It’s not easy finding companies that generate high returns on capital and produce free cash flow in excess. Even if you screen for companies that do exactly that, you can’t be sure you’re looking at a bunch of quality investments.
Last week I ran a screen of companies that produced free cash flow every year for five years and an average return on invested capital of 25% or higher.
What I got back was a bunch of wonderful businesses and not so great investments. The price for these businesses left little room for growth or a margin of safety.
But sometimes you can you find a high compounder with great prospects. And that’s exactly what I found in Evercore Inc. (NYSE:EVR).
Evercore is an investment bank, plain and simple.
They have two operating segments:
- Investment Banking activities and
- Investment Management.
Let’s break down the first.
Evercore specialise in complex financial transactions in their Investment Banking business. What are complex financial transactions?
It might include underwriting activities (facilitating an initial public offering). They could act as a middle man between security issuer and buyer. Evercore could provide equity research and private funds to invest in.
But a large part of Evercore’s Investment Banking business relates to mergers and acquisitions (M&A).
Their business is heavily reliant on experienced advisors. The more respected advisors they have, the better. As Evercore explained in their 2016 letter to shareholders:
“We believe that our growth is ultimately a function of talent addition, both by hiring the most talented and productive professionals and by developing and promoting our own talent.”
Like all investment banks, Evercore is at risk of competitors poaching their best talent. Evercore does it themselves. For example, in 2016, Evercore convinced Goldman Sachs’ head of activism defense, Bill Anderson to jump ship.
In their 2016 annual report, Evercore had 81 advisory senior managing directors in their Investment Banking division.
Throughout 2016, these managing directors helped Qualcomm acquire NXP Semiconductors, CenturyLink acquire Level 3 Communications, Inc., Tesla Motors, Inc. acquire Solar City and Samsung Electronics acquire Harman International Industries among others.
Bagging these big clients act as the ultimate referral tool. What’s more, if these acquisition hungry businesses liked working with Evercore advisors, then they’ll likely come back next time they want to gobble up another competitor.
That’s why it’s extremely important that Evercore advisors think about building relationships.
OK, now let’s look at Evercore’s Investment Management business.
To me, it almost seems like a side project. As the name suggests, they manage other people’s money. They might invest in a standard portfolio, private equity or wherever else they see an opportunity for returns.
If you’re wondering why I said Evercore’s investment Management business was a side project, maybe this table will help paint the picture.
Investment Banking revenues made up more than 93% of total revenues during 2016. You could remove Investment Management from the business and the stock likely wouldn’t sell down too much.
Investment Banking activities also contributed almost all of the group’s growth over the past five years. The segment has grown sales at a compounded annual rate of 19.14%.
If we take a closer look at their Investment Banking business, we can see that advisory fees – what it costs for Evercore’s advice – makes up the majority of sales.
Evercore’s Investment Banking business is also quiet profitable. In 2016, Evercore saw 18.5% of sales trickle down into profits.
Clearly, the Investment Banking business has very attractive economics – hire or build a team of respected advisors and put them to work.
But such a company doesn’t come cheap.
Trading at 33.9-times earnings and 4.7-times book value is pretty pricy. But what should catch your eye is cash.
The group produces so much cash investors are willing to pay up. The group trades at 9.2-times FCF, and as cash generation continues to grow, investors could likely bid up the stock.
Now, let’s talk about debt.
Evercore’s debt-to-equity ratio of 1.1 isn’t ideal. But they do cover interest more than 14-times over. And debt schedule, shown below, which includes Notes Payable and Subordinated Borrowings looks extremely manageable.
Evercore generates free cash flow of more than $350 million. That means the company could pay of their interest bearing debt in full if they wanted to.
Now let’s take a look at Evercore’s financials over a number of years.
Over the years, Evercore has had amazing growth in sales, profit and earnings per share. The table below summaries the companies compounded annual growth over multiple periods.
But to me, it’s not earnings that make Evercore such a wonderful company. It’s their free cash flow generation. Who wouldn’t want to own a capital light business that generates hundreds of millions in free cash flow each year?
In their latest quarterly announcements, Evercore continued to grow.
For the nine months of 2017, Investment Banking revenues grew 19% to $1.12 billion. Operating income for the segment was also 60% higher, totalling $244 million. The segments operating margin also improved from 16.3% to 21.9%.
It was a different story for their Investment Management business however.
Revenues were down 16% for the first nine months in 2017. Operating income also dropped 96%, adversely affected by goodwill write-downs.
As a group, Evercore still looks to be growing. This could be adversely affected by the M&A activity of the market going into the future.
What’s the moat of an investment bank?
Such an industry is extremely hard to break into. “Who’s going to start a bulge-bracket investment bank to compete with Goldman Sachs,” Pat Dorsey wrote in his great book, ‘The Little Book that Builds Wealth’.
That means there’s a slim chance Evercore needs to worry about young upstarts coming in to take market share. However they still have to compete with the likes of Goldman.
This is why Evercore has to build their moat, which they are in the process of doing. Evercore’s moat, like Goldman and other investment banks, is their reputation and the reputation of their talent.
Remember the M&A’s I rattled off above? That adds to Evercore’s moat. So too does the training and hiring of top talent.
Already we can see the effects of Evercore’s efforts to build and strengthen their moat. In 2016, Evercore generated a return on equity and invested capital higher than ever.
And thanks to growth throughout the nine months of 2017, returns are expected to climb even higher going forward.
Is this moat durable? To be honest, I have no idea. The company’s growth and returns seems to be making shareholders happy for the moment. However, what if activity for M&A and other investment banking services declines?
Will Evercore continue to generate cash in surplus? Will earning flat line or nose dive? These are all questions worth thinking about before making an investment into Evercore.
Evercore will not grow at double digits into perpetuity. Over the past five years, Evercore has grown FCF at a compounded annual rate of 22.2%. If we stretch this out over 10-years, FCF compounded at about 11%.
To be on the safe side, let’s assume Evercore can grow FCF at 8% over the next five years and at 3% after that.
This would be a massive slowdown in growth. However, even with these conservative figures, Evercore could be worth as much as $6.7 billion. At time of writing, Evercore has a market value of 3.7 billion.
That means trading at an 82% discount to what I think the business is conservatively worth.
I suggest you do your own research into the company and see if it’s one you’re comfortable investing in.
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