SEEK-ing Returns
SEEK reported its 2015 financial year results on 19 August. While the result itself was in line with the reduced market forecasts following the trading update in late June, the outlook statement caused a significant reduction in forward estimates.
SEEK is a stock we have liked and owned for a while. The virtuous circle of jobseekers gravitating toward the jobsite with the most job ads and employers advertising on the site with the perceived deepest pool of talent was a powerful barrier to entry for SEEK. At the same time the company’s earnings grew rapidly as the market moved from traditional print to online job ad posting. Margins benefitted significantly from SEEK’s growing market power as well as the scalability of its cost base. Adding to this, limited capital investment requirements resulted in strong growth combined with extremely high marginal returns and cash flow generation.
Over the last 6 years, SEEK had reinvested its strong free cash flow in acquiring stakes in the leading job ad boards in a number of countries.
The issue for SEEK is that there is a growing threat to its job board franchise from job ad aggregators. These aggregators could potentially break the virtuous circle by scraping job ads from other sites, thereby deepening the volume of job ads they post to jobseekers. The idea is that if they can bring jobseekers across due to the volume of ads they post from other sites, the employers will eventually follow. Of course, the aggregators still need to be willing to build brand awareness. Indeed launched a marketing campaign late last year to build brand awareness. If successful, this would commoditise the basic job board business of SEEK.
What sets the online job ad business apart from the tradition print media product is the data capture. Online job boards initially disrupted the job ad market as it was significantly lower cost and capital intensive than traditional print.
Increasingly, technology is disrupting industries by replacing labour. This tends to start with low skill repetitive tasks, but as technology evolves it is becoming increasingly capable of replacing more skilled labour.
The high value part of the job placement market is in recruitment. This has traditionally been highly labour intensive with recruiters using their database of jobseekers as well as contacts to match candidates with employers. The market is more focused in its search than the traditional job ad board tool. Where job ad boards bring only active jobseekers to an employer, recruiters also bring passive jobseekers with a more applicable set of skills.
SEEK currently has around 6.3 million resumes on file in its Australian business. This provides it with a significant database to match jobseekers with the skills that the employer is looking for. It also provides a value added service that should increase the efficiency of the job placement function for an employer.
While SEEK has the data, it needs to build the tools to move more significantly into this traditionally high labour intensity and high value added part of the market. This requires investment by the company.
Increased penetration of the recruiter market will inevitably bring SEEK into greater contact with other disruptors like LinkedIn. However, the primary opportunity for both companies will be in displacing the traditional players in the market for many years before having to worry about one another.
One key deficiency in SEEK’s platform relative to LinkedIn is its lack of ongoing engagement with the jobseeker once they find a job. We will be keen to see what products SEEK can launch to improve its ongoing engagement with jobseekers, as this will be key to ensuring that it can effectively tap the potential pool of passive potential jobseekers.
As we discussed in a blog posting from 30 July, low interest rates might actually be reducing business investment in the listed company space due to increased demand from shareholders to boost dwindling interest income with dividend income. Increased alignment of executive and shareholder interests through share based remuneration could be a disincentive for management to reinvest for growth.
SEEK is not in this camp. The problem is that while reinvestment to deliver growth is generally capitalised for most companies as capex, the nature of the investment by SEEK means that a large proportion of the investment is expensed, depressing near term reported earnings. As a result, we expect reported earnings to remain relatively flat in both FY16 and FY17 before returning to growth in FY18. SEEK will test the market’s patience if earnings remain flat for 3 years given the stock trading on over 20 times earnings.
In addition to the expensed investment, the company is expected to capitalise around A$50 million of investment a year. As a result, the marginal return outlook for the company has reduced relative to its history, but it remains very high if the investment is successful.
The risks have increased for the stock, but the reinvestment is necessary to grow the business as well as offset the threat of commoditisation of the traditional job boards by aggregators.
We had identified the heightened risk ahead of the earnings release given market expectations for medium term earnings growth in the face of a combination of SEEK’s reinvestment and the medium term impact of likely changes to the commission structure in the Learning business. As a result, we trimmed our position in the lead up to the earnings release.
We continue to believe that there is downside risk to the market’s near term earnings expectations given the weakening outlook for Asian, Latin American and the Australian economies. However the combination of the risk weighted outlook for marginal returns and growth in the long term remains favourable given SEEK’s position in its core markets.
Stuart Jackson is a Senior Analyst with Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Justin Carroll
:
I don’t venture this as a criticism but I always thought that the bullishness of the Montgomery team on SEK is emblematic of a critical weakness in the growth-at-a-reasonable-price approach that the Montgomery team appears to practise (I say “appears to practise” because, while I am aware that the team’s stated approach to security selection is a value-oriented one, it is an approach that, if it is value-oriented, seeks its “value arbitrage” in the difference between a stock’s current market price and its projected future earnings).
Yet, if, along with death and taxes, there is one thing certain in life, it is that investors who follow the growth-at-a-reasonable-price approach to stock selection will ultimately overestimate future earnings and thus overpay for growth.
The growth-at-a-reasonable-price approach does not pay due regard to (or perhaps loses sight of) the need always to identify stocks trading at a level that gives purchase of them a margin of safety. I am not sure where the Montgomery team saw the margin of safety in SEK when it added to its position at or around 30 June this year. I presume that it lay in the confidence that the team had in its projections of SEK’s future earnings.
I would argue, however, that locating the margin of safety in one’s projection of a company’s future earnings is precisely what value investing does not do. That’s what sets it apart from other investing philosophies.
Stuart Jackson
:
Hi Justin,
There are two components to any investment case; return and risk. The process of assessing both of these elements involves more than a single estimate of value. In that regard, I would agree that a lot of analysis places too much faith in a single estimate of the future earnings stream. Consequently we run a range of scenarios to not only look at the returns expected to be generated under our estimate of the most likely outcome, but also an assessment of the risk around other potential outcomes. In terms of the margin of error required in assessing a growth company’s valuation, the higher duration of growth companies also implies a larger amount of valuation variability on the back of changes to underlying assumptions. This is demonstrated through the scenario analysis and is why this analysis is critical in assessing and understanding the risks of an investment in a company that is activity investing for growth. Additionally, a fundamental component of the risk management process is to constantly re-evaluate the risk/return outlook as new information comes to hand as well as through a more formal periodic refreshing of the analysis of the company’s prospects.
In the specific case of SEEK, the decision to trim the position ahead of the result came from the re-evaluation of the investment case as a whole and had little to do with the issue with the Learning division that led to the company’s announcement in June. As such, the decision to add to the position due to the fall in the share price post the June announcement was independent of the decision to trim the position ahead of the August result release.
Justin Carroll
:
Thanks you for your reply Stuart.
When you refer to risk, I assume you’re referring to something other than a risk of suffering a permanent capital loss. If I’ve understood you correctly, you seem to mean the risk of your estimates being wrong or the risk of an unexpected development.
Either way, my point remains that, where one is seeking to arbitrage between the current market price and one’s projection of future earnings (however sophisticated and varied may be the inputs that go into that projection), one is trying to get a fix on the most volatile aspect of any company, let alone of a growing company: its future earnings.
Now, there is not necessarily anything wrong with that, so long as in projecting future earnings one leaves oneself an adequate margin of safety (rather than a margin for error – there’s quantitative and qualitative difference). That means, to use Buffett’s example, that you don’t try to buy a business worth $83 million for $80 million. You try to buy it for $50 million.
Back in June of this year when SEK was trading at $5.6 billion, it would have taken quite heroic earnings projections in my view to have given one’s purchase of its stock at that level an adequate margin of safety.
John
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In your last blog post on Seek just before 30 June 2015, you advised that you were buying more after the share price crashed. You now say that you were selling just ahead of the results announcement in August 2015. I would be interested to hear your commentary as to what caused this change of heart.
Stuart Jackson
:
Hi John, Thanks for the question. We constantly re-evaluate our positions as new information arises. In the case of SEEK, through that process of re-evaluation, we determined that market expectations in the medium term were overly optimistic as a result of the step up in investment, as well as a number of other factors. As a result, we felt that it would be wise to reduce our exposure to this risk.
John E
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My issue with social networking sites like linkedin, is the privacy you lose. It does appear though that most people are fine with providing their online resumes and other personal details for general consumption. Many people don’t set their privacy setting appropriately.
Roger Montgomery
:
thanks John.
Prasad
:
LinkedIn has certainly killed SEEK in IT market here in Sydney. I get frequently approached by recruiters or employers with highly relevant jobs while my SEEK profile nor resume is nowhere near up to date. LinkedIn correctly display lots of matching jobs from good companies as well. This is even though I haven’t changed companies in 8 years. Lots of my colleagues are actively engaged in LinkedIn. However my partner who is Accounting/Administration her LinkedIn profile is not maintained and most jobs are advertised in SEEK. Unless SEEK innovates it is matter of time.
steven
:
Hi
Very insightful.
One for the suggestion box, next appearance, a change in format;
Buy Hold Sell Trim
Stuart Cook
:
My wife logged her resume on Seek late last year noting your comments around matching job seekers and employers. Unfortunately her email account was spammed by a large number of dubious job offers so she has now removed her resume and is using linkedin only and is much happier with this offering. The LinkedIn site seems more targeted in job ads and user friendly.
Stuart Jackson
:
Hi Stuart. There is definitely going to be some teething problems experienced by some jobseekers and employers in the early days as the job matching algorithms are refined. The key will be how quickly SEEK can improve the product to generate more efficient outcomes for all parties. This is where a lot of the risk lies with the company investing to move into another part of the market. LinkedIn has a larger R&D budget and has been investing for longer than SEEK. It also has a greater amount of ongoing engagement with potential jobseekers. SEEK on the other hand has more detailed information about jobseekers than LinkedIn as well as better local knowledge that is more broadly spread across all industries in the economy. Given those inherent advantages, LinkedIn is likely to perform better in matching employers and jobseekers at the very top end of the market. SEEK should be able to do better in the broader mass market once its products become a little more developed.