- The M&A market has slowed, but the increase in restructuring business will soften the impact.
- Moelis & Company is run on human capital and can match costs to revenues, allowing them to cushion the blow during dips in revenue.
- Carrying no debt allows them to take advantage of opportunities, while others are struggling with liquidity issues.
Moelis & Company (NYSE:MC) is a quality business that has grown both revenue and cash flow since the IPO in 2014. The M&A market has slowed since March, but MC's restructuring business will make up for some of that shortfall and create new long-term client relationships. Management runs the business conservatively and is open about its goal of consistently returning capital to shareholders through dividends. The low debt load will allow them to pursue new opportunities aggressively as others deal with liquidity issues. MC currently trades at 17x earnings (TTM), with earnings expected to drop by about 50% in the current year. A sharp bounce-back in FY21 will mean we may be able to acquire a good business at a reasonable price.
Source: Moelis & Company
Company background and recent developments
MC is an independent investment bank that provides financial advisory services to corporations, governments, sovereign wealth funds, and financial sponsors. Their primary focus is M&A, but they also assist in recaps, restructurings, capital market transactions, and other corporate finance matters. The company was incorporated in 2007 and is run by Ken Moelis, who took MC public in 2014. Mr. Moelis has control of MC through his ownership of Class B common stock (68% of voting power), so any investment in MC will be passive. Revenue for FY19 was $747M, with an EBITDA of $120M and a net income of $105.1M.
MC has been impacted by the slowdown in the M&A market but is expecting its restructuring business to accelerate due to the economic impacts of the pandemic. They have been mentioned in some potentially lucrative deals such as helping Occidental (OXY) reduce their debt load, advising the Treasury on airline aid packages, and advising on the potential sale of Personal Capital (a wealth management app).
Source: Moelis & Company
MC is a great business for the following reasons:
- Its strong presence in restructuring will give MC access to new clients and help them form potential long-term relationships (with surviving companies).
- The business is run conservatively and carries 0 debt on its balance sheet, allowing them to act boldly as opportunities present themselves.
- Their main expense is human capital, which gives them the flexibility to match their costs and revenues.
Management currently estimates that approximately 25% of MC's revenue is generated by restructuring work but caveats this by saying it is difficult to identify what is truly a restructuring transaction (lots of transaction start out as something different and end up as restructuring). However, this figure is a good starting point as they do not split out revenue on their 10K/Q reports. They also believe they can double their current restructuring capacity based on current demand and available human capital. This will help MC fill the sizable gap left by the M&A slowdown (M&A was down 50% in the first quarter YoY).
The restructuring business can also provide opportunities for new lucrative long-term relationships. M&A client relationships typically take a substantial amount of time and effort to develop before a potential revenue-generating deal will be offered to a bank, whereas restructuring mandates tend to be more time sensitive and require clients to pick their partners quickly (no one plans to go bankrupt). This accelerated timeline leads to new business without the typical "courting" phase and, if successful, can lead to repeat business on non-restructuring work.
The downside of the restructuring work is cash cycle can be longer as these deals typically run for 6-18 months. As a significant amount of cash is paid at the completion of the transaction (a monthly retainer is usually paid but the majority is received after the restructuring has been completed), this may mean higher GAAP earnings but lower cash flows. This shouldn't be an issue for MC due to their solid balance sheet, assuming the cash flows comes eventually.
MC is conservatively run with zero debt on the balance sheet. There are two main reasons for this:
1. To take advantage of any opportunity at any time
Obtaining talent (human capital) is one of MC's biggest challenges as their business is based on providing top quality advice to clients. Talent opportunities generally appear when markets are slow, other banks are looking to cut costs, and those banks can't provide their talent with enough opportunities. Carrying no debt allows MC to be "greedy when others are fearful" and increase the rate of hiring while others are doing the opposite. This provides them with the opportunity to grow at a faster rate as they utilize the established relationships of their new hires.
2. The business does not want to finance long-term assets (their human capital) with short-term liabilities
Mr. Moelis explains his reasoning for this in his annual letter;
"We have never believed in putting leverage on a business in which human capital is the primary asset. It is one thing to have debt on your plant, property, and equipment because the building does not have a choice whether to show up motivated and optimistic - but humans do."
Here, Mr. Moelis is recognizing that human capital can become a zero-value asset in short order. Human capital can be maintained by providing opportunities for growth, a great culture to work in, and competitive compensation, but it is very difficult to force individuals to work if they don't want to. Therefore, funding these assets with debt can lead, in a black swan scenario, to a firm with no assets and liabilities to service.
Long term, a conservative structure like MC's will prove to be prudent. Taking on debt for assets that you can't guarantee will show up tomorrow is a volatile strategy. In a world where anything can happen, it is best to look at worst-case scenarios and focus on being around if those scenarios occur.
Having a large amount of human capital might reduce a company's ability to take on a significant debt load, but it does have the benefit of allowing firms to match their compensation to business performance.
MC's compensation expense, their largest, has historically been close to 58% of total revenue. This changed in FY19 due to the second half of the year being very strong (after a weak first half). Management decided to compensate employees based solely on second half financial performance, which led to a ratio closer to 65%. We expect this trend to stay high for FY20 but move closer to 58-60% long term.
We view compensation expense as a variable cost, and therefore, MC's operating leverage as low. A lack of operating leverage will protect MC on the downside, but means it will miss out on some of the upside if performance comes in above expectations (with employees getting a large share of upside through bonuses). Again, this appears logical for a business that relies on human capital. Having employees participate in the upside will motivate them to chase business and bring in higher fees for MC. Most employees have low base salaries (relative to their total compensation) and are paid bonuses based on total fees brought in by the firm.
The ability to match expenses to revenue is a great asset for a business. The low fixed costs mean MC has excess liquidity at a time when other firms are dealing with covering high fixed costs.
We've used a DCF to value MC, with a forecast period of 7 years and then a terminal growth value. It's very difficult to accurately assess expected growth rates, etc., but we'll make our best estimate and then assess potential outcomes. The following key base case assumptions have been used:
CAGR of 6.2% over the period, with a 10% drop in FY20 due to slowdown in M&A (partially offset by restructuring growth), with a sharp rise in FY21 of 15% and then steady growth through the rest of the forecast period (between 6% and 10%). There is a scenario where MC grows above this pace if they continue to build on their current relationships.
Forecast an average of 60% of revenue for compensation expense due to higher relative payouts for FY20 with revenue lower. This assumes management makes a strategic decision and keeps payouts higher this year (relative to revenue). From 1Q 2020, the accrual for payouts ($95M) is tracking around 58% of our estimated revenue, but we expect this accrual to rise similar to last year as they focus on keeping talent motivated by compensating them well.
MC has one class of shares that makes up the non-controlling interest in MC. Group LP Class A Partnership Units (not held by MC) are exchangeable for one share of MC Class A common stock. As of December 31, 2019, there were 12.95M shares of Group LP Class A Partnership Units. For simplicity, we have assumed that all non-controlling interests have been converted into MC Class A common stock (the stated ratio for conversion is 1 to 1) for total shares outstanding of 68.5M. We're then assuming that 100% of earnings are for attributable to Class A common shareholders.
It is worth noting that Moelis & Company Partner Holdings LP holds 10M shares of Class B common stock. This stock is held by Mr. Moelis so he can exercise control over MC (voting power of 10-1). One B share is convertible into 0.00055 shares of MC common A shares, which leads to an immaterial increase in share count and has not been included in the analysis.
10% WACC has been used. This is a personal preference, consistently used as a starting point as we should require something close to this return to put our capital in equities. With low interest rates looking like they'll be with us long term, an argument could be made to lower this number. We'll be conservative for now and leave WACC at 10% (they'll be a sensitivity below if you disagree).
Terminal growth rate
3% has been used as the terminal growth rate. The company has proved they can grow revenue and cash flow, albeit with ups and downs as they rely on M&A activity. 3% appears fair, but we will be using the sensitivity to show multiple possible outcomes.
MC owns approximately 20% of Moelis Australia Ltd. (MOE), which trades on the ASX (Australian Securities Exchange). MOE market cap is approximately $400M (translated at AUS/USD rate of 0.7 USD). A 20% ownership puts MC's investment at approximately $80M ($1.17 a share).
See below for income statement output along with a sensitivity analysis (on WACC and terminal growth rate); this will give us an understanding of the projected numbers along with the valuation it yields.
Source: Tables created by author
The P&L output above shows an increase in net income of 2.3x over the 7-year forecast period, for a CAGR of 12.8%. This is an optimistic view of company performance, but warranted, given the opportunity to gain market share, the operational structure the firm has put in place, and competent management decisions moving forward. The sensitivity shows a price per share of $41, which is close to the current price, given the market run-up. Even though our calculation of MC's intrinsic value is close to its current trading price, I'm still optimistic about its long-term performance due to a reasonable likelihood of MC achieving higher revenue growth than we projected.
Investment risks/downside scenario
Any investment carries risk, and with the robust projected growth rates, we will need to see solid performance for our return to be positive. Revenues have grown at a CAGR of 7.9% from 2015 to 2019, and we are expecting a 6.2% CAGR throughout our forecast period. If MC grows at a slower pace than expected, the investment value will likely suffer. However, the ability of management to lower compensation costs will keep the business profitable even in a downside scenario. In addition, having no debt will mean there are no fixed obligations to service with less revenue or profit. This should also limit the downside.
The business returns most of capital generated to shareholders, which poses a reinvestment risk for the investor. The business has not historically used internally generated profits to reinvest in their operations, instead choosing to return the capital through dividends. The benefit of this is, the investor knows the capital will not be misused for value-destroying acquisitions etc., but the investor will need to reinvest their dividends over the investment period with no assurances of an attractive MC stock price to reinvest.
MC is controlled and run by Mr. Moelis. As he holds over 50% of the voting power and has complete control over the board, the investment will be passive. His interests are aligned with shareholders though, as he owns the equivalent of over 8% of MC (using our calculation of shares outstanding and including his Partnership Class A units, which are exchangeable 1 for 1). His decision to run the company conservatively and for long-term shareholder value creation should give us some comfort.
MC is a great business, but the current run-up in price should make us hesitate before buying. What do we believe the upside is to make the risk/reward benefit attractive? We believe the business is run by competent management and set up for long-term success with its low debt load, but it's not a compounding stock as they return most of their excess capital to shareholders through dividends. The upside will have to come from MC gaining significant market share by creating new relationships and turning them into fees. The current pandemic is a great opportunity for them to do this. I'm bullish on the stock, but aware of the current high price.
This article was written by
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