Earnings Call Transcript - HLI Q2 2021

Operator, Operator

Good day, everyone. Thank you for being here. Welcome to Houlihan Lokey's Second Quarter Fiscal Year 2021 Earnings Conference Call. I will now hand the call over to Christopher Crain, Houlihan Lokey's General Counsel.

Christopher Crain, General Counsel

Thank you, operator, and hello everyone. By now, everyone should have access to our second quarter fiscal year 2021 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 the 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 when 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 quarter ended September 30, 2020 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 then we will open the call to questions. With that, I'll turn the call over to Scott.

Scott Beiser, CEO

Thank you, Christopher. Welcome everyone to our second quarter fiscal 2021 earnings call. We have successfully been working primarily from home now for a little over seven months and our firm has been blessed with very few cases of COVID-19. This pandemic has had a terrible effect on families around the world and we continue to do everything we can as individuals and as a firm to help. We've engineered our business and personal work styles as best as we can in order to provide a safe and successful work environment for our employees, clients, and shareholders. Notwithstanding the ongoing challenges, the firm produced solid quarterly results. Our second quarter fiscal 2021 revenues were $276 million, slightly up from last year and significantly improved from the $211 million reported in the first quarter. Our adjusted earnings per share were $0.75, up 7% from last year and a major improvement from the $0.56 reported in the first quarter. Our second quarter benefited from a significant increase in closings in Financial Restructuring, very strong capital markets, and an improving M&A valuation market. Currently, the overall economic environment is very conducive to our balanced business model. Our Financial Restructuring results are at record levels and we expect to experience elevated levels for some time. Meanwhile, the favorable interest rate environment and stable asset valuations over the last few months have prompted strategic firms and sponsors to reenter the M&A marketplace. This has led to improved deal closings versus Q1, but more importantly, to a substantial increase in new business activity, which should have a positive impact on subsequent quarters. Tempering our outlook, we still have concerns about the pandemic's ongoing influence on world economies, the uncertainty in the U.S. elections, and the ultimate outcome of Brexit. That being said, today we feel more confident about our business prospects than earlier this year. Our Financial Restructuring business reported $125 million in quarterly revenues and $214 million for the first six months of our fiscal year. We have more mandates today than we did during the Great Recession, but there are only a limited number of mega-size restructurings relative to then. We have closed a record 59 deals year-to-date, and the number of active assignments is at record levels. New business activity remains at elevated levels, but the pace of new business in the second quarter slowed from the torrid pace exhibited at the outset of the pandemic. As I mentioned on our last call, we expect short-term restructuring results to be lower than originally anticipated at the outset of the pandemic. But we expect that we will experience elevated levels of restructuring revenues for longer than originally anticipated. Our Corporate Finance business has dramatically improved from the first quarter. In the second quarter, we reported $108 million in revenues versus $88 million in the first quarter. Consistent with revenue growth, we closed 53 deals in the second quarter versus 35 deals in the first quarter. Furthermore, this quarter, we experienced a record level of new business activity. However, it will take some time for this new business to translate into revenues. New business activity is being generated from both corporate and private equity clients. Business is also fairly diversified across our industry groups. Many of the transactions we previously described as on hold are now active again. And the number of new inquiries has accelerated since mid-summer. As mentioned earlier, there are still several macroeconomic factors that may eventually have an impact on close rates for our new engagements. Our Financial and Valuation Advisory business is experiencing many of the same favorable trends as Corporate Finance. Revenues in the second quarter were $42 million versus $35 million in the first quarter and up from $40 million in the same period last year. The number of quarterly fee events, average fee size, and revenues per MD are now similar to last year's results. Our Portfolio Valuations segment continues to exhibit strong growth, and we are experiencing improvement in our Transaction Opinion business as well. Turning to our acquisition activity, in August, we closed on our previously announced acquisition of MVP Capital, and they are off to a great start. We continue to be in active dialogue with several potential acquisition targets. However, the intensity of our discussions has tempered since the last quarter. The rebound in global M&A activity over the last several months has encouraged some funds to remain independent and other firms to increase their valuation expectations to levels we believe are unsupported. That being said, our acquisition strategy has always been to be patient and to find the right firms for the right reasons at the right price. In closing, we have experienced significant changes in the overall business environment, from the positive outlook at the start of this calendar year to the pessimistic outlook this spring, to the rapidly improving market that exists today. We welcome change, and in most instances, may thrive in it. Our commitment to shareholders and employees is that we will continue to build our balanced business model to mitigate the effects of volatility in results. And with that, I'll turn the call over to Lindsey.

Lindsey Alley, CFO

Thank you, Scott. Revenues in Corporate Finance were $108 million for the quarter compared to $156 million for the same period last year. Lower revenues were a result of the decline in the number of closed transactions as well as a slight decrease in our average transaction fee on closed deals. Financial Restructuring had a strong second quarter, delivering $125 million of revenues, a 62% increase from the same period last year. Higher transaction volume and higher monthly retainer fees drove the increase in revenues. We closed 30 transactions compared to 17 in the same period last year and the increase in retainer fees is a result of the significant increase in the number of current engagements driven by the pandemic. In Financial and Valuation Advisory, revenues were $42 million for the quarter compared to $40 million for the same period last year. We had 539 fee events during the quarter compared to 523 in the same period last year. Overall, FVA saw improving results across its service lines with Portfolio Valuations leading the way, which contributed to solid quarterly results. Turning to expenses. Our adjusted compensation expenses were $175 million for the second quarter versus $165 million for the same period last year. We had one adjustment this quarter for deferred payments related to certain acquisitions. Our adjusted compensation ratio was 63.5% for the quarter, which is above our long-term target for adjusted compensation ratio of between 60.5% and 61.5%. Our year-to-date compensation ratio is 63.1%, which reflects a reasonable proxy for the balance of the year. This increase in compensation expense ratio over our targeted range is primarily a result of our estimate that reimbursable expenses for fiscal 2021 will be significantly lower than last year's. Our compensation expense ratio is tied to gross revenues, which is calculated as fee revenues plus reimbursable expenses. While we pay compensation based on fee revenues, our compensation expense ratio increased to account for the lower reimbursable expenses incurred as a result of the COVID pandemic. Our adjusted non-comp expenses were $29 million for the quarter versus $44 million for the same period last year, a decline of 35%. This resulted in an adjusted non-compensation expense ratio of 10.4% versus 16.2% in the same quarter last year. This decline is a direct result of lower travel, meals and entertainment expenses and lower marketing, office-related and other operating expenses, all reduced due to the stay-at-home orders implemented because of the pandemic. We expect to continue to see significantly reduced non-compensation expenses in these two categories, at least through the balance of the fiscal year. This quarter we adjusted three items out of our non-compensation expenses: $1.3 million in acquisition-related costs for our acquisition of MVP Capital, $900,000 in acquisition-related amortization, and $700,000 in Oracle ERP implementation costs, which we successfully rolled out this quarter. The new Oracle ERP system replaces a 20-year-old system and represents the backbone of our financial and accounting system. Our adjusted other income and expense decreased for the quarter to an income of approximately $200,000 versus income of $1.1 million in the same period last year. This was primarily a result of lower interest earned on our cash and investment balances. Our adjusted effective tax rate for the quarter was 27.3% compared with 28.4% during the same period last year. The adjusted effective tax rate is at the lower end of our long-term target range of between 27% and 29%, driven by a significant decline in non-tax deductible items such as entertainment and certain other expenses. As a result, we expect our adjusted tax rate for fiscal 2021 to be closer to 27%. Turning to the balance sheet and uses of cash, as of the quarter end, we had $600 million of unrestricted cash and equivalents and investment securities, which includes the cash raised in an equity offering in May. As a reminder, a portion of this cash is earmarked to cover accrued, but unpaid bonuses for fiscal 2021 and our deferred cash bonuses for fiscal 2020, which will be paid in November. Also in this past quarter, we repurchased approximately 402,000 shares at an average price of $57.72 per share as part of our share repurchase program. And finally, we are pleased to announce that we're paying a dividend of $0.33 per share, payable on December 15 to shareholders of record as of December 2. And with that, operator, you can open the lines for the questions.

Operator, Operator

Thank you. We'll take our first question today from Manan Gosalia with Morgan Stanley.

Manan Gosalia, Analyst

Hi, good afternoon. You spoke last quarter about the fact that the number of deals on hold versus the number of years deals that will nominated is sort of more favorable in the cycle than prior downturns. I was wondering, with the uptick in revenues this quarter, how much of the activity that's come through is due to closings from pending deals that were already on the cards pre-COVID versus how much of it is new activity that announced and closed during the quarter?

Lindsey Alley, CFO

We don't specifically track the distinction between pre-COVID transactions and those that have been announced and closed within the same year. However, we can likely find that information if needed. You can assume that some of the transactions reflected in our Corporate Finance revenues were previously on hold. The M&A process typically takes about nine months. Therefore, while some new transactions that emerged after March 31 have closed, most are expected to close in the third and fourth quarters, provided everything proceeds smoothly. A significant portion of the 108 transactions are likely those that were underway before COVID and were subsequently put on hold and have now been revived.

Manan Gosalia, Analyst

Great. Just a clarification on the comp ratio. Should we look at your year-to-date comp ratio and then take that going forward for the rest of the year or were you suggesting that your comp ratio would come closer to 63.5%? And if you can quantify the impact on the comp ratio from the lower reimbursable expenses?

Lindsey Alley, CFO

Yes. So, we are estimating reimbursable expenses and we've been relatively conservative on our estimates. I prefer not to share that number with you. But with respect to how you should model it, and I mentioned it in my notes, I think our year-to-date kind of 63.1%, 63% is how we're thinking about it for the balance of the year in terms of the target.

Manan Gosalia, Analyst

Great, thank you.

Lindsey Alley, CFO

The 63.5% was nearly a catch-up from the first quarter.

Manan Gosalia, Analyst

Got it, thanks.

Operator, Operator

Next we'll hear from Devin Ryan with JMP Securities.

Devin Ryan, Analyst

Good afternoon, guys.

Scott Beiser, CEO

Hey, Devin.

Devin Ryan, Analyst

Just first question here on your commentary on some of the acquisitions that you've been looking at, obviously it sounds like potentially timing pushed out a bit or maybe they don't happen. And then I know that when you issued the 3 million shares earlier in the year, some of that cash was paid toward acquisition. So I'm just curious, if kind of those deals, as we kind of move along here, looks like they're not happening. Do you increase or think about increasing buyback or returning some of that through dividend or do you like operating with having that additional buffer of flexibility to the extent something else comes along beyond these specific situations?

Scott Beiser, CEO

I think when we raised the capital back in May, we always viewed this as probably a one to two year time horizon in terms of finding and ultimately closing on the transactions, not a one to two quarter, which is really where we are relative to the time period. We are still in active dialogue with a handful of companies, as we mentioned on the call. Some of the conversations we had several months ago have maybe slipped away, they may come back for the reasons that I stated. So we're maybe a little the timing, as you said, has probably been elongated a bit. And ultimately our view is that we will still find attractive acquisitions. But if we don't, if we don't deploy the capital then we would use it through a buyback or a special dividend. I mentioned, we will not hold on to a significant amount of excess capital if that's what happens down the road.

Devin Ryan, Analyst

Okay. I appreciate the color. And then just a follow-up on the capital advisory, I guess contribution, if you will. Obviously, there's been a lot of activity in the market and you guys have a little bit of a differentiated business there as well. I'm curious if there's any way to frame out how that business has trended and your contribution and how that's been scaling within the firm? And just any parameters you can put around in terms of contribution? And then just expectations for the outlook there as well?

Scott Beiser, CEO

It's still a very important part of our business. That was primarily in our Corporate Finance area. It's still growing. We tend to do much more on the debt capital side than the equity capital side. And in the early days of the pandemic, you might call it some form of rescue type of financing that was needed and it seems to be evolving now into financing still for some companies that have some difficulties. But in many cases, it’s now turning into capital to assist in transactions and growth avenues that various companies might have. And we continue to believe very strongly that it will be a growing part of our total business.

Devin Ryan, Analyst

Okay, great. I'll leave it there. Thank you, guys.

Scott Beiser, CEO

Thanks, Devin.

Lindsey Alley, CFO

Thanks, Devin.

Operator, Operator

Richard Ramsden with Goldman Sachs has our next question.

Unidentified Analyst, Analyst

Hey, thanks. It's James Yaro filling in for Richard Ramsden. Thanks for taking my question. So the first one is, how are you thinking about the impact of the accelerating COVID cases and mounting number of shutdowns in Europe? And do you expect this to impact either the revenue pipeline? And is this perhaps one of the factors impacting the ability to acquire firms in that part of the world?

Scott Beiser, CEO

I think none of us have by any means the crystal ball on where we're going with all of the pandemic. For a while, it looked like Europe was improving much faster than the U.S. I mean, the last couple of weeks it’s reversed its case. I think a couple of things; one, and generally speaking financiers, investors, and companies were all figuring out how to live in this environment. So, we clearly have seen, as I think our peers have as well, an improved marketplace. On the other hand, I think there's still volatility to come that could slowdown deals, could be another incremental bump to performance in the restructuring group over time. I don't think that there is some magic time period that we know exactly when all this will end. So, activity is clearly increasing, but we do expect there will continue to be some bumps in the road. And that's part of our commentary on why we think potentially the timing on closing of deals, even the ones that we have reengaged on a brand new, may take a little longer than what we saw pre-COVID just because it may not be a smooth sailing between today and the close out of the pandemic.

Unidentified Analyst, Analyst

That makes a lot of sense. And then just more of a cleanup question, which is, you obviously had a little bit of an off-cycle increase in your dividend relative to when you have historically increased the dividend in prior years. Is this more just a catch-up from the fact that you didn't increased it six months ago and we should think about the timing of future increases to be more at the beginning of your fiscal year or is there some other shift in the capital return priorities?

Scott Beiser, CEO

Yes. I think, historically, you would have found us analyzing and making a change if the board wanted to make a change in our dividend, probably in our May cycle. We happened to do it at this time in our July cycle. And I think it was just recognizing the newness of the pandemic in May, it just didn't seem the right time to raise dividends. We clearly felt much better about the economy, our business model, etc., come July and we continue to feel better about it. So typically, you're right. I would say, the May time period is normally when we look at it. In this particular year, we decided to just kind of delay that decision for a quarter.

Unidentified Analyst, Analyst

Understood. Thanks a lot.

Scott Beiser, CEO

Thank you.

Operator, Operator

Next, we'll hear from Brennan Hawken with UBS.

Brennan Hawken, Analyst

Hey, good afternoon. How are you, Scott and Lindsey?

Scott Beiser, CEO

Hey, Brennan.

Brennan Hawken, Analyst

A quick one on following up on that question on Europe actually, but narrowly focusing it a bit to the restructuring side of things. We saw some sort of a head shake where it looked like Europe had things more under control. And then with the resurge in virus there and now lockdowns, I'm interested in whether or not you saw any shift in the velocity of restructuring activity or mandates? Whether you saw that step back in the region result in any increased activity? And whether or not that would lead you to expect a similar thing to happen if we should experience such situations in other parts of the world?

Scott Beiser, CEO

Yes. I think you really wanted to map out a monthly or weekly new engagements timeline, which none of us look at at that fine-tuned of the time period. But if we did, I don't think much of that difference in statistics has to do with whether Europe was opening up, closing down, or what might happen in the rest of the world. I think what we found is there is still a certain percentage of businesses across the globe, whose business models that once worked will not work or even need to be meaningfully modified going forward. Some of these companies have been able to be helped out because they were able to raise some debt money, lesser extent equity money. And effectively putting on additional debt in a company whose business model still needs to be altered is not a long-term solution; it may be a short-term solution. So, I think we're going to see some waves of incremental restructuring business down the pipe as well. But I don't, like I said, I don't think particular changes week-by-week or month-by-month have been influenced, per se, by what's happening in shutdowns. I think that probably has a more impact, short-term on our Corporate Finance business and less impact on the restructuring business.

Brennan Hawken, Analyst

Can you provide a rough breakdown of the restructuring revenue in terms of retainers or success fees? Is there a way to indicate that composition?

Lindsey Alley, CFO

Yes. Brian, it's a good question. We don't disclose that. I mean, I think we have disclosed before kind of what our breakdown of debtor versus creditor is, but we haven't gotten into the specifics regarding retainer fees, and probably prefer to keep it like that.

Brennan Hawken, Analyst

Okay. Let me approach this differently, Lindsey. I'll revisit that question. Considering the volatility in the restructuring line, should we view the results from the past quarter as a sensible starting point for future projections, or is there still too much variability from quarter to quarter? Additionally, is there any reason to think that the restructuring this quarter was particularly strong and may not be seen again in the near future?

Lindsey Alley, CFO

Yes. I would normally say that it's too volatile to use this quarter as an indicator of what Q3 or Q4 might look like. However, we took on several cases in Q1, and those cases have started to close and will continue to do so into Q3 and Q4. We anticipate continued elevated results in Q3 and Q4, but the volatility with engagements varying from $10 million to $20 million is still a factor. Therefore, the growth profile in restructuring will not be as strong. I believe Corporate Finance will recover from the shock seen in Q1. However, I advise caution in expecting growth in restructuring for Q3 and Q4 to look similar to now; it will still be higher than in previous years.

Scott Beiser, CEO

And Brennan, I might add. Pre-pandemic, we probably ranged quarter-by-quarter in restructuring between $50 million and $100 million, and that's just kind of the normal quarterly troughs and values you have. I think you still have that kind of dynamic post-pandemic. It's just we're at higher troughs and higher peaks than we saw before.

Operator, Operator

We'll now hear from Ken Worthington with J.P. Morgan.

Ken Worthington, Analyst

Hi. Good afternoon. No good conference call can exist without a political question. So, with politics coming into play here, in terms of Corporate Finance, do higher capital gains and dividend taxes for the wealthy threaten or enhance the middle market M&A business? And maybe how might a big round of stimulus impact either the timing or the magnitude of restructuring business, maybe not at all? And then any thoughts if there is a change in the political environment, how that might flow through in any way through the valuation business? Thanks.

Scott Beiser, CEO

Absolutely. I can address those questions. Let's approach this in reverse order. Regarding valuation, depending on the election results, we may see a considerable increase in state and tax planning work in our third fiscal quarter if there is an expectation of tax rate changes in 2021 and beyond, particularly if we can initiate that work in the next week or two. In the long term, any alterations in tax rates typically benefit valuation because people will adopt different strategies when changes occur. Therefore, I see the changes in tax code and election outcomes as either neutral or favorable. On the Corporate Finance front, we've mentioned for several quarters that some companies might want to expedite transactions in order to close by December 31. However, at this point, it is unrealistic for anyone to engage us with just two months left and expect a closure by that date. Even in the last quarter, it was quite difficult to achieve that. We do have some transactions that have likely been influenced by potential changes in the tax code and elections, though probably not as many as we initially anticipated. Thus, I don't expect significant changes in that area. I believe the pandemic has had a greater impact on our Corporate Finance business, helping people adapt to remote work and evaluate business plans, rather than the outcomes of the elections or tax rates. Additionally, I think a stimulus would clearly boost M&A activity, but I'm unsure if it will significantly assist companies that genuinely need to undergo restructuring. Ultimately, if a business plan is outdated in the current economy, even a substantial infusion of funds may only postpone issues without completely resolving them. We constantly consider this in our discussions with clients and prospects. None of us can predict the future, even if we know the outcomes. We do our best in terms of planning, and those are my thoughts on your politically related inquiries across various product lines.

Ken Worthington, Analyst

Awesome, great. Thank you very much.

Scott Beiser, CEO

Thanks, Ken.

Operator, Operator

Our final question comes from Steven Chubak with Wolfe Research.

Unidentified Analyst, Analyst

Hey, everyone. This is Brandon Fancher. My first question is about the differences in recovery between Europe and the U.S. European deal activity has mostly been led by the middle market, whereas the U.S. has seen more large deal activity. How have your conversations differed in these regions? What do you think it would take to stimulate the U.S. middle market?

Lindsey Alley, CFO

I think we should begin with the U.S. The middle market M&A business here is thriving. As Scott noted, we are experiencing a strong level of activity. This includes new engagements, which typically take months to finalize. Therefore, we won't see the revenues from this activity for at least a couple of quarters. However, the current M&A market is quite favorable, particularly in the middle market. This is driven not only by the return of private equity but also by corporate and strategic investors. We're witnessing some well-known names engaging in much larger transactions in the large-cap space, but there's also significant activity in the middle market, which we are benefiting from. Regarding Europe, the situation is somewhat similar. We are observing decent activity levels. Currently, it's uncertain how the recent shutdowns and spikes might impact this; it could affect us significantly. However, before the last couple of weeks, both the U.S. and European markets have been quite active since early September.

Unidentified Analyst, Analyst

Great. And I guess one follow-up on the privates. How much of it do you feel like is pull forward in the case of an increase in capital gains tax? And how much of it do you feel is actually sustainable?

Scott Beiser, CEO

I think I said earlier, I think the whole motivation to get a deal done sooner versus later and kind of your pull forward question has been relatively minor to the overall scheme of our firm. Just it's not been a giant rush, I wouldn't describe it as a material part of the things that we're working on today or things that have closed.

Lindsey Alley, CFO

Yes. We might see some incremental revenues in Q3, but to Scott's point, the rest of it is very sustainable.

Unidentified Analyst, Analyst

Great. Thank you for taking my questions.

Scott Beiser, CEO

Thank you.

Operator, Operator

That will conclude today's question-and-answer session. I will now turn the conference over to Scott Beiser for any additional or closing remarks.

Scott Beiser, CEO

I'd like to thank you all for participating in our second quarter fiscal 2021 earnings call. And we look forward to updating everybody on our progress when we discuss our third quarter results for fiscal 2021 this coming winter. Bye-bye.

Operator, Operator

That will conclude today’s conference. Thank you for your participation. You may now disconnect.