First Advantage (FA): Uncertain Macro Environment Is Major Obstacle To Valuation Rerating

Thesis

First Advantage (NASDAQ:FA) is a provider of background checks that has evolved under new leadership by adopting a more scalable automated platform and restructuring itself around industry verticals and subject matter expertise. In light of the macro uncertainty, I am maintaining my hold rating for FA. Despite the tough labor market, I must admit that FA has continued to execute very strongly, as evidenced by the recent results (revenue only declined 8% vs last year which I had expected much more considering the mass layoffs and headline news of company freezing hires). Although I still expect FA to emerge victorious in the background screening market over the long term and agree that FA should trade at a premium to competitors, I don’t see any strong catalyst in the near-term that will cause the stock to re-rate. My view is that until the macro environment turns for the better, and investors are convinced that the growth ahead is sustainable, then, the stock will tick up. Until then, I think this will be a rangebound-ed stock.

Growth outlook

Due to the continued uncertainty in the macro environment, I anticipate that FA will continue to face pressure in the near future. This runs counter to what has been communicated by management in the form of renewed fiscal year guidance that includes an upbeat outlook on the job market. In my opinion, there is more room for a revenue miss in 2023 now that management has indicated that they expect a base business improvement in 2H23 and that hiring will not worsen. As much as I appreciate management’s optimism, I believe this does not bodes well for FA stock at the moment, when it’s anyone’s guess how the macro environment will develop. The hiring climate, in my opinion, will continue to worsen and will have a much larger impact on the industry as a whole than is currently anticipated. However, rising EBITDA margins could soften the blow of any forecast shortfall. Management is anticipating margins greater than 30% in 2Q23, with further improvement anticipated in 2H23, following a similar pattern to that of 2022. According to what has been said, I am placing my bets that management has something up their sleeves (levers they can pull easily) to help support this claim in margin improvements, as such I expect margins to improve sequentially through FY23.

Innovation

While the current investing climate makes short-term issues a priority, I am optimistic about the company’s long-term fundamentals. Among the many recent investments made by management is the SmartHub product, which employs machine learning and proprietary algorithms to assist customers in optimizing the inquiries into employment verification data (end result is expected to be faster and more cost-efficient). Another area of investment or interest is AI, which I believe FA is a great company to adopt AI in because of its ability to use generative AI to better serve its clientele. One way it could aid FA is by making it simpler and quicker to look up public records. Hence, it was encouraging to hear management having similar views as I do on this front.

Valuation

While I recommend holding, I must admit that FA’s valuation is quite appealing when compared to its own history. FA currently trades at 13x forward PE and has historically traded in the mid-teens to the twenties. The economy will eventually recover, and businesses will need to resume hiring, which will increase demand for FA services. I would also argue that FA’s margin profile could improve further as a result of the investments it has made (for example, leveraging AI). Some investors believe FA’s valuation is too high in comparison to peers such as HireRight (HRT) and Sterling Check (STER). However, I believe FA should trade at a premium, owing to its superior margin profile. Before the current crisis, FA had an EBITDA margin of 30%, while STER and HRT had EBITDA margins in the low 20%s. This difference in EBITDA margins grows over time as FA has more cash to reinvest in the business, either to drive faster growth or to improve margins. While there is an 8 to 10 point difference in margin, this means FA has 40 to 50% higher profits on an absolute basis.

Risks

While management is investing heavily in innovation to drive improvement in the business fundamentals, the risk associated to it should not be ignored as well. Keep in mind that screening is a highly regulated industry, and there are many laws governing the types of information that can and cannot be included in a background check. Also, keep in mind that screeners do, in fact, pass verification costs along to customers, so any increase in the price of this data would result in an increase in the final cost to the customer. The highly commoditized nature of the industry makes price increases a potentially divisive issue that could lead to customer churn.

Conclusion

While FA has shown strong execution and potential for long-term growth, the current macro uncertainty poses challenges for the company. The tough labor market and unpredictable macro environment hinder immediate catalysts for stock re-rating. Despite management’s optimistic outlook, I expect the hiring climate may worsen, impacting the industry as a whole. Valuation-wise, FA’s attractive position compared to its historical range and stronger margin profile justifies a potential premium over peers. Overall, I maintain a hold rating until the macro environment improves and the company demonstrates sustainable growth prospects.