Staffline has had a tumultuous twelve months to say the least. It all began with an ominous trading update in early January of this year, where they mentioned net debt had spiked to £63m from £37m in the preceding half due to acquisition costs and “exceptional items”. Then on the 30th of January, they announced a delay in publishing their results, sending the stock down 33% before it was put into a month-long suspension.
It was at this point that the cockroaches became apparent and the company announcedand interal audit due to “potential underpayments to a limited number of food production facilities and the payment for preparation time” due to HMRC. The firm had included a £4.4m provision for this in the £20m “exceptional” charge they announced in January, but it was quickly becoming apparent that these amounts were insufficient.
They initially increased the provisioning by £3.5m before later adding another £7.2m, taking the total provision to over £15m. To make matters worse, in their May trading update they mentioned that business headwinds had begun to emerge, and they were likely to raise equity capital to avoid any future loan covenant breaches…
Debt continued to balloon, so in late June, the company announced plans to raise £40m via a hugely dilutive placement of 40m shares at 100p (vs. a prior share count of <27m).
Over the last 12 months, Staffline has seen its share price fall from ~£12 to £1…
So why is this dumpster fire interesting?
On July 22nd, an interesting name popped up as a substantial shareholder – HRnetGroup Limited, a Singaporean recruitment operator. The story gets really interesting on 31 July, because it was then that we found out HRnet had acquired 11.7m shares through an off-market deal at a price of 180p (>40% premium to where the stock was trading). This increased their holding to 24.89% of Staffline.
This is when I became interested in the situation, because it now fell into the “special situations” bucket: a larger peer recently acquired ~25%, in the UK if you cross 30% shareholder you are required to bid for the remaining shares at no less than the highest price paid in the prevailing 12 months. Therefore, if it is HRnet’s intention to buyout Staffline, they will have to pay at least 180p and the shares were trading for 150p the following day. Therefore, the setup looked interesting with a bid requiring a minimum premium of 20% over the prevailing market price.
At the time I was busy (summer holidays…) and I didn’t revisit the situation until early September when HRnet announced they’d acquired a further 4.95% taking their holding basically to the limit before a mandatory tender (29.95%).
By this point, I was fairly convinced that HRnet were indeed interested in acquiring Staffline, and they were likely stopping shy of the 30% threshold to arrange financing, conduct further due diligence, watch the Pound depreciate etc. So I purchased a starter position.
What has happened since?
Staffline announced a pretty bleak set of results in September, reducing their 2019 guidance from a range of £23-28m in EBIT to £20m, and net debt continued to grow, now standing at £89m. These factors, combined with an overall twitchy UK share market, sent the stock down from 150p to the current levels around 100p. Recently, the stock approached 90p, which makes the math easier (given a 180p take-out price would be an exact double).
The setup is rather obvious, if HRnet indeed are interested in acquiring Staffline, and wish to do so within the next 12 months, they will have to pay a minimum price of 180p – creating the opportunity for an 80-100% gain from current prices.
In this type of situation, I place less emphasis on fundamental financial analysis (the guy who just plonked down £30m and paid 180p per share knows much more about the industry and company specifically than I ever could) and more on handicapping the different scenarios.
The key questions for me are:
- Would a strategic investor acquire 29.95% of a company and not be interested in making a full takeover?
- If yes, how often would this be the case?
- Is HRnet specifically likely to make a bet of this size, only to walk away or remain a passive holder?
- If an offer doesn’t materialise (or does after 12 months) what is my downside?
- If the potential reward looks attractive compared with the potential loss, why is the market offering up such a juicy deal?
Strategic investor behaviour
This is a critical question for me, as it sets the base rate for this trade – how often does a strategic investor purchase a stake >25% of a Public Company, and not pursue a full takeover?
Most of my thinking regarding this is driven by anecdotal experience and speaking with other investors, advisors and corporates. In general, most agree that it would not be normal procedure for a strategic/corporate buyer to purchase 29.95% of a competitor and not eventually make a full offer. And this seems logical to me, I can’t see many reasons for taking a large passive investment in a competitor/peer.
To put some numbers behind this, of the ~2,500 publicly listed companies in the UK, ~300 have a single investor holding greater than 29% of the shares. Of those 300, only in 37 companies is the largest shareholder also less than 30% (i.e. owns 29-29.9%). Therefore, only 12% of public companies have a shareholder >29% and of those, only around 12% have a shareholder with 29-29.9% of the shares. So, it’s a small group in general.
Also, in most of the 37 companies with a shareholder having 29-29.9% of the stock, said shareholder is a financial holder (i.e. public or private equity fund).
HRnet is an owner (74%) managed business with an exceptional track record of growing sales at a CAGR of 31.6% since 1993 (13% since 2007) and being profitable every year since 1999.
This investment in Staffline is material for them: so far they have put ~£30m into STAF, which compares to their current market cap £350m and net cash (before this investment was made) of £180m.
Given it is sizable and the company is run by the founder, I see the risk of them being “frivolous” with their resources as low, and this was likely a well thought out investment.
In their IPO documents, as well as annual reports since, they mention acquisitions form a key part of their strategy:
- “Opportunistically seek out strategic acquisitions”
- “We will continue looking for new markets, good companies to co-own, strategic alliances and investments, whether in Southeast Asia, Indochina or beyond.”
- “For acquisition targets that are similar or larger in size than our Group (taking into account factors such as revenue, sales consultant headcount, gross profit and net profit), we intend to acquire a shareholding interest of at least 20% in such acquisition target and to collaborate with such acquisition target in mutual areas of interest, such as by way of cross-investment.”
What I find interesting is that if they wanted control over STAF, without taking full ownership, they could have stopped at 25% as this is the level at which one can veto any special resolutions proposed by the Board. However, they didn’t stop there. Instead, they bought another 4.93% – why??
They have recently made some other acquisitions that look more likely to fit into the minority bucket – 8% of a HK listed peer and 5.5% of Gattaca – as they both have substantial/controlling shareholders/founders. Staffline, however, is a completely open register – with many recently getting in at the 100p raising (and likely happy to sell at 180p!)
In summary, it’s inconclusive what their plans are. However, their actions do indicate it is a possibility they are planning a full takeover.
At current prices (~100p) Staffline is by no means expensive. The company is guiding to £20m in EBIT, which seems reasonable given they did £30m+ on 2/3 the revenue 3 years ago…
Taking the 100p price, multiplying by the new share count (~69m), adding on £94m in gross debt, adding £15m in HMRC provisions and deducting £37m in cash from the recent raising, I get an enterprise value of ~£140m. Assuming they can achieve their profit forecast, they are currently selling for an EV/EBIT multiple of 7X.
The obvious risk is: the company has a truckload of debt (management forecasting 2X net debt/EBITDA by year end) and is facing a slowdown in business. This is a story that has played out many times in history, and it doesn’t normally end well. However, all of these issues were known to HRnet (who is an expert in the industry) when they decided to pay 80% above the current price!
So, while I think there is a non-zero chance this investment could be a zero, a well-informed expert in the industry, was willing to bet ~10% of his net worth that it isn’t!
However, in my handicapping, I assume a full wipeout is my downside.
If we assume the takeover occurs at 180p (minimum purchase price under the Takeover Code) and our downside is wipeout, at 100p the market is implying a 55% probability that a takeover occurs. This is the “max probability” i.e. if we assume downside is 50p, then the market implied probability of a takeover is only 40%.
What’s the “right” probability? No idea… But my gut feeling is that 55% seems low. Again it’s hard without the data, but anecdotally, I would guess that 7 out of 10 times, when a strategic investor builds a 20%+ stake in a listed company, they are circling for a full takeover.
A 70% probability implies a “fair value” of 126p (180p x 70% + 0p x 30%). So our expected return (assuming we could run this bet 1,000 times) would be 26%+, a nice return given the 12 month timeframe.
At sub 100p, I think Staffline looks like an attractive bet. Given it’s quite binary, there is a decent chance of 100% loss, and its opaque financials make analysis difficult, I think sizing is critical. Therefore, I bought a small personal position and I will sell if no deal materialises within 12 months (or anything else occurs to change my mind).
As for why such a juicy “expected value” is available – I think a lot of hot money came in after HRnet announced their large purchases at 180p. Since then, a downgrade in September, ongoing BREXIT uncertainty and boredom has probably created a dearth of buyers. Volume in the last few weeks has also been quite a lot lower than historical.
As always, this is not advice, I am wrong often, do your own DD, I don’t stand by any of the numbers etc. and may trade in and out.