Description

THESIS

The Corporate Executive Board (EXBD) earns excellent returns on capital, possesses a significant economic moat, has a long growth runway—and is selling for about 12x my conservative estimate of 2010 FCF. Growth investors have abandoned this stock as fixable sales force problems have slowed revenue growth from the historical annual rate of 30% to 16% in 2007 and 5-10% guided in 2008. The stock has declined steadily from a high of $109 per share in April 2006, more recently falling 34% in the days following disappointing 2008 guidance (announced 2/6/08). At the current price of $41.36, EXBD is an opportunity for patient investors to collect a 4.3% dividend yield while waiting for Mr. Market to recognize the business’s excellent franchise value and growth prospects.

Stock price: $41.36

Diluted shares: 36M

Market cap: $1.5B

Cash: $144M

Debt: $0

EV: $1.3B

BUSINESS DESCRIPTION

EXBD offers best-practices research consulting services on a subscription basis to corporate executives. Its product offerings are geared toward the senior-most executive in a particular function (e.g., the CFO, the CIO, the head of marketing, etc.). Both the subject and the content of the research are user-generated (as explained below), so EXBD’s value proposition can be thought of as being access to peers and their business practices. Subscriptions are predominantly annual and paid upfront; they cost just over $32K on average in 2007.

At the beginning of each year, EXBD polls its clients to determine the most pressing subjects on their minds, which determines the year’s agenda. EXBD’s 900-person research team then works in conjunction with the clients themselves to determine “best demonstrated practices” relating to each agenda item. The findings are delivered in hefty “syndicated” reports, which are followed up with conferences and meetings at which members discuss the findings. For example, the major 2007 topics for EXBD’s Sales Executive Council subscription were: Boosting Sales Coaching Quality; Maximizing the Return on Sales Costs; Realizing the Potential of the Indirect Sales Channel; and Voice of the Sales Force 2.0 (see www.sec.executiveboard.com/Public/CurrentResearch.aspx).

Equally important, EXBD also performs “inbound” research projects on a one-off basis. Members can call an EXBD research manager to inquire, for example, about good IP law firms in Bangalore. EXBD will then reference its library of case studies and/or reach out to other members with relevant knowledge or experience. The inquirer will be presented with a write up and/or a non-competing contact to help with the problem.

Another aspect of membership is “communities” that EXBD fosters among peer executives, in the form of retreats, teleconferences, education sessions, and online discussion boards. Finally, EXBD has accumulated a large database of case studies and benchmarking data, which clients access online.

EXBD counts just over 4,700 companies as customers, including over 80% of the Fortune 500, over 70% of the Fortune 100, and over 60% of the top 300 financial institutions. Of these, 3,653 are categorized as “large institutions” (revenue in excess of $750M). In 2007, large institutions comprised 96% of contract value (the annualized value of all subscriptions in force). The balance derives from EXBD’s “middle market” business, which was launched in 2005. No client comprises more than 2% of revenue; 30% of revenue derives from international clients; and 25% of revenue derives from financial institutions.

MOAT

I believe EXBD has an extraordinary business franchise based on 3 competitive advantages.

1)     Content asset: By working for years with thousands of the world’s top companies, EXBD has accumulated a database of case studies and benchmarking data that would be uneconomical for a competitor to replicate.

2)     Network effect: The value of an EXBD membership to each member increases as members are added. The network has reached a critical mass that would be impossible to replicate.

3)     Customer captivity: EXBD’s customer captivity is based on what Buffett calls the institutional imperative. Corporate executives want to stay abreast of what their peers are doing, so they can do it too. Knowing that their competitors subscribe to EXBD programs, many customers fear being disadvantaged by not doing so as well.

Renewal rates at the subscription level run in the low 80% range. Once EXBD has established a relationship with a client, it aggressively cross sells additional subscriptions. At the end of 2007, the average large institution had about 4 subscriptions; the largest clients spend over $1M annually on more than 20 subscriptions.

A telling trend is that the number of subscriptions a client buys correlates with the length of the relationship with EXBD:

EXBD relationship tenure                              <1 year            1-3 years         >3 years         

Number of subscriptions as of YE 1999        1.3                   1.7                   2.6

Number of subscriptions as of YE 2007        1.3                   2.3                   6.9

These statistics illustrate that clients find additional value in new subscriptions over time. They also illustrate that for a given relationship tenure, the number of subscriptions rises over time.

As the relationship deepens, so does the client-level renewal rate, which overall is high and gradually improving:

                                                              2001    2002    2003    2004    2005    2006    2007

Large institution renewal rates          90%     90%     90%     91%     92%     92%     92%

A few more points:

• Clients can easily cancel their subscriptions at any time and receive a full refund for the balance of the year, but they do so very rarely. Since 1999, the percentage of program subscriptions refunded annually has ranged from 0.3% to 0.9%.

• EXBD historically has raised program prices 3-5% annually.

• EXBD has no scale competitors, and therefore faces virtually no direct competition.

• Last but not least: EXBD’s return on capital is extremely high, as outlined below.

GROWTH & PROFITABILITY

The data below illustrate EXBD’s extraordinary record of growth and profitability:

                                                1997    1998    1999    2000    2001    2002    2003

Revenue ($M)                         39        53        71        95        128      162      210

Y-o-y growth                          42%     37%     33%     35%     34%     27%     30%

EBIT ($M)                              4          8          17        24        32        42        57       

EBIT margin %                      5%       11%     15%     24%     25%     25%     26%    

Net working capital ($M)      (18)     (27)     (35)     (47)     (62)     (85)     (102)  

Net fixed assets ($M)             3          4          10        16        17        15        15

                                                2004    2005    2006    2007

Revenue ($M)                         281      362      460      533     

Y-o-y growth                          34%     29%     27%     16%    

EBIT ($M)                              76        100      104      112                 

EBIT margin %                      27%     28%     23%     21%                

Net working capital ($M)      (127)   (191)   (224)   (230)              

Net fixed assets ($M)             17        18        27        92

A few observations:

• The 10-year revenue CAGR is 30%, and the growth had been consistent until 2007 (discussed below).
• Invested capital is negative because the business requires very little in the way of tangible assets and generates a float from receiving subscription fees at the beginning of the year.
• EBIT / net fixed assets averaged 285% since 1997, though, because of a ½-completed investment in a new headquarters in Virginia, EBIT / net fixed assets was only 120% in 2007 and will be an estimated 95% in 2008.

WHY IS GROWTH SLOWING?

Revenue growth has slowed from the historical high-20s/low-30s% range to 16% in 2007 and 5-10% guided by management in 2008.

I believe there are two causes of this slowdown, both of which have to do with EXBD’s sales efforts. EXBD has two distinct sales organizations: a renewal sales force and a new business sales force. The latter is comprised predominantly of recent college graduates who sell subscriptions to new and existing clients. The former is comprised of more senior sales people, who maintain existing customer relationships and renew subscriptions.

The first issue is an execution failure on the new sales side. Starting in late 2005, EXBD’s sales force began to outgrow its hiring and training infrastructure. New sales people, who historically took 12-18 months to reach average effectiveness, failed to meet productivity targets. This negatively affected revenue while also increasing turnover, which in turn necessitated still more hiring and training. Management initially underestimated the severity of the problem, and the situation snowballed during 2006 and 2007.

Late last year, however, the sales force management team, including the head of sales, was replaced. The new management team is larger and has been in place since the beginning of 2008. EXBD also flattened the compensation curve for new sales people, a change intended to mitigate initial frustrations as they ramp up in productivity. While it will take time to get back on track, this is ultimately a fixable problem.

The second issue is a failure to effectively manage relationships with well-penetrated customers. EXBD’s efforts in this area have been suboptimal for some time, and the problem has grown worse as tenured clients have come to represent a larger portion of the business.

As a client accumulates subscriptions in a particular functional area (e.g., sales and marketing—a vertical with 8 subscription options), increasing that client’s overall spend requires greater service. Specifically, the relationship manager must understand how the client uses the subscription. For example, a client could have ignored Voice of Sales Force 2.0 but decided to pilot an initiative based on Realizing the Potential of the Indirect Sales Channel. This might suggest a pro-active phone call by the research team to discuss how it could support the initiative, possibly using benchmarking data or a case-study from another customer with relevant experience.

Similarly, relationship managers monitor the satisfaction levels of various clients. Some are shoe-ins for renewals, while others are questioning the value of what they have. This obviously has implications for cross selling efforts by the sales force.

The overarching point is that servicing and cross selling tenured clients requires coordination between the relationship manager, the research team, and the sales force. Historically, this has been a weakness, caused, in all likelihood, by management’s emphasis on growth in new sales. As tenured clients became a larger part of the business, new sales growth could no longer mask the issue. In 2007, the cross-sell ratio (average subscriptions per client) among large institutions declined year-over-year for the first time, from 4.15 to 4.03.

My research suggests that management is focused on the problem and has taken 3 steps to address it.

• First, the relationship manager for each client now reports directly to the relevant research managers, to facilitate the kind of customized support discussed above.
• Second, renewal and cross selling efforts are now tightly coordinated. In the past, uninformed sales people haphazardly pitched new subscriptions. Now, cross selling is planned strategically—an obvious but important tactic.
• Finally, relationship manager compensation now rewards cross selling. The historical compensation structure was based entirely on renewal rates, which arguably creates a disincentive for relationship managers to facilitate cross selling by the sales force. My conversations with former employees suggest that this has been a large part of the problem.

The big picture is that the issues EXBD faces are self-induced and fixable. I believe that over the next year or two, tangible evidence of improvement will materialize, in the form of improving new member and cross sell success rates, and a corresponding acceleration of revenue growth. As explained below, however, the current valuation provides a margin of safety such that a quick fix is not necessary to produce an attractive result for investors who are willing to buy at this point of maximum uncertainty.

GROWTH PROSPECTS

EXBD’s growth drivers can be divided into 4 buckets: price increases (3-5% per year), new clients, selling existing products to existing clients (cross sell), and introducing new products.

New clients: EXBD’s clients currently consist of 3,653 large institutions out of 4,200 addressable prospects (88% penetration), and about 1,058 middle-market (less than $1B of revenue) clients out of 18,000 addressable prospects (6% penetration). Clearly the large-institution market is less of an opportunity at this point, though each new customer increases the cross sell opportunity.

On the other hand, EXBD still has a long growth runway in the middle market. EXBD repurposes its large-institution research for its middle-market programs, but does not offer inbound projects as part of middle-market subscriptions. This area of the business is isolated from the sales force issues discussed above, because selling is conducted by phone and internet by a dedicated sales team.

Cross sell: Management calculates that its cross sell opportunity is $1.6B in annual revenue. This would imply selling an additional 10 subscriptions on average the existing client base of 4,700 at $35,000 per subscription.

New products: EXBD has designed 15-20 yet-to-be introduced subscriptions, and has an additional 65-70 in planning stages.

Overall, EXBD pegs its market opportunity at $5B (over 9x the current revenue base), excluding Asia, which it regards as a long-term opportunity. The investment case, however, does not require the company to reach anything close to $5B in annual revenue. Rather, the investment case rests on two propositions.

First, the current growth stall is being caused by fixable sales force problems, which management has identified and is addressing. Second, once these issues are resolved, EXBD can achieve a normalized revenue growth rate in the mid-to-high-single-digits or greater for a long time. This to me seems eminently achievable given the large market opportunity and multiple complementary growth drivers. Even 10% revenue growth for the next decade would produce under $1.4B of revenue, which is less than 30% of the total market opportunity. Given the operating leverage inherent in the business and the fact that EXBD does not require incremental capital to grow, FCF growth should be higher than revenue growth.

VALUATION

For modeling purposes, I begin with a very conservative case in which it takes the company 3 years to get its sales efforts back on track. During this time, revenue growth is 5% annually, and operating margins compress slightly.  For what it is worth, 2008 guidance is for 5-10% revenue growth, as well as 10-15% growth in contract value. This implies 10-15% revenue growth in 2009.

Here are what my numbers look like:

                                                2007    2008    2009    2010

Revenue ($M)                         533      559      587      617     

Y-o-y growth                          16%     5%       5%       5%

EBIT ($M)                              112      109      113      117     

EBIT margin %                      21%     20%     19%     19%

$M:

Net income                             81        70        73        75       

Plus :

D&A                                       16        16        18        19       

Stock-based comp                  23        23        23        23

Deferred revenue*                  8          8          8          8

Less :

Capex**                                  35        45        18        19       

Interest income after tax        10        5          5          5

Free cash flow***                  83        67        99        101

FCF less def. rev.                   75        59        91        93

* Change in deferred revenue arises from upfront subscription payments.

** 2007 and 2008 includes investment in new HQ; capex = D&A after that.

*** FCF = operating cash flow less: capex and interest income after tax

These numbers imply the following valuations:

                                                2008                2009                2010

Shares (M)*                            36.7                 37.4                 38.2

FCF less def. rev. / share        $1.61               $2.43               $2.43

Stock price                              $41.36             $41.36             $41.36

Excess cash / share                 $5.88               $8.52               $11.13

Adjusted stock price               $35.48             $32.84             $30.23

P / FCF less def. rev.              22x                  14x                  12x

* Assumes 2% annual dilution from stock options.

I believe a company with EXBD’s economics and growth prospects is worth no less than 20x FCF, implying a $60 stock price in two years, yielding an annualized return of about 20%.

I should emphasize the significant possibility that EXBD outperforms the revenue and margin assumptions I use above. If revenue growth averages 8% over the next 3 years, then the implied 2010 FCF multiple drops to 10x. At 20x FCF, EXBD would trade at about $73 per share. If EXBD executes particularly well, 10%+ revenue growth is possible, implying a stock price north of $80 on 2010 FCF.

RISKS

In my mind, the primary risk is that the cause of the revenue growth stall is not internal but external—that there is a competitive or demand-related problem, which I have not factored into the analysis.

Aside from that, there is obviously execution risk, but I believe my analysis allows the company a lot of time (3 years) to get on track.

Finally, the growth opportunity I believe is there might not be. But even in that case, you still hold a very high quality franchise at 12x FCF (or less), so I believe the risk of permanent capital loss is low.

This is not a recommendation to buy or sell shares of EXBD. My fund has a long position in EXBD and may change its position at any time.

Catalyst