Healthcare Locums (HLO) by Edmond jackson

Judging HLO's risk/reward profile. The company's success to date is based on shortages of specialist staff at a time when demographics and increasingly complex healthcare means searching abroad to fill the gaps. This is an attractive industry niche although I see two main strategic risks.

First, while management insists that agency staff is a vital cost-effective means for the National Health Service (its main customer) to meet needs, it remains to be seen how the NHS budget and its use of agency staff will trend in years ahead. Various commentary has suggested both being cut, which probably explains why HLO shares drifted from their peak in a 280p range.

Second, HLO is justifiably emphasising its preparation and positioning for the US opportunity as healthcare reforms expand this market for healthcare workers. This is likely to take some years to fully impact revenue, however, and there are many examples of UK smaller companies that entertain high hopes for the US only to find it more challenging.

A year or so ago it was fair to target about 250p a share as HLO squeezed cash from acquisitions (how the group was put together) although targeting 300p plus a share, as some analysts are still doing, appears hardly to recognise these risks.

Furthermore, scope to enhance gross margins - for example cost cutting after acquisitions - is becoming limited while the 2009 prelims showed revenue growth of just 5% to £172.1 million. This is hardly in the growth share league. While revenue for allied health professionals (specialist staff) grew usefully from £59.4 million to £72.2 million, doctors were effectively flat at £55.2 million and social workers declined from £46.1 million to £37.1 million. Management suggested temporary issues affecting social workers however there is always liable to be some kind of shortfall risk somewhere in a business. The overall results therefore created some uncertainty as to the underlying revenue trend, now key to the shares' prospects.

Healthcare Locums is market leader in the UK for providing social workers to local authorities and management says the vacancy rate is an 'acute' 14%; that it is sourcing more highly skilled candidates from Australia and Canada. This division looks positioned to improve usefully although bear in mind the uncertainty of spending cuts, also that management did not caution about the slippage in social workers.

A 25 January pre-close update cited "consistent month-on-month revenue and profit growth in all divisions throughout the year... the company's performance demonstrates that we can continue to deliver very strong organic growth" - which was not exactly supported by prelims.

Even so, demographics and advances in healthcare make it a big market - estimated at £8 billion globally and with the UK currently worth over £1.4 billion. This is a cash generative business with a low cost base, as affirmed by the board's progressive dividend policy which currently implies a useful prospective yield of about 4.5%.

As is typical of a 'people business', the balance sheet is heavily weighed to goodwill and intangibles, representing 97% of non-current assets. Net debt has fallen from £26.9 million to £17.3 million, representing financial gearing of 26% compared with 48%, and management intends to further reduce this.

Company REFS shows brokers' analysts projecting variously for 2010 and 2011 - about £30 million normalised pre-tax profit (before amortisation charges) for 2010 and £37 million in 2011 - for earnings per share (EPS) of about 21p rising above 25p. If this is a realistic view then the normalised price-earnings ratio is in the order of ten times and falling.

Be aware, it involves taking a 'pre-amortisation of intangibles' view of earnings whereas this charge plus reorganisation costs meant 2009 pre-tax profit of £12.8 million for EPS just over 12p. The disparity between a basic and normalised view of the income statement may have concerned some investors, upon taking a closer look, also to explain the post-prelims selling.

The market may remain cautious until Healthcare Locums has delivered results capable of proving organic growth, also given the uncertainty over UK public spending. But the chart has appeared to suggest equilibrium has been found at about 180p a share, after digesting the results, and Equinox Partners' firm buying implies belief in value. At 195p currently, the situation merits attention for steady recovery in sentiment assuming a growth trend is proven.