Kelly Services Is Undervalued Going Into A Cyclical Upswing

Kelly Services, Inc. (KELYA) is trading around $23 near the top end of its 52-week range (~$15-25), but despite this I think the stock has at least another 20% upside from these levels. Kelly's business is supplying businesses with temporary personnel with skills and qualifications in the legal, engineering, and scientific fields as well as providing staffing in more general office settings. Despite that fact that the labor market is only just beginning to heal and likely still has years ahead of it before it becomes "overheated", Kelly Services is trading as though its recent earnings are at or near a peak rather than having significant expansion opportunities ahead. Kelly is trading at 15-16X last year's EPS and 13-14X CY 2014 EPS, and with a TBV of nearly $20 a share by my estimates. In a somewhat expensive market concerned about overseas (especially emerging market) exposure, KELYA is the rare domestically focused value play.

Like most staffing firms, Kelly Services was hurt dramatically by the financial crisis as revenues plummeted and contracts dried up. After all - who hires temps when they are firing permanent employees? But the firm has bounced back from the Financial Crisis (and the EuroZone mess) with a vengeance. KELYA has been reporting consistent profits quarter after quarter since the end of the Crisis, and in fact the firm has lately been surprising on earnings to the upside with an $0.08 beat on earnings and a revenue beat in 3Q2013 and a $0.01 EPS beat and revenue on January 30th for the 4Q2013 report. Given this momentum, the cyclical upswing in the labor markets, KELYA's strong free cash flow generation, solid balance sheet with no long-term debt, and strong level of insider ownership (which incentivizes management to do the right thing for the company and shareholders), I think the company is a steal at today's prices.

Revenue	1Q	2Q	3Q	4Q	Year
2013	1,315	1,367	1,346	1,380	5,408
2012	1,355	1,366	1,354	1,375	5,451
2011	1,339	1,406	1,410	1,396	5,551
2010	1,130	1,209	1,285	1,326	4,950
2009	1,043	1,029	1,049	1,194	4,315
2008	1,388	1,452	1,398	1,279	5,517
EPS	1Q	2Q	3Q	4Q	Year
2013	0.34	0.26	0.49	0.45	1.54
2012	0.24	0.40	0.43	0.23	1.31
2011	0.03	0.53	0.52	0.64	1.72
2010	-0.06	0.11	0.26	0.39	0.71
2009	-0.46	-1.89	-0.43	-0.23	-3.01
2008	0.23	0.30	-0.33	-2.55	-2.35

All staffing agencies have different specializations and areas they are known for. Robert Half (RHI) for example is most recognized for accounting and finance temps. In contrast, Kelly is probably better known for its staffing in education, health care, engineering, and creative services. These lines complement the firm's office staffing group. The company gets roughly 70% of its revenue from the US with another 15-20% from Europe, the Middle East, and Africa (what the company calls EMEA). Less skilled workers in the company's "Commercial" groups make up more than two-thirds of revenue, but I see the professional and technical group as also being very important for the firm. There are lots of companies that can supply semi-skilled labor, but being able to place trained skilled labor with industry experience is an important competitive advantage. A client firm wants to call one staffing agency not three, and from the client's point of view, finding the right expert skilled help is often the driving factor which determines what staffing agency will be used.

While the bulk of Kelly's revenues are driven by its US business (including US companies operating abroad as well as domestically), Kelly is starting to expand its reach internationally. In 2010, KELYA formed a joint venture with Japanese human resources services company Temp Holdings Co. As part of the deal, Temp Holdings bought a 1.6 million share stake in Kelly, while Kelly had previously bought a stake in Temp Holdings. Then in July 2012, Kelly and temp Holdings formed a joint venture - TS Kelly Workforce Solutions, based in Hong Kong - to focus on supplying the staffing need for clients in Northern Asia. This action and the company's focus on cost cutting suggest Kelly is positioning itself for growth while trying to remain lean and efficient. For all of the employment gains over the last five years, it is important to remember that the US is still experiencing anemic growth. This is especially clear given management's recent commentary about investing more in its business in 2014, especially the firm's OCG business and supply chain analytics business. Employment is still well-below the prerecession peak, and demand for labor (temporary or permanent) remains fairly sluggish on a mix of economic and political uncertainty.

In fact though, the area of Kelly's business that is showing the most growth potential in my view is the professional and technical business. Demand for employees in this area is much stronger than the overall labor market - and this is a good thing for KELYA shareholders as the professional and technical staffing lines carry much higher margins than the more general staffing lines. Staffing businesses get paid a portion of the hourly rate that they charge the client firm for the temp's services (with the remainder of the hourly rate going to the temp of course). Thus since technical and professional employees can command much higher rates than semi-skilled office workers, KELYA stands to earn a much greater profit on these P&T placements.

While there is some risk in Kelly's shares due to the possibility of a new global economic downturn, or permanent stagnation in the labor markets, I see these risks as fairly minimal. The emerging market weakness which has roiled the markets for the last few weeks is unlikely to have a significant lasting impact on the US economy (we don't get much in the way of capital flows from those nations, we don't export much to them, and a weakening economy there would ultimately drive down import prices from goods received from those nations, so EM weakness might even help the US). Further, most of Kelly's international business is in developed markets in places like the UK. Thus the risk to Kelly shareholders is low from macroeconomic upheaval at this point. Europe is likely to remain challenging Kelly and other staffing firms for at least a couple more years, but the business there is slowly growing including a nice 6% qoq growth rate in the UK and 11% in Western Europe more broadly.

At the same time, Kelly has historically traded at anywhere from 15-25X ttm EPS on the back of its growth potential and its attractiveness as an acquisition target. (Any acquisition of KELYA would need the approval of T.E. Adderley, Kelly's chairman, who holds more than 90% of the voting rights in the firm through a separate special class of stock. This makes a hostile takeover or a private equity buyout unlikely despite Kelly's significant FCF, but I think a merger with another peer is a possibility in the future.) In 2013, KELYA earned $1.54 which means it is now trading around 15.5X ttm EPS. Thus the firm is far from richly valued right now. With 2014 EPS likely to come in around $1.80 a share in my view, Kelly's growth is an attractive option for investors looking for a pro-cyclical play.

Source: Kelly Services Is Undervalued Going Into A Cyclical Upswing

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KELYA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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