Earnings Call Transcript - HLI Q2 2020

Operator, Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Houlihan Lokey's Second Quarter Fiscal 2020 Earnings Conference Call. I will now turn the call over to Christopher Crain, Houlihan Lokey's General Counsel.

Christopher Crain, General Counsel

Thank you, operator, and hello, everyone. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note that this conference call is being recorded today, October 24, 2019. By now everyone should have access to our second quarter fiscal 2020 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 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, 2019, 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. Hello, everyone, and welcome to our second quarter fiscal 2020 earnings call. Considering ongoing volatile macroeconomic and political factors, we are very pleased with the firm's financial performance in the second quarter of fiscal 2020. This quarter we generated $273 million in revenues with record second quarter revenues in both Corporate Finance and Financial Advisory Services, and we had a solid quarter in financial restructuring compared to an exceptional second quarter in financial restructuring last year. Adjusted earnings per share were $0.70 for the second quarter, and we announced our quarterly dividend of $0.31 per share for the third quarter. Record first half revenues of $523 million are up 6% compared to the first half of last year, and we enter the second half of fiscal 2020 with good momentum across all three of our business lines. We believe there are a handful of factors that have contributed to our continued solid results. We remain committed to a diversified business model that reduces our reliance on any one banker, one product, one geography, one client, one transaction, or one industry. As a result of this differentiated platform, we believe we continue to gain market share and grow our Corporate Finance and Financial Advisory businesses while maintaining a natural hedge against an economic downturn with the largest and most diversified financial restructuring practice on the street. Despite the natural starts and stops of the restructuring marketplace, we believe that future business opportunity is very large and still growing. Our focus on the mid-cap space and corporate finance is unique among our publicly traded peers and results in less volatility, greater client diversification, and provides a very attractive platform to continue to grow our business. And while we are not immune to the impact of current trade disputes, the size and types of our investment banking transactions are likely less impacted than larger cross-border deals. Our financial advisory services business, which produces hundreds of distinct fee events per quarter, helps contribute to the firm's diversification and enhances the reliability of our revenues throughout the market cycles. Our continued focus on improving client relationships and utilizing industry expertise in FAS has contributed to expanding our revenues per MD to record highs. Finally, although our stated goal is to continue to diversify internationally, the vast majority of our revenues are still U.S.-based, and the U.S. continues to remain the most vibrant deal marketplace for our business. However, in this environment, we are keeping an eye on factors that may put pressure on our results in the future. The political environment in the U.S. has become more difficult and uncertain. While we have not seen it yet, as we move towards the 2020 elections, uncertainty may weigh on executive confidence and may affect corporate transactions. Depending on the outcome of the elections, future changes in corporate and individual tax policy could have an impact on client results and transaction motivation, particularly with respect to our financial sponsor clients. Historically, when we have had challenging business environments or economic or political dislocation, our business mix has mitigated the effect of these challenges. In spite of the challenges in today's economy and as a result of the strength of our platform, our three business segments have done quite well year-to-date, with adjusted reported results, retained client mandates, and pipeline prospects all showing growth year-over-year. During the quarter, we recruited two managing directors in corporate finance, one joining our private funds group and one joining our capital markets effort. We continue to look for talent to grow our capital markets business, and we believe it's one of the most exciting areas for us to grow the firm over the next decade. In addition, we continue to hire in the U.K. and Europe, and in fact, our London office is now our second-largest office after New York. To support our growth in this part of the world, I am pleased to say that during the quarter, we opened our new London headquarters and consolidated all of our bankers into one location. Regarding acquisitions, we remain very active and are in various stages of dialogue with potential targets that we believe will help us continue to achieve our stated goals. To that end, yesterday, we announced that we have agreed to acquire Freeman and Company, a New York-based independent advisory firm that provides corporate finance advisory services to companies in the financial services industry. The acquisition is expected to close following regulatory approvals. Lastly, on the shareholder front, ORIX, which has been a significant Houlihan Lokey shareholder since 2006, sold its last shares in our firm in a July block trade. ORIX was instrumental in the development and maturity of our business over the years and very supportive of our collective decision to go public. They have been a great financial partner, and we thank them for their leadership, support, and relationship over these last 13 years. Overall, we are happy with the quarter, and we continue to believe that we offer our shareholders a unique business model that will allow us to achieve solid financial results through all market cycles. And with that, I'll turn the call over to Lindsey.

Lindsey Alley, CFO

Thank you, Scott. Revenues in corporate finance were $156 million for the quarter, up 7% compared to the same quarter last year. We closed 69 transactions in the quarter compared to 62 in the same period last year, and our average transaction fee on closed deals was slightly lower this quarter versus last year. Financial restructuring revenues were $77 million for the quarter, a 17% decline from the same quarter last year, which you'll recall was an exceptionally strong second quarter. We closed 17 transactions this quarter compared to 20 transactions in the same period last year, and our average transaction fee on closed deals was lower compared to the same quarter last year. We would like to remind everyone of the lumpiness of our restructuring business across quarters as it is often driven by the timing of large fee events. In financial advisory services, revenues were $40 million for the quarter, a 9% increase from the same quarter last year. We closed on 523 fee events during the quarter compared to 469 in the same period last year. New business activity in FAS remained steady, and we have continued to see improvements in managing director productivity in our FAS business. Turning to expenses, our adjusted compensation expenses were $165 million for the second quarter versus $169 million for the same period last year. Continuing this quarter, we adjusted for pre-IPO grants and for the deferred payments primarily related to acquisition agreements associated with our two fiscal 2019 acquisitions. The adjusted compensation ratio was 60.7% for the quarter, within our targeted range between 60.5% and 61.5%. Our adjusted non-competition expenses in the second quarter were $44 million versus $41 million for the same period last year. Year-to-date, our adjusted non-competition expense ratio declined to 15.6% versus 15.8% in the same period last year. As we have mentioned in the past, our adjusted non-compensation expense ratio typically runs higher in the first half of the year and lower in the second half of the year because of our revenue seasonality. Our long-term fiscal target for the adjusted non-competition expense ratio is between 14% and 15% annually. This quarter we adjusted out of our non-competition expenses three items. First, approximately $250,000, mainly legal and accounting costs associated with the registered block trade completed in July 2019. Second, $1.7 million of acquisition-related amortization. And third, $6.8 million related to the consolidation of our London bankers into a single New London headquarters. The non-recurring expenses associated with this move are primarily the write-down of lease assets and fixed assets that are no longer in use. In addition, we adjusted our occupancy expenses in London as if the consolidation and move occurred as of July 1, the first day of the quarter, in order to best reflect that going forward occupancy costs for our London location. Our adjusted other income and expense line item resulted in a gain for the quarter of approximately $1.1 million, compared to a gain during the same period last year of $1 million. Our income in this line item for the quarter was primarily a result of interest income on our cash balances throughout the quarter. Our GAAP effective tax rate for the quarter was 28.4%, which is consistent with our targeted range of between 27% and 29%. Turning to the balance sheet and uses of cash, as of the quarter-end, we had $305 million of unrestricted cash and equivalents and marketable securities. In the second quarter, we repurchased approximately 479,000 shares at an average price of $43.80 as part of our share repurchase program. As a reminder, a significant portion of our cash will be paid out as deferred cash bonuses in November to our banking staff. Each year, bonuses paid in May to our banking staff include both the deferred cash element and the deferred stock element. This November payment represents the deferred cash element. And with that, operator, we can open the line for questions.

Operator, Operator

Our first question comes from Devin Ryan of JMP Securities. Please go ahead with your question.

Devin Ryan, Analyst

So, the first question here. Last quarter you cited that there was kind of a lack of a clear trend, I think that's how you framed it in the middle markets at the moment and that was leading to a little bit less steady M&A activity. And so, when I listened to the call here in the prepared remarks, it sounds like there's been a little more clarity recently and the backlog has been growing, so I'm just curious if something shifted today versus three months ago where you're feeling better about at least the business at the moment. I understand that obviously there's plenty of macro dynamics that could create uncertainty in the future, but it felt like a bit of a different tone on this call. Maybe a little more constructive, so I'm just trying to ascertain if I'm hearing that correctly?

Scott Beiser, CEO

Yes, I think Devin, that's a fair perspective. I probably feel a little better about our corporate finance opportunities for the foreseeable future today than a quarter ago, but I still believe that we continue to see the changes in the winds from tailwinds to headwinds and vice versa. So yes, it's a little better today. I don't know what tomorrow will bring, but opportunities do feel a little stronger today.

Devin Ryan, Analyst

And then a follow-up here just on the restructuring business, you know we hear some of the messaging there as well, you know there's some high-profile assignments that we can all see in the press that you guys have been named on and so I'm sure that helps a bit. But, you know more broadly are you seeing an acceleration in activity, and it sounds like you are finding pockets of dislocation? So I'm curious kind of where those are, just again any other ways you can frame kind of what's happening in that business would be helpful?

Scott Beiser, CEO

I think we still see the long-term opportunities that continue to grow. The total amount of indebtedness has potential problems that we feel may eventually evolve with certain circumstances, and I think it's much what we've said in the last couple of quarters. There are some pockets clearly in a few industries; there's still all the various technology disruptors; there are some companies that face too much debt management issues, fraud issues, and the whole series of issues that have occurred, but we’re still by no means in a robust restructuring environment. We think we've done very well in still a very low default rate, and I would say the ongoing trends include some new pockets of restructuring activity.

Devin Ryan, Analyst

And then just last modeling question here. Lindsey, I apologize if you went through this, but on the other operating expense, I know that can be a bit lumpy but I didn't hear anything flagged there, but that did step up from last quarter decently? So I'm just curious what was in that number and can you think about it going forward for the other expense?

Lindsey Alley, CFO

This is our kind of below the line other income and expense line item that you're talking about.

Devin Ryan, Analyst

I'm looking at other operating expenses.

Lindsey Alley, CFO

Yes. So I think if you're looking at the GAAP results, part of the add back relating to the London move is incorporated in both rent and then also in other operating expenses. So there is an increase in that, primarily driven by the London move, and that has been a part of our adjustment includes other operating expenses as well as rent.

Operator, Operator

Our next question comes from Michael Brown of KBW. Please proceed with your question.

Michael Brown, Analyst

So just a follow-up on the non-comp, we were a bit surprised to see kind of the increase this quarter. So, appreciate the color, Lindsey, on the seasonality there. Could you just give some additional color on what was driving the increase in the IT and communication expenses this quarter, you saw that increase sequentially?

Lindsey Alley, CFO

Yes. A couple of quarters ago, we reclassified some consultants that were previously categorized under professional service fees to IT service costs, as we believed they were more appropriately aligned with that category. As a result, you are observing an increase in IT expenses, while there has likely been a corresponding decrease in professional service fees due to this reclassification.

Michael Brown, Analyst

One of your peers had kind of mentioned that some of the deals experienced some timing issues. It sounds like maybe the time to close was elongated on some of those transactions - I know that was an issue that you guys experienced at the beginning of the year, was kind of curious if you had seen any of that occurring in the quarter. Are you seeing any pickup in that or any deals being shelved at all?

Scott Beiser, CEO

We mentioned that, I think it was two quarters ago, that we saw some delays in timing. We really have not seen that in the last quarter. There’s always a subset of clients that our transactions might not close or get a little elongated, but nothing out of the ordinary in this particular quarter.

Michael Brown, Analyst

That sounds like nothing systemic there. And then just one last one on Freeman & Co. just kind of curious how many employees and MDs are expected to join Houlihan once that transaction is closed.

Scott Beiser, CEO

We announced that there'll be two MDs and one senior adviser. And it's like many of the other acquisitions, it's effectively a mid-sized group that will add to our bench strength in the FIG industry.

Operator, Operator

Our next question comes from Brennan Hawken of UBS. Please proceed with your question.

Brennan Hawken, Analyst

I just have one on restructuring. When you think about restructuring and modeling, this is obviously a really lumpy business. It's one that's prone to large events even though I believe recently you've indicated that there's been some diversity in the size, some smaller fee mandates in there and percentage completion and such. Is there a good way to think about modeling this quarter-to-quarter, or is this just something where we as analysts for the company should just be resigned to understanding that quarter-to-quarter weakens not always understand how it might move around year-to-year and quarter-to-quarter and comparisons are tough, and we should just look at a rolling average? Any insights on that front?

Scott Beiser, CEO

Yeah. I think we are all better off probably looking at some rolling average, whether that's 12 months or whatever timeframe you want to use. We don't have a whole lot of control over the timing of closings and restructuring. And I think unlike in corporate finance, they are not often impacted by calendar year-end issues for tax reasons or even fiscal year-end issues. And so we do find it's a little tougher to predict that from a quarter-to-quarter standpoint. I think historically you could look at our corporate finance business and see that it does have certain seasonality to it; it's much harder for us to gauge any particular quarter versus another quarter in restructuring.

Brennan Hawken, Analyst

And generally, it seems the outlook remains pretty steady there, continuing to see good levels of activity despite the low default environment. Is that fair, is there any shift in that business since last quarter, any additional color that you can give on how that market has developed?

Lindsey Alley, CFO

Yes. I mean I think Brennan, as we sit here today similar to Scott's comments regarding corporate finance, we probably feel a little bit better about our restructuring business for the coming year than we did three months ago.

Operator, Operator

Our next question comes from Jim Mitchell of Buckingham Research Group. Please proceed with your question.

Jim Mitchell, Analyst

Maybe just a question on the – you have a pretty big exposure to the private equity client base. Any sense on how they're feeling? I think earlier in this year there were some hangovers from that group and worried about valuations as the market tanked and rebounded. What's your sense with that client base, are they reengaging pretty aggressively with lower rates? How do we think about the activity levels among the private equity buyers?

Scott Beiser, CEO

Yes. I think they've clearly picked up from the negative stock market activity point to kind of December 2018 of recent lows. That being said, I think for the last year or so when they're out buying businesses, they do model in some kind of a downturn in the economy case that they might not have done three, four, five years ago. So that's a vantage point that they have. But in terms of activity, both buying, selling, and raising capital being able to procure capital for transactions they're doing, we still see it as an effectively healthy marketplace.

Jim Mitchell, Analyst

So there is not a lot of valuation discrepancies holding to expect what you’re saying?

Scott Beiser, CEO

No. I don’t really think there is a huge disconnect between the buying and selling world at least as of now.

Jim Mitchell, Analyst

And then maybe Lindsey just another question on just the geography of the charges and how do we think about the London office? You said it's split between other and rent. I think you only disclosed it in aggregate. Is there a way for us to know, can you help us with the run rates in both those expense lines for modeling purposes?

Lindsey Alley, CFO

Yes. I'm not. This is not going to be exact, but I would say it's probably about $1 million of the add back is in your other operating expenses and the balance is in rent. There might be a little bit in a couple of other categories, but that's probably the easiest way to think about it.

Operator, Operator

Our final question comes from the line of Jeff Harte of Sandler O'Neill. Please proceed with your question.

Jeff Harte, Analyst

A couple from me. I mean we were kind of beaten on non-comp a lot here, but as we look at the non-comp, is the current quarter, the last quarter is $44 million, a pretty clean starting point for us to think about trending forward and to kind of historical seasonal trends that we've seen as far as this quarter rolling into next quarter? Do you think that general historical trends should still hold percentage-wise?

Lindsey Alley, CFO

No. I think the historical trend, there’s no reason to believe that shouldn't hold, and I think this is a pretty clean on an adjusted basis. It's a pretty clean quarter for non-compense as relative to second quarters of previous years.

Jeff Harte, Analyst

And as far as the competitive environment goes, I'm thinking primarily in kind of the middle market corporate finance, but I suppose restructuring as well. We keep hearing more and more from multi firms kind of trying to move into the middle market and really focusing on smaller transactions. Have you noticed a change in terms of the competitive environment there? And I guess just as much specifically, are you seeing more of the bulge bracket firms trying to compete in the middle markets?

Lindsey Alley, CFO

So, we get this question a lot. And you may be hearing about it, but we're not seeing it. I think that largely the disconnect is when the bulge bracket talked about the middle market, they're still aiming higher than our average transaction size. That's not to say we don't compete against bulge bracket firms, but when we're competing against bulge bracket firms, that's at the very high end of our range or I would say our normal range of clients. And for the vast majority of the transactions that we work on, we just don't see the bulge bracket, and I don't believe that when they talk about middle market, that's the size range they're talking about.

Jeff Harte, Analyst

Then I suppose, but a lot of comparable environment, we've touched on restructurings well. And I am thinking more from you guys being an established leader there, but it seems like every boutique we talked to is now kind of building up restructuring. Have you noticed a meaningful change in the competitive environment there? Are more and more firms seeing meaningful restructuring now?

Scott Beiser, CEO

We still think the core competitors that we run across are pretty much the same today as they were three years ago or five years ago. That's not to say that there are some other probably newer entrants or smaller firms that are in it. But the core players, I think it's a very stable group over the last half dozen years and haven't really seen any new competition meaningfully impacting the type of business that we're pursuing or winning.

Operator, Operator

Thank you for your questions. I will now hand the call over to Scott Beiser for any closing remarks.

Scott Beiser, CEO

So I want to thank you all for participating in our second quarter 2020 earnings call, and we look forward to updating everybody on our progress when we discuss our third quarter results for fiscal 2020 this coming winter.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.