Monday, April 28, 2008

Wall Street Journal Does not Like FTI Consulting (FCN)

FTI Consulting (FCN) is materially weak this morning; looks like due to this WSJ story.
  • Judging by its financials, FTI Consulting Inc. looks like a great place to make money. For investors, looks can be deceiving. FTI, which provides legal, financial and public-relations services, handsomely pays the hundreds of professionals it has been adding to its ranks through a series of acquisitions. In the first quarter, FTI bought eight companies and added 445 employees in 49 days.
  • But FTI's method of paying for its new companies and rewarding its new executives largely avoids any negative effect on earnings. As a result, its operating income looks bigger, fueling its share-price rise and winning praise from analysts and investors. Meanwhile, its sizable and growing compensation-type payouts and loans go largely unnoticed by investors.
  • FTI, which has a market value of $3.3 billion, is trading at 27 times estimated 2008 earnings, or a 50% premium on average to its peers, such as the smaller Huron Consulting Group Inc., according to Thomson Reuters. (HURN also misses its quarter almost every quarter) Only one analyst rates it a "sell." Others rave about earnings growth and how the sagging economy will benefit FTI's restructuring practice, which made up 26% of the company's revenue of $1 billion last year. (well that's why I like it!)
  • Like other companies that count people as their main asset, FTI uses "earn-outs" to pay many executives who come with its acquisitions. Under this model, an acquirer gives its new company an upfront payment and then gives the company's owners or executives additional payments over the next few years based on performance targets.
  • While there isn't anything technically wrong with these additional payments, they make expenses look smaller and earnings appear larger than they otherwise would because the earn-outs aren't treated as compensation expense, which is subtracted from earnings.
  • "I think of earn-outs as a mechanism for inflating operating income," says Michael Winter, a portfolio manager at hedge-fund Otter Creek Management, which manages about $160 million in assets and doesn't own FTI shares. "For a true quality-of-earnings figure, an investor needs to add those amounts back to earnings as compensation expense."
  • Earn-outs aren't small change for a company that has made so many acquisitions and that reported pretax income last year of $150 million. In the first quarter, FTI paid nearly $43 million in earn-outs for earlier acquisitions, and it has said it expects to pay $49 million in earn-outs over the next few years for its latest deals.
  • Some analysts regard earn-outs as a necessary evil. "It is important to be cognizant of the financial and accounting ramifications of earn-outs, but they're an important way for professionals-based companies to make sure interests are aligned," says Timothy McHugh, an analyst for William Blair & Co. who has a "buy" rating on FTI stock
  • Another practice employed by FTI, doling out "forgivable" loans, is far less common in corporate America. In 2006, it launched an incentive compensation program that involved granting $30 million in cash payments "in the form of unsecured general recourse forgivable" loans, to senior managing directors and other employees. Last year FTI paid out $35 million in forgivable loans to about 57 senior managing directors and others.
  • FTI typically amortizes the cost of these loans over five years, meaning a fraction of them have an impact on income in the current periods. The total costs aren't reflected until FTI fully forgives the loans. While they are a great incentive to employees, their effect on earnings is delayed.
  • "It seems that they really go out of their way to compensate people very well and avoid affecting the income statement," says Donn Vickrey, head of research firm Gradient Analytics. Mr. Vickrey is an earnings-quality analyst who doesn't formally cover FTI. "It gives them a whole lot of room to make their earnings number every quarter."
Long FTI Consulting, Huron Consulting in fund; no personal positions

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