2023-09-27 22:50:39 ET
Summary
- The company's growth has normalized after a remarkable period, but it's still fundamentally strong, with solid profitability and a dominant position in M&A, Restructuring, and Fairness Opinion services globally.
- The stock's valuation has risen considerably over the past year, reflecting a broader trend in the Investment Banking and Brokerage industry. Despite this, it may still offer value in the long term.
- HLI remains ahead of its peers, with a lower correlation to the market and better returns, making it an attractive diversification option for portfolios.
- One significant factor supporting its prospects is its involvement in bankruptcy and restructuring services, which could thrive in an economic downturn, potentially benefiting from the current economic challenges.
- However, downside risks include concerns about revenue growth in segments other than restructuring. Overall, while the investment appeal has decreased from the previous year, HLI still offers potential and it remains a Buy.
I had recommended Houlihan Lokey ( HLI ) to readers with a Strong Buy close to a year ago. During that time the stock has returned 39% against the S&P500's 19% handily beating the index. My thesis during that time was simple -
1. The company's topline numbers were like a growth stock, but its fundamentals made it the best of breed among growth stocks
2. The nature of the business meant that it still makes money in an economic downturn
3. Its valuation was low considering how well its top and bottom lines had grown
4. Its performance made it the best among its peers.
One year since, I find it is a good time to review our investment and see how much of the thesis still holds true. Some factors have remained true, while other factors have normalized or deteriorated. This has brought down the appeal of the stock as an investment so my rating has been downgraded from a Strong Buy to Buy.
Growth that has normalized
After exhibiting stellar growth during 2021 and 2022, recent quarters have been a disappointment. To a degree reverting to long-term growth rates was expected as the company had an outstanding quarter for December 2021 (Fiscal 2022 experienced record results during extremely bullish market conditions)
But profitability is still intact and ROE is at 16% and ROA is at 9%. Revenue growth has a five-year CAGR of 13%
Revenue share per segment over the years (Investor Presentation)
The company still maintains its dominant position globally as a top M&A, Restructuring, and Fairness Opinion firm. In Calendar Year 2022, the company closed 381 M&A deals and 58 distressed debt and bankruptcy restructuring deals. It also maintains its leading market position as an advisor in Business Services, Consumer Food and Retail, and Industrials. The firm's corporate finance group closes more deals than any other firm anywhere in the world.
The takeaway from all this is that even though the growth seems down, it is just normalizing after a record year and there is no cause to worry as its position has remained sound.
Valuation that is no longer as attractive
The rise in the price of stock while the earnings have declined has contributed to inflating the earnings multiple. Last year saw a low of 12x, its lowest in history, to 28x presently, its highest in history.
When we compare this against its peers in the Investment Banking and Brokerage industry, we observe that many of them have undergone similar behavior (multiples have inflated over the last year)
Company | P/E |
Stifel Financial ( SF ) | 12x |
Jeffries Financial ( JEF ) | 18.5x |
Evercore ( EVR ) | 16x |
Lazard Ltd ( LAZ ) | - |
Moelis & Company ( MC ) | 84.5x |
Piper Sandler Companies ( PIPR ) | 29.5x |
For the immediate quarters, I do not expect the forward PE ratio to see any improvement. But if we believe the long-term growth in the bottom line holds at 10% (Approx. average rate of growth over the last 5 years), the following years could see the PE deflating.
2025 | 2026 | 2027 |
25.3x | 23.3x | 21.1x |
As I will explain towards the end, even in this environment valuation could be justified for this company based on the nature of their business and I believe the market recognizes that to a certain degree as well which has inflated their earnings multiple over the last year.
Ahead of the pack
One of the other points that has held true even after one year of my analysis is its lower correlation to the index while at the same time offering better returns not only against the index but also against its competitors. With a beta of 0.8, its returns have beaten the index by almost 2.5x (60%) and it has a similar drawdown as the index (33.7%). These quantitative metrics have made the stock very attractive if an investor wants to bring this angle of diversification to a portfolio.
Company | Beta (5Y) | 5Y Returns | Max Drawdown |
Stifel Financial ( SF ) | 1.2 | 86% | 52% |
Jeffries Financial ( JEF ) | 1.4 | 103% | 51% |
Evercore ( EVR ) | 1.5 | 52% | 67% |
Lazard Ltd ( LAZ ) | 1.4 | -17% | 59.5% |
Moelis & Company ( MC ) | 1.5 | 18% | 58% |
Piper Sandler Companies ( PIPR ) | 1.4 | 127% | 62% |
Houlihan Lokey ( HLI ) | 0.79 | 159% | 36% |
I understand that past performance is no indicator of future behavior but the setup has remained unchanged in the last year. As we saw the company has not given up its dominance in multiple facets of the industry and going forward it may even gain from the economy's pain which leads me to believe that it may continue to outperform the market.
Gaining From Economy's Pain
A significant portion of Houlihan's revenue comes from the Bankruptcy and restructuring segment and it is becoming more and more evident that we may be heading to an economic downturn which eventually leads to restructurings. Multiple market participants are calling for a soft landing or a no landing but this looks highly unlikely given the conditions we are in (Yield curve inversions are a time-honored recession signal).
Unfortunately, there is no way to check how this stock performed during the last recession as the company was not public during that time. But from the company's financials, we do see that it played an active role in the bankruptcies of prominent firms (e.g. Lehman Brothers)
Investor Presentation
There are also early indicators of a rise in bankruptcy filings in recent times. In the twelve months ending on June 30, 2023, both personal and business bankruptcy filings experienced a notable uptick, marking a 10 percent increase compared to the preceding year. These statistics, sourced from the Administrative Office of the U.S. Courts, reveal a total of 418k bankruptcy filings during the year concluding in June 2023, as opposed to the 380k cases observed in the previous year. Specifically, business-related bankruptcy filings surged by 23.3 percent, climbing from 12.7k to 15.7k cases within the same timeframe. Non-business bankruptcy filings also saw an uptick of 9.5%, reaching a total of 403k compared to the 367k filings recorded in the prior year. It's worth noting that bankruptcy figures over the past 12 months have seen only sporadic increases since their peak in 2010, despite initial disruptions related to the COVID-19 pandemic in early 2020 causing a temporary dip in bankruptcy filings.
I believe what we are seeing now is the result of a domino effect that started in 2020. The U.S. economy has been grappling with the aftermath of the COVID-19 pandemic, characterized by supply chain disruptions that triggered the most substantial inflationary pressures seen in the past four decades. Additionally, loose monetary policies and record deficits in government spending have led the U.S. down an unknown path.
To address sky-high inflation, the Federal Reserve raised interest rates on 11 occasions between 2022 and 2023, propelling borrowing expenses to their highest point in a decade. Consequently, refinancing became a challenging endeavor, precipitating a surge in the number of bankruptcy filings.
If this situation continues to get worse, Houlihan Lokey would be in a prime position to benefit from this as it is a leader in this segment. In short, gaining from the Economy's pain.
What are the downside risks to this thesis?
I have downgraded my rating from Strong Buy to Buy primarily because there are factors that do not look as good as it was a year ago. We have already discussed valuation and how the multiple has inflated. We have also seen how revenues have normalized and it is no longer the high-growth stock we saw last year. My bigger concern is that the revenues from its restructuring segment may not make up for the fall in revenues from other segments. This may cause a further dip in earnings and our long-term growth rate may be affected further in a 5Y period. This could make the company less prospective as an investment.
As of this point, I think the attractiveness of this investment still holds (although not as much as last year) and I continue to be an investor in this company.
For further details see:
Houlihan Lokey: It Can Gain From Economy's Pain