Interactive Investor

Stockwatch: two mid-cap momentum buys, or time to take profits?

Edmond Jackson ponders whether recruitment firms like PageGroup deserve their growth ratings

9th July 2021 09:47

Edmond Jackson from interactive investor

With his original tips showing a tasty profit, interactive investor’s stock picker decides what to do with these two ‘growth’ stocks.

In my last two articles I have examined soaring small-cap retail and technology situations, and whether or not they indicate an overvalued market. I was sceptical, a franchising model can sustain a price/earnings (PE) multiple over 30, but have seen high ratings endure where technology has a strong market position and long-term takeover potential. 

It is pertinent also to consider two mid-cap recruiters on 12-month forward PEs of 20x or higher. A time-tested adage is to beware when cyclicals become rated as growth stocks, which on the face of it now applies to £550 million professionals’ recruiter Robert Walters (LSE:RWA), and also its larger £1.9 billion mid-cap brethren PageGroup (LSE:PAGE)

Both have more than recovered pre-pandemic market levels, trading at an exact same 27% premium to end-February 2020. It's not as if Walters’ premium is due to momentum buyers in a relatively tighter market. 

A sceptic would say this simply is not justified: recruitment is inherently cyclical with low visibility, hence a sign to sell equities generally.  

Bulls might argue, circa 20x earnings is rational pricing after a 2020 trough. Forecasts are cautious and Walters surprised on the upside last Wednesday, saying 2021 profit will be significantly ahead of what was indicated only a month ago. Such companies are operationally geared, so if fundamentals are looking up then do not worry about high price/earnings.

Pagegroup - financial summary     
Year end 31 Dec 201520162017201820192020
Turnover (£ million) 1,0651,1961,3721,5501,6541,305
Operating margin (%)
Net profit (£m)
Reported earnings/share (p)
Normalised earnings/share (p)21.323.126.432.432.2-1.7
Return on capital (%)39.539.340.842.133.54.3
Operating cash flow/share (p)26.328.427.428.348.942.9
Capex/share (p)
Free cash flow/share (p)21.520.320.820.340.735.8
Ordinary dividend per share (p)11.512.012.513.113.70.0
Special dividend per share (p)16.06.412.712.712.70.0
Covered by earnings (x)
Cash (£m) 95.092.895.697.797.8166.0
Net assets per share (p)68.075.682.697.098.796.1
Source: historic Company REFS and company accounts   

An all-time high for Walters after second-quarter update

Both recruiters are oriented to white rather than blue collar recruitment, although Walters has an Asia Pacific bias with relatively modest US engagement unlike PageGroup.

I have favoured both: Walters at 555p in January 2019 and PageGroup at 442p two months later, achieving capital growth of 36% and 32% respectively since, although the table shows PageGroup's returns enhanced also by special dividends. 

Note also, high single-digit operating margins versus low single-digit for Walters, also return on capital up to 42% versus 34% for Walters.

The market appears to have shrugged off its fears when Walters de-rated from 754p three years ago to what appeared a long-term trend-line around 500p in July.

This was despite earnings per share (EPS) around 45p in respect of 2019 implying an 11x price earnings at 500p. Covid then intervened for a drop to 240p, then a rally to 400p and a drift to 350p before last November’s vaccines’ rally triggered a bull trend up to 755p currently. A reminder, this stock can get volatile.

For the second quarter of 2021, net fee income – the key performance measure – jumped 25% to £89.0 million, or by 31% at constant currency.

It did however benefit from the 2020 comparator being down 33% from £106.4 million in 2019. Business momentum has continued to accelerate with June especially strong. 

Asia Pacific contributed the most: a 39% advance to £40.9 million with Europe up 22% to £23.4 million.

The UK rose a modest 9% to £18 million and “other international” by 11% to £6.7 million. With 46% of group net fee income deriving from Asia Pacific, Walters justifies a premium to most UK-listed cyclical stocks given its prioritising the world’s most dynamic region. 

Before this update, consensus had been for £19 million net profit in 2021 rising to £30 million in 2022 – relative to £35 million achieved pre-Covid (see table).

That implies a forward price/earnings of 29x easing to 20x which feels high enough if the 2022 scenario is essentially being brought forward.

Robert Walters - financial summary     
Year-end 31 Dec 201520162017201820192020
Turnover (£ million) 8139991,1661,2331,216938
Operating margin (%)
Operating profit (£m)
Net profit (£m) 15.319.929.335.634.05.7
Reported earnings/share (p)18.725.438.945.844.97.5
Normalised earnings/share (p)19.326.039.546.245.08.9
Price/earnings multiple (x)     80.4
Return on capital (%)24.725.233.932.223.36.8
Operating cashflow/share (p)19.337.642.480.892.3131
Capex/share (p)
Free cashflow/share (p)
Dividend per share (p)7.18.512.014.74.515.5
Yield (%)       2.2
Covered by earnings (x)
Cash (£m) 43.462.661.979.9112156
Net assets per share (p)119133162202211222
Source: historic Company REFS and company accounts   

Or is a cash flow valuation more appropriate?

Possibly, the market is willing to credit a premium PE because Walters’ cash flow valuation looks dirt cheap.

Agency type businesses do enjoy strong free cash flow because once human teams, offices and IT are established, then a revenue surge quickly boosts net fee income and profit - unless remuneration schemes cream it off for bonuses.

Walters’ table shows that in 2015, net cash from operations of 19p a share compared with 7p a share of capital expenditure; yet over five years capex rose only to 13p while cash flow soared to 131p. 

That lifted 2020 free cash flow up to 118p a share, for a multiple of just 6.4x at the current market price. It could be construed as more of a prop than a current 2.3% prospective yield.

While potentially lucrative for private equity buyers, a dilemma is human assets disappearing very quickly if they do not like a new owner’s culture

Meanwhile, PageGroup is on 16.3 x historic free cash flow with its stock at 585p.

PageGroup is slightly ahead of its 2019 record level

Operationally, PageGroup has an edge on Walters given its second-quarter update (also last Wednesday) cited a 94% like-for-like rebound in net fee income to £220 million. 

Performance was mixed within Europe, the Middle East and Africa, the largest regional contributor at 49% of group net fee income, up 70% like-for-like. Asia Pacific soared 80% to constitute 21% of group total; the Americas rebounded 116% to 16% of total, and the UK bettered this to 136% representing 14% of total. 

PageGroup can therefore be regarded as the truly global recruiter, and it has also achieved a 2% overall advance on second quarter 2019 at constant currencies. Management is taking a prudently cautious line to say that despite various macro uncertainties and restrictions, profits are looking up – with annual operating profit currently targeted at £125 million to £135 million.  

Very strong cash positions in support of payouts 

PageGroup had £168 million net cash at end-June versus £113 million for Walters, though is nearly four times Walters’ size.

This compares with PageGroup paying out £83.5 million as ordinary/special dividends in 2019 before Covid forced a battening down. If such pay-outs were to fully recover, its prospective yield would be 4.5%.  

Walters was paying out nearly £11 million pre-Covid and tends to be the more cautious company; for example, reinstating a 4.5p interim dividend last November but citing “low visibility” as to market conditions.

In light of bumper free cash flow, I am surprised there is not some element of special pay-out.  

Stance reduces to what view on the global economy? 

Both these recruiters appear fully valued unless the global economy continues to gain momentum without inflation becoming ingrained.

If you are in the “transitory” inflation camp, then conceivably both stocks are momentum buys – given the possibility of serial upgrades. 

Yet a significant reason why equities are falling right now is latest US Federal Reserve’ minutes suggesting this key central bank might be closer to withdrawing stimulus. Cyclicals could be in the forefront of any such mood change. 

I have noticed PageGroup sustain PEs as high as 20x in past years, so frankly it regaining this as economies open up is no huge surprise.

Walters has the slightly more volatile long-term chart; I have followed this company since in floated in 1996, hence does appear more cyclical than growth stocks, otherwise it should be larger by now.  

Risk-conscious investors might prefer to lock in some gains, given the range of scenarios possible. Like many stocks currently, there is scope to refine your action according to preference and outlook. Overall: Hold

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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