This Stock Is Cheap, but Should You Buy?
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the overall market valued at a generous multiple of future expected earnings, it is difficult for sensible investors to find good investments. However, there are a few exceptions in industries that are currently out of favor. For instance, consulting firms are trading at a low multiple of historical profitability. FTI Consulting (NYSE: FCN) in particular looks cheap.
FTI Consulting is primarily involved in litigation consulting and bankruptcies. As a result, it has a fair degree of protection during cyclical downturns, where bankruptcies and default rates tend to increase dramatically. In addition, the company has lower employee turnover than its peers. A consulting firm's assets are its people; people are a lot easier to lose to a competitor than, say, a wind turbine. If the company's assets were to disappear, their profits would disappear as well. So a relatively low employee turnover rate gives FTI a competitive advantage (though it is doubtful that this advantage is sustainable over the long run).
High employee retention -- in addition to being active in profitable areas of expertise -- allows FTI to earn higher EBITDA margins than its peers.
However, even with a recent history of retaining employees, that can change almost overnight. The competition for employees in the consulting industry is the highest of any industry, so the threat of a large chunk of the firm's assets suddenly jumping ship to a competitor is worrisome. However, FTI's revenues are spread out across employees more evenly than at a typical consulting firm, so the loss of any one group will not have a catastrophic effect on earnings.
In addition, since FTI operates primarily in bankruptcies and similar litigation, it does not compete with firms like Navigant Consulting (NYSE: NCI). Navigant is in a great position to take advantage of changes in the health care sector brought on by the Patient Protection and Affordable Care Act (commonly referred to as 'Obamacare') as well as the booming energy sector. Navigant is also active in litigation involving Wall Street banks' involvement in the subprime lending market during the boom years. This, too, has been a boon for the company. However, it does not compete with FTI in most of its litigation practices.
Meanwhile, Huron Consulting Group (NASDAQ: HURN) advises on litigation and bankruptcies, but only as part of a diversified group of consulting areas. Huron has its roots in now-defunct Arthur Anderson. It has gone through an accounting scandal of its own and survived. The company is profitable year after year and is considered to be one of the better, but smaller, consulting groups. However, at 12.3x EBITDA, it is not particularly cheap.
Should You Buy?
If you look back over the last ten years of operations, you'll find that Navigant earns about 14 cents in free cash flow for every dollar of revenue it brings in. However, that number has been lower in recent years, so free cash flow has been somewhat depressed. If the company earned 14 cents in free cash flow for each dollar in revenue it brought in over the last four quarters, it would have earned $220 million in free cash flow. At a 10x multiple, the stock would be worth over $54 per share. At a current stock price of $32.90, FTI looks like a good investment.
However, investors should carefully consider the inherent risks in this business before investing. Most consulting contracts can be cancelled by the client at any time. In addition, employee retention rates never stay high for long, so valuable assets can walk out the door with little notice.
Most people view the concept of margin of safety as buying at a steep discount to the stock's intrinsic value. However, it is better to look for a margin of safety in the business. Coca-Cola has downside protection because Pepsi cannot woo valuable Coca-Cola brands over with incentives. In other words, Coca-Cola has control over its assets. FTI Consulting does not. And that is why I'm not going to pull the trigger on FTI even though it looks cheap.
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