As a much-younger investor, I received a very practical piece of advice: "Don't invest in investment banks. Work for them." Investment banks pull a lot of money in, but they're even better at paying. That can be a less-than-winning combination for shareholders. Under former CEO and fabled rainmaker Bruce Wasserstein's leadership, M&A advisor and money manager Lazard (LAZ) embodied this spirit.
During his tenure, Lazard reclaimed its position as one of Wall Street's elite deal makers. But the boutique advisor's middling margins, and fat compensation packages, also paid homage to its history as a closely held private partnership. With Wasserstein's passing in 2009, that's changed under new CEO Ken Jacobs. Lazard's taken a much more shareholder-friendly tack -- targeting lower compensation ratios, paying a decently sized dividend, and repurchasing shares. More recently, activist investor Nelson Peltz's Trian Partners took a 5.2% position in Lazard, and rather pointedly noted compensation as an area for improvement, in a June white paper.
And so, today, Lazard breaks the investment banking mold. Enterprising investors can benefit from this, and a bevy of near- and longer-term catalysts. A newly shareholder-focused management team, cost-cutting efforts, and the ever-tenacious activists at Peltz & Co. are targeting capital allocation -- and higher shareholder returns. As one of the Street's preeminent M&A advisors, Lazard stands to benefit as transaction activity recovers from historic lows. An underappreciated, workhorse asset management business and possible S&P inclusion put a cherry on the sundae.
I'll be taking a position equal to 3% of my Real Money Portfolio's capital.
A tidy package
For the sometime obsession with "built to last" organizations, Lazard stands apart. Founded in 1848 as a dry-goods company in New Orleans, it's metamorphosed into a truly global, world-class investment advisor over the years -- serving clients throughout North America, Europe, and emerging economies. While best known for its M&A advisory franchise, revitalized and restored to glory during the Wasserstein years, Lazard isn't a one-trick pony. The company's also built highly respected asset management and restructuring advisory franchises.
The model has served Lazard well. Because M&A advisory is pro-cyclical and restructuring counter-cyclical, the segments buffet Lazard's results from macroeconomic shocks. Lazard's advisory revenues declined just 17% during the credit crisis, whereas competitor Greenhill's (GHL) sales slumped a whopping 40%. Should the eurozone crisis hit full-bloom, I expect Lazard's restructuring segment, which has advised on Greek debt deals, to meaningfully contribute to the bottom line. As an independent boutique bank in a post-credit-crisis world -- without many of the conflicts of interest faced by larger advisors Citigroup (C 1.41%) or Goldman Sachs (GS 0.22%)Lazard and its counterparts have consistently gained market share.
At 2007's close, Goldman's share of advisory revenue was 3.5 times Lazard's, whereas currently, Goldman's share is less than two times Lazard's. And where investors in bulge bracket banks risk balance sheet bogeymen, and ugly heretofore "unknown" risks, Lazard's advisory focus limits balance sheet risk. Of particular significance, Lazard's differentiated itself from its boutique peers via global scale, employing 140 managing directors dotting the globe at 2011's close, versus 95 at Greenhill and 65 at Evercore (EVR 0.58%).
Though globetrotting deal makers catch headlines, Lazard's quietly grown its asset management segment, focused on emerging-market and international equities and institutional clients, into a cash cow. In 2011, the segment generated 85% of Lazard's operating income, and from 2005, grew assets under management 81%. According to a June Goldman Sachs report, Lazard managers, on a collective basis, outperformed their benchmarks on one-, three-, and five-year bases. Importantly, 90% of Lazard's AUM, at 2011's close, are institutional clients. Institutional money is typically "stickier" -- owing to longer time horizons, tolerance for volatility, and defined, long-term investment parameters. Looking forward, the segment's growth prospects remain strong, as investors increasingly allocate funds to emerging markets.
Why Lazard, why now?
Despite the fundamental attractiveness of Lazard's business and strong competitive advantages, a few warts remain. A still-tentative global economy and depressed M&A activity, history of fat compensation packages, and an underappreciated asset management segment have depressed Lazard shares. Those things are changing -- some sooner, and some later. The presence of activist investor Nelson Peltz, a management team dedicated to shareholder-friendly capital allocation, and an eventual earnings pop from higher interest rates provide additional upside catalysts.
1. The M&A picture: At November's end, M&A activity sits at 50% of 2007's peak levels, and at the third quarter's end, global M&A was down 19% from 2011. At 2011's close, global M&A activity represented 5.5% of global market value, well below the 6.5% 20-year average. In short, global M&A activity is quite depressed. And while the eurozone's troubles and fiscal-cliff-related ditherings may cap near-term activity, the long-term is much brighter.
I expect Lazard will continue to gain market share. In the near- and mid-term, the M&A market has powerful fundamentals at its back: Cash balances at U.S. companies are near all-time highs, credit is cheaper than ever, and profits are still robust. At some point, executives will feel the itch to "do something." Just a slight reduction to near-term uncertainties could turn the switch. Given a longer-term view, M&A activity will almost certainly turn higher. Lazard will profit.
2. Fat compensation packages: New CEO Ken Jacobs has made laudable strides toward refacing Lazard as a shareholder-focused organization. But there's still work to be done: Lazard's awarded compensation ratio sat at 62% in 2010 and 2011, and averaged 69% from 2006 to 2009. For the same time, I estimate Greenhill's average compensation ratios were 7 to 10 percentage points lower. Likewise, Eaton Vance, a similarly sized asset manager, reported compensation ratios around 38% for the past three years, where Lazard's were well above 40%.
Recognizing room for improvement, Lazard's undertaken a plan -- to reduce compensation costs, cut administrative and operational costs, and achieve 25% operating margins by 2014. I'm not sure the 25% is attainable without productivity reductions or defections by managing directors, but certainly, improvements are.
3. A shareholder focus and capital structure: For my jab at investment banks, Lazard looks much less like a single stakeholder organization, in recent years -- instituting a meaty dividend, and steadily repurchasing shares. Management's returned $432 million to shareholders via repurchases and dividends over the past five years and telegraphed intentions to continue repurchases; shares currently yield 2.7%.
Next on the hit list is Lazard's chunky debt load, $1.1 billion at a 7% rate. That interest expense eats a lot of cash flow, and while some companies benefit from (or need) a debt, Lazard has no use for it. Recognizing this, and the company's ability to repay its debt, CEO Jacobs intimated plans to pay it down, in time.
4. The Peltz factor, and asset management: All this talk of reasonable compensation, shareholder-friendly capital allocation, and debt reduction could easily be empty rhetoric, if management were left to their own resources. But in June, no-nonsense, straight-talking activist investor Nelson Peltz's Trian Capital established a 5.2% position in Lazard shares. Peltz has a long history of slowly, surely nudging management teams to cut costs, repurchase shares, and spin out underappreciated segments of businesses. Peltz brings accountability to management's happy-good talk. He'll push if management loses its way.
I see one less publicized but equally significant source of value. Even in today's economic environment, I'd wager Lazard's asset management segment can grow revenues at a mid- to high-single-digit clip on increasing fund flows and market appreciation, and earnings at a similar or higher rate. By my math, this means that at today's stock price, we're buying the asset management segment at fair value, and Lazard's venerable advisory business free. There's an easy way to remove that discount: Spin off the asset management segment or advisory. Peltz is just the guy for the job. Considered in the cold light of day, there's little strategic merit to pairing the two businesses. Research shows newly spun off organizations as remarkably adept at finding expense reduction, and growing margins.
5. The interest rate kicker: That the government, in real terms, gets paid to lend via Treasuries tells the tale. Interest rates sit near generational lows. With investments and cash nearing $1 billion, Lazard's interest income has fallen off a cliff -- from almost $90 million in 2007 to $17 million currently. And while we don't know when, interest rates will at some point turn higher. When they do, a slug of virtually costless interest income will hit the bottom line.
Valuation
Taking inventory of current market conditions, the possibility for compensation reductions and better capital allocation, and certain inevitabilities given a long-term view -- higher M&A activity and interest rates, for example -- Lazard has a lot of things working in its favor. That we're buying the advisory segment for free helps a bit. In my valuation, I anticipate a gradual return to historically average M&A levels, incremental market share gain by boutique banks, interest rates turning higher by 2017, and mid- to high-single-digit revenue growth in Lazard's asset management segment on market appreciation and new investments -- translating to 8.5% revenue growth over a 10-year period. I also expect that as Peltz and company work their magic, operating margins will increase to 21% on lower compensation costs and administrative efficiencies, and management will reduce its debt from 2015 to 2017. On this basis, I peg the shares at $43.
Risks
The biggest risk to Lazard's near-term prospects is a middling economy, in which case M&A activity would suffer but Lazard's restructuring franchise wouldn't pick up the slack. Likewise, a full-on bust in the eurozone (where 30% to 40% of Lazard's sales come from), or continued uncertainty in the U.S. economy, might impact near-term M&A activity. In the long run, the possibility for cost reductions, recovering deal volumes and equity markets, or some combination of the two mutes the risk of long-term capital impairment from today's share prices.
That being said, Lazard's reputation and results are only as strong as its people. Should attempts at curtailing costs result in reduced productivity, defections, or declining morale, Lazard's cash generation -- and prestige -- might suffer. This bears watching.
The bottom line
A first-class franchise with still-depressed results, a proven activist, and multiple means of improving cash generation tilts the odds of Lazard shares returning a tidy sum in our favor. That's why I'm buying Lazard today.
