FTI Consulting (FCN or “the Company”) is “one of the largest U.S. providers of turnaround, restructuring and bankruptcy related consulting services. FCN is a roll-up of a number of consulting practices that initially focused on litigation consulting and applied sciences. In early 2000, FCN entered the restructuring world when it acquired Policano & Manzo, a financial consulting firm specializing in restructurings, workouts and forensic accounting. FCN bought it right (about 5x EBITDA) and their timing was extraordinary. In October 2002, FCN doubled its revenues and profits when it acquired the U.S. Business Recovery Services division of PricewaterhouseCoopers. As a result of these two acquisitions and internal growth, FCN has increased its profits from financial consulting from $5 million in 1999 to over $90 million (pro forma) in 2002.
Investment Idea: Short FCN.
Investment Rationale: Profit from the turn in the credit cycle, which is (albeit, slowly) occurring. If I’m wrong, downside is limited in that FCN’s valuation is so stretched that the Company is likely to do no more than grow into its rich stock valuation.
There are no public comparables of consulting firms that focus on bankruptcy/restructurings. The closest comparables are Accenture (the former Andersen Consulting) and BearingPoint (the former KPMG Consulting).
FCN (a) ACN BE (b)
Enterprise Value $1,265 $12,709 $1,391
LTM Revenues $333 $13,119 $3,464
LTM EBITDA $93 $1,775 $237
Employees 766 75,000 16,000
EV / Revenues 3.8x 1.0x 0.4x
EV / EBITDA 13.6x 7.2x 5.9x
P / E (2003 est.) 19.5x 13.9x 13.6x
Revenues / Employee $435k $175k $217k
EBITDA / Employee $121k $24k $15k
EV / Employees $1,649k $169k $72k
(a) Pro forma for the acquisition of Business Recovery Services.
(b) Last 6 months annualized, because of a significant acquisition.
FCN is richly valued by any traditional measure: multiples of revenues, EBITDA or earnings. On a per employee valuation, it is simply off the charts. ACN and BE are valued at $169,000 and $72,000 per employee, respectively. FCN is valued at $1.65 MILLION per employee. That is ten to twenty times the valuation of ACN or BE. Remember, the typical FCN professional is an accountant that bills around $350/hour and can leave and work for a competitor at any time. Admittedly, FCN employees are currently generating significantly higher revenues and earnings than ACN and BE employees. Even so, the employees are not that different by education or training. Each of the firms hires a lot of accountants, MBA’s and lawyers. Financial restructuring is hot now. It will not always be.
Corporate Credit Cycle
FCN’s results have been turbocharged by the stressing of corporate credits. From a historical perspective, the current downturn in the corporate credit cycle has been quite severe. Moody’s recently published an analysis of corporate defaults for the period from 1920 to 2002 (available on its website). Corporate defaults in 2001 and 2002 (measured by percentage of issuers defaulting) were higher than any years since the Depression. The only comparable years were 1970 and 1991. To put things in perspective, there were 186 and 130 global corporate defaults in 2001 and 2002, respectively, compared to an average of approximately 20 per annum from 1993 to 1997. There are clear signals, however, that the credit cycle has begun to turn. The ratio of upgrade/downgrades has improved from .3 in the first quarter of 2002 to .65 in the first quarter of 2003. Moody’s predicts that the default rate will improve from 8.3% in 2002 to 6.9% in 2003, a reduction of 17%. The rally over the last 6 months in the high yield market confirms these improving credit statistics. To be sure, the 2003 default rate is still quite high by historical standards, but the trend is unmistakable. Restructurings have peaked and are on their way down. In its 2002 10-K (filed at the end of March), FCN brags that it has been retained in the bankruptcies of Enron, Worldcom, USAir and Adelphia. Revealingly, the most recent bankruptcy filing among these companies is Worldcom, which filed nine months ago.
By its actions, FCN’s management has acknowledged this reality. Following several years of rapid hiring (in 2002, FCN net hires increased the number of financial consulting professionals by a third), FCN reported on its February conference call that the Company did not expect any net hirings in 2003. Management insisted that it will still achieve its 2003 organic growth targets of 15% revenue growth and 20% earnings growth . Such growth, however, will not come from additional hours worked. Instead, half the revenue growth will come from price increases and the other half from mix changes (i.e. less experienced employees will be replaced by more experienced new hires, which will be billed at higher rates). That might work for a while (although I doubt it), but it is difficult to understand how that can work for very long.
Managing a downturn is tricky in the financial restructuring advisory business. To understand why, consider the staffing pattern in such a business. Professionals are typically assigned to several multi-month projects. Currently, FCN’s professionals are working at more than 100% capacity (at least they were the last time FCN reported this number). As business slows down, it is difficult to quickly reduce the slack. If a professional is working on three assignments and one of them ends, but is not replaced, does it make sense to fire him? Obviously not. What if two of the assignments end and are not replaced? Even then, it is not obvious. A professional working at 33% of capacity is not profitable, but what does it say to the client on his remaining assignment if you fire him? Is the client even going to permit you to replace an integral member of the project team just because his other assignments have lapsed and he is underutilized? Unlikely. The negative operating leverage can be muted somewhat by reducing bonuses, but the problem remains. Thus, when the inevitable slowdown occurs, margins will compress in a hurry.
Management appears to endorse my analysis by its actions. The Company recently completed the sale of 2.45 million shares of stock at $40/share. The use of proceeds was to repay all the debt of the Company. With $90 million of EBITDA and limited cap ex requirements, $100 million of debt is not exactly an onerous burden. Why else sell stock other than the price is right? Management’s personal investment decisions even more clearly endorse my analysis. Jack Dunn and Stewart Kahn, the Chairman/CEO and President/COO of FCN, have received, via option grants and the sale of their businesses, 1.05 million and 1.43 million shares, respectively, since their affiliations with FCN. Since the beginning of 2001, Dunn has sold more than 60% and Kahn has sold more than 75% of their holdings in FCN. (Note that these percentages include options that are not currently exercisable. If we count only options that are currently exercisable, Dunn has sold 65% of his holdings and Kahn has sold 88% of his holdings). To put the selling in perspective, the proceeds from the stock sales by just these two officers equals more than half of the Net Income (before extraordinary items) for 2001 and 2002. Selling by other members of management and board members has also been heavy.
One Final Thought
Policano & Manzo sold their firm to FCN in 2000 for 5x EBITDA. PricewaterhouseCoopers sold Business Recovery Services for less than 5x EBITDA late last year. Why should someone pay almost 14x EBITDA for a company whose private market valuation is less than 5x EBITDA?
FCN is an attractive short because:
(1) A richly valued stock.
(2) Priced for significant growth when management has indicated that such growth is unlikely.
(3) Opportunity to profit from the nascent turn in corporate creditworthiness. Such a turn is evident in the credit statistics and is being signaled by the rally in the high yield market.
(4) Significant insider selling.
This is a “value” short. Like all value shorts, it can be painful to be early.
Even a modest strengthening in corporate credits should cause an earnings miss either next quarter or the quarter thereafter.