Korn/Ferry (KFY) recently reported its fourth quarter results, concluding the fiscal year of 2016 which was dominated by the transformative acquisition of the Hay Group. Investors are very disappointed with the results as organic growth is slowing down, while the first quarter revenue outlook is uninspiring, to say the least.
Shares lost a fifth of their value in response to the results, creating a potential buying opportunity in my eyes. While topline growth is challenged by a potential slowing economy and integration distractions, the future looks reasonable in my eyes.
At $23 per share, shares now trade at 10 times forward adjusted earnings, while the balance sheet remains healthy after the purchase of Hay. The potential synergies resulting from a successful integration process, prospects for topline sales stabilization, and potential valuation multiple inflation, can all act as compelling reasons to sent shares higher.
Fourth Quarter Performance
Korn/Ferry reported fourth quarter fee revenues of $399.9 million, an increase of 47% compared to the year before, mainly the result of the contribution of Hay. Adjusting for this deal, organic sales growth came in at 4.9% as this number included a 220 basis point headwind from the strong dollar. The overall growth was driven by the North American market as well as the Futurestep segment.
While growth was still relatively solid, there are some worrying signs as well. Fee revenues were up by 7.5% on an organic basis for the full year, indicating that growth has slowed down quite a bit. The sequential decline is also pretty large given that third quarter organic sales were up by 14% on a local currency basis.
The slowdown is also very much reflected in the outlook of the business. Adjusted fee revenues for the first quarter of the upcoming fiscal 2017 are seen at $371 to $391 million, indicating a roughly 4-5% drop in sales on a sequential basis. While the company did not discuss the seasonal fee fluctuations for Hay, it should be said that first quarter revenues of 2016 were down by 1% on a sequential basis as well.
What About The Margins?
Korn/Ferry remains very busy with the integration of Hays, pressuring today´s GAAP results. Fourth quarter earnings fell by 78% to just $5.8 million, with full year earnings being down by 65% to nearly $31 million. This means that GAAP earnings come in at just $0.58 per share.
The adjusted earnings metric shows that full year earnings were up by 16% to $110.9 million, equivalent to $2.08 per share. Even better, fourth quarter adjusted earnings were up some 28% to $32.8 million. The discrepancy between GAAP and non-GAAP earnings is huge this year, but most of the difference can indeed by explained by the acquisition and integration of Hays. In previous years, the difference between GAAP and non-GAAP earnings metrics has been limited to just 10%.
Note that even if conditions do not improve, Korn/Ferry should see some tailwinds in 2017, given that Hays contributed just 5 months to 2016s results. The full year contribution of Hays into the upcoming fiscal year and gradual realization of synergies should be supportive for earnings growth, even if topline sales developments are challenged.
That said, the first quarter of the fiscal year of 2017 will be somewhat difficult as management predicts adjusted earnings of $0.50 to $0.58 per share. This means that earnings are likely to fall on a sequential basis as well from the $0.58 per share reported in the fourth quarter. It might very well be that the integration of Hays, the quick pace of recent growth, and the consolidation of offices, might actually create some distractions which hurt the operating performance.
What About The Valuation?
The integration process of Korn/Ferry takes a lot of work but provides real opportunities as well. Based on the Q1 outlook, annualized fee revenues could grow to $1.5 billion per year. Based on the adjusted earnings outlook for Q1, full year earnings could come in at $2.00-$2.30 on an adjusted basis, not taking into account the full realization of synergies yet. It should be said that the outlook for the first quarter is a bit disappointing, leaving room towards the upside if conditions actually stabilize.
It should furthermore be said that the company continues to operate with a very strong balance sheet. Cash, equivalents and marketable securities stand at $414 million by the end of the quarter. Regular debt stands at just $140 million, for a net cash position of $274 million, or nearly $5 per share given the 56 million shares outstanding. The investable cash load is just $90 million, after adjusting for bonus and compensation accruals, actually resulting in a very modest net debt load of $50 million.
Following the disappointing first quarter outlook, shares have fallen to just $23 in response to the continued charges and slower topline sales growth trajectory. With earnings trending at an annual rate of $2.00-$2.30 per share, Korn Ferry now trades at just 10-12 times adjusted earnings.
While GAAP earnings will again see pressure in 2017 on the back of charges, synergies are anticipated to provide an ongoing boost to earnings, offsetting some of the topline sales headwinds. Synergies from the Hay deal should amount to $17-$23 million at an annual run rate by the end of this year. That is equivalent to $0.25 per share on an after-tax basis.
On the conference called executives indicated the potential to achieve adjusted EBITDA margins of 16-18% in the long run, following a successful integration of Hays. Executives actually indicated that the high end of this range might be achievable.
Such 18% margins, on $1.5 billion in annual fee revenues, amounts to potential adjusted EBITDA of $270 million. This would mark an increase of $80 million in EBITDA versus the 2016 number, equivalent to roughly $50 million after taxes. If that would be achieved Korn/Ferry has the potential to post adjusted earnings of $160 million by 2017/2018, equivalent to roughly $3 per share.
A 20% plunge in the value of any investment might look terrifying, but in this case it actually provides opportunities in my eyes. This is even the case if sales growth is anticipated to slow down further, or even turns slightly negative.
The solid financial state of the business, the successful integration of Hays, still solid profitability and low valuation multiples make me upbeat on the prospects for the shares. With exception of the economic crisis, when the company essentially broke even, Korn/Ferry has been able to structurally earn margins of around 10% on an operating basis.
Leading positions in market niches, reasonable aggressiveness with regards to dealmaking, while maintaining financial prudence all act as reasons why I am upbeat on the shares going forwards.
Disclosure: I am/we are long KFY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.