And he read Principles of Accounting all morning, but just to make it interesting, he put lots of dragons in it. ― Terry Pratchett,
Accounting is a wonderful tool for understanding a business. It outlines the amount of capital employed, how the capital is financed, the amount of cash the business is producing, and illustrates expenses across all levels of activity.
Yet accounting can also be treacherous. Revenue can be front-loaded, expenses can be capitalized, and a thousand other tricks can lead to a mirage for investors. There are multiple tools to counteract these mirages. Cashflow awareness, footnote diligence, and a broad knowledge of accounting all reduce the risk of miscomprehension.
Like any tool accounting is great if you have control, but a lack of comprehension or focus leads to danger.
In the staffing industry the unique accounting related to sales & profitability lead to a wide range of misconceptions both when screening for the stocks and when judging investment merits. I’ve heard multiple times that staffing had too low margins to be an investable business. I’ve also heard that the Price-to-Sales ratio indicated a good purchase on many staffing stocks.
Below is a small compilation of times that not knowing the accounting on staffing revenue would have led to overlooking or overestimating staffing stocks.
Produced by Author. Sources range across 5-10 investor-focused articles from major websites such as Forbes, Nasdaq, etc.
The Business and Accounting of Staffing Agencies
The staffing business is at its core a brokerage business. As covered in my primer the business centers on joining individuals seeking temporary placement and corporations seeking a temporary workforce for several reasons.
Regular brokerage businesses carry transaction volume as a separate footnote or line item and the take-rate is revenue. If you want a boat and I introduce you to my friend who owns one in exchange for a $200 commission, brokerage accounting would have $200 as sales while traditional retailers would carry the whole boat as sales (seeing as they carried it at cost in inventory).
Visa and Mastercard don’t carry total transaction volume (in the trillions) on the income statement, only their >0.5% take. Online brokerages such as Ebay carry their “bite of the cake” as net revenues and show gross merchandise value in footnotes. Actual stock brokerages use the same model.
For sales almost every brokerage model doesn’t use the gross transaction volume, but only the slice that ends up at the firm. Investors could be excused for assuming that staffing would operate similarly, but it doesn’t.
Staffing sales are counted as the total wages paid to the employee. That includes employee wages, workers’ comp, federal unemployment, state unemployment, health, and insurance costs. Gross profit is the take-rate of the staffing agency. The categorization of payments leads to the what should be sales ending up as gross profit.
The sales of staffing agencies are in effect the GMV of online retailers, the transaction volume of card networks, or the total sums managed by brokerages. The gross profit constitutes the true sales.
How the Accounting Distorts Screening and Cross-industry comparisons.
As the sales of staffing agencies include ALL the wages paid to their placed temp. staff, the margins are extremely thin and the price-to-sales ratio is equally low.
For investors focused of net profit margins (as demonstrated in the top image) this might lead to categorizing staffing firms as ‘dogs’ and commoditized. Many investors have minimum requirements for margins which is extremely rational. It is traditional micro-economic theory and investment considerations (from the time of Graham) that the lowest cost manufacturers (lowest margins) are leveraged towards commodity prices.
It is entirely reasonable to avoid certain commoditized, low-margin business models, but not when they’re only optically low-margin due to an accounting exception.
For investors focused on low price-to-sales (as showcased in the photo above) the unnatural accreditation of sales will result in a seemingly “value-style” stock on a revenue basis.
The low margins might inspire false confidence as I’ve heard from some commentators on manned security and staffing agencies. They will argue that margins are so low that nobody wants to disrupt or compete. In reality the margins at some firms are in line with most industries today on an adjusted basis.
On the other hand I’ve seen arguments that certain aspects of staffing that doesn’t involve employee wages, such as recruitment process outsourcing, will face contracting margins because they’re so “attractive” when compared to staffing revenues.
All of these arguments are entirely invalid based on traditional accounting measures. My argument isn’t that staffing stocks are likely to be under- or overvalued as a result of this phenomenon.
My comment is simple: Be extremely wary if you see an argument related to margins or price-to-sales of staffing stocks.
Staffing Companies on an Adjusted Basis
I’ve tried to summarize the difference in a comparison between a “normalized” income statement and the status quo income statement.
(1) An adjusted Income Statement contrasted with the current version.
While the absolute numbers are the same (e.g. both versions would end up at the same absolute profit figures) the inclusion of wages in sales and cost-of-goods sold severely disrupts any investor screen aiming at “high-margin” companies.
So you’ve learnt how staffing accounting differs widely from what is usually applied to brokerage-type businesses. That means you’re ready to go screen for the best staffing companies.
Not so quick young buck.
There is yet another complication. Staffing companies often derive income from permanent placement fees/direct hire fees. Direct hire fees are charges to staffing agencies for finding an employable candidate.
An explanation of Direct Hire Fees from Talent Plus Staffing.
Direct hire fees don’t have the wage component in goods of goods sold. Aforementioned means it’s extremely high gross margin as most of the expenditures are based in operating expenses.
Direct hire fees are good examples of products that should be treated as direct revenue. As the two different fees mix, it skews the gross-margin upwards. Be aware of this fact when comparing margins across companies within the industry. Industry-relative comparisons are disrupted by direct hire fees not being treated like pure staffing revenues.
With that last explanation in mind you’re now cognizant of the intricacies surrounding staffing margins. Go and impress some girls at the bar with it!