Korn/Ferry: Cross-Selling And Capital Allocation Will Drive Future Upside For This Wide Moat Stock

May 19, 2015 – May 19, 2015 —

• Stable revenue profile supported by retained recruitment model, diversified revenue mix and lower risk of technological disruption.
• Strong brand and customer loyalty by virtue of low cost-to-benefit of executive recruitment services, the “nobody got fired for hiring IBM” mentality and network effects.
• Significant cash & marketable securities on its balance sheet implies upside potential assuming optimal use of capital in value-accretive initiatives such as M&A.
• Target price implies a 20% upside based on a forward EV/EBITDA multiple of 10 times and my estimated FY2016 EBITDA of $178 million.

Elevator Pitch

When one mentions staffing stocks, it immediately conjures up images of several headhunters chasing after potential candidates and suggests a competitive and low barriers to entry business. Executive search firm Korn/Ferry International (NYSE:KFY) is an outlier among its peers. It boasts a stable revenue profile and a wide moat supported by strong customer loyalty and a leading brand that makes it an attractive investment candidate. The significant excess cash that Korn/Ferry has on its balance sheet could provide further potential upside for shareholders in the near future. I arrive at a target price of $39.38 for Korn/Ferry by applying a 10 times forward EV/EBITDA multiple to my estimated FY2016 EBITDA of $178 million, and adding net investable cash of $205 million. My target price implies a 20% upside based on Korn/Ferry’s share price of $32.75 as of May 16, 2015.

Company Description

Korn/Ferry is a leading executive search firm focused on board-level, chief executive and other senior executive positions with annual compensation in excess of $250,000. In April 2015, it was ranked as the top executive search provider in North America and the world by Hunt Scanlon Media in terms of revenues and number of consultants. Its closest publicly listed peer comparable, Heidrick & Struggles International (NASDAQ:HSII) was ranked third with less than half of Korn/Ferry’s revenues. Korn/Ferry also offers talent management services such as leadership development, success management and organizational alignment under its Leadership & Talent Consulting (LTC) business division, and non-executive recruitment services with its subsidiary, Futurestep.

Stable Revenue Profile

Excluding fiscal 2009 and 2010 (year ended April), which were affected by the Global Financial Crisis, Korn/Ferry grew its top line in eight of the past 10 years. Between FY2015 and FY2014, Korn/Ferry achieved a respectable 10-year revenue CAGR of 11%. I outline the reasons for Korn/Ferry’s stable revenue profile below.

Firstly, Korn/Ferry operates on a retained recruitment model, unlike its peers such as Robert Half (NYSE:RHI), which work on a contingency recruitment model. Contingency recruitment firms are tasked by their client to search for candidates on a non-exclusive basis, and as the name suggests, they are only paid if the job placement is successful. In contrast, Korn/Ferry, as a retained recruitment firm, receives a retainer fee (in tranches over the search period, usually equivalent to a third of the first year annual salary of the position, irrespective of the success of the job placement. In other words, once a retained recruitment firm like Korn/Ferry is appointed by a client, a significant part of the retainer fees is in the bag. This leads to more stable, visible and predictable revenues for Korn/Ferry. In comparison, the number of clients and assignments that a contingency recruitment firm has on its books is not a good indicator of future revenues, since the “hit rate” might vary. Also, it is important to understand why the retained recruitment model will stay relevant, particularly C-suite positions such as CEO, CFO etc. The retained recruitment model ensures that the recruitment firm will be focused on finding the “right” candidate, rather than recommending “any” candidate to get paid.

Secondly, Korn/Ferry is diversified with respect to service type, end-market, geographic exposure and single customer concentration. It derived 59%, 24% and 17% of its FY2014 revenues from executive search, the LTC segment and Futurestep respectively. In comparison, Heidrick & Struggles generated less than 10% of its FY2014 (year ended December) revenues from leadership consulting services. Korn/Ferry is also geographically diversified with North America, EMEA (Europe, the Middle East and Africa), Asia Pacific and Latin America contributing 57%, 24%, 15% and 4% of its FY2014 top line. It is also less vulnerable to an industry-wide downturn, as no single end-market accounted for more than 28% of its FY2014 top line. Cyclical and economically sensitive industries, financial services and technology, each represented 15% of Korn/Ferry’s revenues in the most recent fiscal year. Korn/Ferry also has limited customer concentration risks. All but one single client accounted less than 1% of the Company’s FY2014 fee revenue (that one client contributed 1.5% of Korn/Ferry’s revenues).

Thirdly, Korn/Ferry is less susceptible to technology disruption compared with its non-executive staffing firms. Social media networks (e.g. LinkedIn (NYSE:LNKD)), online job boards (e.g. Monster) and vendor-neutral workforce outsourcing providers (e.g. ZeroChaos) are among the technology and innovative recruitment solutions that have threatened to disrupt the traditional headhunter and recruitment agency model in recent years. While the jury is still out on the potential of such threats, executive-level recruitment firms are unlikely to be affected. CEOs neither find a new job by uploading their resume to an online job board, nor do they get matched with a new prospective employer using advanced analytics. The relative scarcity of executive-level positions (the number of available CEO positions versus accountants) and the high level of confidentiality demanded (no CEO wants his or her employer to know he is considering greener pastures and vice-versa) imply that Korn/Ferry’s traditional headhunter and recruitment agency model will stay relevant for the foreseeable future.

Lastly, there might be a counter-cyclical element to executive-level hiring. While companies are likely to be laying off people and implementing a hiring freeze in weak economic conditions, there is also a possibility of a musical chairs among CEOs (which will benefit Korn/Ferry) as companies choose to hire new people to lead them out of the storm.

Wide Moat Derived From Strong Branding And Customer Loyalty

Korn/Ferry boasts tremendous customer loyalty, with approximately four in five assignments that Korn/Ferry executed in FY2014 were with past clients, which have previously engaged them at least once in the past three fiscal years. There are several factors contributing to Korn/Ferry’s strong branding and high client retention rates with respect to executive recruitment services.

Executive recruitment services have a low cost-to-benefit ratio. The benefit of hiring a good CEO (and his or her positive impact on the Company’s bottom line) outweighs any cost savings from engaging Korn/Ferry’s competitors offering cheaper fees. Since it is subjective to quantify the contribution of a good CEO, it might be easier to think about the damage that a bad CEO could do. Would Microsoft Corporation (NASDAQ:MSFT) have conceded its leadership in the technology space (particularly mobile) to its rivals, if Steve Ballmer was not at the helm of the Company? It is not just about the person’s capability, integrity matters as well. Would any company want to hire ex-Enron CEO Ken Lay, if he was still alive today? Korn/Ferry’s knowledge of potential job candidates, accumulated over the decades that it has been in business, gives it the edge in finding the people with the “right fit” for its clients.

Also the mentality of the Board is also something to be considered in assessing the bargaining power of Korn/Ferry. The “nobody got fired for hiring IBM” mentality is very much alive and kicking in the corporate world. Fortune 500 companies will not want to settle for anything but the best in everything they do, especially in the area of hiring talent to run their businesses. Engaging the services of the largest and top-ranked executive search firm in the world, Korn/Ferry, is a no-brainer for most directors of the leading companies in America and globally.

Korn/Ferry is also a beneficiary of the power of network effects. As the executive search firm with the most number of leading corporates as its retainer clients, Korn/Ferry has the greatest appeal to CEOs, CFOs seeking greener pastures. Similarly, having worked with the smartest and most capable people in their job hunting histories, Korn/Ferry has the trust of the largest companies that it has access to the right pool of talent that they are looking for. A virtuous cycle is at play here, as the strong gets stronger. This benefits the incumbent like Korn/Ferry, as clients engage the executive recruitment firm with the widest network of talent, and top executives prefer to place their future in the hands of agencies with the largest number of Fortune 500 companies as their retainer clients.

Cross Selling For Future Growth

In the past three fiscal years, about 94% and 84% of the Fortune 100 and FTSE 100 companies have engaged Korn/Ferry’s services. Although these statistics are impressive and are a testament to the Company’s strong brand name, it also suggests that new client growth is unlikely to be the key future growth driver. Instead, Korn/Ferry is putting a great emphasis on leveraging its relationships with the Board and C-suite of its clients to cross-sell its other services. It is natural for CEOs, who were placed in their current position by Korn/Ferry, to be more open to utilizing the Company’s complementary services. The fact that approximately 88% of Korn/Ferry’s largest 50 clients engaged the Company for a minimum of two of its service lines in FY2014, validates Korn/Ferry’s past success in cross-selling its leadership & talent consulting services. Looking ahead, the non-executive recruitment services offered by Korn/Ferry’s subsidiary Futurestep will be a key growth driver for the Company.

Launched in 1998, Futurestep is focused on recruitment for non-executive professionals and provides services such as recruitment process outsourcing, project recruitment, individual search and talent consulting. In particular, recruitment process outsourcing, where Futurestep handles the entire recruitment process from job profiling to new hire orientation, accounted for 60% of Futurestep’s Q3 FY2015 revenues. This is in with emerging trends where companies are increasingly outsourcing their non-core processes and functions to improve productivity. In addition, Futurestep has an edge over its competitors, because it can leverage on its parent, Korn/Ferry’s intellectual property and knowledge accumulated over the years. One example is Korn/Ferry’s data aggregation warehouse & database, Foresight, which enables Futurestep to be literally a step ahead in identifying, targeting and analyzing potential candidates.

The numbers speak for themselves. In the past year, quarterly fee revenue growth for Korn/Ferry’s executive recruitment segment was flat, with segmental revenues of $143.4 million in Q3 FY2015, compared with $144.0 million for Q3 FY2014. In contrast, Korn/Ferry’s quarterly fee revenue derived from its Leadership & Talent Consulting business was $64.4 million in Q3 FY2015, representing a 3.4% growth. More significantly, Korn Ferry’s non-executive recruitment subsidiary Futurestep recorded a 16.2% year-on-year growth in quarterly revenue to reach $41.7 million for Q3 FY2015, validating the growth potential of this business segment. At the end of fiscal 2014, Futurestep had a client base of 1,130 clients, compared with 2,414 clients for Korn/Ferry’s LTC business segment and 5,175 clients for the Group as a whole. This suggests there is a long growth runway ahead for Korn/Ferry in terms of cross-selling its other services to its core executive recruitment client base.

Potential Upside From Optimal Capital allocation

As of the third quarter of 2015, Korn/Ferry was debt-free with cash and marketable securities of $453 million. Assuming that one adjusts for the cash reserved for deferred compensation arrangements and for accrued bonuses from cash & marketable securities, Korn/Ferry will still have $205 million in net investable cash. There are multiple ways that Korn/Ferry could utilize this cash balance to create greater value for shareholders. One possible use of the excess cash is M&A. In March 2015, Korn/Ferry completed the acquisition of Pivot Leadership, an executive development firm, which will strengthen its Leadership & Talent Consulting business. Management has guided that Pivot will contribute $23 million of annual fee revenue on an adjusted EBITDA margin of 14% to 15%.

At the Q3 FY2015 earnings call, CFO Bob Rozek commented on the Company’s approach to capital allocation:

As we always talk about we’re going to take a balanced approach to capital on the use of buybacks will come into play when the other M&A and internal uses, we don’t see anything that’s real interesting there.

Target Price

I arrive at a target price of $39.38 for Korn Ferry by applying a 10 times forward EV/EBITDA multiple to my estimated FY2016 EBITDA of $178 million, and adding net investable cash (deducting cash set aside for deferred compensation arrangements and for accrued bonuses from cash & marketable securities) of $205 million.

Korn/Ferry’s peers Heidrick & Struggles International, Robert Half, Kforce (NASDAQ:KFRC), Manpower Group (NYSE:MAN), On Assignment (NYSE:ASGN) trade between 7.8 and 11.9 times forward EV/EBITDA. I believe that a forward EV/EBITDA multiple of 10 times is conservative, considering Korn/Ferry’s stable revenue profile and strong customer loyalty outlined above. I expect Korn Ferry to grow its FY2014 revenue of $960.3 million by a two-year CAGR of 6% to $1,079.0 million in FY2016. I also forecast Korn/Ferry to improve its EBITDA margin from 14.4% to 16.5% over the same period, resulting in a FY2016 EBITDA of $178 million.

My target price implies a 20% upside based on Korn/Ferry’s share price of $32.75 as of May 16, 2015.

Variant View

Notwithstanding Korn/Ferry’s relatively stable revenue profile highlighted above, Korn/Ferry is not immune to the adverse effects of a severe economic slowdown. This risk is partially mitigated by Korn/Ferry’s diversified revenue mix. But if economic conditions worsen to the point where companies implement hiring freezes and cut back on third party consulting and outsourcing services, all bets are off.

Source:
Seeking Alpha, by Mark Lin
http://seekingalpha.com/article/3192286-korn-ferry-cross-selling-and-capital-allocation-will-drive-future-upside-for-this-wide-moat-stock