Contents
Summary
- Korn/Ferry released Q1 results on September 6 and reported a loss of $0.70/share. This included a one-time $106.6 million trade name write-off which management had communicated in June 2018.
- Other than the one-time write-off, results were positive and I view the price plunge has having brought shares into fair value territory.
- I view KFY as being less likely to experience a sizable pullback in its stock price should we experience a long overdue market correction.
- I have acquired shares and have employed a conservative covered Call option strategy to lower my cost base and to generate additional positive cash flow while I wait for KFY shares to appreciate in value.
Introduction
I am being extremely cautious given that I am of the opinion a broad market correction is long overdue. While I am reluctant to make significant investments, I am scanning for opportunities where good companies appear to have hit a ‘speed bump’. I view Korn/Ferry International (NYSE: KFY) as such a company.
On September 6th, KFY released its Q1 results and the stock pulled back 23.45% from the previous day’s close.
KFY reported a Q1 FY2019 diluted loss of $0.70/share versus diluted EPS of $0.51/share in Q1 FY2018 and adjusted diluted EPS of $0.78 in Q1 FY2019 versus adjusted diluted EPS of $0.55 in Q1 FY2018.
The reason for this loss under GAAP is that on June 12, 2018 KFY’s Board of Directors approved a plan to go to market under a single, master brand architecture and to simplify the Company’s organizational structure by eliminating and/or consolidating certain legal entities and implementing a rebranding of the Company to offer the Company’s current products and services using the “Korn Ferry” name, branding and trademarks. In connection with that Plan, KFY indicated that the intent was to sunset all sub-brands (ie. Futurestep, Hay Group and Lominger).
The purpose of harmonizing under one brand was to help accelerate the firm’s positioning as the preeminent organizational consultancy and to bring more client awareness to its broad range of talent management solutions.
KFY indicated the rebranding would have no impact on the financial reporting for its various segments with the change in reporting to commence Q1 FY2019.
While Q1 FY2019 fee revenue was $465.6 million, an increase of 16.0% (15.7% increase on a constant currency basis) compared to Q1 FY2018 with increases due to organic growth in all areas of the business, the operating margin was (11.8%) in Q1 FY2019 compared to 10.5% in Q1 FY2018. This decrease in operating margin was primarily due to the $106.6 million trade name write-offs in Q1 FY2019 and an increase in compensation and benefits which was partially offset by an increase in fee revenue; adjusted EBITDA margin was 15.2%, compared to 15.0% in Q1 FY2018.
Looking at the Q1 FY2019 Balance Sheet we see that Intangible Assets as at June 30, 2018 were reduced to ~$93 million versus ~$203.2 million as at April 30, 2018 (the company’s fiscal year end).
With one stroke of the pen, KFY’s Assets were reduced by over $100 million. This Intangible Asset write-down, however, had no impact on the company’s cashflow.
In this article I:
- explain why I think KFY is now fairly valued;
- offer a conservative option strategy to generate additional income while you wait for KFY’s stock price to appreciate in value.
Business Overview
KFY opened its first office in Los Angeles in 1969. Today, it operates in 106 offices in 52 countries. As at its most recent fiscal year end (April 30, 2018) it employed 7,643 full-time employees, including 1,392 consultants who are primarily responsible for client services. Clients include many of the world’s largest and most prestigious public and private companies, middle market and emerging growth companies, as well as government and non-profit organizations. 88% of KFY’s assignments performed during fiscal 2018 were on behalf of clients for whom it conducted assignments in the previous three fiscal years.
KFY provides Executive Search services to help clients attract and hire leaders. This business is managed by geographical region leaders with a focus on recruiting board-level, chief executive and other senior executive positions for clients predominantly in the consumer, financial services, industrial, life sciences/healthcare provider, technology and educational/not-for-profit market sectors.
It also has centers of functional expertise. The Board & CEO Services group, for example, focuses exclusively on placing CEOs and board of directors in organizations throughout the world. The relationships established by Executive Search allow KFY to add incremental value to its clients through the delivery of other organizational consulting services and solutions.
The Executive Search services group concentrates on searches for positions with annual cash compensation of $300,000+, or comparable compensation in foreign locations. The industry is comprised of retained and contingency recruitment firms. Retained firms, such as KFY, typically charge a fee for their services equal to approximately one-third of the first-year annual cash compensation for the position being filled regardless of whether the position is filled. Contingency firms, however, generally work on a non-exclusive basis and are compensated only upon successfully placing a recommended candidate.
The Advisory segment of KFY is comprised of 3,454 of leadership and organizational advisory consultants and thought leaders.
KFY partners with many of the world’s most admired organizations because of its track record delivering successful outcomes. Clients depend on its products and platforms to connect KFY’s solutions to their business challenges. KFY helps clients design their organization (structure, roles and responsibilities) and shows them the best way to compensate, develop and motivate their people.
The Recruitment Process Outsourcing (‘RPO’) and Professional Search segment uses data-backed insight and IP, matched with strategic collaboration and innovative technology, to meet people challenges.
KFY’s approach to RPO allows its clients to attract top people while reducing expenses and time to hire. Using a variety of tools, KFY looks closely at each candidate, combining data from multiple recruitment systems to determine which candidates have the potential to match both a particular organization and a specific role. It offers customizable end-to-end solutions which combine recruiting expertise with state-of-the-art technology platforms and sophisticated methodologies to help clients streamline recruitment processes, enhance candidate experience, and improve quality of hire, ultimately impacting the long-term success of an organization.
Greater detail on KFY’s business can be found in Part 1, Item 1 in the FY2018 10-K.
Q1 FY2019 Results
KFY’s Q1 Earnings Release can be accessed here, its Q1 10-Q can be accessed here, and its Q1 Earnings Presentation can be accessed here.
Q2 FY2019 Outlook
Management provides guidance solely for the upcoming quarter.
When KFY released its Q4 and FY2018 results on June 13, 2018 it also released the following outlook for FY2019.
Source: KFY – Q4 Fiscal 2018 Earnings Release – June 13 2018
In my opinion, KFY delivered on what it had forecast for Q1 FY2019.
The following guidance for Q2 was provided September 6, 2018.
Source: KFY – Q1 Fiscal 2019 Earnings release – September 6 2018
Credit Ratings
KFY has negligible debt and is not rated by any of the major ratings agencies.
Details of KFY’s long-term debt can be found in Note 10 of its Q1 FY2019 10-Q starting on page 22.
KFY’s minimal long-term debt relative to its overall financial position is appealing to me.
Free Cash Flow (FCF)
FCF for FY2011 – FY2018 has amounted to (Expressed in Millions) $68, $52, $49, $101, $85, $38, $56, and $177.
Valuation
If I were to use GAAP earnings, the projected PE would be significantly elevated. KFY reported a loss of $70/share in Q1 and the forecast for Q2 is $0.73 - $0.81 or a $0.77/share mid-point. If we go on the basis that Q3 and Q4 earnings will be similar to the mid-point of the Q2 projected EPS range, we arrive at full year EPS of ~$1.61.
With KFY having closed at $49.60 on September 20 and projected full year EPS of ~$1.61 we get a forward diluted PE of ~30.81.
I do not think the Intangible Asset write-down is going to be a recurring event, and therefore, I have elected to use adjusted earnings to determine a fair value for KFY shares.
We know that KFY generated adjusted diluted EPS of $0.78/share in Q1. If we use the mid-point of the Q2 FY2019 forecast which is $0.80/share we get adjusted diluted EPS of ~$1.58/share for the first half of the year. Double this estimate and we get projected adjusted diluted EPS of ~$3.16/share for FY2019.
With KFY trading at $49.60 I get us a forward adjusted diluted PE of 15.7.
Adjusted diluted EPS in FY2017 and FY2018 amounted to $2.24 and $2.72. Using the following table extracted from KFY’s FY2018 10-K, I get a mid-point stock price of $25.86 for FY2017 and $43.32 for FY2018; KFY’s adjusted PE was ~11.55 in FY2017 and ~15.93 in FY2018. These levels give me some sense that my rudimentary 15.7 forward adjusted diluted PE is not unrealistic.
Source: KFY 10-K page 30 of 164
Dividends
The fact KFY has no webpage devoted to its dividend policy/history suggests KFY is not the type of stock which will appeal to investors seeking a steadily increasing stream of dividend income.
KFY’s dividend history is relatively short as its Board of Directors only adopted a dividend policy on December 8, 2014. This dividend policy reflected an intention to distribute a regular quarterly cash dividend of $0.10/share with the first dividend under this program having been paid on April 9, 2015. The dividend has not changed since it was established.
The declaration and payment of future dividends under the quarterly dividend policy depends upon many factors, including the Company’s earnings, capital requirements, financial conditions, the terms of the Company’s indebtedness and other factors the Board of Directors may deem to be relevant.
Capital Allocation
KFY’s capital allocation priorities are as follows:
- Invest in growth initiatives, such as the hiring of consultants, the continued development of IP and derivative products and services, and the investment in synergistic accretive M&A transactions that earn a return superior to the Company’s cost of capital.
- A return of a portion of excess capital to stockholders, in the form of a regular quarterly dividend, subject to various factors.
- Share repurchases on an opportunistic basis and subject to the terms of our credit agreement.
On December 8, 2014, KFY’s Board of Directors approved an increase in the stock repurchase program to an aggregate of $150.0 million; common stock may be repurchased from time to time in open market or privately negotiated transactions at the Company’s discretion subject to market conditions and other factors.
Although KFY’s share count has increased from ~44 million shares as at the end of FY2009 to just under 57 million as at the end of Q1 2019, KFY began to repurchase shares through this program in Q2 2017. It has repurchased ~$33.1 million and ~$28.8 million of common stock during fiscal 2018 and 2017, respectively.
Option Strategy
I think KFY’s stock price stands a good chance to increase in value over time but I don’t think it will happen in the short-term. As a result, I think there is an opportunity to purchase shares at the currently depressed level and to write covered calls to generate some income while you wait for the shares to appreciate in value.
If you purchase 100 shares @ $49.60 and write a covered Call expiring March 15, 2019 with a $55 strike price, you would receive ~$2.40/share. This premium thus lowers your breakeven level to $47.20 ($49.70 - $2.40).
If KFY rises in value to >$55 come March 15, 2019, you could buy back the Call and write a new Call for a later expiry.
Alternatively, you could just let these shares get called away. In such case, you would receive $55/share on top of the $2.40/share you receive when you write your covered Call; you generate total income of $57.40/share. Subtract the $49.60/share originally paid to acquire the shares and you have generated a profit of $780 (each option contract is for 100 shares). The $780 profit on your original $4,960 investment is a ~15.7% return over 6 months.
Final Thoughts
In my opinion, KFY’s stock price has pulled back to a ‘fairly valued’ level and if we do get a long overdue market correction, I do not envision KFY’s share price getting hit as hard as many other overvalued companies. Having said this, I also do not envision KFY’s stock price will appreciate significantly in the short-term. I, therefore, view my newly acquired 300 KFY shares as an opportunity to write 3 covered Call contracts wherein I can generate additional income while I patiently wait for the share price to appreciate.
I hope you enjoyed this post and I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected]
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long KFY.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
