Can This Small Cap Keep Defying the Experts? (pt. 2 of 2)
Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Kelly Services (NASDAQ: KELYA) is an international workforce solutions provider, headquartered in Troy, Mi. Kelly's shares have bounced wildly from $11.26-$18.09 this year mostly on good or bad employment headlines. However, the stock has outperformed regardless of employment numbers as its beaten analysts expectations the past 11 consecutive quarters; most recently it beat quarterly estimates by 16%! Kelly is set to report earnings again in just a few days on November 7.
Now Down to the Good Stuff
In part 1 of this earnings preview we, briefly, went over the areas that have been strengths for Kelly Services recently. Kelly is in the process, in my opinion of transitioning itself from a low margin temporary staffing provider to a full service staffing and HR solution provider similar to aforementioned service providers Barrett Business Services (NASDAQ: BBSI) and Insperity (NYSE: NSP). These businesses excel because they start with a single service offering their client may need (say temporary labor) and end up taking every piece of outsourced business available; because they offer so many services. The entire investment thesis for Kelly relies on its ability to transition into this type of company and for us to be able to purchase it before the market realizes it has done so. These are the areas we’ll want to keep an eye out for when Kelly reports earnings on Nov. 7 to make sure that the investment thesis is intact.
Higher Margin Temp Business
We'll want to see if they can build on last quarter’s 12% gain in operating earnings and 3.5% decrease in cost of services as an indicator that they're making gains. Furthermore, Kelly should deliver a better gain on gross margin than the .05% gain they showed last quarter. We'll want to hear management's comments about each area (scientific, legal and engineering) on the conference call and hear from management if they plan on staying solely in these markets.
In my opinion it would be a mistake if Kelly got too involved in the more white collar (accountants, etc.) staffing world dominated by competitor Robert Half International (NYSE: RHI). Robert Half’s brands are synonymous with the services they provide (i.e. “Accountemps”) and Kelly would have a hard time penetrating this market; a move like this for them might be a red flag of desperation. We want Kelly to be going after high margin temp business, but we want them doing so by leveraging the relationships they already have; particularly in manufacturing and thus Engineering. If Kelly is truly continuing to move into these higher margin, lower risk areas then we should see all three metrics (operating earnings, cost of services, gross margins) come in strong.
It's no surprise that competitor Manpower Group (NYSE: MAN) trades at a higher multiple of 15 than Kelly's P/E (just around 7); Manpower is larger so investors naturally assume that TAPFIN will gobble up the market share in this space. Many others don't even know that Kelly offers this service. This is where the real edge for the individual investor lies as Kelly has the much more efficient service with the stronger VMS technology leveraged through their namesake brand "Kelly." It's just less confusing and more efficient for clients to think of them as a one stop shop and therefore they've been outpacing Manpower's TAPFIN with the growth of their OCG services coming in at a robust 24% gain last quarter! This is the most important area for Kelly to continue showing growth if it is truly transitioning into the company (BBSI, NSP, etc.) we want it to be. Last quarters numbers were impressive and we'll want to see growth of at least 15% or better, again.
Another reason Kelly is a superior investment to Manpower is that it is not as heavily reliant on recessionary European economies. Manpower does its largest % of business in Europe, which is the largest reason I wouldn't touch the stock. This was a great way to position their business ten years ago as most European Countries (such as France and Germany) had laws guaranteeing employment, leading employers to use temps to avoid fines. Back in those days the fact that it couldn't successfully penetrate those markets was seen as pitfall for Kelly. Now the only pitfall on Kelly's most recent quarter was its European business which saw an 11% decline in revenues. Furthermore, with Manpower having to deal with increased headwinds in Europe it simply has to devote resources to areas where Kelly does not. While Manpower continues to bleed profits in France, Kelly should be able to invest its earnings into the company and grow market share of Kelly OCG.
As of the most recent quarter Kelly did 70% of its business in the Americas and with its recent acquisition of top Brazilian staffing provider Tradição Tecnologia e Serviços Ltda. complete that number should be increasing. So we'll want to hear from management how the transition into this fast growing market (as well as Asia-Pacific) has been coming along and we'll want to hear what steps they are taking to shield themselves from their exposure in Europe.
How We'll Know if the Story Remains Intact
I like Kelly's story. I feel it's wildly misunderstood by the market because it's transitioning itself into the ideal "tailor to the customer" type of employment services provider that can win in any market. However, nothing moves up in a straight line forever and narratives change. To make sure that the Kelly story is on track we'll want to see gains in higher margin temp business, Kelly OCG and growth in emerging geographic markets. If we see that, great; if not, it's time to change the way we view the stock.
A Final Word on How to Trade it All
I'm typically not for "day trading," I think if you like a company you should hold onto it for the long term; through the ups and downs. That said, employment services stocks are very misunderstood right now, and I can't stress that enough. Kelly has outperformed for 11 straight quarters yet misconceptions (bad employment headlines) keep it stuck in a trading range. What typically happens (like last quarter) is the good earnings come out and it pops (up 16% in one day last time) then comes back to its trading range. This also happened when I recently recommended Dice Holdings (up 15% in one day, then back) for the same reason.
People don't understand these companies. So while I feel that you should hold on long term (assuming the quarter is good) because eventually the market will realize its value (pre-recession price was near $30). If you must sell on a rally, I can almost guarantee you'll get another good entry point on some random, bad jobless figure.
Adem Tahiri owns shares of Kelly Services. As of this writing he has no intentions to change his position in the next 72 hours. The Motley Fool owns shares of Robert Half International. Motley Fool newsletter services recommend Robert Half International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.