The business of providing temporary workers on a contract or project basis is always going to be a volatile one, so investors in Resources Connection (Nasdaq:RECN) just have to make their peace with that. What's a little more challenging, though, is figuring out how that volatility will break. Does a stagnant economy in North America encourage companies to hire temporary workers in lieu of full-timers? Will a recession in Europe destroy more business than it creates for this company? Can this company regain attractive past levels of cash flow production and returns on capital?

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A Decent Fiscal Second Quarter
Resources Connection reported that revenue rose a little less than 5% from last year and a little more than 5% from the prior quarter. The U.S. remained weak, as revenue was up just a bit more than 1%, while Europe and Asia were strong with over 17 and 9% constant currency growth, respectively.

Profitability was OK, but not as good as the reported GAAP numbers may suggest. Gross margin slid about 160 basis points from last year. For the quarter, the company saw its average billing rate fall about 2% (to $129 per hour), while its average pay rate rose 2% to about $66 per hour. Although reported operating income rose 33%, the real year-on-year comp (after adjusting for items) was basically flat. (For related reading, take A Look At Corporate Profit Margins.)

Mixed Signals in a Muddy Market
Management was surprisingly upbeat in its commentary. Although acknowledging plenty of uncertainty about the situation in Europe especially, it looks like business is stronger than generally believed. It wouldn't surprise me if Resources Connections is seeing a balancing-out of iffy overall business activity, with more substitution of temporary workers. In other words, there's plenty of news about banks (to pick one example) firing people, but there are still essential functions that need to get done and it may be cheaper in some cases to outsource them to companies like this, rivals like Robert Half (NYSE:RHI) or consultants like Huron Consulting (Nasdaq:HURN).

The company also noted that it was seeing relatively stronger demand in IT, supply chain management and compliance. The news of strong demand in compliance isn't surprising - banks, other regulated companies and publicly-traded companies have that requirement no matter what happens with the economy, and the same could be true with IT. With supply chain management, it could be a case of simply trying to drive additional costs out of the systems in tougher times.

A Valuable Offering, but a Tough Market
The value proposition for temporary workers is not really in doubt anymore; companies like Robert Half, Manpower (NYSE:MAN), Adecco and Kelly Services (Nasdaq:KELYA) have all built sizable businesses on it. Likewise, consulting providers such as Navigant (NYSE:NCI) and FTI Consulting (NYSE:FCN) have validated the need for highly-skilled project-specific labor and services.

The challenge for Resources Connection is keeping an attractive collection of talented professionals and splitting the bounty. The internet has been a boon to independent contractors and there's always that trade-off of working with/for someone and using their infrastructure, and going it alone and keeping 100% of the fees. There's also a challenge from more traditional staffing firms looking to expand their offerings in higher-value services. Clients are increasingly willing to outsource these jobs and qualified workers are increasingly willing to accept temporary assignments, as inflation for skilled workers remains stubbornly high.

The Bottom Line
The trouble with analyzing Resources Connection is that this business has produced some really impressive free cash flow in the past, but the revenue, returns and free cash flow have proven to be quite volatile. Although another global economic meltdown would be bad for them, the company should be looking at an operating environment that gets better with time. At these prices, this is not a bad speculation on a company that is very cash-rich and potentially very profitable in good times. (Free cash flow is a great gauge of corporate health, but it's not immune to accounting trickery. For more, see Free Cash Flow: Free, But Not Always Easy.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.