JPM - PJT Partners: A High Quality Company In A Challenging Industry

2023-10-20 13:12:11 ET

Summary

• It is difficult for companies that operate in highly competitive industries to generate attractive long-term returns for shareholders.
• PJT Partners operates in the highly competitive investment banking business but has been able to outperform market indexes since coming public in 2015.
• PJT has delivered strong results growing earnings at a 16.7% CAGR since 2016.
• I am initiating coverage of PJT with a hold rating as I do not find the current valuation compelling relative to the S&P 500 and other financials.

It is often challenging for companies that operate in highly competitive industries to generate attractive long-term returns for shareholders. However, there are exceptions to this rule for particularly well run companies. Perhaps the best example of this is Southwest Airlines (LUV) which operates in the highly competitive airline industry. While LUV's recent performance has not been great, it is the only major U.S. airline that has not gone through bankruptcy. LUV has generated strong returns for early investors. Another example is Nucor (NUE), a company which operates in the ultra-competitive steel industry yet has been able to reward long-term holders with very compelling returns.

While less competitive than the airline business or steel business, the investment banking advisory industry is highly competitive. Despite operating in this highly competitive industry, PJT Partners ( PJT ) has generated a ~184% total return since going public in late 2015 compared to a ~156% return for the S&P 500 and ~112% return for the Financial Select Sector SPDR Fund ETF ( XLF ) during the same period. The competitive dynamics of the industry may make it hard for PJT to continue outperforming the S&P 500 going forward.

Company Overview

PJT is a premier global independent advisory-focused investment bank. The company was formed in 2015 when Blackstone ( BX ) merged its advisory firm with PJT Capital, the strategic advisory firm founded by Paul J. Taubman. PJT has 11 offices globally and does business in more than 60 countries. The company is 40% owned by its employees. PJT's business includes three segments: Strategic Advisory, Restructuring & Special Situations, and PJT Park Hill. ~87% of PJT's revenue comes from advisory services while ~13% comes from fund placement services. Despite its relatively small size with just over 920 employees, PJT has advised on a number of mega transactions including T-Mobile's $59 billion merger with Sprint.

Highly Competitive Industry Resulting in a Thin Moat

The investment banking advisory business is highly competitive. Some of PJT's direct competitors include Moelis ( MC ), Lazard ( LAZ ), Houlihan Lokey ( HLI ), Evercore ( EVR ), Perella Weinberg ( PWP ), Centerview Partners, and Lincoln International. PJT also competes with large investment banks such as Goldman Sachs ( GS ), Morgan Stanley ( MS ), JPMorgan Chase & Co. ( JPM ), Bank of America ( BAC ), Barclays ( BCS ), UBS Group ( UBS ), and many other global banks.

In addition to being highly competitive, the industry has very low barriers to entry. Each year a number of top investment bankers leave their firm to start an independent advisory firm. In fact, PJT traces its roots to just this phenomenon as Paul J. Taubman left Morgan Stanley in 2012 to launch PJT Capital.

Investment banks also face that the challenge of retaining customers as customer switching costs are very low. A company can hire PJT for one transaction and then decide to use another investment bank for its next transaction without any friction.

Another challenge for companies operating in the investment banking advisory business is the competitive market for talent. The main cost for providing investment banking services is the cost of labor. PJT spent ~65% of revenue on compensation and benefits in FY 2022. Other independent advisory firms tend to spend a similar amount on employee costs while larger full-service investment banks tend to spend slightly less. The highly competitive nature of the industry means that investment banks are in constant competition with each other to retain top talent.

The combination of a highly competitive industry, lack of barriers to entry, low switching costs, and high costs for talent has led independent advisory firms to operate at very low profit margins. As shown by the chart below PJT and its independent advisory firm peers tend to have net profit margins in the high single digits to low double digits. Comparably, more diversified investment banks such as Goldman Sachs ((GS)) and Morgan Stanley ((MS)) which are engaged in lending, sales and trading, asset management, and wealth management have much higher profit margins.

Strong Historical Performance and Strong Balance Sheet

PJT has posted strong financial performance since going public. PJT has grown EPS at a 16.7% CAGR and revenue at a 12.7% CAGR (2016- 2022). Strong financial performance has allowed PJT to return a significant amount of capital to shareholders through repurchases and the initiation of a dividend.

PJT has a strong balance sheet with no long-term debt and $151mm of cash. The strength of PJT's balance sheet is important given the highly volatile nature of the business and its high degree of economic cyclicality.

Relative Valuation Analysis

As shown by the table below, PJT receives a D- valuation grade from Seeking Alpha quant ratings. I am inclined to agree.

PJT trades at 16.6x forward earnings compared to 17.7x for the S&P 500. On a PEG basis, using the 12% growth rate, the S&P 500 trades at a PEG of 1.48x. Given the highly volatile nature of PJT earnings from year-to-year, I believe it makes sense to look at the earnings growth rate based on the compound growth rate from 2022 to 2025. PJT reported an EPS of $3.92 for 2022 and the current consensus estimate for 2025 is $4.97. The CAGR is ~8% which results in a forward PEG ratio of ~2.07x, a significant premium compared to the 1.48x ratio of the S&P 500.

PJT is trading broadly in line with its advisory-only peers such as EVR, MC, and HLI. However, PJT is trading at a premium to more diversified investment banks GS and MS. While PJT may be able to grow more quickly over the next couple of years, I believe GS and MS are higher quality businesses with a more defensible moat compared to PJT.

Historical Valuation Analysis

PJT is trading close to its historical valuation averages on both a forward PE basis and an EV to revenue basis. This suggests to me that PJT is neither significantly over or undervalued at the moment.

Q3 2023 Earnings Preview

PJT is set to report Q3 2023 earnings on October 24, 2023. Consensus analyst estimates call for PJT to report quarterly EPS of $0.43 per share which represents a year-over-year decline of 55.2%. Revenues are expected to come in at $218mm, an 18.1% decline from the same period a year ago. Given the uncertain economic environment, I believe market participants will be especially interested to hear from PJT regarding the outlook for 2024 and how the deal pipeline is shaping up. Given current valuations, I believe the upside and downside heading into the report is largely symmetrical.

Conclusion

PJT has delivered impressive results for shareholders and has significantly outperformed the S&P 500 and the financial sector more broadly since its IPO in 2015. The company has been able to grow earnings at an impressive 16.7%. This performance is especially impressive given the highly competitive nature of the financial advisory business. I believe the combination of high levels of competition, low barriers to entry, high costs of talent, and low switching costs for customers make it very challenging to build a wide-moat business in this industry. Currently, PJT trades at average levels relative to its historic valuation range and a premium valuation relative to more established diversified peers such as MS and GS. For these reasons, I rate PJT a hold at current levels and will continue to evaluate the investment opportunity in the future.

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