Houlihan Lokey: A Stock To Hold For The Recession And Beyond

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Investment Premise

The last decade has sent the investors the wrong message about investing. For a long period of time it seemed that growth at any cost was the mantra. In fact, if a firm was not showing explosive growth while at the same time losing copious amounts of money it didn’t seem like the investment was worth anyone’s time. In this mass of names if you have to pick the best name do you have to settle for something that loses the least amount of money? I don’t believe so. As a matter of fact, there are names which have given above average industry growth while also significantly expanding their bottom line. But what if I told you in addition to this there was a business whose business model would be resistant to an economic downturn? In the next section let us break down our premise and examine the reasons why Houlihan Lokey (NYSE:HLI) could be worth our investment.

First Reason – Financial performance that went parabolic

For a company with 5.6B market capitalization, latest FY revenues came in about $2.3B, net income at $400M and OCF at $700M. This is quite impressive for a Financial services firm that went public only 7 years ago. Looking at the summary table below it is quite clear that the business gathered steam post 2020 with the average revenue growth for the last two years being 40% and Net Income expanding 55%

Growth in revenues, income and cashflows

Financial Growth (Author Computed)

The most important point to note here is that the company has been able to grow while maintaining consistent cash flow growth and low levels of debt (debt is well covered by operating cash flow). Debt ratio has been maintained below 0.5 and precisely the company’s objective is to operate with low debt to allow it to pursue strategic opportunities. From their latest investor presentation

We operate with extremely low levels of debt. We maintain a revolver of $100 million which has remained largely undrawn. We are focused on maintaining this balance sheet flexibility in order to enable us to be opportunistic, especially regarding acquisition opportunities

Profitability

No talk of financial performance is complete without talking about profitability. At 30% Return on Equity and 17% Return on Assets, these ratios rank high within the Financials sector (Sector median for ROE and ROA is 11.5% and 1.2% respectively) This clearly demonstrates that growth need not always come at a cost (unlike the norm that we have been repeatedly asked to accept in recent years) and it is entirely possible to expect growth and profitability at the same time.

Profitability metrics such as ROE and ROA

Profitability Score (Seeking Alpha)

Latest Quarter

After all this excitement about the company’s financial performance in recent years, let us talk about what happened in its most recent quarter. Against a challenging economic backdrop, latest comparable QoQ growth rate slowed down considerably but it still came in at $419M – an increase of 13%. Within its three segments, although Corporate Finance and Valuation Advisory revenues increased by 26% and 19% respectively, Financial Restructuring’s revenues decreased by 20% primarily attributed to a significant decrease in the number of closed transactions. The company was able to show this resilience mainly because of their diversified business model structure and its market leader position in “Global Distressed debt and Bankruptcy Restructuring” and this resilience is expected to continue in the future as well. From their Q1 2023 earnings press release –

We had a solid first fiscal quarter and our diversified business model is performing as we would expect it to in the face of current market conditions. We are seeing a slowdown in global M&A closings; however, new business activity in both our corporate finance and financial and valuation advisory business segments remains healthy. Furthermore, we are beginning to experience a meaningful increase in distressed business opportunities. Regardless of the business environment we encounter in the coming quarters, we believe we are well positioned to successfully address a variety of market conditions

Market leadership exhibited by HLI in the segments that it operates in

Leadership in covered segments (Company website)

Second Reason – Diversified Business Model

Houlihan Lokey, Inc. is a leading global independent investment bank with expertise in mergers and acquisitions, capital markets, financial restructurings, and financial and valuation advisory. A common characteristic of a growing company could be repeat and increasing business from a small group of clients. This could put the company at risk with the loss of any single client hitting the top line. However, in this case we see the situation being completely different. With a base of over 2000 clients, there wasn’t a single transaction that represented more than 2% of the revenues. Also, within the industry distribution, there was no single industry contributing to more than 20% of the revenues. This is important as each industry goes through boom and bust cycles of their own but since the revenues are well diversified across industries the revenue from the full industry mix is always balanced out.

Client mix, product mix and industry mix

Diversified Business Model (Company website)

Third angle – Attractive Valuation

PEG ratio

For a company that has expanded its bottom line ≈30% in the last several years with a business model that can benefit even during an economic downturn, PE multiple would not be as useful and PEG ratio would be more helpful in telling the full story.

PEG ratio over the last one year

PEG Ratio (Y Charts)

From the chart above we see that PEG ratio has been climbing over the past one year and current value of 0.6 (derived at projected 20% growth) is still less than 1 which is considered as an undervalued investment.

To avoid being too reliant on just one method let us also use a levered DCF approach and arrive at the intrinsic value of the company.

DCF Levered

Step I – Forecasting cash flows for the next five years, I have a used a conservative growth rate of 10% increase in revenues (much less than the average growth of the last five years). Operating Cash flow as a percentage of revenues is also at a conservative level of 20% and capex is maintained at the average rate of last five years (-0.9%)

Projecting cash flow for the next five years

FCF Projection (Author’s projection using company data)

Step II – Next step is to find the Weighted average cost of capital. We are setting a value of 4.14% for our risk-free rate (current 5Y treasury yield). Market Risk premium comes out to be 3.16% (Market Risk Premium = 5Y real returns of the stock market – risk free rate) (7.3% – 4.14%) giving us (WACC) at 6.11

WAC

WACC (Computed using publicly available data)

Step III – Plugging this number (WACC) for our Free Cash Flow build-up gives us the sum of present value of the leveraged Free Cash Flow at $2.5B.

Using WACC to calculate free cashflow buildup

FCF Buildup (Company data and Author’s calculations)

Step IV – Calculating the Terminal value using growth in perpetuity method with Long-term growth rate at 2% gives the present value of terminal value.

Present Value of Terminal Value

Present Value of Terminal Value (Author’s calculations)

Step V – At the final step, we calculate the intrinsic value and compare this against the current market price. The gap (>50%) we observe indicates to us that this stock is undervalued and there is a very strong case for buying at these levels.

Equity value per share computed using publicly available data

Intrinsic Value (Company data and Author’s calculations)

The big gap we observe is because of the net debt levels of the company. The negative net debt implies that the company possesses more cash and cash equivalents than its financial obligations and if the firm were to increase its debt levels, we could a see reset of our valuation to the downside. Another potential trigger that could affect us would be the increase of 5Y yields which would increase our Risk-Free rate resetting our intrinsic value lower. With regard to revenues and operating Cash flow, I see very little risk to our calculation as I was quite conservative in my projections and all indicators point to the revenue and OCF being much higher. Lastly but probably the most important factor is the Beta value. HLI’s volatility when compared to the overall market is much lower (helps making a stronger valuation case) and I will expand more on this in the next section.

Fourth Reason – Price Action stability

Five year return of HLI versus SPY

5Y Total Returns (Y Charts)

The popular idea is that if you are chasing growth then higher volatility and bigger drawdowns(when compared to the index) are acceptable. While this is true in most cases, Houlihan Lokey proves out to be a winner even in this regard. 24M Beta stands at 0.79 and 5Y beta stands at 0.66 both of which suggest that this stock has less momentum when compared to SP500. Also, Year to Date when a lot of growth names saw their returns got hammered, HLI experienced a decline of 25% in its stock price comparable to the same period for SPY.

Beta and Drawdown of HLI versus comparables

Beta and Drawdown (Author collected)

Above table is an extension of the idea that not only has the stock volatility been lower than its comps, it has also beaten the index returns in the 5Y timeframe. This kind of performance is extremely rare to come by and any experienced investor will tell you the biggest enemy of CAGR is drawdown further cementing our case on Price Action stability.

Risks

Houlihan Lokey has been making good use of its cash through multiple avenues (stock buybacks, dividends, acquisitions etc.) but one of the major ways this can fall apart is from a failed acquisition. As recently as October 2021, company spent over half a billion dollars to acquire GCA corporation but there is no guarantee this integration will be successful or if they can reap the expected benefits of the acquisition. As of now total goodwill and intangibles exceed $1.2B and any impairment of this would affect our earnings. Another minor risk is the strength of the US dollar compared to foreign currencies. In most situations this is negligible but the strength of the dollar exhibited against Euro and other currencies this year could be a cause for concern as the company generates more than 25% of its revenues from international operations.

Wrap Up

This stock has been punished as much as the index but we explored multiple reasons why this could be a great investment. A combination of explosive growth over the last few years and the future earnings being resilient due the nature of its playing field, low valuation, robust/diversified business model and most important of all price stability which allows you to have a good night’s sleep makes this a must have for one’s portfolio. In the coming days, I will be initiating a long position in HLI and hope to benefit from its performance in the future.

Editor’s Note: This article was submitted as part of Seeking Alpha’s best contrarian investment competition which runs through October 10. With cash prizes and a chance to chat with the CEO, this competition – open to all contributors – is not one you want to miss. Click here to find out more and submit your article today!

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