Tuesday, February 5, 2008

Tough times ahead for Evercore Partners (EVR)?

In keeping with my recent theme of finding cyclical companies trading at peak earnings, enter Evercore Partners (EVR): a near pure-play investment bank specializing in advising US M&As on behalf of corporate clients. Currently trading at 13x what I believe are peak earnings, and with a pipeline that is in the process of drying up, I believe the company's cyclicality will reveal its full force in the financials as soon as next quarter. Despite clearly slowing M&A trends in Evercore's main market, analyst estimates are still nowhere near reflecting likely trough earnings in this business. Current estimates are counting on a H2 rebound above and beyond the peak M&A activity experienced this year, which I believe will not materialize. For regular readers of this blog, the argument below will share a striking resemblance to the argument I laid out for shorting staff stocks several months ago. As earnings are revised downward to become inline with likely future results, EVR should fall even more than it has already as the true trough earnings emerge.

The M&A Cycle
Mergers and Acquisitions activity fluctuates in tandem with the equity markets and general economic activity. M&A activity tends to peak in economic boom times, as optimism, easy credit, and fluffy growth prospects rule the day. As economic times head south, companies tend to slam the brakes on M&A furies: credit dries up, attractive growth stories become harder to find, and CEOs have enough to fix in their own companies that they can't bother to be distracted by integrating acquisitions. There are other factors at play at well, but for simplicities sake, lets leave it at that. Lets take a look at total global M&A volumes from 1997-2006 (estimates from dealogic):

Total RoW US
1997 $1,512.82 $632.2 $880.6
1998 $2,307.69 $307.7 $2,000.0
1999 $3,073.77 $1,637.0 $1,436.8
2000 $3,459.02 $916.8 $2,542.2
2001 $1,764.71 $953.9 $810.8
2002 $1,400.00 $933.3 $466.7
2003 $1,411.76 $878.4 $533.3
2004 $2,037.67 $1,190.1 $847.6
2005 $2,875.86 $1,582.8 $1,293.0
2006 $3,891.72 $2,096.4 $1,795.3

In the tough economic years of 2001-2003, M&A fell off a cliff. The results look particularly awful when we take a look at the US only (look at the US drop from 2000-2002!), despite falling interest rates. Several bulls have come out on M&A because of the falling interest rates, but they are not taking into account rising corporate yields (the real cost to buyers), nor stricter credit standards, which were basically non-existent in 2006 and early 2007. Similar trends repeat themselves to varying degrees in nearly every recession of the last 30 years. This time truly may be a little different. Most notably, M&A activity abroad has picked up substantially in recent years, and the trends are even more pronounced in 2007. Though not pictured here, M&A activity has slowed down substantially since the credit crunch, as easy credit has dried up and economic prospects outlooks have turned downward. Things will likely get even worse as private equity firms, currently flush with cash, run out of money and have trouble raising new funds.

How the M&A cycle affects Evercore
Evercore was one of the prime beneficiaries of the latest M&A boom, and is also likely to be one of the greatest victims when this current cycle turns. EVR derives ~90% of their revenue from M&A advisory (helping companies sell themselves or buy other companies), with over 80% of that revenue coming from the US. EVR also tends to focus on mega deals ($5b+ acquisitions), that have been all the rage the last two years due to the LBO craze, which has officially come to an end. Going forward, we are likely to see declining overall M&A volumes, increasing volumes in the rest of the world compared to the US, and sharp declines in both the number and size of megadeals. These trends, which I will discuss in detail, do not bode well for EVR.

EVR provides a financial advisory services, including M&A advisory, recapitalizations, and restructuring, but the biggest chunk of that is M&A. Unfortunately, the company--probably for good reasons--does not break-out advisory revenue into its different segments. They are often hired by the acquiror or the seller to advise on a prospective deal. They are typically paid a % of the total deal size upon the deal's closing, ranging to an average of about .06% of the deal size for sub $1B deals, .224% for $1B-5B deals, and .545% for <$1B deals. These numbers are estimates, but they should be relatively accurate. If the deal does not close (if EVR cannot find a buyer to match with a seller, or find a deal for a buyer), then the company makes no money.

The Mega-deal decline:

Even if the only thing to decline is the number of mega-deals, EVR will be in serious trouble. Megadeals have accounted for the majority of their revenue the past few years, and are likely to decrease in both number and size. Below is the estimated dollar value megadeals ($5B+ deals) that EVR has closed since 1997:

1997 $0.0
1998 $0.0
1999 $0.0
2000 $52.5
2001 $10.4
2002 $0.0
2003 $0.0
2004 $46.8
2005 $24.0
2006 $194.7

Note megadeals have generally peaked as the market has peaked, and can even dissapear entirely from EVRs pipeline in more mild economic times. This trend has continued in 2007, though we've already seen the completed mega-deal number for EVR come down substantially as megadeals are increasingly being done in non-US markets, or by foreign companies in US markets (neither of which EVR is particularly strong in). Megadeals have accounted for an estimated 78%, 55%, 94%, and 84% of EVR's deals in 2004, 2005, 2006, and 2007 respectively. The numbers are a bit lower as a % of revenue (since the % fee per deal dollar is lower), but it is stil substaintial: likely 50%+ in each of the last 4 years). EVR has only one mega-deal in its pipeline (the ADS deal, which has blown up and likely won't happen), and odds are seemingly increasingly likely that even if they do nab one or two of these deals in 08', the average value of these deals is likely to be smaller than the average mega-deal size in 07' and 06'. This development alone could cut revenue in half (or more) in 2008, even if small to medium size deals increase slightly.

The vanishing pipeline:
US M&A activity has grind to a halt since August, but because deals take time to close after they are announced, EVR's revenues have held up deceptively well. In the most recent quarter (Q3) they closed on two megadeals they'd announced moths early (KKR and CVS acquisitions), as well as a variety of smaller deals done before the credit crunch. They are estimated to have closed only $15B in Q4, and go into 2008 with a relatively tiny backlog of $18B. The company only announced $5B in new deals in Q4 according to dealogic. If production continues at these levels, EVR will come nowhere close to equaling the amount of deals they completed in 2005-2007. Yet, analysts somehow are projecting continued revenue growth, mostly due to newly hired MDs. Even if the new MD hires allow them to grab some market share, I expect this will be more than offset by declining macro trends.

EVR set up to disappoint in 2008
I estimate that EVR may earn between $.42-$.62 in 2008, well below the $1.70 consensus. EVR has almost no tangible book value (~2.50 v. $19 share price), so there is little in the way of a margin of safety if earnings drop as I expect they will.

To get to my revenue estimates, I assume that completed M&A deals below $5B/deal will revert to 2005 levels, which seems like a reasonable assumption given that much of the M&A growth of the last 3 years was unsustainable. I assume Mega deals ($5B+) will revert to 2004 levels for simmilar reasons. I also add in the fees from the current estimated backlog going into 2008 (~$18B), as well as some amount for non-M&A advisory revenue (~$20M). I assume a 25% pre-tax margin, vs. the 30-35% experienced the last couple years, due to lower revenues on a partially fixed cost base.

The earnings range comes by assuming different market share numbers for EVR. Even under the most optimistic of share scenarios, I estimate revenue should fall between 40-70% if the M&A market (particularly the US market) contracts as much as history would suggest.

Note: Author is short EVR.


Fair Winds said...

Thank you for the interesting short idea.

Would you mind briefly discussing the capital structure, specifically how many shares are outstanding? Yahoo lists their market cap as 209mm, against book value of ~110mm. If your thesis is correct, presumably they're using the wrong data.

Also, their balance sheet includes a lot of cash. Any idea how much of that is excess and how much they need to run the business?

Thanks again for the idea,


Research Intensive Investing said...

Hi James,

Thanks for the question. The capital structure is complex, and as you probably guessed from the write-up, yahoo and Capital IQ are not accurately capturing the true number of outstanding shares which, in turn, is making the P/B look higher than it actually is. I should probably have included this in my write-up.

In addition to the ~13.2mil outstanding diluted common shares, the company has a bunch of vested and unvested "partner units" that are owned by the employees. There's a good write-up on this in the Nov. 12 BofA analyst report, but I believe you can also see the specific breakout in the filings. Overall, I estimate there are about 33.5M diluted shares including these partner units, which is roughly what analysts model as well.

The balance sheet is a black box that I am still trying to understand. It does look like they have a lot of cash, but after accounting for the liabilities I get net tang BV of about ~$113M. I'm not remembering how I got to the $2.50/share number I quoted in the article. But, regardless, tangible book is way below the current value of the shares.

There are a good deal of seemingly exotic assets and liabilities on the balance sheet that I honestly need to get a better grip on--for example the Mexican repurchase agreements and the enormous securities sold under agreement to repurchase. I doubt there is much embedded value here in these large transactions, but I would not be surprised for there to be significant tail risk that this blows up.

Also, to give you a sense of their investment judgment, the company's asset management arm is sitting on huge losses from ABK. So I think there is also some real balance sheet risk in those exotic items, if their risk judgment in asset management is an indicator.

I will do more work on the balance sheet and likely post an update if I find anything juicy. If you have any additional thoughts, I'd love to hear them.


Fair Winds said...


Thanks for your response. I appreciate all the further detail.

Unfortunately, I don't really have any novel insights - I've just started to look at this - but I'll leave a comment if I come across anything interesting.

As an aside, Google Finance seems to have the correct share count and market cap.


Research Intensive Investing said...

Thanks, James. I have a call into the company to try and learn more about the repurchase agreements. I'll post an update if I uncover anything of interest.


Research Intensive Investing said...

Hi James,

Not sure if you are still looking at this, but Q4 earnings surprised me a good deal to the upside. I closed some of my position and am trying to schedule a call with management. I can't explain the discrepancy between M&A completed and announced vs. what the revenues were showing, and am afriad I do not have as good a grasp on the drivers of the business as I thought I did.

Fair Winds said...

Hi Eric,

Let me offer a very belated thanks for the update. If you've been able to talk with management, I'd be interested to hear what they told you.

I just had a chance to look at EVR again over the 3-day weekend, and here are some random thoughts:

-The earnings PR states, "Evercore is experiencing a high level of strategic discussions... continuing the shift in activity from financial sponsors toward corporate acquirers." If you assume that LBOs were the driver of the the recent M&A boom, then IMO this is pretty much a tacit admission that their business has dried up atm.

-They recently hired a bunch of (presumably quite expensive) managing directors. So they're adding operating leverage in the face of a down market.

-At the top of the PR they say "Advisory backlog remains strong," but as far as I could see they don't disclose the relevant figures anywhere in the release. I haven't listened to the CC - do you know if they mentioned it there?

-The earnings PR was full of pro forma numbers and seemed vague to me. It goes back to what you wrote about the company being a black box.

-Looking at their recent transactions - http://ir.evercore.com/rectrans.cfm - there's a clear trend toward smaller (and presumably less profitable) deals. All transactions listed for the past six months are <1500mm, whereas previous deals were frequently many times larger. There's also a trend toward acquisitions of minority stakes rather than full-fledged takeovers.

-Like you, I was surprised by the strength of their earnings report. I'm not sure, however, that it makes much of a difference in the scheme of things. Your original post makes a compelling case that M&A is deeply cyclical. So considering that -- especially considering how much M&A has increased just from 2004, itself a boom year - IMO it's a given that M&A volumes (and EVR profits) will drop precipitously in an ongoing credit crunch or even a mild recession.

One can argue that EVR is a best-in-class company with strong secular growth, but I think that over the next couple of years negative cyclical factors will overwhelm whatever long-term advantages they possess.

All the best,