iBanking: An Analysis of 2 Investment Boutiques

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The 2000’s were a tough time for investment bankers toiling in the traditional advisory areas.  In the wake of Sandy Weil’s game of chicken with the U.S. Congress that led to the repeal of Glass-Steagall, commercial banks encroached on the turf of the investment banks and the investment banks responded by bulking up.  It was the decade of the trader, VaR exploded as banks embraced risk and the revenue growth that came with it, and those on the advisory side were increasingly relegated to the role of salespeople for the more favored arms of the companies they had so long dominated.

But within every broad market move there are counter-currents, and slowly, under the radar at first and then more clearly, boutique advisory firms began to gain share.  Leading the charge have been Lazard (NYSE: LAZ), Evercore Partners (NYSE: EVR), and Greenhill & Co. (NYSE: GHL)Jeffries Group (NYSE: JEF) occupies an odd middle ground, seemingly desirous of both the benefits of a boutique but unable to turn away from the temptation of using its balance sheet to juice profitability.  These firms honed a pitch that was, and remains, simple and appealing: a back-to-basics approach to advisory services in which the advisory firm had nothing to sell but its expertise. 

Firms like Goldman Sachs might pat themselves on the back that they could manage byzantine conflicts of interest with its clients, based on the view that its clients are sophisticated and should know to be cautious; but these boutiques intuited a truth that it too often forgotten in finance and professional services in general: clients want to hire someone they can trust, not mercenaries they need to be on their guard against.

The downside of advisory pure-plays is that business can fluctuate wildly.  A weak deal environment can send profitability plunging, as Q3 results illustrate:

  • Lazard saw an even steeper profit drop of 47% (or 33%, according to management’s preferred non-GAAP measure).
  • Evercore saw a profit decline of 13%, driven by a 15% decline in its investment management business.
  • Greenhill looked like a winner by posting Q3 profit that was flat over the year ago period.  But remember, in Q2 Greenhill suffered a 90% plunge in profitability.
  • Meanwhile, Jeffries Group Q3 results highlighted the benefits of sources of revenue beyond advisory and investment management.  While net earnings were up 45% year over year, Investment Banking revenue was down 11.4%, and asset management revenue eked out only a 1% increase.

The question every investor needs to ask when assessing an investment bank is simple: what will be left over for the shareholders?  Compensation is the 800 pound gorilla that these companies must wrestle with, though increasingly it appears that consensus is building on Wall Street that something fundamental did change following the 2008-9 recession, and that in order to thrive, the compensation model for these companies will be different moving forward.  Arguably, much of the appeal of the boutiques has been that they represent a safe place for talented investment bankers to work, unencumbered by any limits that may be placed on systemically important institutions.  Nonetheless, signs indicate that change has come to the boutiques as well.

Let’s dig into two of these boutiques, and see what value there might be for investors:

Jefferies Group         

  • Revenue Breakdown: As stated above, Jefferies is in many ways a mini bulge bracket bank rather than a true boutique advisory firm.  In FY 2011 the company had the following breakdown of its (total) revenue sources:
    • Interest (35.4%)
    • Investment Banking (31.8%)
    • Commissions (15.1%)
    • Principal Transactions (12.1%)
    • Other (4.3%)
    • Asset Management (1.3%)
  • Compensation: Excluding certain expenses, the compensation ratio was 59.4% in 2011and 59.2% in 2010. 
  • Leverage: Jefferies has a $34.4 billion balance sheet supported by $3 billion of net tangible assets, for a ratio of 11.5x.  Despite this moderate leverage, Moody’s recently downgraded Jefferies to one level above junk, citing risk management concerns. 
  • Valuation: At an EV/Revenue (ttm) of 0.9, Jefferies looks like a reasonable buy, but management must do something to increase the anemic Return on Equity, currently an uninspiring 8%.
  • Recommendation: Jefferies is in the mushy middle of investment banking, and while it seems reasonably priced, it does not look cheap enough to generate any real enthusiasm.  Additionally, with the company only one notch above junk, the downside risks are considerable. Pass on this one.

Lazard         

  • Revenue Breakdown: Lazard is a study in simplicity, though simplicity writ large.  Wresting control of this company and taking it public was the crowning achievement of M&A legend Bruce Wasserstein, and there is poetry in the focus of this storied company.  In FY 2011 the company had the following breakdown of its (total) revenue sources:
    • Financial Advisory (54.2%)
    • Asset Management (49.1%)
    • Corporate (-3.3%)
  • Compensation: Undoubtedly an area in need of attention, compensation expense rose to 63.9% of net revenue in 2011, from 62.7% in 2010. 
  • Leverage: Lazard’s $3 billion balance sheet is supported by $310 million of net tangible assets, for a ratio of 9.6x. 
  • Valuation: At an EV/Revenue (ttm) of 2.0, Lazard looks to be too richly valued for a company that has yet to demonstrate an ability to get a handle on compensation costs.  The fact that Return on Equity, is at 10% in spite of poor cost control suggests this could be a worthwhile investment once fiscal discipline is established.
  • Recommendation: Lazard is not going away, but investors have no reason to jump aboard this company until compensation expense is firmly under control.  Pass on this one as well.


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Jefferies Group. Motley Fool newsletter services recommend Jefferies Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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