Houlihan Lokey, Inc. (HLI) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Houlihan Lokey Fiscal 2017 Second Quarter Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded today, November 1, 2016. I would now like to turn the call over to Christopher Crain, Houlihan Lokey’s General Counsel. Please go ahead, sir.

Thank you, operator and hello everyone. By now, everyone should have access to our second quarter fiscal 2017 earnings release, which can be found on the Houlihan Lokey website at www.hl.com in the Investor Relations section. Before we begin our formal remarks, we need to remind everyone that the discussion today will include forward-looking statements. These forward-looking statements, which are usually identified by use of words such as will, expect, anticipate, should or other similar phrases are not guarantees of future performance. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect and therefore you should exercise caution in interpreting and relying on them. We refer all of you to our recent SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. We encourage investors to review our regulatory filings, including the Form 10-Q for the second quarter ended September 30, 2016 when it is filed with the SEC. During today’s call, we will discuss non-GAAP financial measures, which we believe can be useful in evaluating the company’s financial performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measures is available in our earnings release and our investor presentation on the hl.com website. Hosting the call today we have Scott Beiser, Houlihan Lokey’s Chief Executive Officer and Lindsey Alley, Chief Financial Officer of the company. They will provide some opening remarks and will then open the call to questions. With that, I will turn the call over to Scott.

Thank you, Christopher. Hello, everyone and welcome to our second quarter fiscal 2017 earnings call. Overall, this was a good quarter for Houlihan Lokey. We reported second quarter record revenues of $187 million, up 18% from the previous year. Our first half revenues of $367 million, is also a record and is up 21% from the previous year. Our adjusted earnings per share for the quarter is $0.37 versus $0.28 from the previous year and our first half adjusted earnings per share is $0.72 versus $0.55 last year. Despite a market environment that can’t maintain a consistent positive or negative trend for any length of time, all three of our reporting segments reported revenue growth from the previous year. Consequently, we are very pleased with the results today. For our Corporate Finance business, we closed more transactions this quarter than any other previous quarter. We continue to see solid results in Corporate Finance, notwithstanding that the number of U.S. and global mid-cap transactions has declined over each of the last several quarters. Our Financial Restructuring segment has produced its strongest first half results since the last recession, capitalizing on the pockets of distress in oil and gas and other commodity-driven industries. Our Financial Advisory Services business continues to see growth across most of its product lines offset by ongoing weakness in transaction opinions as a result of a soft M&A market. Financial Advisory Services remains our most diversified business segment by clients and by product line and this quarter we are seeing the benefits of that diversification. During the quarter, our firm hired 6 managing directors who had unique skills, contacts and experiences. Four are in the United States, adding capabilities in business services, energy, healthcare and M&A and two are in Europe, focused in general M&A and financial sponsor coverage. In addition to our senior level hires, this past summer, we successfully trained one of the largest new analyst and associate classes the firm has ever had. Additionally, as a result of recent investments we have made in human capital management and a focus on employee satisfaction at the junior levels, the turnover rate of our existing analysts this year was approximately one-third lower than what it was in the last couple of years. This reflects our concerted effort to provide a challenging and rewarding work environment for all of our employees. Now, for some comments regarding each of our three business segments, in Corporate Finance, one of our primary missions is to quarter-after-quarter, year-after-year increase our market share of mid-cap M&A transactions. The firm has been achieving this goal. However, for the fourth consecutive quarter, the number of closed mid-cap M&A transactions in the U.S. has declined relative to prior year’s quarter. Furthermore, as stated earlier, the overall market has not maintained any consistent trend in stock market valuations, interest rates, oil prices or GDP forecasts. Despite these directionless factors, our clients remained committed to using M&A as a way to grow their revenues through a challenging economic environment. This is driven by the fact that client confidence in the organic growth of their businesses is weaker than it was a year ago. Combating these headwinds, Houlihan Lokey has added to its MD count via internal promotions, acquisitions and hirings and we have meaningfully expanded our European presence. We also continue to diversify our product offerings to clients through the growth of our capital markets business, our illiquid financial assets practice and a stronger mix of buy-side work. Overall, the number of new engagements we signed up quarterly remains strong, our close rate on transactions remain high and the time to close transactions has held steady over the last few quarters. In Financial Restructuring, there continues to be a bifurcated market environment, where the majority of industries remain healthy but with some notable exceptions. The oil and gas, coal and metal and mining industries continue to provide near-term revenue growth to our Financial Restructuring results and this momentum should continue over the next couple of quarters. However, the recent stabilization of oil and gas prices has slowed down new business activity in that sector. Generally speaking, the restructuring environment for most industries remained sluggish as a result of below average default rates. Consequently, new business activity has slightly declined since the oil and gas crisis that occurred 9 to 12 months ago. Considering the firm’s large, highly experienced restructuring team, we remain poised to capitalize on future business distress when it happens. Our Financial Advisory Services segment remains our most steady business with most product areas performing well. Portfolio valuation work continues to grow as the number of hedge funds and alternative asset investments grow and the need for transparency regarding the valuation of their illiquid holdings grows. Results in transaction advisory services have increased as we continue to penetrate the market and supplement our practice with additional industry experts. Also, our strategic consulting work is growing and taking advantage of the firm’s broad industry and financial sponsor relationships. Partially offsetting these positive trends, the large cap transaction opinion work is down, consistent with the overall M&A market. Through the first six months of fiscal 2017, the firm benefited from many strategic and tactical business decisions we have made over the last several years. In the first six months of our fiscal year, we closed over 125 transactions in our Corporate Finance and Financial Restructuring businesses and we had over 700 fee events in our Financial Advisory Services business. Our client and transaction diversification remains one of our pillars and we seldom have any single transaction that exceeds 2% of our firm’s revenues in a fiscal year. Progress with our existing mandates remains strong and we feel good about our prospects for the balance of our fiscal year. Regardless of the future direction of the business or the political and economic environment in which we operate, we hold steadfast in our purpose to operate a firm that is highly diversified across clients and industries, which advises clients throughout the world and a firm that performs well in any economic environment. We are proud of what we have built and look forward to continued success in the years ahead. With that, I will turn the call over to Lindsey.

Thank you, Scott. In Corporate Finance, revenues grew 11% to $100 million for the quarter compared with $90 million during the same period last year. Activity during the quarter was strong in Corporate Finance as we closed 56 transactions compared to 30 in the same period last year. Our growth came despite a 21% decline in the number of closed M&A transactions globally during the same quarter. Although our transaction growth was significant, we had a lower average transaction fee for closed transactions in Corporate Finance, both for the quarter and the year-to-date period. We believe that the decline in our average transaction fee is a result of the recent acquisitions we have made and the fact that they have not yet fully matured on our platform. Financial Restructuring revenues were $57 million for the quarter, an increase of 39% from the prior year. We closed 12 transactions in the quarter compared to 10 transactions in the same period last year. The growth in revenues was primarily driven by a significant increase in the average transaction fees on closed transactions for the quarter versus last year. Financial Restructuring is seeing current benefits from the pickup in new activity in the fall of 2015 and the winter of 2016 that Scott has alluded to in his previous comments. In Financial Advisory Services, revenues were $29 million for the quarter, a 7% increase from the prior year, driven by stronger performance in portfolio valuation and strategic consulting and offset by lower revenues from transaction opinions. Despite a slow first half in transaction opinions, FAS has seen some stabilization and improvement in that product line despite the softness in the M&A market. FAS also saw an up-tick in average project fees for the quarter as compared to the same quarter last year. Turning to expenses, our adjusted compensation expenses were $118 million for the second quarter of fiscal 2017 versus $107 million for the same period last year. The increase in adjusted compensation expenses was primarily a result of the increase in revenues for the quarter and partially offset by our change on October 1, 2015, from a revenue sharing model to a target adjusted awarded compensation ratio. For the second quarter of fiscal 2017, we had one adjustment of $6.5 million relating to the vesting of grants that were issued in connection with our IPO. This resulted in an adjusted awarded compensation ratio of 65% for the second quarter of fiscal 2017 versus 69.5% for the second quarter last year while we were still operating under our pre-IPO revenue sharing model. This is the last quarter where we will be comparing against the historical quarter that operated under the old model, which should smooth out comparisons in future quarters. As we have said in the past, we manage our business using an adjusted awarded compensation ratio as we believe this ratio best matches current compensation costs with current revenues. For the second quarter, our GAAP compensation ratio, adjusted for pre-IPO grants, was 63.5%. We expect that for the balance of this fiscal year, the GAAP compensation ratio adjusted for pre-IPO grants will be between 150 basis points and 175 basis points lower than our adjusted awarded compensation ratio. Our non-compensation expenses in the second quarter were $27 million or 14.3% of revenues versus an adjusted $22 million or 13.6% of revenues in the second quarter last year. The increase in non-compensation expenses was primarily a result of increases in general operating expenses associated with the growth of our financial staff as well as increased client activity and amortization experiences related to our acquisitions. As a result of the fact that our revenues tend to be back weighted towards the second half of the year, we expect to achieve a lower non-compensation ratio for the balance of this year than what we achieved in the first half. However, we are experiencing slightly higher than expected non-compensation expenses as a result of the higher cost of doing business overseas and higher placement fees as a result of the external hiring of nine managing directors in the first half of the year. Our GAAP effective tax rate for the second quarter of fiscal 2017 was 39%, which is similar to our rate in the first quarter of 2017. Moving to the balance sheet, as of September 30, 2016, we had $156 million of cash and equivalents and debt of $51 million. In the second quarter, we paid down our revolver to zero. We paid our quarterly dividend. We made another scheduled principal payment of $7.5 million to ORIX on their outstanding note. And we paid down $10 million in loans payable to former shareholders. While we do not provide earnings guidance, we remind everyone that the key drivers of our financial performance are our revenues and our compensation ratio. We continue to target long-term revenue growth of between 7% and 10%, which we anticipate will occur through a combination of organic growth and growth through acquisitions. We target and have been delivering an adjusted awarded compensation ratio of between 65% and 66%. We are slightly increasing our long-term target for our non-compensation expense ratio to between 12.5% and 13.5% and slightly lowering our expected effective tax rate to between 39% and 40%. We believe that our continued growth overseas will result in a slightly higher non-compensation ratio and a slightly lower tax rate, but will add to our long-term diversification strategy. With that, operator, we can open the line for questions.

Thank you. Today’s question-and-answer session will be conducted electronically. [Operator Instructions] We will take our first question today from Michael Carrier with Bank of America.

Hi, this is Mike Needham in for Mike Carrier. First one, just on the hiring environment, we did see the few new hires and you said the six, I think MDs that you brought on recently, I was hoping you could talk about where you are going to be focusing your hiring efforts over the next year, so – and t doesn’t look like the headcount grew, the MD count, at least this quarter from last, so I guess what kind of net headcount growth could we expect over the next year?

Yes. I think we continue to look opportunistically where we can to continue to add to the team. We are still looking at various industries and sub-industries where we can add to the bench strength that we already have. And we have continued to add and we will continue to look at people in Europe to add to the team in the acquisitions that we made over the last year and we are looking for people also on our Financial Advisory staff. Don’t have a specific target or goal in terms of number of MDs we want to bring on. I think we have always hired MDs year-after-year as the businesses continue to grow. And a lot of it just depends upon where we see the market is what our needs are and what’s available out in the market? I would still expect we will continue to grow the headcount on the foreseeable future. But like I said, no strategic statistical numbers that we have in terms of how we are managing the business.

Okay, thanks. And then on Corporate Finance, it’s a pretty strong quarter, I know it’s hard to determine, but was there any like pull forward of deals in the quarter because of election or are there other reasons or maybe said another way, would you expect next quarter to be seasonally strongest as usual?

Well, the first part of your question, there is not a particular project or even groups of projects that we think for this particular quarter got pulled forward or pushed out. Don’t really see any change in behavior with the pending election results coming up. And we typically have – as Lindsey mentioned, we do better in our second fiscal half than our first fiscal half. So we would continue to expect that trend to continue, that we will have a stronger fiscal third and fourth quarters than typically what we have in the first and second quarter.

Okay, great. Thanks for taking my questions.

Thanks Mike.

And we will take our next question from Devin Ryan with JMP Securities.

Hi, thanks. Good afternoon, Scott and Lindsey. How are you guys?

Good, Devin.

How are you?

Good. A couple here. I guess first just on restructuring and I want to make sure I understand the comments, obviously a little bit of better in the back half for some of the sectors that have been hardest hit there, so I am curious are the number of mandates actually shrinking or is just the pace of growth slowing, I know you would kind of spoken last quarter about the pace of growth slowing from a really good pace earlier in the year, so I am trying to I guess, understand that and then – that’s part one. Part two, just thinking about kind of the revenue trajectory for the business because there is still, I assume a fair number of deals that are in the backlog that you have been working on for some time and so those will start to close here at some point, so I am just kind of thinking about those two points?

Yes. At this point, the pace of growth has slowed. And I think it was two or three quarters ago I had mentioned some significant increase in growth of new mandates. So that growth has slowed, but we are still getting a large number of mandates coming in. And you are correct. Typically, the timeline of projects from when we get hired and when they close can be several months to a few years and there is still a lot in that we are currently working on that’s still expected to close in subsequent quarters.

Got it. Okay, that’s great. This might be a tougher one, but we were talking about an economy that can’t really find a trend and a lot of kind of conflicting data points. And I am just curious when you think about your business, is an anemic or slow growth backdrop actually the best case scenario, because that drives or fuels M&A in companies that just need to find growth and at the same time, you still have some level of restructuring or do you actually think that this is not as constructive a backdrop as maybe as it could be if we actually had some acceleration and call it, global growth?

I think two ways I might answer that from the standpoint of our clients. Actually, in the mode that we are in right now, it is helping both the healthy part of the business in Corporate Finance and the part that works in a more distressed environment, restructuring, continue to both do well. I think it’s tougher on an internal basis, as you are always planning and should you be growing, should you be hiring, should you be making acquisitions, what industry groups do you want to build. That’s a little more difficult when what we have described is kind of in a trend less or less direction type of market, because it seems to change every couple of months.

Got it. Okay. And then just last one here. Just on the S-3 that we all saw filed today, is there anything there around timing or anything else you can share around that? And would there need to be an organized filing there or can – or it’s actually – just start selling into the market?

Yes, I would not read anymore than I think it’s very customary after the first anniversary of an IPO, which we crossed back in August. And in fact, the company like ours, we just filed a shelf registration statement, registered some of the shares of our existing shareholder and nothing more than just kind of a typical you can do an S-3 filing after a year.

Yes, got it, okay. That’s very helpful and I appreciate the color and congratulations on the nice quarter.

Thanks, Devin.

And we will take our next question from Conor Fitzgerald with Goldman Sachs.

Good afternoon.

Hey, Conor.

Maybe one just on kind of the private equity or sponsorship side of your business, are you seeing any changes in behavior from that part of your client segment, maybe getting more acquisitive as kind of dry powder builds or are they still, relatively speaking, in a wait-and-see mode?

Yes. I wouldn’t describe it as a wait-and-see mode. I think for the business that we are in, whether it’s by size or geography or industry they still remain very active. We still see a lot of opportunities. They are still putting a lot of businesses up for sale and they are still a buyer of many of the businesses. And like I said, we get the good feeling, bad feeling every month or two that it kind of changes. There just is not a new trend, I would describe, in terms of the behavior of the private equity clients that we deal with on a daily basis.

Got it. And then I just wanted to ask on the non-comp guidance, I know it’s a pretty modest increase in your target. But can you kind of help us understand how much of that was maybe due to acquisitions versus maybe just a little of bit of a higher kind of non-comp base in your legacy business? And I guess faux [ph] that is if you continue to do acquisitions in Europe, is it possible you would raise the target further as that became a larger part of your business?

Yes. So, I think with respect to our core U.S. business, I don’t think there is any non-compensation trends any different than what we have historically – how we have historically operated. I think really it’s the acquisitions, as you alluded to, but more importantly, it’s the acquisitions in Europe. As we have continued to grow our European business, the cost of doing business over there are a bit more than a third than they are in the U.S. And as that business continues to expand, our expectation is that, that will push our non-compensation expenses just a bit higher. Your last comment, in a perfect world, if we are fully diversified in Europe, yes, we might experience some higher non-compensation expenses, but we are a long ways away from there. And so I think over the long-term, the slight increase in non-compensation expenses we feel very comfortable with. On the flipside, as you would expect, the European tax basis – our rate across most of the countries over there, particularly in the UK, is much more favorable than in the U.S. And as a result, we would expect a big chunk of that to be offset by a lower tax rate, as you have seen with some of our peers who have a bigger business over in Europe. So with the slight increase in non-comp expense, we are also experiencing a small decline in our effective tax rate.

Yes, that’s helpful. And then just last one for me, you called out larger average fees in your restructuring business. Was there anything kind of lumpy or one-off to call out there or would you expect the larger average fee to continue in restructuring?

Yes, I don’t say there is any one-off we have experienced the last several quarters. The average size deals that we are closing are slightly bigger than they were a year or two ago and thus producing slightly higher fees. So, it’s very much driven by the size of the transactions and they have been growing but they are still nowhere where they have been in past down cycles when you look at the last recession or the last couple of recessions.

Very helpful. Thanks for taking my questions.

Thanks, Conor.

[Operator Instructions] We will go next to Brennan Hawken with UBS.

Hi, good afternoon. Thanks for taking the questions. Just a quick one on restructuring here to start out. So, other firms have commented that they have seen a wide range of mandates beyond the energy and commodity sectors. Why is it that you think you might not be seeing that? Do you think that it’s because of your creditor side orientation in your business and a component of relatively accommodative refinancing markets or is it something else? Is there anything you can give us to kind of square that cyclically?

Yes. I think we are still seeing a disproportionate amount of work is currently on the broadly defined commodity driven space, which I think is similar to our peers. We are still operating in a below market default rate compared to what it’s been historically over decades. We do continue to see other sub-pockets of industries outside of the commodity space that are kind of growing in defaults. And so I think we are seeing growth in some of that areas as well, but right now, we still believe that it’s mostly the oil and gas, the coal, natural resources, etcetera, which is driving a more meaningful amount of the revenue stream than we have seen in previous years.

Okay. And when we think about the slowing growth in that business, which you seem to be indicating fairly clearly, is it that you are starting to see the mandates and the pace of growth slow and so we should be thinking about that pace of growth starting to show up in subsequent few quarters or is it that, right now, you are also running into tougher comps and so the natural law of large numbers is going to make that growth rate crash? How is it that we should think about the math from a model perspective from there?

I think you have got to take a couple of steps backward and we have gone through cycles where you have periods of very large amount of transaction works that’s coming in because of the economy is just going through some distress. And then we have gone through periods where it would be a relatively healthy economy. And you have kind of seen over the years, what I will call it is maybe our baseline of restructuring revenues. And then what we have had is not only the baseline of work, but we have had some extraordinary amount of work that’s coming in these particular industry sectors. We think there is still more work to be done in the oil and gas sector. It’s just a year ago, there was not nearly the amount that – which has started to come in about a year ago. And so the growth in terms of number of new projects in that area has slowed down. And depending upon where oil prices go would, I think, determine whether there is another round of substantial increase in oil and gas activity or whether we are all just kind of working through the middle of the curve or there is really more to come.

Another way to think about is for modeling purposes, if we had strong new mandate growth 9 to 12 months ago, you are going to see that strong new mandate growth closing this quarter, next quarter, the following quarter. If the new mandate growth is slowing today, you are a year plus out before you start to see the effects of that. So, I think that the comments relating to restructuring are very forward-looking versus what’s going to be experienced over the next couple of quarters.

Perfect, perfect. And of course, that’s basically saying based upon the mandate of trends that you guys see. Yes, perfect. Great, thanks. Last one is just on the mid-cap M&A market. You commented the last few quarters, you have seen that it’s slowing here. You also made the comments about somewhat of a more moderate growth to the economy, and therefore, a bit of a trend-less market, I assume that those two are squared and those two are sort of in to each other, but please correct me if that’s not the case. And is there anything else that you might attribute to the softness in the mid-cap market, obviously you had indicated that the sponsors you have seen have been active but not remarkably so, is there – is it down to anything else, is there any other additional color you can ascribe there?

So I think look you can – to us, we think it’s more important when you look at the number of transactions that either get announced or closed, more so than the dollar volume. We have noted that the number of transactions quarter-over-quarter have been shrinking, but our actual number of transactions we closed or our market share relative to that total pie is still a very small number, albeit we think it’s one of the biggest, if not the biggest, for what we do in the mid-cap space. And our focus has been for the last couple of years and for the seeable future is how do we actually grow on a percentage basis as well as on a natural basis regardless of what happens to the market itself, our Corporate Finance business. And we will continue to do that by adding extra bankers, adding extra industry strengths, continue to grow in financings, buy-side work, etcetera, all things that we have mentioned. So we don’t see any particular brand-new macro trends that are out there today that gives us a great pause about what will occur down the road. But we have noted that there has always been bumps in the road and whether it was Brexit a couple of months ago, whether it’s oil price collapsing several months before that, China devaluation, there always appears to be something that is causing what we will call a little bit of a less trends that you can see. But we are still able to continue to grow the number of transactions that we have been working on. And the final comment is once again, I don’t want to be in this and we still see the private equity community, at least that we work with this still very active. It hasn’t necessarily gotten any stronger or any less strong. I think we have just gotten to be a bigger and more important player to the private equity community that we work with. And that’s what’s continued to drive the number of new assignments and the number of closings that we have been able to accomplish over the last several quarters and the last couple of years.

Perfect, that’s helpful. Thanks a lot.

Thanks Brennan.

[Operator Instructions] We will go next to Ann Dai with KBW.

Hi. Good afternoon.

Hi Ann.

Hi. Earlier you spoke about increasing the diversification of the business through growth at some of these areas, like liquid financial assets business, capital markets, doing some more buy side works and so I am just wondering if there is any way you can quantify some of that growth or at least frame it relative to what those businesses might have contributed a couple of years ago, just trying to get a sense of the scale?

So versus a couple of years ago Ann, it’s hard to answer. But I did take a look at the product mix this quarter versus last quarter. And as Scott suggested, our product mix is stronger quarter-over-quarter in some of the areas where we have focused our attention, particularly on the buy side happened to be this quarter. So I – we are not in a position to be specific regarding revenue comparisons across the product lines within Corporate Finance, but all of those factors are contributing to a broader diversification across the services that we offer within Corporate Finance. And we have seen that trend continue over a 2-year to 3-year period.

Okay, great. Thanks. And my second question is fairly specific, but I am just wondering if you are seeing any heightened interest in discussions around deals in the retail brokerage space, being driven by the upcoming DOL fiduciary rule, which is set to be effective in April?

Yes. I don’t think – nothing in particular. And at this point, we have a very diversified work on so many different transactions in a variety of different industries. There is nothing that I think we would specifically point out that more narrowband within the FIG space.

Okay, thanks. That’s all for me.

Thanks, Ann.

And we have no further questions at this time. I will turn the call back to our speakers for any additional or closing remarks.

I want to thank you all for participating on our second quarter fiscal 2017 call. And we look forward to updating everybody on our progress when we discuss our third quarter results in the winter. Thank you everyone.

And that does conclude today’s conference. Thank you for your participation. You may now disconnect.