Houlihan Lokey, Inc.

Moat: 3/5

Understandability: 4/5

Balance Sheet Health: 5/5

Houlihan Lokey is a global investment bank specializing in mergers and acquisitions (M&A), financial restructurings, and valuation advisory services, with its primary focus on middle-market clients.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Houlihan Lokey (HLI) operates within a highly specialized and competitive niche of investment banking, where its expertise and brand reputation in the middle-market segment create a narrow moat, but one which is vulnerable to shifts in deal flow, competition, and talent acquisition.

Business Overview

  • Revenues: HLI’s revenues come from three primary sources: 1. Corporate Finance: This segment, responsible for the bulk of the firm’s revenue, focuses on M&A advisory, providing guidance and execution on transactions such as sales, acquisitions, divestitures, leveraged buyouts, and private placements of debt and equity. 2. Financial Restructuring: This segment offers advice and execution for companies facing financial distress or bankruptcy, covering debt restructurings, distressed asset sales, and other related transactions. 3. Financial and Valuation Advisory: This segment provides valuation opinions and advisory services for various purposes, including fair value opinions, solvency opinions, and intellectual property valuation. This often also encompasses tax opinions, due diligence, and fairness valuations relating to restructuring and M&A deals.

  • Industry Trends: The investment banking industry as a whole is subject to cyclical trends, as deal volume tends to fluctuate with broader economic conditions and market confidence. Within M&A, certain sectors like healthcare and tech have been relatively consistent drivers of transactions in recent years. There is a growing trend of financial sponsors (private equity) playing a bigger role in M&A. Restructuring is also cyclical to an extent, often tied to economic downturns and credit cycles, and has increased markedly with the current economic uncertainty. Financial and valuation advisory is slightly less cyclical and less dependent on transaction volumes as it is on an increasing need for valuations.
  • Margins: HLI’s operating margins vary due to the nature of its work, but it has consistently maintained high margins of 23 to 25% in the past year, indicating strong pricing power and efficiency. The company’s revenue structure is relatively low in fixed costs and high on variable costs and salaries tied directly to the amount of revenues generated in each period.
  • Competitive Landscape: While HLI does not face direct competitors that can offer their full services across the value chain and different segments they operate, M&A and restructuring deal making is quite a competitive industry with some very large bulge-bracket banks and boutique banks as well as consulting firms and big four accounting companies making their mark. HLI, however, primarily competes in the middle-market. The competitive landscape within financial and valuation advisory is also very competitive. The company competes with a range of smaller boutique firms, Big Four accounting firms, and valuation departments of other large financial institutions.
  • What Makes HLI Different? HLI’s primary focus and branding in the middle-market is a major competitive advantage. The firm does not compete with bulge-bracket companies in larger deals, nor is it willing to engage in smaller deals, where prices are more pressured. HLI’s focus on middle-market deal-making, therefore, helps it maintain better pricing power and a client base that it has developed expertise in. Additionally, HLI’s long experience and expertise in restructuring also set it apart, as there are very few firms that have such deep expertise within this niche market, according to management. Its employees are also among the most experienced in the industry and this has translated to very high win-rates in the past.

Financials

HLI is a low-capital business, as its main expenses are employee compensation, and it does not need a lot of physical assets to operate. This has led to very strong cashflows and very healthy finances, coupled with a good cash management strategy.

  • Revenues:
  • HLI’s revenues are volatile, as they are tied directly to the number and the size of deals completed in every reporting period. In the past few years, there has been a very high level of activity in M&A and restructuring, which led to revenue increases year-over-year. In the past year (September 2021 - September 2022) revenues have been on the decline, as the high levels of capital that were present have started to dry up due to changing macroeconomic conditions, interest rate hikes, and supply chain issues. In the current reporting period (June 2023 - September 2023), revenues declined by 11%.
  • Margins: HLI has historically had great margins as mentioned above and the margins remain quite high around 20% in the latest reporting period. * Debt
    • HLI has virtually no debt on its balance sheet and manages its capital allocation very well. The company keeps on hand a sizable portion of cash.
  • EPS: EPS has varied greatly, given the volatility in revenues. diluted EPS has gone up from $1.42 in 2018 to $4.31 in 2022 and the most recent quarter showed $1.37 diluted EPS. EPS is directly proportional to revenues as costs tend to be relatively steady year-over-year.
    • Capital Allocation: HLI has returned cash to shareholders by paying dividends and, at times, also through share repurchases. The latest reporting period shows that a significant amount of cash has been used to acquire the company’s Class B stock at an average price of $95 per share. Given that current stock prices trade at around $85, the company is buying its own stock while it is undervalued.
    • Valuation: While HLI is a high-quality business that seems to be attractively valued at a P/E ratio below 15, valuation has to be done in accordance with an investor’s specific parameters, risk tolerance, and the perceived stability and long-term outlook of the business.

Moat Rating: 3 / 5

  • HLI’s moat comes mainly from its specialized expertise and brand in the middle market space, which attracts clients that value its experience and capabilities in handling their specific needs. These include restructuring, M&A transactions, and valuation advisory. Although the barriers to entry are not too high, as there is no complicated technology or manufacturing involved, and the business does rely heavily on its employees, its deep network and reputation in the specialized area makes replicating its full value chain difficult, giving it a narrow moat. This is especially true for the restructuring segment where the company has a lot of expertise. However, the deal-making environment is highly competitive and there is very low pricing power if a company does not have a specialized position, with high returns on capital. The company’s ability to get better-paying clients in high-fee segments also helps in maintaining returns on capital as well as brand.
  • The company’s focus on middle market deal making allows it to avoid direct competition with large investment banks, which tend to focus on larger transactions.
  • There is low pricing power, as competition can drive down fees.

  • The reliance on employees, though also its strength, makes the business’s moat somewhat fragile. If large numbers of key personnel leave, the moat can be weakened.

  • Justification for 3/5: The company’s moat is solid but not as strong or durable as a company with pricing power stemming from strong brands or very high switching costs, which provide an enduring advantage. HLI has a brand name, but the company relies heavily on its employees. A few changes in their personnel could lead to a weakening of their moat.

Legitimate Risks That Could Harm the Moat and Business Resilience

  1. Cyclicality of Deal Activity: HLI’s main revenue sources from M&A and restructuring are very dependent on overall macroeconomic conditions, and market sentiment. A downturn in the economy could cause a sharp decrease in deal volume. Although HLI does have a valuation and advisory business, which is less dependent on deal activity, it does make up a smaller part of the overall business.
  2. Competition: The investment banking industry is intensely competitive, with established players and new entrants frequently vying for business. New boutique players with very high fees and low operating expenses and bulge-bracket companies offering the full suite of services and capital are a great threat.
  3. Dependence on Key Personnel: HLI relies heavily on its experienced professionals for deal origination and execution. The loss of key employees or partners could impact its ability to attract and execute deals successfully. HLI has said in recent calls that it is actively investing in retaining key employees, especially in the current conditions.
  4. Regulatory and Legal Challenges: HLI faces complex regulatory and legal frameworks both in the United States and other jurisdictions, that could increase compliance costs or otherwise affect its ability to operate profitably. The company has recently had an inquiry from the SEC about a new fee structure that is being used by private equity companies which is currently being investigated.
  5. Changes in Capital Markets The company is exposed to changes in capital markets through its involvement in leveraged buyouts and financing for restructurings. It is therefore highly exposed to swings in the credit markets, as well as changes in interest rates, which both have an effect on deal activity and borrowing terms.
  6. Technology The company’s technology must remain relevant to new trends and business demands, while also maintaining security and privacy standards for the client data, that it is entrusted with.
  7. Integration Risk: As HLI grows via M&A, it must successfully integrate the acquired companies without disrupting operations. Integration risks are compounded further when there are personnel or cultural challenges.

Understandability Rating: 4 / 5

  • HLI’s business model is relatively straightforward. They offer advice and execution on M&A, restructuring, and valuation, which are all easily identifiable and easily understandable in principle. However, the company’s financial statements tend to be quite complex, and understanding what drivers a specific segment can be tricky for those unfamiliar with financial accounting. Because the company deals with many different clients and transaction structures, the business can quickly become very complex, with many different revenue recognition methods and costs, along with the complexity stemming from accounting for acquisitions and other special financial items.
  • The long-term historical performance, although not easily translated to future expectations, helps in understanding the business, and the business has great metrics that can help a basic investor in understanding it.
  • The business is relatively straightforward to understand from a business perspective, but it is more complex when you start looking into its financials and how deals are structured.
  • The business has a consistent structure and is very resilient to changes in macroeconomic conditions.
  • There is a high level of transparency from the management team.

Balance Sheet Health Rating: 5 / 5

  • HLI has a very strong balance sheet, characterized by minimal debt and a large amount of cash on hand. Given that the business is a professional service business, this is to be expected, and also reflects the low-capital nature of its operations. Given that, the management team has made very smart capital allocation decisions and the business is highly financially stable.

Conclusion

HLI is a high-quality investment banking company that operates in a niche of the market with few other competitors having the same level of expertise. The company is likely to be able to maintain high returns on capital over the long term. That being said, the company is very dependent on general macroeconomic conditions and the global deal-making environment. Therefore, those relying on strong and consistent revenues will have to look elsewhere. From a financial perspective, HLI is a well-run company with great financial stability and returns. Therefore, despite being in a cyclical industry, HLI can be considered a great investment, but with caveats and limitations mentioned above in the report.