Huron Consulting: Getting Too Close to Its Roots

For people scanning the large stock movement last Monday (Aug 3), they must have noticed Huron Consulting (HURN) dropped 70% that day. And the news announced was bad. Huron has to restate their earnings since 2006, lower their 2009 guidance, and the whole top management team resigned, including Chairman and CEO, CFO and CAO. The key thing causing this is the very disturbing accounting treatment of so-called “redistributed earnings” to a few key employees who have been involving in M&A acquisitions, along with a few other accounting irregularities such as allocation of chargeable hours.

Huron was formed by 25 partners from Arthur Andersen, led by a senior partner who had become Huron’s Chairman and CEO until his resignation last week. We all know Arthur Andersen was indicted related to the Enron scandal, which was one of their largest customers and had paid Arthur Andersen well to cook their books. A few months after it was formed with capital provided by another Chicago firm, Huron quickly landed its first project and client, United Airlines (UAUA). No wonder they say management consulting is basically a relationship business, not a problem solving business. Since then it had been a home run - until last week.

For the last 7 years, Huron has been growing in high double digits and their stock was over $80 at one point, which gave them a market cap of over one and half billion. Even there was a big stumble in March 2008 when they missed everything they promised previously, and consequently the stock dropped to $40 from $60 in a short time; they blamed on the recession and collapse of the financial industry. And investors believed them and still thought Huron was a growth story with over 25% growth every year, never suspecting there was something really wrong fundamentally with the firm.

Huron's business has been focusing on financial and legal consulting services in the financial and healthcare industries - both very lucrative and enjoying a high margin of profit due to the highly regulatory environment in both sectors. In other words, Huron help their clients to deal with regulations and accounting pitfalls. Unlike other consulting firms, Huron had been very aggressive making acquisitions and conducting M&A activities, which eventually brings them to today’s accounting “kickback” scandal.

Huron denies the word “kickback” in their statement, but the speculation is that in order to grow the firm, the top management has encouraged a few senior partners in their firm to make acquisitions. By compensating those few key employees boldly taking the risk and buying other companies, Huron would provide them with prearranged so-called (if we don’t use the word “kickback”) “earn-out” payments from the selling shareholders of those companies being acquired. This is trickier than the bonuses issue of Wall St. banks, since for the banks, it is basically an issue whether taxpayers should pay any bonuses to these banks, but at least it doesn’t involve any accounting manipulation. Because Huron has to restate earnings since 2006, this kind of “kickback” pattern is likely very consistent during last 3-4 years, which had been a heavy and busy acquisition period for Huron.

Unlike other consulting firms, Huron also ramped up huge amounts of debt in the last few years due to aggressive acquisitions. The latest Q1 balance sheet shows it has bank loans of $322 million, 1:1 ratio to its equity as well as market cap, the scale of which you wouldn’t see at any typical consulting firm. Another very negative thing about Huron is it has huge amount of 'goodwill' at $506 million, again from their Q1 statement. Consulting firms usually should have minimum assets, since their main asset is people, their employees. Even Goodwill shows up at balance sheet as an “asset”, but it is an accounting illusion. In reality, Goodwill is just past expenses from buying other firms, and will be expensed or amortized in future years. It is actually a large burden for shareholders, let alone “asset”. If you look this way, Huron actually has huge negative assets.

The consulting business model is worse than that of law firms. Even though both are sending in large teams of people, billing ridiculous hourly rates to their clients (probably around $500/hr on average), at least the services provided by law firms are somewhat measurable, such as winning or losing or settling for a litigation matter. The management consultants come into a firm that usually hires them to solve a small problem such as organizational restructuring, but in the process of “finding” solutions by sending a team of 10-20 people and producing tons of confusing and conflicting reports no one reads. At the end, not only the original problem is never solved, but also they “discover” many other “new and large” problems. This way, they can continue to bill their clients, more importantly, they can send more teams to “tackle” other “problems” to grow their business. This is the typical practice and business model for management consulting firms. Once you hire them, you can never get rid of them, and your bills keep growing.

The only measurable benchmark becomes how much paper they have wasted to produce those reports which are still on the senior manager’s bookshelf. The correct approach for investors to look into a firm should be: the more consulting fees they pay, the bigger problem and trouble the firm is in. A few years ago, an executive of a major US company noticed consulting fees becoming a ridiculously large expense item on their income statement, and famously said, “fire all the consultants”. Only very few CEOs in the US understand that firing consultants not only saves their bottom line but, more importantly, improves the firm’s image and the investor’s perception oftheir firm.

Reputation and people usually are the only assets a consulting firm has, especially in the case of Huron. Huron’s main business is to help their clients to deal with regulations and avoid accounting pitfalls. How ironic when they can’t even deal with these issues themselves. How are they supposed to teach and help their clients?

When a scandal hits a consulting firm, it is typical for clients to stop their services, and consultants gradually leave the firm, a vicious circle which will eventually bring the firm down. Investors should be concerned about Huron as a going concern, especially their unusually large amount of debt. With likely future revenues shrinking, it is very questionable whether Huron can even afford to service the interests on their $322 million bank loans. From their Q1 statement, Huron doesn't seem to generate much operating cashflow to cover interest payments. I have never seen such high leverage on a consulting firm. A restructuring and negotiation with banks will likely wipe out the equity holders when banks convert their loans into equities, similar to what happened to GM and Citigroup.

The large goodwill is also alarming in that Huron may not be able to make much profit in the future, and this expense item is like a knife hanging over the investor’s head. In addition, what has happened to Huron so far could be just the tip of the iceberg. When a firm faces an accounting scandal, usually it opens up a can of worms leading to many unexpected and unimaginable irregularities. A small distortion discovered could lead to unknown large scale accounting abuses. Do you remember Enron?

It is actually a very sad story that Huron was formed by former partners of Arthur Andersen. You would expect that they, as seasoned professional consultants, had learned their lesson to stay away from accounting troubles. Quite the opposite, they have endorsed a more aggressive strategy and likely will fall as hard as their former employer. Unlike the hedge fund world where Meriwether from LTCM has risen from ashes twice (now down again, probably for good), in the consulting business where reputation is everything, it is very difficult to get your reputation wiped out twice and come back again. Those former Arthur Andersen consultants will likely never be able to get back on their feet again.

Many people speculate why they called themselves Huron 7 years ago when it was established, which sounded too close to Enron for comfort, given the context. Huron denied it had anything to do with it. However, no matter what the real reason was, naming themselves Huron seems to have been a bad omen from the beginning.

Comments

[District Ba...:]

Thanks for restating everything I read about Huron a week ago. Do you have any insights into WorldCom?

Aug 10 03:47 PM

[LYoung:]

Hi All -

I work with a law firm that's filed suit against Huron on behalf of shareholders.

If any investors are reading and want to get involved in the class-action suit you can visit hbsslaw.com/huron.

Aug 10 04:10 PM

[Pj568:]

You have to wonder how low it'll go or how long Huron will exist after it establishes legal reserves and writes down goodwill now that the total market cap is just a little above current assets value.

Aug 12 04:30 PM

[GMM:]

This is a very speculative article, and also somewhat inaccurate. Huron did not kick back money to its employees; the selling shareholders distributed their earn-outs to top performers for hitting earnings targets. There was nothing illegal about this, but the secondary accounting was done incorrectly. Huron has a deep client base and talent that, so far, has stuck around since the restatement news broke. Here's hoping that they can weather the storm and focus on maintaining their core business of healthcare and education consulting.

Aug 13 09:57 AM

[thomast2:]

GMM: Please read the news again. This is directly from Reuters: "Huron's board audit committee discovered that shareholders of four businesses that Huron acquired between 2005 and 2007 redistributed portions of their acquisition-related payments among themselves and to certain Huron employees." Please note "to certain Huron employees". This is kickback to a few key own employees. Unless Huron Audit Committee is also wrong, then I really don't know what to say about Huron.

Also since this is the only comment you have made so far on SA, so I assume you register at SA just to make this comment to my article. In this sense, I am honored. Thanks.

Aug 13 02:44 PM

[elipsemaster:]

This article strikes me as most articles do on seeking alpha, and for the most part the entire web. Now I don't claim to know if Huron is a good or bad investment. In order to know that I would have to plow through the last four or five years of annual reports, attempt to construct a DCF analysis, and, at least in the case of this company, attempt to speak to some of their clients. But Mr. Tan's article is based purely on his opinions and very little on fact, which I guess is okay. Except I fear there will be people acting on this article. If they are long they may sell. If they hold no position they may short it or buy puts. In any event they may put their money at risk because of this superficial article.
In the end, therefore, I feel I must ask the question what is the point? Is it just to see your words in print.
If you want to help the small investor, do some real in -depth analysis. Tell us why a company is underrvalued based on sound analysis and DCF analysis. Don't give us your opinion: it's worthless.

Aug 15 11:15 PM

[thomast2:]

I have pointed out many weak spots from Huron’s latest financial results, such as immediate liquidity risk to cover their interest payment on their huge debt, the goodwill issue, the risk of equity holders being totally wiped out during a debt restructuring, etc. etc. At the same time, how much value it offers if the last 5 years’ financial reports are all fraud, which they are in the process of re-stating and re-issuing all of them? You can go back to read them all if you like, but do you know how much truth they said is really there? Can you tell the difference between the truth and the lies in those reports?

Obviously you think DCF, or more specifically the cash flow projection, is the only way to evaluate a company. Since you are a big fan of DCF, then tell me what do you think the discount rate (or hurdle rate) to use in this DCF model based on Huron’s management quality and their fraud financial reporting for the last 5 years? The weakest spot for Huron is its culture and management, or the so-called soft aspects of a company. Tell me how will you evaluate it based on DCF analysis?!

If you want this kind of analysis, fine, just go to buy UBS analyst report, which reiterate “Buy” rating when if it was traded at $45 and before it plummeted to $14, if that is the kind of DCF analysis and “serious” research report you want. Contrary to your view, I think SA and other websites provide their readers a platform of more diversified opinions about a firm, instead of a few mainstream Wall St. firm’s analysts only knowing how to grab numbers of cashflow and discount rates in the air and make up false assumptions in their DCF models. Those research reports along with their false DCF analysis are indeed worthless.

Aug 16 09:23 AM

[elipsemaster:]

I stand by my criticism. Your article gives us nothing. Had you written this article, minus your bias rant about consulting firms, before the company imploded, then you'd be offering the small investor some value. But instead I just see you as piling on.
Part of doing DCF is examing debt and goodwill. When you find a company that is growing its earning by acquissitions you would probably walk away quickly. Thus you would not need to try to project it's future cash flows.
As a true value invetor you look for a company selling for half it's intrinsic value, or, as Seth Klarman would say, it's margin of safety.
I doubt that any value investor would have ever looked at HURN before. But they'd probably look at it now. Had you approached the company from this point of view, that perhaps this could be a good investment now, a cigar butt, then I believe you'd be offering real insight.
And finally, I can't defend analyst reports. I've never read one.

Aug 19 10:12 AM