Compelling Short Call on Cloudy $1 Billion Consulting Business

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Quick Thesis:
In short, the company consists of about 2,800 revenue generating professionals who have some sort of advanced degree (think PHD, MBA, JD, CPA, etc). They are consultants but unlike the consultants at say Anderson or McKinsey who owe quite a bit of their success to the intellectual property and brand of the parent company, the professionals at FCN usually hold the value in the relationships with clients and the intellectual capabilities they possess. For example, a corporate client may hire an “expert witness” for a trial from FCN because he has a PHD in economics from MIT, not because he works for FCN.

We mention this first because it is a critical point in understanding both the competitive dynamics of the company and industry but most importantly who holds the cards when it comes to the cost structure and profits of the company.

It helps to understand this when analyzing the cost structure of a company that although may appear very profitable is in fact less so. In sum, the structure is very much like a law firm where nearly all the profits go to the partners. There is a reason why few, if any, law firms are publicly traded – there is very little ability to share the profits with outside shareholders who add little value to the company. Although by all accounts the accounting at the company is within standards, it certainly does not reflect the true profitability of the company. We see 5 areas where the cost structure is not transparently reflected in the financial statements:

1) Forgivable loans to employees
2) Earn outs
3) Employee grants of stock options and restricted stock
4) Stock price guarantees
5) Excessive compensation, termination clauses and regular layoffs

We do find some irony in the fact that a company (FCN) that is supposed to have “expertise” in corporate valuation makes valuing their own company very ambiguous. It almost useless to look at the income statement or managements claims of free cash flow or EBITDA. They simply don’t reflect their true earnings power of the company.

We also think the balance sheet does not reflect the true liabilities at the company as it may not accurately reflect earn outs, forgivable loans, stock price guarantees and employee termination costs. There is far less flexibility to cut costs without associated liabilities that are not easily quantifiable. We take the view that the acquisitions and terminations are nothing more then regular hiring and firing costs that every company incurs. The acquisitions come with very few if any physical assets. The assets are the employees that come in through the purchase and to some extent the current client engagements they bring with them. But clearly these engagements are contingent on the employee remaining with the company.

Although it may appear aggressive, we view the true profitability of the company through a simple calculation of CFO-Capex-Acqusitions-Stock Issuance expense. When viewed through this lens the profitability of the company has dramatically decreased over the last 3 years.

We believe the true earnings of the company in 2011 was closer to $1.00 per share – putting the stock at close to 24x earnings at $24 a share. Although the stock has already declined near 45% this year we think it is anything but cheap and that with the lower stock price may come higher expenses through the hidden liabilities mentioned above. We believe the stock can fall to $15 or less.

Conclusion
Even though FCN is down near 45% YTD and might look compelling off management’s prior year calculations of FCF and EPS, we believe the earnings power of the company is weak and will continue to weaken as the stock falls further. FCN is a company that should have remained a private partnership as it is run primarily for the benefit and compensation of its employees as they are the true assets at the company. There are numerous hidden costs and liabilities that will eventually become apparent over time, unmasking the weakness of the business model. We recommend shorting the stock with a price target of $15.

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