Description

Abstract

Lazard was a popular short about a year ago when the stock was trading in the fifties, both due to fear of overly optimistic outlook for M&A (given strong 2014 & 2015) as well as a general trend of capital flow from active to passive asset managers. The short has worked well although the thesis hasn’t materialized, and the stock is now 40% lower from where it’s been exactly one year ago. I believe this situation has created a very compelling opportunity for the longs here, as a depressed valuation of 9x P/E and 17% FCF yield reflects a very dire future. My view, and the purpose of this writeup is to try and explain why current market expectations are way too pessimistic and the future actually looks quite bright for Lazard’s shareholders.  

Warren Buffett once (or more) described the best business as one that generates a lot of cash with no need for reinvestment in the business. Well, Lazard happens to be just that kind of business. It requires no CAPEX to fund future growth, it consistently generates higher FCF than its GAAP’s net income, and it returns all excess cash flow to investors via dividends and buybacks. Cash returned to shareholders in the last twelve months reflects a 11.5% yield on current price ($327m of dividends + $173m of buybacks on a $4.2b valuation).

However, we know both investment banking (advisory) and asset management as cyclical businesses, so could we be looking at a peak year? This is what the market is currently pricing, but as I’ll try and show below, I believe we’re more likely to see continued trend of multi-year growth and Lazard’s earnings will most likely be higher than 2015 on average in the next 3-5 years.

Business Overview

Before diving in, I’ll note that throughout this write-up I’ll be discussing Lazard’s earnings on an adjusted basis, applying some necessary adjustments to the reported GAAP figures. I’m not taking management’s adjustments “as-is” but I believe management’s figures are closer to the “real” numbers than the GAAP ones. Most of their adjustments should be applied in order to get a “clean” picture on earnings, but the ones that shouldn’t were obviously excluded.  

The adjustments I’ve applied to GAAP earnings were as follows:

Awarded vs. Reported compensation expense - GAAP requires Lazard to capitalize some of its one-time compensation expense (signing bonuses, etc.) and then amortize them through several years. Management believes that a more appropriate figure is the “Awarded Compensation” which better reflects the cash and stock grants that were paid in a specific year, excluding any capitalization and amortization. I’m on the same side as management here and have used the awarded figure throughout the analysis (as a side note - in the past these figrues were quite different and the adjustment was material. However they’ve pretty much converge in the last couple of years and in 2015 the difference between awarded and GAAP compensation was, as GAAP compensation wss $1,319m and awarded compensation was $1,329m).

Operating vs. Net revenues - since Lazard is reporting as a financial institution, oddly enough GAAP demands them to present some financial expenses as a deduction from revenue and not in the financial income/expense line below operating profit. This doesn’t make a lot of sense as Lazard is not in the business of lending and investing but basically collecting different kind of fees. It’s as operative business as it comes. I’ve used the operating revenue figure in my analysis.

Redemption of 2017 notes - during 2015 Lazard recorded a non-cash expense of $60m due to the early redemption of the 2017 notes. This expense was adjusted as well.

Investment Banking

Lazard is a top-tier investment bank and asset management firm. It's the biggest independent ("boutique") investment bank, where competition is either the big banks (GS, MS, JPM) or other independents (Evercore, Moelis, Greenhill). Lazard has a unique market position since its IB division is big enough to rival bulge-brackets for mega-deals, but it still enjoys a "boutique" firm reputation. To illustrate where this advantage comes in handy, let’s look at M&A transactions valued at over $10b each. In 2014 alone, Lazard advised on 12 of these, while Evercore, Moelis and Greenhill all together advised on one such transaction (GS and MS led the group, advising on 18 & 17 such deals, respectively). In terms of total Advisory revenue, LAZ was ranked 4th globally in 2014 and 5th in 2015 (behind GS, JPM, MS, BOFA).

Generally speaking, the pendulum has definitely swung towards the independents since the last financial crisis. There are probably few reasons for such turn but mainly the fact that big parts of the world blamed the big banks for the crisis (and their reputation as advisors for just about anything took further hit from their massive reported losses). Excluding GS which has done remarkably well, independents have consistently took market share from big banks in the financial advisory space since 2007. For example, in 2007 MS was doing 2x the advisory revenue of LAZ, JPM was 1.8x and BOFA 1.8x as well. In 2015, MS was doing 1.5x LAZ’s advisory revenue, JPM 1.7x and BOFA 1.05x.

Obviously, Lazard's advisory revenue is highly dependent on M&A volume, which tends to be quite cyclical in a historical perspective. The market is currently intimidated by the chance the cycle is turning again and to my view most financial advisory firms and Lazard especially are priced as if we've already peaked in 2015. To this I can say two things:

1. We are still far away from being anywhere near the last couple of tops in terms of M&A activity. Of course no one guarantees we’ll reach a similar top in this cycle as well, but by all common measurement metrics (mainly (i) announced M&A as % of global market cap and (ii) M&A as % of global GDP) we have only crossed the multi-year average in 2015 for the first time after staying below it for between 6-7 years, more than in any other cycle in the last 30 years. In addition, low interest rate environment is highly supportive for high-level of M&A activity and CEOs feel the pressure to grow in a low-inflation world where organic growth is very hard to achieve (and we’re past the cost-cutting and operational efficiencies phase).  

Again, I have no idea if we reach the same M&A levels as we did in the peak of the last two cycles, and it might be that we are experiencing some kind of a pullback in volume and announcements as we speak (or we might not with last week’s ARM deal and today’s announced acquisition of JOY Global), but I’d still argue that anything similar to the previous down cycles is not to be expected anytime soon if historical figures tell us anything.

Despite general conception I still claim financial advisory (especially M&A related) is a secular growth industry between the cycles. I've spent several years as a transaction consultant with E&Y and worked with many management teams on M&A deals. I’ve seen zero boards who were willing to approve a deal without supporting work from external advisors. Whether it’s just to cover their *** for future screw-ups or because of the real value generated from the process is a legitimate question, but of little relevance here I guess. I’m aware of the fact that there are boards out there who work differently (Berkshire, Google, etc.) but from my experience they represent a tiny fraction of the market and I don’t see this changing in the foreseeable future. Also worth mentioning Lazard’s advisory revenue had 10-year CAGR of 5% through the last/current cycle (2005-2015).

2. Even if we’ve peaked and the cycle does turn, restructuring revenue should mitigate big part of the decline in M&A volume and related fees. Lazard has one of the top 2 restructuring practices in the business (they claim it's #1 but it's a close call as can be seen here: http://www.alixpartners.com/en/Portals/alix/news-docs/4Q2015_Distressed_Debt_Bankruptcy_Restructuring_Advisory_Review.pdf).

2015 has had the lowest restructuring revenue for Lazard since 2006 and management indicated on several occasions it was starting to pick up in 2016, especially in the oil & gas industry. Restructuring revs lag the actual downturn in an industry for obvious reasons, as in most cases it takes management teams quite some time to acknowledge the severity of their problems. Most of the trouble in the energy and commodity-related businesses will only convert to actual restructuring revenue for bankers in 2016 & 2017.

In 2009, restructuring revenue tripled compared to the year before, so while M&A advisory revenue was cut in third, total revenue was only down 4% for the year. I think this should provide some conviction to own Lazard here even if you’re not sold on the continued expanding M&A cycle expansion.

In fact, given the previous point on where we are in the broader M&A cycle, there’s a chance that the next 1-2 years will benefit from both strong M&A market as well as a boost to restructuring. This was basically what Lazard’s CEO Ken Jacobs was telling investors in the latest quarterly call:

“Third, while we generally only have visibility into the next three to six months in our business, it appears that this period into which we do have this decent visibility, the first six months of 2016 will be one of those unusual periods in which both M&A and restructuring activity will be strong.”

If the cycle is really turning this restructuring trend is only about to grow stronger. While I’m certain that a big financial crisis will be very painful for Lazard’s advisory business, I suspect it should be viewed as a temporary hiccup in the long-term growth with at least partial mitigation coming from the restructuring practice.

Asset Management

Lazard is a top-100 global asset management firm in terms of AUM with a decent track record in both performance and money raising (net flows). Lazard was able to grow AUM by 7.8% CAGR in the last 10 years (2005-2015), vs. a 6.6% CAGR for the S&P 500 for the same time.

Asset Management is an attractive business. It’s very scalable as from a certain size it demands almost no incremental increase of cost when assets under management grow. It also enjoys recurring revenues and high returns on invested capital. On the flipside it suffers from what is considered a secular trend towards passive management, which I’ll be getting to in a bit.

Lazard has 81% of its AUM in equities, which might make the journey more volatile, but also more valuable from an asset manager perspective due to a couple of factors: (1) equities earn higher management fees than fixed income; (2) equities compound at a higher rate over time, boosting AUM growth as well as generating performance fees along the way.

The advantageous asset mix is one factor, but it wouldn’t be worth a lot in the absence of superior performance. From the eight $1b Lazard funds ranked by Morningstar - half (4) received five stars which means they’re in the top 10% in their category, 2 funds got four stars which means they’re in the next 22.5% (so basically in the top third) and 2 got three stars - which means they’re in the middle 35%.

Both of these factors - asset mix and better-than-average performance, are also reflected in AUM CAGR of 11% from the 2008 lows, compared with an industry average of 7%.

The long-term outlook for AUM growth is critical since AUM is ultimately the driver of this segment revenues and earnings. Revenues as % of total AUM ranged from 0.53% to 0.60% since 2005, so this is not as cyclical business as one would think and it can certainly survive downturns pretty successfully. Operating margins for this segment averaged 33% in the last 3 years and 31.5% in the last six.

As impressive as the historical performance may be, the market clearly is worried about the future and especially a secular trend of assets flowing from active to passive management. I believe this view is well priced in most asset management firms’ valuation multiples, and Lazard is no different.  I have several arguments that I think worth considering in this active vs. passive debate:

1. It’s still quite hard to deploy large sums of money in certain strategies via passive products - especially when big clients (endowments, etc.) are trying to get exposure to emerging market, different currencies, etc. Lazard currently has only 17% of its AUM in strategies that focus on US equities - an asset class which is probably the most prone to the threats of passive products.

2. If the passive management industry grows to be too big - it will start to move markets by only following a small number of active management who will dictate the original price movements. This will eventually hurt passive investments performance vs. active managers and ultimately balance the trend of underperformance by active managers.

3. People still enjoy the act of actively buying and selling shares, and that is not about to change soon. Even more importantly, the many thousands of people who sit in investment committees for various institutions around the world are not likely to admit that they are simply redundant, and that the money could be deployed passively with similar results.

On top of the reasons mentioned, for Lazard specifically this so-called secular trend simply doesn’t reflect in the numbers. While the passive industry has grown considerably in the last few years, Lazard enjoyed net inflows in 3 of the last 4 years. If this was indeed a trend affecting Lazard, it should've been seen in the numbers already.

2015 was definitely a great year for the passive management industry. Not only that active managers showed poor performance in aggregate, the passive industry enjoyed further tailwind from the media including an article from the Economist declaring that “Consumers are finally revolting against an outdated industry” (Article is titled ‘The tide turns’).

To understand how strong this trend really is I’ve looked at 2015 net flows of small-to-medium publicly traded asset management firms - ones that are comparable with Lazard’s AM Business. The results are below, and two things can be read from them:

• Average net outflows of -0.8% don’t strike me as terribly worrisome.

• While Lazard outperformed the group on average (and only trailed two asset managers in terms of net-flows), it’s still valued at a discount (could be the effect of the IB business).

General / Other

Generally speaking, investment banks are very agile when it comes to cost-cutting. Goldman for example is letting go of 5% of the workforce every year regardless of where we are in the cycle, and more than that in years where they feel the business won’t be growing (like 2016). Historically, Lazard had a cost structure problem, as it was lagging the industry in terms of margins and got a lot of shareholders upset with its high levels of compensation. They were basically overpaying as a strategy to attract the best talent around, which isn’t necessarily a bad thing and probably helped them build out a fabulous brand that is rivaled by almost no one in Wall-Street (other than GS I suppose).

However in 2012 current CEO Ken Jacobs announced a restructuring plan to get Lazrard's alongside industry peers in terms of margins and comp. structure. The goals he set to reach by 2014 were as follows:

• 25% operating margins.

• Compensation expense to range at mid to high 50%'s of operating revenue over the cycle (55%-59%).

• Non comp. expense at 16%-20% over the cycle.  

These goals were all reached in 2014 and remained on track in 2015 (25.9% operating margin, 55.8% awarded compensation ratio and 18.2% non-compensation expense to total operating revenue). The question remains whether the 'over the cycle' part is achievable. Obviously if we’re facing a severe financial crisis like 2008 or worse, it's highly unlikely that they'll be able to be anywhere near these numbers. However my view is that i) 2008 was not a normal end for a cycle, and most cycles end with a softer landing. Given the multi-year margins in the industry and the flexibility of the cost structure I believe it's possible to keep operating margins at 20%-25% throughout the cycle. ii) Nonetheless, if a major financial crisis strikes, Lazard is still well prepared to live through it. Its relatively small debt balance is due in 2020 and 2025 so I don't view failure as a valid option even in the hardest of financial storms (not to mention a lot of money will be spent on restructuring if this type of crisis comes along).

Management is very much focused on capital allocation with all excess cash flows returned via buybacks or dividends to investors as a policy. Lazard pays a quarterly dividend (currently yields 4.6%), makes share repurchases that will at least offset any dilution from share-based compensation and with whatever is left either pays an additional annual dividend or increase share repurchases, opportunistically. With where the share price has been this year, I think it’s safe to assume that most excess cash flow will be returned via buybacks. As of April 20, Lazard purchased $119m of share YTD and has remaining authorization for additional $300m. At current market cap this means they’ll be able to buy back more than 10% of the shares outstanding, all while returning a 4.6% yield via regular quarterly dividends.

The business has a solid moat in its brand and personal connections the managing directors bring with them. As someone who tried in the past, it’s practically impossible to win advisory deals from current Lazard’s clients (same goes for GS) - there's a very high stickiness factor in this business which is based on personal ties (not limited to but including playing Golf together). I also think that having handling so many mega-deals of over $10b in value is a solid differentiator from other boutique/independent investment banks, and having being a boutique-independent firm still acts as a differentiator from bulge-bracket banks.

Valuation

As I mentioned earlier, Lazard’s current price reflects 9x adj. LTM EPS and 17% FCF yield (less than 6x FCF multiple). In this regard it’s worth noting that Lazard’s free cash flow has been higher than net income throughout the cycle due to a couple of reasons. First, there are still amortization expense on historical acquisitions ($6m in 2015, or 1.3% of net income). Second and more significant, a major part of compensation is basically non-cash - in the form of stock options and RSUs. While it’s true that it is an expense just like any other, one should notice that since the stock is down 30% Year-to-date, and since Lazard is buying back all share granted to employees, this is certainly a situation in which expenses are overstated, as per GAAP the stock-based-comp expense is recorded based on the share price on the day of the grant, while the purchases that occur throughout the year are now much cheaper.  I haven’t quantified the specific amount since I don’t know the dates for the buybacks, but investors should keep in mind that in today’s prices, Lazard’s eventual cost of buying back the share it has expensed as SBC will have a positive net cash effect on the company (i.e. FCF will again be higher than net income).

Lazard’s average P/E multiple over the last 10 years stands at 18x. Moreover, industry peers such as Evercore Partners and Moelis currently trade at 50% higher than Lazard, at ~15x adjusted LTM EPS. So what’s driving the current depressed valuation?

1. Fears from ‘top of the cycle’ earnings in M&A;

2. Fears of a secular money flow from active to passive managers.

3. Market currently discounting cyclicals and companies with less predictable earnings.

As for (1) - following the discussion on Lazard’s investment banking segment above and given current M&A volumes, my base case is that whether the cycle has turned or not, Lazard should be able to keep its long term CAGR at ~5.0%, similar to the CAGR achieved in the last 10 years (2005-2015). Due to labor intensity, rising wages and competition for talent, I’m cautiously assuming no more margin expansion from scale, as the company will keep an operating margin for this segment at 25%.

Asset management is a more lucrative business, and applying historic 10-year AUM CAGR of 7.8% should results in low-double-digit earnings growth, as advantages to scale are much more apparent. However due to lower consensus expected return from equities in the next decade (~5%), as well as the risk of money flow to passive instruments, I’ve assumed net flows to be flat in the next 3-5 years. Due to Lazard asset mix, and if we assume equities exposure will compound at similar rates as the market and fixed income at 2%, we get average AUM growth of 4.4% going forward (80% of assets growing at 5% and 20% at 2%). Given the natural advantages to scale, this should result in 6%-7% earnings growth.

As for the third factor, the growing divergence in valuation between companies with predictable cash flows and ones of a more volatile/cyclical nature - this is becoming more and more a topic for discussion among money managers in the last few quartes. Most recently, KKR’s CIO Henry H. McVey has mentioned this growing gap as an arbitrage opportunity in his mid-year update:

“As we discuss in more detail below, our bigger picture belief is that financial assets with predictable cash flows could now be overpriced in many instances. On the other hand, “complexity” (i.e., stories that lack EPS visibility or some type of industry taint) now seems to be trading at a discount, particularly in unloved sectors of the market. In our view, this discrepancy may be one of the most important arbitrages in the market right now.”

In the hands of a common shareholder, a Dollar of cash returned by a cyclical business is equal to the Dollar returned by a steady industrial giant. Therefore although I don’t know exactly how this will be played out, I do expect this reversal of the trend at some point during the cycle.  

Going back to Lazard’s future earnings, some short-term tailwind could be expected from lower interest expense on the corporate level due to refinancing that took place in 2015 (I expect $43m of interest expense in 2016 compared with $59m in 2015). And additional upside further down the road could come from the investment portfolio, which currently includes $530m of investments at fair value. On a multi-year outlook this portfolio should contribute to earnings more than the 2% it did in 2015. Historically, returns on Lazard’s investment portfolio averaged 5% - so the difference is worth additional $17m for pre-tax earnings (~3% of PBT). Alternatively, one could take the $530m investment portfolio at book value and simply look at a discounted EV excluding this item. I don’t do this since I think there’s very little chance it will be liquidated so earnings are probably the only way a common shareholders will see gains from this portfolio (it could still be viewed as some kind of a downside protection though).  

Everything mentioned above implies a 5%-6% earnings growth over the next 3-5 years and through the next cycle. Assuming these mid-single-digit growth in both EPS and FCF, and with current P/E of 9x and FCF yield of 17%, you don’t need any sophisticated model or math skills to see that the stock should gain about 70%-80% from here only to return to historical average multiples.

Catalyst

Earnings, buybacks, dividends - investors won’t remain indifferent to double-digit yield for much longer.