CRA International: Now What?
- CRAI traded at a steep discount to peers for years despite any real firm-specific issues.
- Two consecutive years of strong performance has seen the valuation gap close.
- The stock is up almost 200% since the end of 2015, and while CRA is a good business, it shouldn't outperform the peer group much longer.
CRA International (NASDAQ:CRAI), or "Charles River Associates", is a global consulting firm that offers economic, financial and strategic expertise to law firms, corporations, accounting firms and governments around the world. The company has been around for more than 50 years and provides expertise in a wide range of areas, including antitrust, intellectual property, cybercrime, damages and valuation, forensic accounting, international arbitration, labor and employment, life sciences, M&A, regulatory economics and compliance and transfer pricing.
CRA went public in 1998 and for much of the last decade its stock flew under the radar. In the years following the financial crisis the company lost 75% of its market value and revenues fell by a third. Some of this was due to restructuring, but a lot of the weakness was spread throughout the sector as business activity around the world cooled off for a bit. Things gradually started to turn around again and utilization rates normalized, but the stock continued to trade at a steep discount to consulting peers despite a lack of firm-specific issues.
Figure 1: Stock Graph
This all started to change in 2016 thanks to some strong results and prudent capital allocation decisions. Revenues increased 20% on a two-year stack, reflecting a mix of organic growth and acquisitions and the company aggressively bought back stock. Peers, on average, grew sales less than 10% during this period and purchased far fewer shares: total shares outstanding decreased 5% for the peer group compared to 9% for CRA.
The stock is now up 173% since the beginning of 2016 and the valuation gap to peers has closed. CRA returned almost 20% annually over the past three years, compared to an average of 6.1% for the peer group and the stock trades at its highest level in more than 10 years. We estimate that CRAI is slightly overvalued and that there's limited upside for investors at this time. CRA is a good business, but now that it's caught up to competitors it shouldn't continue to outperform.
Based on peer group price multiples, we estimate CRAI's fair value should fall somewhere within the $47-$48 range, compared to the current price of $50.91 (Figure 2). You'll notice that with one or two exceptions these companies trade at very similar ratios, which reflects that there's not a lot between them in terms of their business fundamentals and growth prospects.
Figure 2. Peer Group Comps
Source: Madison Investment Research
The main difference is that CRA is much smaller. The company did $370M in revenues last year, compared to an average of more than $2 billion for the peer group and this lack of scale hurts margins. Wages are the industry's biggest expense and consulting companies can't afford to skimp in this area, unless they want to lose their valued employees to competitors. But firms that are able to spread their fixed salary expenses across a larger revenue base can effectively lower their costs below smaller competitors. CRA has an average operating margin of just 5.8% over the past 5 years, compared to an average of 9.7% for peers.
Margins across the sector have come under pressure during the last five years due to rising salary costs and fringe benefits and FY17 was actually the first year that CRA's cost of sales increased at a lower rate than revenues since 2014. That being said, it's unlikely that margins will converge to the peer average anytime soon. This would first require a significant increase in scale, but we suspect the recent headcount additions will also continue to weigh on profit growth. Management expects a non-GAAP EBITDA margin of 8.8%-9.8% next year, compared to 9% last year.
CRA ended the year with strong results across services and geographies. Q4 revenue increased 22% y/y, thanks in part to the C1 acquisition, as well as double-digit growth in energy, forensic services, labor and employment, life sciences and Marakon practices and solid contributions from antirust and economics and finance practices. North America operations grew nearly 15% and Europe increased more than 50% y/y. In addition, the board expanded its share repurchase authorization by $20 million.
CRAI reported a net loss of $2.3M, but non-GAAP net income, which excludes the effects of valuation changes to contingent consideration liabilities, considerations paid in connection with IQVIA transaction and the estimated impact of the Tax Cuts and Jobs Act, increased 183% y/y to $5.9M or 6.1% of revenue. Most of the increase was due to non-operating items (non-GAAP adjusted EBITDA increased just 23% in comparison), but there were a lot of encouraging signs beyond the headline numbers.
Utilization, which the company defines as the total hours that employees worked as a percentage of the total hours they were available to work, improved from 71% to 75% and year-end headcount increased 15%. Utilization has important implications for cash flow (paying your workers when they aren't working isn't good for profits) and the rise in headcount further points to strong business activity and healthy demand. Looking forward, management expects constant currency revenues of $380-$392M in FY18, which implies growth of 4.3% based on the midpoint and utilization rates in the mid-70% range.
Q4 capped off a second consecutive year of strong performance that saw CRAI close the valuation gap versus peers. CRA is a good business, but investors shouldn't expect the abnormal returns of recent years to last. Management anticipates mid-single-digit revenue growth going forward, which is more-or-less what CRA's competitors are forecasting and limited margin upside. Stay on the sidelines for now.
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