KELYB - Kelly Services: Already Undervalued But Wait For More Certainty

2023-10-08 06:08:03 ET

Summary

• Kelly Services, Inc. is a $660-million market cap firm that offers workforce solutions across various industries.
• Kelly Services reported a decrease in revenue and gross profit in Q2 2023, with declines in most segments.
• The company expects flat or slightly increased revenue in the second half of FY2023 but faces challenges in the labor market.
• Based on my calculations, KELYA stock is already massively undervalued. But uncertainty in the labor market may impact its near future performance.

The Company

Kelly Services, Inc. ( KELYA ) is a $660-million market cap firm that offers workforce solutions across various industries through 5 segments:

1. Professional & Industrial (P&I) - 30.9% of total sales in Q2 - provides staffing and placement services in office, professional, light industrial, and contact center fields;
2. Science, Engineering & Technology ((SET)) - 24.7% of total sales in Q2 - offers similar services in science, engineering, technology, and telecommunications;
3. Education - 17% of total sales in Q2 - specializes in staffing, placement, and executive search for early childhood and higher education;
4. Outsourcing & Consulting Group ((OCG)) - 9.3% of total sales in Q2 - offers recruitment process outsourcing, payroll process outsourcing, talent advisory, and managed services; and
5. International - 18.5% of total sales in Q2 - provides staffing, RPO, and placement services in Europe and Mexico.

In Q2 2023, Kelly Services reported a 3.9% decrease in revenue to $1.2 billion (down 4.5% in constant currency), with declines in 4 of its 5 segments. The Education segment was a bright spot, showing significant growth of ~33% YoY, while the SET segment decreased by 7%, the OCG segment was down 9%, and the P&I segment saw a 9% drop. International segment revenue also declined by 9% (13% in constant currency).

Gross profit was also down 8.3% YoY, and SG&A expenses decreased by 3.4%. Earnings from operations were $6.2 million after accounting for transformation-related charges. Adjusted EPS, excluding these charges, was $0.36, down 20% compared to Q2 2022, missing the consensus for Q2 significantly:

The company ended Q2 2023 with $125 million in cash, and no debt, and executed a share repurchase program of ~980,000 shares for $69.5 million. Perhaps that's why the stock was able to survive the consensus misses on both sales and EPS numbers.

During the latest earnings call , we found out the management expects the firm's 2H FY2023 revenue to stay flat or increase by up to 50 basis points year-over-year. They anticipate maintaining a gross profit rate above 20% but foresee a decline in permanent placement fees and ARPU due to soft demand for full-time hiring. In general, I think the >20% gross profit margin forecast is pretty strong, given industry changes and the inevitable slowdown in hiring - in any case, a few years ago Kelly couldn't get above 17-19%:

Adjusted SG&A expenses are projected to be 5% to 6% lower than the same period last year, reflecting cost optimization measures and workforce reduction actions. Adjusted EBITDA margin for 2H FY2023 is estimated to be ~2.4% in the mid-range, with an exit rate of ~3% in FY2023. So Kelly can't escape the downturn in the labor market.

In recent years, Kelly Services has undertaken restructuring and efficiency initiatives to drive profitability. They have streamlined the organizational structure, renegotiated supplier agreements, and made workforce reductions to align resources with new ways of working. The firm is now focused on accelerating profitable growth through various initiatives, including a comprehensive go-to-market strategy, technology improvements, organic and inorganic growth opportunities, and a sharper focus on driving free cash flow.

In the historical context, Kelly stock returns are strongly correlated with the behavior of the company's margins and profitability. This is clearly visible when we superimpose the dynamics of the corresponding indicators on the stock price chart:

So everything will depend on how much profitability the company’s business will generate for its investors per unit of invested capital in the foreseeable future.

The management said that the improvement in EBITDA margin is a key goal of their transformation efforts, but they have not provided specific guidance for EBITDA margin beyond the exit rate mentioned for FY2023.

The biggest challenge for the company, as well as for the industry as a whole, is the prevailing uncertainty. There is a lack of precise knowledge about when the unemployment rate could rise significantly and what exact impact this will have on the business landscape.

In economics, various indicators have traditionally been used to predict economic downturns, and some of these indicators are closely related to the unemployment rate. BCA Research [October 2023, proprietary source] suggested a modernized version of " Sahm Rule " - the "Joshi Rule," which is a real-time recession indicator, is activated when the three-month moving average of the unemployment rate among 'job losers not on temporary layoff' increases by 0.20 percentage points from the previous 12-month low, indicating the onset of a recession in the United States. If we look at what this rule shows us now, we have very little time left before the recession triggers:

I believe that the labor market is still at its worst, which will definitely have a negative impact on Kelly Services stock, regardless of how many of its shares the company is willing to buy from the market. The backdrop is pretty murky now, as far as I can see.

But what about valuation?

The Valuation

According to Seeking Alpha Quant System, KELYA stock has a strong "A" rating as most of its multiples are well below industry multiples:

Most likely, the market is already seeing the risks in KELYA stock that I described above - a weakening EBITDA margin and a continued revenue decline that is already happening. Therefore, the forward EV/EBITDA is at an extremely low level compared to the long-term norm and the TTM multiple:

But at the same time, the market is projecting 30% EPS growth in its FY024 estimate, based on the latest data :

Forecast FY2024 EBITDA is also much higher than this year [FY2023], according to YCharts data:

If KELYA really earns $148.5M in EBITDA in FY2024, then returning to its usual EV/EBITDA ratio of ~7x, the company should have a market cap of nearly $1.1B [taking net debt into account], which is 65.9% more than what we've been dealing with so far.

But how close will this EBITDA forecast be to reality next year if the labor market continues to deteriorate?

The Bottom Line

I like the transformation in KELYA's business that the company continues to go through - the focus on quality development and margin expansion is definitely helping the stock grow higher, and as we can see from the company's current valuation, that growth can be even greater. However, Kelly Services faces a major macroeconomic obstacle that will prevent the company from doing what it is trying to do. So I would be cautious with KELYA today - perhaps we should wait for more certainty.

Thanks for reading!

For further details see: