Description

Short FTI Consulting – ticker FCN

Summary

FCN is basically a consulting firm that does corporate finance advisory and restructuring services. 

Stock at $40, target downside to $24, down -40%.  No dividend

The stock is still near highs (this has historically been a good short in the low/mid $40s over the last 6 years, with $45 a ceiling)

On consensus #s, trades at 9.2x 2017 EV/EBITDA and 17.2x P/E, closer to the high end of the its historical range

When times are good, it looks like they can do $2.30+ EPS, people put an 18x  multiple on it, and it trades at $40-45

When times get worse for them, people run rate their earnings and it looks like they can do <$2.00 in EPS, at 15x, that’s a <$30 stock

I think EPS expectations could fall to $1.60 again, and it’ll trade back to 15x P/E, 8 .4x EV/EBITDA getting to $24

They haven’t grown EPS over the last 8-9 years.  EPS has basically ranged between $1.60 and $2.70 since 2007.  The peak was $2.70 in 2009 (they do well in recessions) and it’s been generally declining since (aside from an abnormally good 2016 with a temporary boost restructuring and M&A).  FCN is generally counter cyclical and benefits from increased regulation, litigation, and bankruptcies.    They haven't been able to grow EPS organically or from M&A either since 2007

This trades the high end of its historical price range.

The issue with FCN is that for what they do, they’re already have penetrated a lot of their client base  They’re already well known in the restructuring / distressed side.  And already well known for the anti-trust advisory side.

On the tech e-discovery side, it’s a tough business with a lot of competition and prices are falling.  That segment is a continued heavy drag

So overall, there’s just not a lot of room to grow, and they rely on the general macro environment, which has been getting worse for them because in general, they’re a counter-cyclical company. 

As restructuring falls and we enter a less burdensome regulatory environment, FTI will have less work to do.  Meanwhile, the new CEO continues to hire people (mostly junior people) in hopes that they can grow organically.  But it’s been clear that hiring people hasn’t translated directly into revenue growth (they’ve tried for 3 years).  Hence, margins will get squeezed while revenue falls back down after an abnormally good 2016

 ------

What Drives FTI consulting?

Basically, FTI consulting is a counter-cyclical stock overall.  Because of its strengths in restructuring, litigation, and forensic accounting, they’re usually brought in when the economy is bad and a lot of companies are going through bankruptcy. Also, during downturns, that’s when the tide goes out and the lawsuits rise.  Hence in 2008-2009, the company did quite well

Changes in regulations aren't really drivers for FCN.  FTI consulting is mostly 'event based / transactional' work around restructurings, M&A, litigation & lawsuits, etc.

FTI isn't really industry vertical focused, unlike other consulting firms that have expertise in particular industries

For other consulting firms or strategy consulting firms, changes in rules is helpful.  E.g. all the changes in healthcare benefitted guys like Huron, LEK consulting, and other strategy consulting firms like McKinsey.  FTI tried to start a healthcare practice recently but they're not known for it

Guys like Oliver Wyman are the go to people for financial services for instance.  Others are better at supply chain (like A.T. Kearney).  Booz Allen for defense. etc.  FTI is known for antitrust and restructurings.

With lower regulation, fewer bankruptcies, and a Republican controlled administration and legislature, there are headwinds for FCN’s business

-----

Catalysts to the downside

- fewer bankruptcies and legal work

- employees argue for a bigger piece of the pie (like the economic consultants did in 2014,  when segment EBITDA margins went from 20% to 13%)

- continued hiring that depresses margins

- Also, with the presidential transition, that could cause a hiccup (in Q4 and Q2) in government instigated investigation and litigation abate as people wait for the new administration, and top government positions turnover

- Trump administration wants to get rid of regulation and red tape

 ------

Valuation

On consensus 2017 #s, trades at 9.2x 2017 EV/EBITDA and 17.4x P/E, closer to the high end of the its historical range

 I think EPS expectations can fall to $1.60 again, and it’ll trade back to 15x P/E, 8.4x EV/EBITDA getting to $24 target price

 A lot of consulting firms trade from 8-11x EV/EBITDA,  and mid-teens to low 20x P/E multiples

 I think FCN trades rich for a company that doesn’t grow (but that's battle I won't fight).  Historically it’s traded between 22x P/E to 12.5x P/E

-----

Business Segments

 FTI has 5 rather disparate and somewhat disparate segments

- Corporate Finance & Restructuring

35% of EBITDA

Majority of this segment is restructuring

They’ve been involved in bankruptcies like Lehman, GM, Enron, WorldCom, CIT, Arch Coal, Caesars, RadioShack, etc.

This segment has done well in the last 2 years with increased bankruptcies

 They also do some corporate finance related stuff and PE advisory that is more pro-cyclical

 I think this segment will decline back to much lower levels now that many commodity bankruptcies are over

- Economic Consulting

25% of EBITDA

They have former top officials at the FCC, FTC, and DoJ.  They also have 2 Nobel laureates and a lot of economic PHDs

They’re known for their antitrust & competition economics

Customers included AT&T/DTV, Office Depot/Staples, Dell/EMC, Sysco/US Foods, Aetna/Humana,  Expedia/Orbitz 

 This segment benefits from M&A, so had a good 2016.  I think it’ll decline from 2016 levels, also since regulatory reviews and red tape will likely be lower with the Trump administration.  Although I do think that M&A could rise partly as more companies try to merge and cash gets repatriated if we get a tax holiday.  However,  FCN is more countercyclical than cyclical anyway

 Notably, In 2014, the economic consulting segment employees demanded a bigger piece of the pie.  They recut a contract with FTI consulting which tanked FTI’s EBITDA margins.  Clearly, the power is with the employees to a large extent,  not with FTI here (the same can be said for Corporate Finance and Restructuring as well).  Segment EBITDA margins went from 20% to 13%

- Forensic and Litigation Consulting

20% of EBITDA

Investigated Bernie Madoff, Bush vs. Gore, and the MLB steroid investigation, PokerStars, and various MBS/mortgage litigation.  They provided graphics and consultation on the OJ Simpson trial

 This segment is OK at what they do, but it’s a random and lumpy biz

 It’s been down in the last 2 years due to light legal work in general.  I think that will continue

- Strategic Communications

10% of EBITDA

Basically PR work around mergers and bankruptcies or other crisis issues

Clients included Perrigo, Transocean, Allstate, Anadarko, etc.

 This segment doesn’t really grow.  They’re not particularly good or notable here.  I think it’s just an aspect of their restructuring biz

- Technology

10% of EBITDA

This is their e-discovery segment.  This is a highly competitive area with a lot of competition.  Pricing is tough because they charge based on cost of storage (which is of course declining exponentially as data storage keeps getting cheaper).  Plus they haven’t reinvested in the technology much

This has been a very bad segment and has been doing poorly as large project roll off.   I think it’ll continue to struggle as they lose share and pricing is tough. 

 They tried to sell it in 2016.  Decided to keep it and they’re now trying to have 3^rd party distributors re-sell the product for them.  They used to keep it internal as a consulting service. 

-----

History

 FTI started in 1982 as Forensic Technologies International, which provided expert witnesses for litigations and providing visuals for complex technical concepts for juries.

 They went public in 1998.

 They took advantage of the recession and changes from Sarbanes Oxley, which forced accounting firms to divest their consulting practices. 

 FCN bought PWC’s restructuring segment for $250mm in 2002, and then bought KPMG’s dispute advisory services in 2003, and also bought Compass Lexecon (a top economic consulting firm)

 Then they bought Ringtail Solutions in 2005 (at the time a top e-discovery and document management product).  Basically, they assist law firms and c corporations when going through discovery, emails, and documents. 

 Then, in 2006, they bought a communications consultancy (which basically for PR / media relations work for companies)

 They further made a bunch of other small acquisitions over time, which didn’t really move the needle

 Basically, their early acquisitions worked very well because they were buying premier consultancies that were going through forced sales during the recession.  

 Since then, the acquisitions did not create value (although they didn’t dilute the value either).  They’d buy the firms, which would grow revs,  but EPS was basically flat.  As is usually the case with ‘people’ businesses,  when you buy a firm, the previous partners work to get their earn-outs and vest,  then they leave with their rolodex after a few years

 ------

EPS History

2007 $1.95

2008 $2.34

2009 $2.70 < does well in downturns

2010 $2.22

2011 $2.49

2012 $2.17  < continued declines in work as the recession waned and cases were worked through

2013 $2.09

2014 $1.64 < economic consulting margins recut lower

2015 $1.84

2016 $2.35

2017 $1.60 < I’m modeling a notable decline in restructuring work back to more normal levels, less economic consulting work as well, continued declines in technology and litigation consulting, and flattish strategic communications.  I expect margins to fall also as they keep hiring and utilization falls.

 Of course, maybe it’s not this bad, maybe it’s more like $1.80-$2.00 in EPS,  but still that’s 25% downside, using $1.90 EPS and a 16x P/E multiple.

 ------

Management

 They brought in Steve Gunby (current CEO) from Boston Consulting Group.  Steve worked at BCG for 30 years and was Chairman of the Americas.  He came in and his goal was to stop doing M&A (which was the company’s history and DNA, but had stopped work) and grow organically instead.  He’s been hiring many new employees (at about a 5% growth rate), but it hasn’t helped the bottom line or translated into growth.   He gave very lofty aspirational goals, which hasn’t really come to fruition.

 I think he’s recently begun to realize that his strategy hasn’t worked.  He has started talking about doing M&A again (which hasn’t worked for FTI in the last 14 years).  Although he realizes that you have to be picky

 The company has only been saved in 2015 & more noticeably in 2016 by a spike in bankruptcies and a heightened increase in complex M&A

 The old CEO and management team’s mantra was to buy growth.  The previous CEO had served from 1995 till 2014.  He certainly did a good job buying firms post-recession from the 2001-2006, but since then, the magic wore off.  The prior management team was also a bit wasteful (jets, 2 headquarters, etc.).    FCN also had hairy accounting from all the acquisitions, which was picked up as a red flag at many forensic accounting research providers.

 New and old management are on the promotional side (they are consultants after all).  They also enjoy saying ‘right to win’ way too much

 ------

Why they can’t grow

 I think FTI can’t grow because they’re already very good in the areas that they’re good at, and they already serve many of the largest companies out there. 

 Their restructuring biz is one of the top ones (up there with Houlihan Lokey and AlixPartners. It’s tough to grow from there

 Their economic consulting side is also widely regarded as being very good.

 They already service 10 of the 10 top banks, 92 of the top 100 law firms, and 48 of the top 100 global corporations.  They already have 81 offices around the world

 Their other 3 segments (Technology, Strategic Communications, and Forensic Litigation and Accounting) aren’t anything special, so I think it’s just hard to grow it

 In this consulting business, you have to keep hiring rainmakers to grow.  But it’s hard to find the next rainmaker in such niches.  Unlike in banking, there are many obvious rainmakers to poach

 -----

Trading History

FCN has been rangebound for the last 7 years, between $ 25-30 at the lows, and $40-$45 at the highs

 The stock has round tripped 4 times

 As mentioned above, basically periodically, they luckily put together a few good quarters, and then the sell side and buy side starts assuming that they can do around $2.23-$2.50 in EPS,  put an 18x multiple on it and you get a $40-$45 stock

 Then, periodically, they miss or chunk a few quarters as projects dry up.  It looks like they can only do ~$1.50-$2.00 in EPS and put a 16x P/E on it, and it trades at $24-$30

 Rinse, repeat

 ------

Holders

So why do people own FTI?  It’s mostly owned by mutual funds who use this as a counter cyclical component of their portfolio.  As far as I know, no one is in it for the management team or the quality of the company.   It’s just a counter cyclical hedge to some extent

 ------

Capital Structure

 Market cap $1.7bn

$470mm debt, $225mm cash

 42.4mm shares outstanding

3.8% % of float shorted

Share count is generally flattish as the buyback stock to offset stock based comp

 -----

Earnings

They’re scheduled to report on 2/28/2017 Tuesday before market open.  I think they could give disappointing 2017 guidance

More often than not, FCN disappoints on their earnings

The stock moves on average 7% on earnings.

The stock has gone up only 11 times out of the last 35 earnings reports.  It is relatively frequently down 5-20% on earnings

Catalyst

Catalysts to the downside

- fewer bankruptcies and legal work

- less complex M&A that requires their services 

- employees argue for a bigger piece of the pie (like the economic consultants did in 2014,  when segment EBITDA margins went from 20% to 13%)

- continued hiring that depresses margins

- Also, with the presidential transition, that could cause a hiccup (in Q4 and Q2) in government instigated investigation and litigation abate as people wait for the new administration, and top government positions turnover

- Trump administration wants to get rid of regulation and red tap