When we hear the phrase “normalized earnings” on CNBC and Bloomberg, we nearly always associate it with bank earnings, but the race to normalized earnings also applies to fallen angels. These are companies that have taken a major hit because of a scandal or a perceived new threat or some other factor that causes the stock price to fall dramatically. Sometimes these companies keep falling, right into bankruptcy. Sometimes their new environment causes them to operate at a reduced level of profitability in the future. Other times, though, a fallen angel stock can climb back to its previous levels either because the threat that caused the stock to fall never actually materializes or, over time, the earnings return to a level considered “normal.”
Huron Consulting (HURN) is a business consulting firm that rose out of the ashes of Arthur Anderson and experienced tremendous growth measured by any metric. The number of consultants exploded, the number of clients increased exponentially, and its earnings and stock price rose accordingly. Just one example of this growth was a rise in revenue from $51 million in 2002 to $680 million in 2009.
Unfortunately this demand for continued revenue growth led to the scandal that nearly ruined the company. On August 3, 2009, the stock dropped from $44.35 to $13.69 after announcing it had to restate its earnings for 2006, 2007, 2008 and the first quarter of 2009. The chairman and CEO, who was one of the firm’s founders, was let go, as was the CFO and a few others. It turned out that, allegedly, there were kick-back schemes associated with a number of acquisitions during this time period. If there was any silver lining in the experience, it’s that the board of directors actually did their job. It was the audit committee of the board that found out about the schemes and investigated them.
For a consulting firm, your reputation is your moat. This was a major reason why the stock dropped so heavily. When your reputation suffers you can easily lose your clients, which is obvious. What is not as obvious, though, is that you can easily lose your consultants. Consulting is all about relationships, and when scandal causes a consultant to leave, the relationships they had with their clients goes out the door as well. It’s been more than seven months since the scandal hit, which is enough time to determine if there will be a mad rush of clients and consultants leaving.
There are a few things we know. On the whole, the clients have not left. Yes, a few may have canceled projects, and perhaps a few more used the scandal as an excuse to delay or cut projects. But, look, the scandal was very public and the senior leadership was forced out. It’s very impressive that the company can come and give 2010 revenue guidance of $600 to $640 million, which they call conservative. Conservative or not, it’s only slightly below last year’s revenue.
How about consultants? On the most recent conference call, we heard that only two out of 100 managing directors in their health and education field have left. Health and education covers 58% of their firm. We don’t know for sure how many managing directors left companywide because of the scandal or because of natural turnover. Either way, though, it certainly hasn’t been catastrophic.
Before we can decide whether valuing a company based on an expectation to get back to normalized earnings is the right way to go, we need to determine whether the negative event has passed. I’m comfortable that the damage from last year has been contained. There will still be some lawsuits out there, but the leadership has been replaced, the new leaders seem to be talented and focused, and revenue and profits are back on the right trajectory. It seems that their reputation has been salvaged.
At Arquitos Capital Management, we take a long-term investing approach. While the meaning of that phrase seems obvious, I think it is often misunderstood. Taking a long-term approach doesn’t mean we’re buy and hold investors. It doesn’t mean we ignore short term factors. It doesn’t necessarily mean we’re hitching our faith on the brand of the company or its leadership. What it does mean is that we recognize our advantage is attempting to value a company a few years ahead, not predict its stock price three months ahead. The price of the stock in the short term really is unpredictable. Too many things that are out of the control of the company can affect a company’s short term stock price. For example, macroeconomic factors can crush the short term earnings or P/E ratio or a sector can temporarily be out of favor. If Huron Consulting was a private company and you wanted to buy it, you’d want to know what it is worth in three years, not three months. It’s that private sale price that allows for some connection to its stock price.
Of course there is risk attempting to determine the value three years ahead or, in this case, attempting to determine what normalized earnings are. To account for that risk, we need to have a large margin of safety. We have this margin of safety to account for unexpected events or mistaken analysis. Taking a long-term approach also gives us plenty of time to allow for a company’s stock price to fully reflect a company’s value. We try to buy a stock when it’s trading for 50 percent or less of what we think the current value should be today, discounted back from, in this case, our predicted normalized earnings. For more stable businesses, we may want to use a discounted cash flow analysis, not a normalized earnings analysis. To be honest, though, most of the stocks we’re interested in just don’t lend themselves too easily to a discounted cash flow model.
Once we feel comfortable that the company can regain a lot of its past glory, we try to make a prediction. We want to see the forest, not the trees. We’re not concerned that, for example, the first quarter of 2010 is going to be light on the revenue side. Although we’re following the guidance set by management, we want to remain skeptical, so we also look to the history of the company and other factors like the opinion of their competitors. As we mentioned before, the company expects between $600 and $640 million in revenue for 2010. The company also provided guidance of GAAP EPS of $1.55-$1.75 for 2010. Looking ahead three years, let’s put GAAP EPS between $2.00 and $2.50. You should note that their non-GAAP figures are higher.
Huron is out of favor now, for obvious reasons, so its stock price isn’t going to reflect its historical P/E. The fact that it has already run up from its low of $11.30 in early August doesn’t help either. But, three years from now, we’ll assume the P/E has returned to where it should be, or slightly lower than where it should be. Historically Huron has traded at a P/E between 15 and 38. Let’s put a 23 on it, which gives us a range of $46 to $57.50. Then, let’s determine the present value of that stock price by applying a 5% risk free rate. This gives us a present value of $39.74 to $49.67. So, given this information, we’re willing to buy in at anything below an amount between $20 and $25. Inexact? Yes, but that’s how this type of analysis should be done. It’s the big picture that matters.
So, we’re willing to buy in at a max of $25, and with the information we know right now, we want to sell out at $39.74 to $49.67.Of course that sale price will change as time goes by, because the present value is different. It will also change as new information comes forward, either negative or positive. It’s also important to keep in mind that even with our margin of safety, I’ve made a number of conservative assumptions along the way. The P/E ratio is on the lower end of its historical range, and the EPS growth rate is lower than in the past, which I think is justified due to the problems with acquisitions that led Huron to where they are today. Because of that, there probably will be fewer acquisitions over the next three years. On the other hand, margins are still strong, revenue is near record levels, and EPS should recover. As the economy improves, all of this should continue to get better.
I’m going to end with the risks, because it’s always important to keep the risks at the front of your mind. We want to be vigilant about monitoring these risks and do more research if we think any of them change. While it appears that clients and staff have not left, we want to keep an eye out for it. I also have some concerns about their debt level, which is high for a consulting firm. I’m not a big fan of stock based compensation, but it seems to be inherent in the consulting business. The SEC is still involved as well, and we need to follow that. I’m also concerned that a lot of revenue this year will be back-loaded to the end of the year. While I’m not as concerned about a one year revenue miss, I do want to keep an eye out for the reasons if the back-loaded 2010 revenue slips into 2011.
My firm, Arquitos Capital Management, owns Huron for our clients and would be a buyer under $25. We can’t predict the short-term stock swings, but we feel confident that over the long term, Huron’s stock price will reflect its full value. At that point, we’ll exit our position and be satisfied with a healthy gain.
Disclosure: Long HURN