After hours on Jan. 28, FTI Consulting
FTI Consulting had been growing rapidly through the acquisition of smaller consulting firms and divisions of larger firms, such as KPMG and PricewaterhouseCoopers. Here are the sales, earnings per share (EPS), and compound annual growth rate (CAGR) figures for 1998-2002:
The trailing 12 months earnings from continuing operations to the third quarter of 2003 were $67.6 million and EPS was $1.69. The company had been a stellar performer, indeed. However there have been some warnings of lower earnings growth. In September (.pdf file), FTI lowered fourth-quarter earnings guidance and, in what may have been a critical action, noted that $2.1 million in incentive bonuses would not be paid now as earnings targets would not be met.
One month later, FTI again lowered earnings guidance. In the first half of 2003, FTI had been consistently reaffirming its expectation of continuing sales growth of 15% and earnings growth of 20%, so the September announcement signaled a reversal in company guidance.
So now FTI has to deal with the defection of some critical staff. A consulting firm's assets are essentially the reputation and quality of its senior consultants, and, like many consulting firms, part of the consultant's remuneration is in the form of Employee Stock Options (ESO's). This can be problematic if those options ever go underwater and the consultants jump ship. That is what happened at FTI.
In 2000, the company issued 2.01 million options at a weighted average exercise price of just $4.65. In 2001, it issued 0.85 million options at $17.11. In 2002, FTI issued 1.93 million options at a weighted average exercise price of $34.55. So now consultants have not only lost their expected bonuses, but they have also seen their big options payday evaporate. It's a risk any company that relies on options as compensation has to contend with.
FTI's stock price has fallen 40% from $22.99 at the close on Jan. 27 to last night's close of $13.71, a new 52-week low closing price. In April, the stock price had reached a lofty $32.45.
Hidden Gem or value trap?
Can FTI recover and resume its growth or will more consultants jump ship and the stock price continue to slide towards Davy Jones' Locker? Is it a potential Hidden Gem value play or a value trap?
Well a few years ago another restructuring consultant, The Metzler Group, also lost some key consultants but eventually managed to rebuild its practice by purchasing some key businesses from Arthur D. Little and renaming itself Navigant Consulting
FTI has an excellent balance sheet, with $133 million in cash and equivalents and total debt of only $20 million. So let's now look at how the staff desertions may affect the bottom line.
The company says that the departing consultants represent 21% of the 2003 earnings before interest, taxes, depreciation, and amortization (EBITDA), which in the last four quarters was $128.3 million. That would be a reduction of some $27 million if all the clients follow the defecting consultants. So, by my calculation, net income would be reduced by about $17 million to $50.6 million, or $1.21 per share. Free cash flow, which had been matching earnings, will take a similar hit.
In valuing the company, I would use the $50.6 million as a base for net income. If, and that's a big if, management can regain even 10% earnings growth over the next five years, the stock is fairly valued and could churn out a 12% annual return over that period. A return to 15% growth puts today's fair value at around $20 and the annual return at 19%. In arriving at these values I have allowed 4% annual share dilution from employee stock options.
In my estimation, FTI Consulting is definitely worth placing on your watch list, but management has to show that they can plug the holes and right the ship before it can join the ranks of Hidden Gems and be worthy of your cash.
Talk about it on the FTI discussion board.