratio and ability to generate FCF.
• Adecco's cost-cutting plan is expected to improve margins, but short-term headwinds are expected due to increased spending on FTEs.

Thesis

Though Adecco Group ( AHEXF ) beat expectations in 4Q22, reporting organic growth of 5% and revenues and gross profit that were above expectations, I give my hold rating. What's interesting is that for the first time in many years, the AHEXF organic growth gap to peer- Randstad ( RANJF ) has narrowed. With organic growth now seemingly on track to improve, I expect investors to shift their attention to margins, where the gap still remains wide. To give context, in EBITA margins terms, 4Q22 RANJF stands at 5.2%, while AHEXF is at 3.7%. This is a 250bps difference that is nearly 70% of AHEXF margin. Given that management has maintained dividends for FY22 to be paid out in FY23, I think investors will start to focus on AHEXF's leverage ratio of 2.5x at 4Q and the business' ability to generate FCF. This worry stems from the fact that EBITDA is expected (consensus) to decline in FY23. If AHEXF's FY23 performance is lower than expected, and if the reaffirmed dividend must be paid out, the company may be forced to increase its leverage ratio by taking on new debt. This would certainly put pressure on the stock valuation. Thus, I think the new G&A cost cutting plan, which can help address the margin gap, is a positive catalyst that might help with stock re-rating. The risks to margins in 2023 are still very much in sight, however, as the benefits of these cost-cutting measures are not expected to become apparent until later this year and into 2024. That said, also expect limited long-term benefits, due to the higher wage inflation's impact on AHEXF's own cost base, unless the company makes structural changes to the cost base. I'm keeping my hold rating because I think that solid execution is essential for a long-term uptick, and so far, it is too early to tell.

Growth outlook

Not only did APAC and Europe perform well, but they both performed exceptionally well. Management claims that the company's investment program has helped it gain a larger share of the market in these areas. The United States is still struggling, with negative organic growth of 13% for the quarter, as noted by management. In the United States, sales struggled because of weaker-than-expected demand during the busy holiday period. In part due to the success of Career Transition & Mobility, LHH's grew 1% organically. As we have heard commentary of additional layoffs in the US tech sector in FY23 so far, I believe AXEHF is benefiting from the current turmoil in the US tech sector, especially as this should support the growth in Career Transition. Akkodis' synergies are developing as planned, with €25 million realized in FY22, and the year-end total synergy run rate (€45m EBITA) compares favorably with the targeted €50-55m synergies for year two. Of course, those are important, but I also think it's noteworthy that AHEXF GBU outgrew the market by 550bps. It's strong evidence that AHEXF's efforts to reinvest with a focus on regaining market share were fruitful. All in all, with a lower starting point, AHEXF should outpace RANJF in organic growth in FY23, but the gap compared to levels before the pandemic will likely remain sizable. This can be viewed from 2 lens:

1. AHEXF has plenty of room to grow as the organic growth vs pre-pandemic level is still wide
2. There is still something lacking in the growth equation that needs to be fixed (this points back to my point of execution)

Either way, so far the progress has been encouraging which certainly help with narrative.

Cost saving plan/restructuring

As I mentioned before, investors are likely switching attention to margins. On that point, AHEXF opex increased by about €30 million in 4Q22 as a result of spending on FTEs. As the cost annualized or reflect a full quarter, I believe this might have some minor headwinds to 1Q23 EBITA. That said, net-net, I believe that management's ongoing emphasis on driving productivity will improve overall margin once the incremental margin from these investments is reflected in the P&L. (i.e. FTE becomes more productive). Additionally, the G&A program is on track to deliver €150 million in synergies by 2024, although the majority of it would be backend loaded. While all is good, I like to set expectations right, in that, in order to close the organic growth gap with RANJF, AHEXF will likely keep investing in FTEs, which will offset these cost savings in the short term. AHEXF guidance likely already accounts for these factors, as management has forecasted flat SG&A for 1Q22 sequentially, a period in which growth is anticipated to slow.

Taking a step back, I'd also like to remind readers that AHEXF introduced a new business strategy, Future@Work Reloaded, in its 3Q22 results. This new business model streamlines operations and changes incentive structures to increase both top-line growth and EBITA margins. And with this change, there will be some negative impacts to earnings and FCF due to cost associated with the restructuring program. Specifically, in FY23, the program's associated restructuring costs are projected to total €100 million, with an additional €35 million coming from the AKKA integration. Previously, investors looked to growth recovery (and, I believe, put less emphasis on margins), but now that the growth gap to peer Randstad has reversed, I believe the focus has shifted to profitability and cash generation. Therefore, I believe that this new strategy, if carried out effectively, could deliver what investors are looking for, albeit with results not being seen until FY24.

Long-term margin

Keeping on the topic of margin, I think the 6% target set by management is reasonable. The fact that AHEXF's business mix now includes more high-margin, non-core staffing business complements the cost savings and revised strategy already in place. I think the AHEXF GBU can easily achieve margins greater than 5% (RANJF is already greater than 5%) if management can execute well and drive productivity.

Conclusion

While AHEXF reported better-than-expected organic growth in 4Q22, I believe that maintaining a hold rating is prudent due to concerns about the company's ability to generate FCF and its leverage ratio. The new G&A cost-cutting plan is a positive catalyst that could help with stock re-rating, but the risks to margins in 2023 are still in sight, as the benefits of these cost-cutting measures are not expected to become apparent until later this year and into 2024.

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