Harte Hanks: The Stock Cooled Off, But Business On A Good Track

Introduction: Business description & coverage history

I’ve been covering Harte Hanks (NASDAQ:HHS) stock since mid-July this year and I’ve been either Strongly Bullish (very first article) or just Bullish (last 2 pieces) the whole time.

Harte Hanks Inc. is a marketing and customer experience company with a market cap of just $75 million. It operations through 3 business segments:

1. The Marketing Services segment delivers strategic planning, data strategy, performance analytics, creative development and execution, technology enablement, marketing automation, and database management;
2. The Customer Care segment operates teleservice workstations in the United States, Asia, and Europe to provide advanced contact center solutions such as speech, voice and video chat, integrated voice response, analytics, social cloud monitoring, and web self-service;
3. The Fulfillment & Logistics Services segment includes printing, lettershop, advanced mail optimization (including commingling services), logistics and transportation optimization, and monitoring and tracking to support traditional and specialty mailings.

In my very first article about the company, I pointed out the phenomenal pace of the business turnaround – the new management of Harte Hanks was trying to restructure each business segment, get rid of a complex capital structure (buying back preferred stock), and also invest in the Fulfillment & Logistics Services segment, which management said was one of the most promising. Here is how the management viewed the company of the “past” and how they saw the company of the “future”:

Less than 1.5 months after the publication of this article, HHS increased by about 40%. I then decided to publish the second article downgrading my original rating (from Strong Buy to just Buy) and warning of a possible mean-reversion effect. HHS then entered the RSI range just north of 75, with the stock trading 25% above its 20-day moving average – a cool-down seemed inevitable. However, the company itself was still slightly undervalued from a fundamental perspective (in my opinion) – so I remained bullish at that moment. Since that time, the share price has already fallen by 39%.

My third article was based on technical analysis – HHS seemed to have fully absorbed the selling volumes that hit it, so a rebound seemed close. And so it did happen – during the consolidation phase, HHS reached +10% about a month after that article was published. In the end, however, that level proved to be resistance, and HHS is down 4.3% since the date of my third publication. Let us analyze the current state of affairs and understand what growth prospects the company has shortly.

Q3 2022 earnings review

From the MD&A section of HHS’ latest 10-Q, the company’s 3Q2022 revenue growth slowed somewhat from the start of the year – revenue grew only 8.6% y/y, while operating expense growth outpaced revenue growth by 1.9%, resulting in a 10.7% (y/y) decline in EBIT.

Operating margin was down 152 basis points, but EBT is up 83.3% YoY – why is that?

It’s all about “other income,” which has risen from $350,000 last year to $4.6 million this year (Q3/Q3) – an increase of more than 13 times. Management explains this as the sale of some IP addresses that were no longer useful to the company and a decrease in foreign currency revaluation. In future periods, HHS will not benefit as much – so the earnings per share (surprise of almost 105%) resulting from this one-time income did not positively affect the stock (HHS fell 8.29% on the report release day).

But let’s look at the income statement in more detail. HHS reports on OPEX including costs of goods sold (COGS) – primarily labor and production & distribution. The labor cost is still the main expense for the company (over 50% of operating revenues). However, as a percentage of revenue, it decreased a lot last quarter compared to Q3 2021 – from 54.77% to 50.78%.

The cost of restructuring has dropped to zero, but due to the increase in production and distribution costs (+43.6% YoY), we see an increase in total OPEX of 152 b.p.

P&D costs increased in the COGS structure due to the shift in the revenue mix from Marketing Services and Customer Care towards the Fulfillment & Logistics Services segment, which grew 55.6% year-over-year. I talked about this above – management had previously announced an active expansion into this segment, and now we see the firm getting more than 40% of all consolidated revenue from this area for the first time. So I do not quite agree with SA colleague Jim Van Meerten, who wrote that HHS is a Strong Sell because it has an unfavorable technical picture and that a possible recession will hurt the marketing budgets of its clients.

I agree that a recession is more likely than not next year – read my outlook for 2023 if you have not already. Still, when assessing HHS, we need to look at the long-term prospects – it’s essential to consider fundamentals, valuation, and expectations.

The business turnaround is now in full swing, and by shifting the company’s focus to logistics, I believe HHS’ business is now diversified enough to weather a mild recession.

Let us take a look at the balance sheet – HHS paid $5 million in cash to get rid of its long-term debt. Obviously, the management team was correct in its assessment of the outlook for the economy over the next few quarters – the company’s credit risks for the company are now lower after the repayment.

The company remains “truly profitable,” or rather, “free cash flow positive”, with FCF per share as in 2017, when 1 share cost $15-16.

To sum up the fundamentals, I think management is doing everything right and is roughly sticking to its previously announced turnaround plan.

Valuation and expectations

If you open HHS’ earnings estimates here on Seeking Alpha, you’ll see the EPS forecast for Q4 2022 is almost 4 times lower than the actual EPS we saw in Q3 2022:

Why such a sharp decline?

The CEO stated on the recent earnings call that Q4 2022 figures will be similar to those of Q4 2021 – when the company earned only $0.20 per share – hence these modest projections.

While Q4 2021 was one of our strongest revenue quarters in recent history and despite the macroeconomic environment, we think Q4 2022 Harte Hanks total revenue will look similar to last year.

Source: HHS’s CEO Brian Linscott [the Q3 2022 earnings call transcript]

Analysts forecast EPS growth of only 5% year over year for Q4 2022. However, we have heard other facts from the earnings call that could lead to either an upward revision of the estimates or another EPS beat in March 2023. Here’s what specifically caught my attention:

• Some of the cross-sale opportunities will be realized in Q4 this year, but most of the opportunities we expect to materialize in 2023.
• Our sales pipeline remains strong. When compared to the start of 2022, our pipeline has nearly doubled in size.
• At the beginning of 2022, we brought back our 401K match for our U.S. employees while improving labor efficiencies and the bottom line EBITDA.
• The repurchase of the preferred shares will eliminate the dilutive impact to common shareholders and give us greater flexibility with our capital structure going forward. We anticipate the final conclusion of this matter to occur in the fourth quarter.
• Monetizing the exited Jacksonville lease will generate additional cash flow of approximately $750,000 in 2023 and it will result in improved P&L performance as well.
• I think investing in tech is important to us, when I think longer term, we have clearly spent some CapEx this year as it relates to light automation and building out some of our Kansas City facility. So, those things are behind us. I do think some additional tech investment is required on a smaller scale.

-Source: HHS’s CEO Brian Linscott [emphasis added by the author]

The company has managed to double its sales pipeline in 9 months, avoid the dilutive effect of the upcoming preferred stock buyback, and also invest in technology CAPEX thanks to one-time gains (selling IP addresses) that will now require fewer investments in 2023. In any case, operationally, next year should be much better for the company than in 2022.

Covid project shutdown (mailing) will negatively impact the bottom line – but YoY growth of 5% in Q4 2022 seems quite pessimistic, as does the prospect full-year 2023 EPS decline of 13.18% (YoY).

If we see YoY EBITDA margin expansion in Q4 2022 and FY 2023, I think the current valuation levels appear too modest – just compare them to the median levels of the last 10 and 5 years:

Summary thesis

Based on the above, I draw the following conclusions:

• Harte Hanks is still in the process of a planned turnaround, but it seems to be ahead of the initial schedule;
• The company’s fundamentals look good for the long term;
• The valuation multiples are too pessimistic – as are the EPS/sales expectations, which the company is likely to exceed in Q4 2022 and FY2023;
• Recent corporate events – cost optimization, CAPEX thanks to excess one-time gains, preferred stock repurchase – give us hope for future margin expansion, so necessary to exceed analyst forecasts.

All of this follows in my summary thesis – Harte Hanks remains a fairly interesting company over the long term, and possibly even over the medium term, given the RSI divergence on the daily technical chart:

Thank you for reading!