Description

Evercore – Long Thesis

Introduction

Financials look cheap. Their stock prices have been weak for obvious reasons – interest rates and term spreads have collapsed, credit risk and loan loss provisions are up, while trading & transactions in commercial and investment banking have plummeted.  And while the financial system is in better shape -- with stronger bank balance sheets and less exposure given a drop in riskier lending since the 2008 financial crisis -- persistent economic weakness could lead to larger than expected loan losses that could limit their profitability in upcoming quarters.  The Fed’s recent decision to cap dividends and buybacks after its latest stress tests highlight the risks associated with a prolonged downturn and its possible effects on capital buffers under dire Covid scenarios where the labor market remains weak.

Despite the risks and macro uncertainty, I think long term the sector is undervalued and offers compelling risk-reward.  Names like JPMorgan, Goldman Sachs and Well Fargo – businesses with irreplaceable franchises, relatively strong capital positions and diversified revenue sources – will handily absorb losses and weather this downturn and likely preserve and strengthen their long-term earnings power.  As dislocations have largely dissipated, the recent strength in capital markets provides them with an unusual opportunity manage exposure to risk assets across consumer loans, mortgages, corporate debt CLO’s and commercial real estate.  The scrutiny of regulators on capital plans adds a layer of risk management that long-term oriented shareholders should ultimately welcome.  Considering the unprecedented (seemingly unlimited) liquidity and backstop of the economy by the policymakers – propping up the various debtors and counterparties that underpin bank loans – the more likely scenario is the government will absorb a material portion of the economic losses.

I also don’t see existential threats from upstarts as credible.  Innovation and fintech are a source of opportunity, not a threat, and as these banks grow their tech budgets and adopt digital era tools for the benefit of their clients and customers.  The form and mode of delivery might change, but banks will continue generating predictable fee streams from everyday economic transactions.  From an investment standpoint what’s not to like? -- dominant scale, cost advantages (cheap deposit bases, operating efficiencies and economies, low customer acquisition costs) and switching costs provide them with significant competitive moats.  Bottom line, these are solid long-term core holdings and I believe now is as good a time as any to establish or add to a position. I have been adding. 

First quarter results were painful with a massive rise in loan loss provisions -- but with the boost in unemployment benefits from the CARES Act, mortgage forbearances and the numerous government lending programs supporting businesses, it is possible that provisions in the second quarter will be lower than expected and the overall outlook will improve and look increasingly more benign from a credit exposure standpoint.  Irrespective of the short-term effects of this recession, and the temporary restrictions on capital distributions, banking stocks over time should continue to generate decently high ROEs in the mid-teens and return capital to shareholders in the form of healthy dividends and buybacks. 

If the leverage, complexity and the credit exposure of the mega-banks make you nervous, there are other areas within financials that have been unfairly punished due to cyclical weakness.

One area within Investment Banking that I particularly like is advisory.  It doesn’t require capital, is relationship driven and fee based.  In the last 10 years, mega-banks have diversified away from their core IB businesses and in the process have lost some of their appeal and cachet in the eyes of clients as their size has inhibited their ability to market themselves as “specialized” and “focused”. Banks like JPMorgan clearly possess a full spectrum of capabilities, but in M&A transactions CEO’s and boards increasingly look for specialization, and there is a benefit to being perceived as independent vs. integrated; not to mention an accelerating trend of clients seeking firms that are free of potential conflicts of interest that are inherent in bulge-bracket firms.

I present to you Evercore (EVR) – the leading independent boutique investment bank that derives most of its revenue from M&A advisory and, to a lesser extent, a strong restructuring practice.

High quality business

Evercore (EVR) is a global investment bank with 1,900 employees across 28 offices in 12 countries.  The firm has three businesses – Institutional Equities (Sales & trading / research), Investment Management (Wealth mgmt. and Trust Services) and Global Advisory (Strategic / Restructuring and Capital Mkts advice).

EVR’s core business and crown jewel is the advisory practice, where over the years it has built a remarkably strong brand having consistently gained market share for the last 10 years making it now the #4 advisor behind Goldman, JPMorgan and Morgan Stanley.  Since its founding in 1995 it has advised on over $2 Trillion of announced M&A deals and now owns ~8.6% of the deal market (up from 2.3% in 2010). 

Evercore's president and CEO Ralph Schlosstein, strengthened the advisory business after the GFC by aggressively hiring senior talent while larger BB firms retrenched and diversified under the scrutiny of regulators.  Between 2017 and 2019 headcount grew by 300, or nearly 20%.  In the long run, investing in top talent, has led to industry leading productivity per senior MD at ~$15 MM per annum – stellar numbers which have led to banner years in terms of growth and profitability. 

Hiring late in the cycle, however, hasn’t come cheap as average pay last year hit $622k and compensation rose to absorb 58.2% of revenue, up from 56.7% in 2018.  In January, management acknowledged the need to rightsize in order to preserve profitability and productivity.  However, as with most human capital business models, there is a lag from the time you “onboard” expensive talent to the time they become profitable “producers” – so while the year started with some fine-tuning layoffs, management has conviction a large proportion of recent SMD new hires (~30 out of 112) have yet to meaningfully produce and thus are investments that will ultimately payoff in future years.  Obviously Covid has impacted the trajectory of the new talent ramp, but as explained in the thesis section below, dealmaking will snap back and these assets will eventually generate a return in the medium / long run.

In 2014 EVR acquired ISI Group – now Evercore ISI – which has given the Institutional Equities platform the scale and scope in research and distribution to offer a broad menu of services to its 1300 institutional investor clients.  Led by renowned economist Ed Hyman, the ISI group has won accolades and awards, placing its analysts and research among the highest rated in the street: https://rb.gy/jryul3.  Importantly, while the revenue contribution of Institutional Equities is still miniscule -- and the trading business is intensely competitive -- the platform’s solid reputation, growing coverage and distribution capabilities, create natural synergies with its underwriting and advisory businesses.  This has led to recent wins for Evercore being selected as lead bookrunner in notable transactions.  The strength in research and capital markets, as a capability, are key in continuing to attract top talent – which reinforces the network effect on the relationship side of the business that seek end to end solutions around advisory and execution.

Finally, the Investment Management group, Evercore Wealth, is a 12-year-old business that provides discretionary and non-discretionary investment advisory, financial planning and investment consulting services to high-net-worth individuals and associated trusts, estates, pension plans, endowments, foundations, etc… It is ranked by Barron’s as one of the top independent RIA’s -- https://rb.gy/mu1yjx, has ~600 clients and >50 advisors.  As of December 31, 2019, Evercore Wealth managed a total of approximately $9.1 billion with a 10 year CAGR of 14%.  The most recent ADV outlines various aspects of the business, its fee structure and the various services it provides: https://www.evercorewealthandtrust.com/adv-brochure/. Their quarterly journal, Independent Thinking, targeting HNW, FO’s and Institutional clients, provides color on the group’s philosophy and new CEO, Chris Zander, target market and the : https://rb.gy/l7x3zz.

Overall, EVR’s long term growth and fundamentals have been stellar:

·       20% CAGR in Revenue since 2010

·       24% CAGR in EPS since 2010 (from ~$0.96 to $7.70 in 2019 – peak $9.01 in 2018)

·       Over $2 billion in Net Revenue for 2018 and 2019

·       Operating Margin expansion from mid-teens to mid-twenties, hitting $450 to $550 MM in the last 3 years

EVR’s execution in the last decade has been near flawless.  The main driver behind its profitable growth has been its aggressive recruitment of top talent – leading to a 40% increase in SMD headcount since 2015 (from 79 to 112)

“We are a human capital business and our revenue and profits are tied to the number, quality and performance of our people. Our ability to pay appropriate levels of compensation in the form of equity incentives has enabled us to recruit, retain and motivate high-caliber talent dedicated to our long-term growth and success. We effectively use our equity compensation program as a form of capital expenditure to invest in, retain and grow the business through our people.”

EVR’s equity-based comp has been a mix of RSU’s and other equity awards with long vesting schedules that are tied to individual and company performance.  Employees own over 25% of the company on a fully diluted basis; however, SBC expenses and the resulting dilution is managed and offset through yearly share repurchases.

From a capital allocation standpoint, plowing back cash to fund new hire equity awards has generated terrific long term returns on a consolidated basis.

Featured Transactions

In 2019 EVR advised on some of the most prominent M&A, spin-off, restructuring and activist defense campaigns of the year.  Evercore advised on 7 of the 10 largest global M&A transactions and 5 of the 5 largest U.S. transactions.  Also during 2019, the divestitures group worked as an independent advisor on the two largest spinoffs of all time and the restructuring group worked on 8 of the 10 biggest bankruptcies by liabilities highlighting some of the debtor and creditor capabilities to serve clients in and out of court. The activism group advised on $1 trillion in market value in activism-related defense.

Some notable examples include:

 ·       Activism Defense of Bristol-Myers Squibb against Starboard Value on its $93 billion acquisition of Celgene.

·       United Technologies $55 billion merger with Raytheon and spinoffs of Carrier and Otis

Some of the restructuring situations that highlight EVR’s capabilities and are particularly relevant in originating business in 2020 are:

 ·       Challenging stakeholder negotiations

·       Obtaining covenant waivers and amendments

·       Structuring and executing liability management transactions such as exchange or tender offers and consent solicitations

·       Raising new debt and equity capital for complex and/or highly leveraged situations

·       Designing and implementing financing-driven recapitalizations

·       Buying or selling non-core assets or entire companies in a distressed context

·       Developing, negotiating and executing prepackaged or pre-arranged chapter 11 restructurings

·       Traditional chapter 11 restructurings

·       Cross-border and international recapitalizations

·       Providing expert valuation and testimony services

Investment Thesis

 2020 is going to turn out to be a pretty awful year for M&A volume as the market environment is expected to remain challenged.

EVR won’t be spared.  As mentioned earlier, even before Covid hit, EVR’s 1Q results were impacted by higher compensation and “business realignment costs” – with the stated goal to decrease headcount by 6% or ~115 individuals.  Pre-Covid cuts were focused on people that weren’t performing up to expectations, with the intention to reinvest into growth areas.   Earlier in the year, Schlosstein pointed to large white / grey spaces where SMDs would shine – e.g. in Europe in the software industry and advising financial sponsors.

Nevertheless, Covid is here and Deals #’s will continue to be bad.  Some sectors with end markets disproportionately affected by Covid have seen significant late stage deals being pulled — e.g. Boeing walking away from acquiring Embraer’s jet business, and Simon Properties Group terminating the Taubman Centers acquisition despite strong deal protective clauses.  Merger arb hedge funds have increasingly been shorting targets, betting deals get delayed, renegotiated at lower prices, or fall through.

According to Northstar Risk Corp, a software provider to arb traders, the combined implied probability of deals not closing spiked to 33% in March, up from 4% in January (based on spreads of 300 current deals they track).  That is down to 20% as of the beginning of June but still incredibly high by historical standards -- in the last 5 years around 98% of announced deals have closed.  So clearly Mr. Market remains quite skeptical about previously announced deals closing in the near term.

But what about new deals?  The M&A Leadership Council recently completed a survey of 50 C-level executives and corporate development leaders about their plans.  Here is a HBR article that outlines the survey and the findings: https://hbr.org/2020/06/what-ma-looks-like-during-the-pandemic.

While a critical mass of respondents clearly state they plan to halt or implement a “temporary pause” on current deal activity and will remain so until there is more clarity around an economic recovery, data reveals “an important and encouraging counterintuitive growth strategy for those executives and companies prepared to turn crisis into opportunity. We noted a significant percentage (23% of respondents) reporting either “no impact in 2020 forecast deal volume” or their intent to “accelerate” deal volume during the remainder of 2020 based on the increased number of opportunistic targets or more palatable valuations brought about by the crisis. Further analysis of these respondents provided vital insights for other executives and deal-makers intent on growing their companies during and after Covid-19.”

And while some companies in position of strength look to take advantage of bad markets to take out vulnerable targets at cheaper valuations, others will be motivated by strategic imperatives to pursue deals that offer promising growth technologies.  For example, transactions that help accelerate digital transformations are arguably top of mind across verticals.  Other deal type objectives, besides distress and growth targets, include non-core divestitures to shore up balance sheets, and cost takeout consolidation deals.

EVR has outlined its priorities in response to market volatility and Covid, noting the difficult market environment has led to a significant decline in announced M&A volumes, numerous downgrades and expected defaults and a decline in leveraged finance and equity issuance.  Clients are expected to be less M&A focused and more restructuring, balance sheet management and capital raising focused. 

Their needs will evolve as they transition from disruption, to stabilization and recovery and EVR has outlined the repositioning of its internal capabilities to serve these needs in their advisory business creating fee generating opportunities until a more normalized environment returns in strategic M&A.

Things I like about Evercore during this crisis:

·       Brand built on reputation as “most experienced” and “credible” dealmakers. Extensive M&A coverage network, considered a destination for talent.

·       Pristine balance sheet, plenty of liquidity ($846 MM of Cash & Liquid Investments) and flexibility in cash comp cost structure – limiting risk if M&A volume stalls for longer than expected

·       No lending risk or complexity relative to the large integrated mega-banks and broker dealers

·       Dealmaking volume has a floor in bad economic environments

o   Financial sponsors have plenty of dry powder and will act opportunistically

o   Consolidation makes sense in oversupplied markets

o   Strategic acquirers will pounce on weaker targets to strengthen their competitive market position

·       Distress cycle is a boon to restructuring practice, which despite the smaller scale of the business should somewhat counteract temporary weakness in M&A

·       Long term growth opportunities in sector and geographic coverage: TMT, Consumer, Financial Sponsors, Large Cap Multinationals in Europe.  TAM analysis highlights a pool of 10,000 sizeable companies SMD’s have screened as possible target clients

In the end, determining whether EVR can pivot and offset short-term cyclical weakness is less important than understanding the underpinnings of why this is unique firm with a franchise brand that has a reputational and talent stronghold over a significant piece of the dealmaking market.

Global M&A deals announced in 2019 and 2018 were $3.8 and $3.9 trillion, respectively.  YTD during the first 6 months of 2020 global $ volume is down 50% at around $1 trillion, with sharper drops in within the America’s region.  In 2008/09 top line revenue for EVR dropped 40% and it had a compensation ratio of 75% that year.  Assuming non-compensation expenses are fixed, a drop of that magnitude in 2020 would imply a ~$100 MM operating loss or ~($2.10) / share.

However, for long term investors, the only thing that really matters is the healthy balance sheet with ample liquidity and the fact that EVR’s earnings power, built over the last decade, will be preserved and resume once M&A activity snaps back to normal levels.  I expect the 2H of 2020 and 2021 to start showing some signs of life and healing as CEO’s start to seek strategic deal advice to adapt to this new market.  I expect normalized EPS of $7 to $9 in the next 2 years and believe further market share gains could warrant a mid-teens multiple in that time frame – translating into a $120 stock price.

Catalyst

-Rebound in M&A post COVID disruption

-Increasing focus on financials that are balance sheet lite by investors 

-Strong demand for advisory work as corporations work through financial stress/distress