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FTI's Siren Song


It's tough to resist, but what's under the surface?

I have now mentioned a few times the appeal of FTI Consulting (FCN). In a nutshell, the company gets paid some $300/per hour to send droves of braniacs to unravel the consequences of the credit crunch, bankruptcy filings, class action law-suits, M&A fights, accounting frauds, antitrust battles, and so on.

Truly, reading through the 10-K one can't help but feeling that what's been hitting the front pages of the Wall Street Journal for the last nine months spells "J-A-C-K-P-O-T" for these guys. Unfortunately, when I say "these guys" I mean the guys who actually work for FCN, and not necessarily FCN's shareholders.

Rather than digging into the minutia of FCN's income statement, these are the critical points to understand about its business model: (i) highly sought-after intellectual talent ("the consultants") wants to find deep-pocketed clients for whom consulting expenses are not an issue; (ii) by matching the right consultants with the needy clients, FCN has built a rock-solid reputation for addressing the clients' problems; (iii) FCN's business does not exist without "the consultants", so the latter can extract several pounds of flesh from FCN in the form of eye-popping compensation agreements, which include fat salaries, huge bonuses, ridiculous option grants, and last but certainly not least, what every self-respecting capitalist aspires to, the "non-recourse"/forgivable loan, i.e. cash in the consultants' pockets today, without having to pay taxes on it until way way later.

The shareholders' problem with the above model is fairly clear: the consultants and FCN have a nearly perfect symbiotic relationship which does not need outside capital except for tangential purposes, such as working capital and acquisitions. Hence, the incentive for FCN's management and "the consultants" is to secure such financing for the least possible cost, i.e. the lowest return the shareholders will accept for continuing to fund the company's operations and acquisitions-led expansion. Beyond that, FCN's management and the consultants are the ones working their tails off, and you can almost hear them ask, "why should we share the bounty with others, when we're then ones doing all the work?"
If I sound like my classic cynical self, just look at the return on capital over the last three years – which has been stuck in the 6-8% range – despite annual sales having grown 134% in the same period. The rub in this equation shows up in the Cost Of Goods Sold, i.e. what the consultants get paid, which increased 129% in the same period.

As much as I'd like to buy into FCN to benefit from the coming tsunami of business, I can't shake the feeling that the consultants and FCN's management won't let me. As a shareholder, I am a hanger-on and as such I'll be fed the leftovers. That does not mean that the stock can't go up if the business booms, in fact it would not surprise me a bit if it goes much higher. After all management and the consultants want to see their options appreciate. But you can rest assured that return on shareholders' equity will not keep up with the growth in the business. So my stock profits will depend more on an increase in the demand for the shares, than an increase in the intrinsic value of the company.

That's a tough model to get in bed with. And it is the principal reason I have been buzzing that the current valuation makes the stock a difficult long. One thing is to try catching a rising tide, another is to bet that a high tide will get higher.

For now I'm involved in a very small way through the sale of out of the money puts. They are fairly expensive, and it lets me scalp some profits simply by watching time pass. That said, it may be as close as I care to get to the siren song of FCN's stock.
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Position in FCN
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