This Consulting Firm Is Finally Turning Things Around

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Navigant Consulting (NYSE: NCI) has been under pressure since the recession; after a strong 2008, sales fell nearly 13% in 2009. In addition, the company's margins contracted further during 2009. The combination of falling revenue and shrinking margins has impaired the company's profitability and has sent investors running for cover. However, investors who look closely will find that there is a lot to like about Navigant.

Poor recent results

Reductions in corporate spending sent revenues into a nosedive for the entire consulting industry during and after the 2009 recession; the industry has yet to fully recover from the drop-off in business. However, while most firms were able to lower compensation expense to offset the revenue decline, Navigant's gross margin contracted.

<img src="/media/images/user_13490/nci-gross-margin_large.png" />

The gross margin for a consulting firm is simply the difference between revenues earned from services provided and the compensation given to the consultants who provided those services. During the recession, Resources Connection (NASDAQ: RECN) and Robert Half International (NYSE: RHI) took advantage of their variable cost structures. This means that companies's expenses can easily go up or down according to how much revenue they bring in. Resources Connection and Robert Half International accomplish this by simply keeping the amount it compensates employees in line with the revenues those employees bring in.

Unfortunately, Navigant and Kforce (NASDAQ: KFRC) could not lower compensation levels despite lower revenues. The two companies were not able to place as many of their employees in projects as they had hoped, which resulted in a significant part of the workforce earning a salary but bringing in no revenues.

Long-term trend is positive

Despite a rough few years as of late, Navigant has substantially improved its operations over the last decade. After recovering from an accounting scandal in 1999, the firm has steadily lowered SG&A from almost 25% in 2002 to under 17% in 2011. This is encouraging because reducing corporate overhead is much more difficult than reducing headcount, which would enable the company to increase gross margins. As a result, the company will likely experience margin expansion in the coming years.

An alternative to laying off employees is to increase employee utilization to bring in more revenue per employee. As Congress passes increasingly complicated legislation, companies hire consultants to help them make sense of the new rules and how best to navigate in the new environment. Navigant has received lots of business from healthcare companies seeking consulting on the healthcare reform law. With Congress still deadlocked, any legislation that comes out of Washington is likely to be extremely complicated and stuffed full of obscure rules. This is a positive for the consulting industry.

Valuation

In valuing a company, an investor should focus on the long-term trend instead of the most recent results. Navigant's recent results were actually quite good: in 2011, the firm earned $98 million in EBITDA and $101 million in free cash flow.

However, the company's profitability has been much lower in most years. From 2003 to 2010, the company produced an average of $56 million in free cash flow. But this includes years when the company had fewer employees and thus lower potential revenues to produce free cash flow. To counter this, we can take the company's average free cash flow margin -- the percentage of sales the company converts into free cash flow each year -- and apply it to the last four quarters of revenue to get a ballpark estimate of normal free cash flow.

From 2003 to 2010, the company averaged a 9.34% free cash flow margin. 9.34% x $816 million in trailing twelve months sales = $76 million in free cash flow. So, in an average year, we can expect Navigant to turn $816 million in sales into $76 million in free cash flow.

However, sales can easily expand or contract according to the business environment going forward. At $1 billion in sales, the company's earning power is $96 million. At $600 million in sales, earning power falls to $56 million.

If you apply a 10x multiple to each of the estimates of Navigant's 'normal' earning power, you get values of $11.02, $14.98, and $18.36. So it appears that Navigant's intrinsic value ranges from $11.02 to $18.36. At a recent price of $11.54, the stock appears to be trading at a safe price for investors to buy in.


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