A Black Swan Event on Renrui?

Or is it?

On a normal night after I put my daughter to sleep, I came out of her room around 9.30pm and feeling really sleepy as usual after listening to some podcast in her dark room. Then I read my HKEx Alert in my inbox (one of the several emails I receive daily from all the HK listed companies I own or follow), and the bomb dropped. Renrui’s biggest customer, Bytedance, terminated its flexible staffing contract with Renrui. Bytedance accounted for 37.6% of sales in FY2020, a whopping RMB 1,064mn, and it will all but vanish starting from 1 Jan 2022. The news jolted me to become wide awake.

Some of the other key points highlighted in the announcement are:

• Reason for the termination is that Bytedance wants to bring all these info verification and client representative employees contractually in-house.

• Other services provided to Bytedance, including professional recruitment and BPO services will continue and be unaffected.

• From now until the end of 2021, the service premium paid by the customer will be reduced until the pending termination, and the impact on FY2021’s adjusted net profit from this termination will be a drop of 10% to 20%.

• Renrui plans to introduce a new product ‘HR SaaS’, a subscription-based service model which will allow its customers to subscribe to the Group’s proprietary HR management software (not much details are given)

• Despite the termination, business relationships with the other top 10 customers remain stable

As I wrote in my previous post, one of the biggest risks for Renrui is customer concentration. I didn’t expect it to happen so soon. I thought the probability of Bytedance to cancel its service will be very low, given that this part of the business is ripe for outsourcing and it makes much more sense for Bytedance to focus their resources on more value-adding areas. In the Investor’s call the next day, which happens to be a public holiday and markets are closed, Renrui’s management team kept reiterating that this is a one-off black swan event, and that the rest of customers are all fine. The call was somewhat reassuring and the tone of the management didn’t sound like they are defensive or trying to hide anything, but I can sense also that not many investors in the call are convinced, and there are doubts lingering around (maybe more a reflection of my own inner voice than what other investors really think).

After I gathered the data I need from the Investor’s call, I did a rough calculation to see what is the impact on sales and profit going forward. Adjusted NPAT was RMB 140mn in FY2020, and roughly RMB 90mn without Bytedance. Assuming a historical ex-Bytedance growth rate of 25% conservatively (the actual CAGR was closer to 30-40%), the adjusted NPAT will be RMB 110mn in FY2021, and RMB 140mn in FY2022. So if indeed this is a one-off black swan event, Renrui should see its profit back up to FY20 levels by FY22.

I was expecting perhaps a 30-35% drop in share prices when the market opens on Friday, but the cruel reality hit me right in my face. The stock opened down 45% and quickly moved to almost down 50%. As a result of Bytedance’s termination, half of the company’s value evaporated in a few hours.

As I settle into deep thoughts on what I should do next (honestly there are only three options – dump all, sell some or hold), I was reminded of the imaginary person Mr. Market and his all-too-often manic-depressive nature. I can see why people want to run as fast as possible to the emergency exit, and I can also see why that may not be the wise move and that the fire was a fake call. Here are my half-empty and half-full view of what the future may lie:

The Half-Empty View

• The loss of Bytedance is not merely a loss of revenue, it is a strong invalidation of the core fundamental business model for Renrui – one that provides tremendous value for clients in the fast-growing unicorn startups and the unique demands of the new economy. The loss can be interpreted that either there is no real value in its services, customers can easily switch providers, or that once its revenue scale to a meaningful size, the customer has incentive to cut costs and bring it back in-house.

  • ]This view will imply that all the flexible staffs deployed to other customers, particularly in the role of info verification and customer services, may be on a flimsy ground

  • A loss of such prominent player in the internet space will mean that Renrui’s credentials and reputation may be scarred – e.g., can they still get Kuaishou if they want to?

  • I suspect this is the main factor that cause share price to halve, as anything else is secondary once the core business model is fractured.

• The tremendous growth over past 3 years was driven in a large part by Bytedance. Given this loss and the shaky business foundation, the growth of the remaining businesses may slow down and the entire theses riding on fast-growing unicorns may not stand, and hence valuation multiple needs to be re-rated.

• Although the management team also recognized these shortcomings and has started to reap results in other areas such as BPO and ITO services, it may not take off as quickly as flexible staffing, and hence hard to fill up the ‘hole’ left by Bytedance.

The Half-Full View        

• This is indeed a one-off black swan event that could hardly have been prevented, and could happen to any other B2B businesses with large customer concentration. Few postulates that I have in mind on why Bytedance decided to do this:

  • Bytedance’s internal strategic review concluded that they want more control over its employees and create a better culture among employees (there are a lot of complaints online about whether an employee is a bona-fide Bytedance employee or not). However, this reasoning is least strong given that these info verification and customer rep employees are really administrative functions and may not even sit together with main employees (hence less culture issues).

  • Decision was driven from a pure cost cutting initiative, and because they have determined internally that these employees are more or less needed permanently, hence it’s better to do it in-house rather than give the 10% service premium to a third party like Renrui. This argument is also flimsy as they will need a much bigger and stronger HR team, which eats into the savings (not to say the amount of additional time and resources needed to recruit, onboard, train, exit, etc.). Assuming that they indeed can save all the premiums, would a company with FY2020 sales of USD 34bn and operating loss of USD 2bn want to go through the hassle to just save USD 15mn? Not impossible, and perhaps this is also a result driven by the recently joined CFO Chew Shou Zi from Xiaomi?

  • The most probable answer, in my opinion, is perhaps due to regulatory requirements and tighter scrutiny among internet giants by the Chinese government. As a result of recent uproar due to Meituan’s delivery personnel not having social security payments (五险一金), government has probably initiated a list of investigations into these ‘new economy’ employees to ensure proper adherence to social security payment. Bytedance, learning the lesson in Meituan (whose share price plunge due to this saga) and in its preparation of the highly anticipated IPO, wants to pre-empt this issue and decided to ensure they abide by the government’s regulations. Although Renrui claimed that they pay all these flexible staff 五险一金, it’s hard to enforce totally and the only way to ensure 100% compliance is to bring them in-house, given the reputational risks involved.

• If we buy into the argument that this is indeed a black-swan event, then this loss may only be a short-term pain which the company can recover and fill up the hole in 2 years. In fact, this may even turn out to be a positive event for the company long-term. Why is this so? Because it forces Renrui to focus on the higher value, higher margin business of professional recruitment, other higher salaried roles, BPO services, ITO services and HR SaaS.

  • This is especially true because delayed gratification is hard, both for humans and for businesses. It’s hard to reject and forgo easy revenue from Bytedance, even though it may not be beneficial in the long run.

• As confirmed by the management, there is no additional impact on the costs or any form of compensation needed, and no need to redeploy these manpower.

• The fact that Bytedance didn't switch suppliers and wants to bring those employees in-house meant that this decision is not due to poor service by Renrui, which are more detrimental to the business model.

• If we think of the intrinsic value of Renrui in 2 years’ time, where it no longer has a ticking bomb of customer concentration from Bytedance, a much mature and growing BPO and ITO business segments, overall moderate growth of 30% CAGR both topline and bottom line, would it deserve the current valuation of RMB 1.5bn, cash of RMB 1.1bn and implied ex-cash P/E and P/FCF of 3-4x?

• There could be an upside as they have hinted some M&As brewing and looking to close in H2 2021, though this is not something that any investor can count on until it’s announced. It could also go both ways depending on the target being acquired.

The key lesson for me here is to always think of second order effects of a big risk happening. To be completely honest with myself, I didn’t spend much time thinking through the possibility of Bytedance terminating their service, and what that will imply. The first order impact is loss of revenue and profit, but the second order impact is the crumpling of the business foundation in the minds of investors. Have I thought more deeply about this issue, I may have tried to find out more from people working in Bytedance or speak to people in the industry to understand the stickiness of the business model.

As it stands, given the facts now I am not able to have a firm decision on either the half empty or half full view. I plan to closely watch for more facts and data from the Interim Report to help me decide on the next course of action. I still do trust the management team and have confidence in them, but the brutal reality of capitalism spares no one.