2023-07-05 10:32:15 ET
Summary
- Houlihan Lokey is showing early signs of recovery with high client engagement and new business activity across all sectors, particularly in Europe.
- The firm's restructuring business is performing well, and I expect it to continue growing during the ongoing economic downturn, benefiting from high rates and tight debt markets.
- Despite these positive signs, the current valuation is not appealing, and it is recommended to wait for at least two quarters before making any investment decisions.
Summary
Houlihan Lokey (HLI) is a boutique investment bank in the United States that specializes in serving middle-market clients in the areas of corporate finance advisory, restructuring, and financial valuation. Previously , I recommended a hold rating as the consensus was expecting HLI to reach FY22 earnings in FY25, which seemed unlikely given the earnings trajectory. My recommendation appears to be right since the stock price is still in the same range today. However, I believe the time to invest in HLI is getting near as the business has shown early signs of recovery. Looking across segments, Corporate Finance reports high levels of client engagement and new business activity across all sectors, with buyers and sellers coming into greater agreement on business transactions. Similarly, restructuring is performing well, with management anticipating a new revenue this cycle. Most significantly, management stated that the market for M&A and the hiring environment have both improved. All of these are preliminary indications of recovery, and so I anticipate that the time to invest will soon come, but not just yet. I continue my recommendation to stay neutral, exercise caution, and wait for at least two quarters before making any kind of investment decision.
Corporate finance
Despite the fact that revenues have not bounced back, the rate of decline has slowed considerably from -59% in 3Q23 to -8% in 4Q23, suggesting that we may be returning to normal. In particular, management remarked that new business activity is robust and that they anticipate growth in Europe. And because Private Equity players have to deploy capital within a certain timeframe, I expect the slowdown in Private Equity deals that began at the beginning of 2023 to become a strong tailwind for HLI. Although I can't say when it will happen with any certainty, I believe that the longer it is postponed, the stronger the tailwind will be. Management believes that private equity firms are on the cusp of a period of rapid transaction acceleration as a result of the increasing urgency with which they must deploy available equity capital. Nonetheless, I'd like to remind you that HLI's exposure to macro uncertainty, difficult financing markets, and prolonged deal timelines remains high.
Restructuring
As I mentioned before, restructuring, which is a natural defense against economic downturns, has been a growth driver despite the state of the market. As the debt market remains tight due to high rates, I anticipate that restructuring revenue will continue to grow sequentially and throughout this downcycle. HLI restructuring business should benefit from this as companies seek out tried-and-true methods of dealing with imminent debt maturities (i.e., in CY24 and CY25) such as traditional restructuring and liability management. Given the persistence of high inflation and a healthy labor market, I do not foresee rates coming down anytime soon, so I anticipate this cycle to extend over multiple periods.
Capital allocation
HLI increased their quarterly dividend by 2c to 55c. While some investors might be disappointed in this increase (consensus expected 57c), I think a big increase is not needed as HLI should make preserving cash a priority so they can deploy in the coming quarters. Nobody knows when the cycle will turn, as such, I rather management hold on to cash, so they are always ready, rather than returning capital to shareholders. With that, I also expect management to reduce amount of share buybacks as the ROI of buying its own shares is not really attractive at 4x book value (1x above its average).
Valuation
My price target remains the same ( ~$137 ) as HLI valuation is not particularly appealing at the current levels, and the market appears to be pricing in a recovery by FY25, based on consensus estimates. As I previously stated, while the signs are becoming clearer, nothing is set in stone. Many things could happen over the next two quarters to derail this positive trend. The consensus positive view on the timing of the recovery has also driven the 1-year forward PE up to 19x, which is 1 standard deviation higher than the historical average. If the recovery does not occur as expected, I believe the stock will experience multiple reversion to reflect consensus expectations on recovery timing. However, if growth remains strong across segments for a couple of quarters, I would take that as a sign to evaluate if this could be a buy.
Risks
The war for talent is the biggest threat, in my opinion. HLI's business model is, in my opinion, a return on investment in human capital. HLI's personnel are its most valuable resource, so a mass exodus of workers for any cause would have a devastating effect on the company.
Conclusion
While there are early signs of recovery for HLI, it is prudent to remain neutral and exercise caution before making any investment decisions. The corporate finance segment is showing improved client engagement and new business activity, with the potential for growth in Europe. The slowdown in private equity deals could become a tailwind for HLI, but the timing of this acceleration remains uncertain. The restructuring business is performing well and is expected to continue growing during the ongoing economic downturn. HLI's focus on preserving cash rather than returning capital to shareholders indicates a readiness for future opportunities. However, the current valuation is not particularly appealing, and market expectations for recovery by FY25 may lead to multiple reversion if the anticipated recovery does not materialize. I recommend waiting for at least two quarters to observe further developments.
For further details see:
Houlihan Lokey: Signs Of Recovery, But Still Neutral