Description

IDEA- SHORT FTI CONSULTING (FCN) OR BUY LONG DATED PUTS

Description:

FTI Consulting Inc. provides forensic and litigation consulting, corporate finance, strategic communication, economic consulting and technology services. The Company offers services designed to help companies address critical issues and improve performance before encountering disputes or financial difficulties.

THESIS

- FCN is a perceived beneficiary from the global credit crisis as it is one of the most prominent corporate finance/restructuring consulting firms in the country. However, the true economics of the consulting businesses are not reflected in the income statement as the company uses forgivable loans (which are amortized over 5 years) and contingent payments (which flow through the cash flows from investing) to compensate its consultants.

- FCN is a serial acquirer that employs aggressive accounting tactics that enable the company to show revenue, EBITDA and EPS growth without accounting for the applicable compensation expenses in the income statement.

- Management appears to be overly promoting the merits of the business model to naïve investors and sell-side analysts while paying themselves handsomely based on inflated reported EPS and EBITDA. Management has been dumping millions of dollars of stock over the past 2 months- during that time span management has appeared at multiple investment conferences touting the business model.

- Investor perception of FCN drives their ability to grow. Both equity and debt capital markets (and a high stock price) are necessary to grow the business through acquisitions. If you look at the pattern the company has undertaken the last several years, the company taps the capital markets in the back half of each year and then goes on an acquisition spree with the newly raised capital.

• Q3 2005 issued $350mn in debt - made 4 acquisitions in 2006
• Q4 2006 issued $215mn in debt - made 7 acquisitions in 2007
• Q4 2007 issued $253mn in common stock - made 16 acquisitions in 2008
• Q3/Q4 2008 FCN failed to monetize its tech consulting business - have announced no material acquisitions in 2009

- We believe that it is no coincidence that FCN has not announced a significant acquisition since last summer. FCN has not been able to raise capital since Q4 2007. FCN had high hopes to monetize its e-discovery tech consulting business in the back half of last year, and was unable to do so.

- We expect that future earnings releases will begin to reflect the true profitability of the businesses as we lap a period of time with no acquisitions - this will likely occur in the 2nd half of 2009 and into 2010. 

- The economics of the current business model reward management and consultants, not shareholders.  

Low Quality Earnings

FCN hides compensation expense through forgivable loan programs     FCN provides its key employees general recourse forgivable loans (which essentially are signing bonuses and retention bonuses) that are amortized to expense over their forgiveness period, which is generally 5 years.  Beginning in 2006, FCN adopted the Senior Managing Director Incentive Compensation Program.  A key component of compensation addressed in that program is forgivable loans.  We see the growth in this program below as provided in the footnotes of the 10Ks.

                                                                                    2005    2006    2007    2008

Forgivable loans disbursed each year                               0.0       31.0     35.0     26.3 

Notes Receivable from employees, current                        2.7       6.8       11.2     14.6    

Notes Receivable from employees, net of current               4.5       33.7     51.3     56.0

It is important to note the impact of forgivable loans on the income statement.  Since it is amortized over 5 years, only 20% of the loan (bonus) is expensed in the income statement.  For example, in 2008 directors received $26.3mn in bonus compensation in the form of forgivable loans, but only $5.3mn (our estimate based on 20% of $26.3mn) of that bonus was expensed.  Given FCN reported $205mn in pretax profits in 2008, one could argue that true profits were much lower given that $21mn was not expensed.  Admittedly, this is a simplistic example because it does not factor in the amortization from prior loans and/or potential repayments if a director left, but directionally we'd argue that profits are lower than they appear.  By what amount is the real question.    

FCN hides compensation expense through additional contingent consideration programs (earn-outs)  It is no surprise that an acquisitive company has earn-outs.  Most experts would even argue that acquisitions should have earn-outs.  We do not disagree.  However, we note that earn-out accounting does enable aggressive companies to manipulate earnings.  Given the promotional nature of management and poor corporate governance at the board level, we suspect that there could be some levers being pulled.  At a minimum, it should be considered that these payments are necessary in perpetuity to retain these employees in the long-term.  Thus, earn-outs should be included in the expense line to understand the company's l-t potential earnings power. 

Note in Q1 2009 - a quarter which "blew away" Street estimates, FCN paid $25.7mn in "payments for acquisition of businesses, including contingent payments".  In fact, in the 10Q it states that it paid $25.5mn in contingent payments.  Given FCN reported $31.7 in after tax profits, $25.5mn is quite a large figure.  Given that every segment outside of corporate finance appeared not especially robust, we wonder who received these payments and what metric is it based on? 

FCN paid $52.6mn, $43.1mn and $17mn in earn-outs in FY2008, 2007 and 2006.  FCN reported pretax profits of $205.6mn, $149.8mn and $79.2mn in 2008, 2007 and 2006.  These earn-outs are very large figures in the context of reported profits.

Management and Corporate Governance

We'd argue that Corporate Governance is poor at FCN and Management compensation is excessive. 

- Compensation is based on subjective metrics, but loosely based on EPS and EBITDA growth.

- FCN moved Headquarters from Maryland to West Palm Beach, FL in the last 2 years. Management spends the winters in FL and summers in MD?

- Named Executive Officers have the following perks: access to the corporate aircraft, company car allowances, golf membership fees paid for, season tickets to the Baltimore Orioles (some might argue that's not a perk). See: http://www.footnoted.org/buried-treasure/pretty-sneaky-at-fti/

- Note, the Compensation Committee determines the scope of the Senior Managing Director Incentive program. Gary Wendt, the former highly-paid CEO of Conseco pre-bankruptcy was Chair of this committee up until last month's proxy. We note that per FCN's 8K filed on 4/6/09, FCN, based upon the recommendation of the Compensation Committee, approved and authorized amendments to the Non-Employee Director Compensation Plan to provide for the acceleration of vesting of currently outstanding and future equity awards to non-employee directors upon the cessation of a non-employee directors term. One month after this filing, FCN revealed in its proxy that Gary Wendt was leaving the Board. See 4/6/09 8K filing for full detail. Gary Wendt filed to sell 37,500shares on June 18^th. Were these shares accelerated?  

- Also, a side note, where is the CFO?  I have listened to 2 years' worth of conference calls, and he rarely, if ever, participates.  This is interesting given the aggressive nature of the accounting.  He did sell stock on 5/20/09 at 53.50 though! 

Recent Events

Since reporting "blow-out" earnings on April 29th, Management has been out heavily promoting the business.  FCN has presented at the Baird, JMP, UBS and Blair conferences.  13 analysts now cover the stock, and 13 analysts have it rated Outperform or Buy.  In recent weeks FCN's Executive Chairman, CEO, CFO, COO and several directors have sold over $10mn worth of stock.  If business is so great, why are so many FCN insiders, while actively promoting the stock, dumping it as well. 

Valuation

In our opinion, it is meaningless to value FCN on any reported EBITDA or EPS figures.  The largest component of FCN's P&L is compensation expense.  Yet, FCN structures forgivable loans and additional contingent consideration, which is compensation, such that very minimal amounts flow through the income statement.  Simplistically, FCN maintains an enterprise value of $3B.  Expectations are for $1.5B in topline in 2009.  That's a hefty multiple to revenues.  Peers historically trade at 0.8- 1.5 EV/Sales.  The Street estimates EPS of $2.74.  We'd argue that FCN is not worth 18x forward "inflated" EPS.  Especially, since much of the growth is expected to come from successful acquisitions.

CONCLUSION:

- FCN is a serial acquirer that employs aggressive accounting tactics that enable the company to show revenue, EBITDA and EPS growth without accounting for the applicable compensation expenses in the income statement.  

- The company "hides" the compensation expense to current consultants and newly acquired consultants by classifying compensation as "general recourse forgivable loans" (generally amortized over 5 years, so impact on earnings delayed) and "additional contingent consideration" for acquisitions (which flows through the cash flows from investing, not the income statement).

- Poor corporate oversight determines compensation plans.  Management, consultants and directors are compensated based on inflated EPS, EBITDA.  Notably, stock is a large form of compensation as well.  It is of FCN's interest to have an elevated stock price to compensate current employees. 

Catalyst

• Future earnings releases provide true color of business model earnings power
• Potential future goodwill write-offs
• The law of large numbers- FCN requires larger acquisitions to show material revenue growth.  This increases risks on a number of levels.
• We'd also highlight page 70 of FCN's 10K.  FCN has provided stock price guarantees on many of its acquisitions.  I.e. in deals where there is a large stock component, the company is required to make cash payments to acquired entities for the difference in the stock price at time of acquisition and stock price at the time the guarantee lapses.  If FCN stock price fell considerably (below $30), FCN would owe substantial cash outflows.  Why would any management do this?