HSBC: Business services stocks: assessing possible low water marks for valuations - 10/2001

Stocks are likely to rally once they are cheap, they are currently fair value (but not cheap) assuming a 90ís -esque recession.

An alternative way of viewing the issue is that they are fair value (but not cheap) assuming the prevailing levels of risk assumed before the bull-run of the late nineties.

There is a real risk that stocks only mount a sustained rally when investors see under-valuations of 10-15% suggesting similar % downside for the sector.

Commentary
The share prices of business services stocks, like staffing companies have fallen dramatically. The question is rapidly becoming how close to the bottom are share prices in the sector. In order to assess this we have done some preliminary work on a number of stocks. We have taken Hays and Adecco to represent the staffers. Our aim is to assess if stocks have reached a likely low, or not.

What are current prices assuming for numbers
To see what markets are expecting we use a discounted cash flow model. This tries to estimate how much cash a company will generate and then discounts each yearís cash flow today. That basically means that the cash it makes this year is worth more than the cash it might make next year. The difference in value is the risk that next yearís, or the year afterwards isnít what you projected. In short money now is worth more than money in the future, unless the money in the future is so much bigger as to make it worth the risk of waiting.

Using this discounted cash flow model to see what operating performance we would need to see to get to current prices suggests the market is currently assuming a prolonged slowdown but very sharp bounce thereafter. Giving Adecco no recovery for 2002 and 2003 (as a flat cash flow for the next three years) would see prices fall to c.55 Swiss francs per share. Using a flat cash flow for 3 years renders Hays fair value of 130p.

To assess the fairness of such assertions is difficult, but EBITA for staffing companies remained flat (in absolute terms) for the first 5 years of the 1990ís. In essence the market is discounting (all other things being equal) that the economic ramifications of the current crisis equate to economic performance akin to the early 1990ís. These assumptions strike us as credible, and thus the stocks with earnings risk, such as staffing companies are not offering tempting value yet.
Risk appetite
The other way to assess what the market is doing is to look at the discount rates, in effect how much risk does the market apply to its own forecasts.. Again using our DCF we can see that the current price for the staffers (using Hays and Adecco as proxies) that the market seems to have reverted to a risk premium of c5.5% (ie the cash flows are just over twice as risky as the yield on a government bond). We, as the market did, moved to an equity risk premium of 3.5% during the late 1990ís (assuming that the world was a less risky place). On HSBCís our existing published numbers the fair value at a 5.5% equity risk premium would be 55 Swiss francs per share (from 65 using 3.5%). On Hays it knocks the fair value to 150p (from 210p using 3.5%). Thus staffing companies are fair value, if the world is as risky as it was between 1950 and 1990.

Assessing if it is fair to use a 5.5% discount rate is harder, but this is effectively the long-term historical rate for the equity risk premium. Using such a rate in essence suggests that the general risks of holding equity are higher than in the late 1990ís but akin to the level of risk between 1950 ñ 1995. This again seems ëfairí. In essence it is returning the market to more normal levels of risk aversion, another way of putting that would be a lower multiple on earnings.

Double whammy = cheap?
This double whammy of discounting a recession of the nature of the early 1990ís and risk levels from before the bull run does seem harsh (it has an element of double counting) and perhaps suggests a bottom for share prices. In P/E terms this equates to the point where earnings will rise and so will the multiple.

Adopting a higher equity risk premium of 5.5%, and assuming flat free cash flow until 2004 knocks the Hays target price to 78p. Assuming flat FCF till 2004 and a 5.5% risk premium for Adecco puts the price at 45 Swiss Francs per share. Thus if we put in higher risk and lower cash flows then the stocks are still overvalued.

Buy on greed
We remain of the opinion that stocks will rise when they are below fair value assuming normal risks. Thus investors who are being prudent about risk can see enough upside to temp them to buy. This in practical terms takes two forms, value and personal risk.


Value - Investors to perceive tempting cheapness on harsh assumptions.

BUT - Our analysis suggests that either a more ënormal risk premiumí or a prolonged period (two more years) of no profit growth suggest fair value not upside. Both would suggest further downside. We would regard both as capitulation.

Risk - Lower personal risk

BUT - performance bonuses are close and thus personal risk of jumping too early will not recede until very late this year or early next. After bonuses are set investors will have 12 months until next bonus and as such risk (at the personal level) will recede 12 months.

Neither factor seems fully in place yet, but it may not be long.

Conclusions
We are approaching the point that valuations look cheap and a rally occurs but we believe that the market must first discount as bad as it might be - and it is not yet doing so. Thus we remain underweight the sector, favouring stocks with growth but negligible cyclicality. These stocks while exposed to a rising discount rate are not doubly exposed (earnings are not likely to decline). Similar analysis does suggest downside for all growth stocks.

Traditionally the buy signs for the staffers have been fundamental and usually related to the underlying US product/service markets for each company (once they turn positive investors ëlook throughí and European slowdown). The current political environment makes it possible the bottom will occur before these traditional triggers but valuation triggers are probably lower down. Fundamental triggers for the cyclicals are certainly not flashing yet.

A rally will occur and the likely winner then are still the cyclical growth stocks, most notably staffing stocks.

HSBC Business Services Team
Matthew Lloyd 44 207 336 3009 matthew.lloyd@hsbcib.com
Tom Sykes 44 207 336 3108 tom.sykes@hsbcib.com
Jaime Brandwood 44 207 336 2298 jaime.brandwood@hsbcib.com