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2019-10-22 11:16:46

The Company

Evercore Inc. (EVR) is an independent investment bank, offering investment advisory, merger & acquisition, restructuring, IPO underwriting, equities research, and debt issuance services. It's ranked #1 among independent firms for announced M&A deals, #1 independent research provider, and has the second-highest number of research analysts ranked #1. Its market share of advisory revenues grew from 2.3% in 2010 to 6% in 2016 to 8.5% as of Q2 2019.

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In short, EVR has become and continues to establish itself as a leading independent banking firm, especially as it relates to its advisory services. Just in the last year, revenue from investment advising rose at a 21% annualized rate.

It continues to grow its employee headcount as well, expanding from 1,475 in Q2 2017 to ~1,800 individuals worldwide in Q2 2019. Being an independent firm that does not engage in proprietary trading, along with boasting an already-top-tier roster of talent, tends to attract some of the best talent in the industry, including poaching from other investment banks. In this regard, EVR has become competitive with the likes of Goldman Sachs (GS), Bank of America (BAC), Morgan Stanley (MS), UBS (UBS), and Deutsche Bank (DB).

With an expanding headcount, EVR's advisement and research capabilities also expand, thus widening its potential future revenue sources. On the equity research side, the company now covers 775 stocks in 40 industry sectors, representing 80% of the S&P 500 (SPY) by market cap.

The investment bank also has $10.1 billion in assets under management for high net worth individuals and institutions, an amount which has grown at a 10% compound annual rate since 2010.

Interesting to me as a dividend growth investor, the company maintains a long-term commitment to shareholders that involves growing the per share dividend steadily with the growth in earnings as well as offsetting (significant) share dilution from compensation and new hires with buybacks (from cash available after dividends and investments). Because of these share buybacks, the per-share dividend has grown at a 14.75% CAGR over the last decade, while the total amount distributed to shareholders has only grown at a 5.1% annual rate.

Operations

EVR's core revenue generator is in M&A advising. This is a cyclical business that tends to grow in 5- to 8-year up-cycles followed by 2 to 3-year down-cycles, correlating highly with total market capitalization.

Source: Q2 Company Presentation

Total market cap, while plunging during recessions, does tend to grow over time - a long-term tailwind for the likes of EVR. Moreover, M&A activity is also negatively correlated with interest rates such that when rates fall, M&A activity tends to rise, and vice versa. The combination of a strong economy and low interest rates is a powerful one for an advisory firm such as EVR.

The company has advised in four of the five largest M&A deals announced this year, including Bristol-Myers Squibb's (BMY) acquisition of Celgene (CELG) and Occidental Petroleum's (OXY) acquisition of Anadarko. Amazon's (AMZN) acquisition of Whole Foods, advised by EVR, was awarded the M&A Deal of the Year by the Global M&A Network in 2018.

EVR's growth in market share of M&A activity is a large contributor to its breakneck revenue growth during the current bull market:

Source: Q2 Company Presentation

What's more, as the company has grown more proficient in advising, it has also grown more efficient financially. If operating margins continue to grow at their current pace, they will have doubled from 2010's metric in a few years.

Source: Q2 Company Presentation

But while M&A activity is EVR's bread and butter, its advisory capabilities are diversified, with revenues also coming from financial restructuring, shareholder activism, and general capital advisement. EVR has advised Toys R US and General Motors (GM) in restructuring deals, General Electric (GE) and Qualcomm (QUAL) in shareholder activism, and Lyft (LYFT) and Iron Mountain (IRM) in general capital advisement, to name a few.

While M&A is cyclical, increasing in strong economies and dropping during recessions, corporate bankruptcies and restructurings are the opposite. The restructuring cycle peaks during recessions and slowly declines thereafter.

During poor economies, it would seem that the increased supply of restructuring deals would offset the fall in M&A deals. However, there are some good reasons to think that the next downturn will not result in as many bankruptcies and restructuring deals as one might think, given the elevated level of corporate debt outstanding.

According to David Hillman, co-head of Private Credit at the Restructuring Group of Proskauer, the next restructuring cycle is likely to look very different than previous cycles. While lending standards have been tightened at banks, private credit and shadow banking firms have stepped in to satisfy the thirst for debt. Private credit currently manages over $770 billion in debt, compared to $275 billion in 2009. This explosive growth, says Hillman, is poised to continue even in the case of another spike in defaults.

There are a few reasons for this. First, due to the sheer amount of money sloshing around the financial markets, searching for yield (because of ultra-low Treasury yields), competition has heated up among lenders. This competition has led to significantly more borrower-friendly loan terms, including covenant-lite and covenant-loose standards.

Writes Hillman:

A massive 85% of global leveraged loans are now covenant-lite, according to S&P, compared to just 23% in 2011. And an astounding total of $452 billion of new cov-lite loans were issued last year alone.

Source: David Hillman, Proskauer

With global leverage ratios high and debt issuer ratings having gradually fallen over the last decade, one might think that the next recession would provide ample opportunities for EVR to offset the inevitable drop in M&A with restructurings. But the overwhelming shift to cov-lite and cov-loose loan terms calls that into question.

Lenders will have less leverage over borrowers to execute remedial action, claim collateral, or force a restructuring. This gives distressed borrowers greater ability to delay negotiations with lenders while actions are taken to address problems. Dividend-cutting, cost-cutting, asset sales, or additional debt incurrence can be used in lieu of fundamental change. This translates into fewer restructuring deals.

Second, the huge amount of money searching for yield cuts in more than one way. It has loosened credit and covenant standards, but it also offers a way out for companies that get into financial trouble. Howard Marks of distressed debt investment house, Oaktree Capital, has lamented about the lack of investment opportunities in his area of specialty. As such, Oaktree and other distressed debt investors have huge sums of money on the sidelines, waiting for opportunities to arise.

All that dry powder will likely step in to provide a lifeline to distressed corporations that might otherwise have gone the route of bankruptcy and restructuring. This, again, results in fewer available deals for advisory investment banks like EVR.

Ultimately, because of ultra-low interest rates and QE, the rifeness of cash in the financial system along with the search for yield means that the next recession is likely to cause zombie firms, more so than bankruptcies, to proliferate. Of course, there will be an increased volume of bankruptcies and their resulting restructurings, but increased leverage and zombification will be more substantial.

Indeed, since interest rates peaked in the 1980s, bankruptcies have trended lower and lower (aside, of course, from the notable exception of the Great Recession):

Source: Trading Economics

But even that spike in the Great Recession was mostly from consumer bankruptcies, not corporate ones.

Recession Performance Vs. Today

During the Great Recession, revenue fell by almost 40%.

Data by YCharts

The stock price, on the other hand, began falling much earlier than revenue did and ended up dropping by a little over three-fourths of its previous high.

Data by YCharts

Today, on the other hand, the stock price has fallen only by about 32% from its all-time high, and during the Christmas Eve selloff in 2018, it was about 43% off.

Data by YCharts

What about revenue? Well, revenue continues to climb, although the double-digit growth that has been ongoing for years is expected to slow to mid-single-digit growth next year. And net income growth has paused, slightly below its all-time high, but it is not abnormal for net income to be flat for several quarters in a row.

Data by YCharts

Compared to both earnings and free cash flow, EVR's stock price is currently trading on the lower end, with the P/E ratio signaling slow-to-no growth going forward.

Data by YCharts

Given the recession risks EVR faces, the company's valuation seems fair to me right now, though the stock is certainly beginning to look attractive.

The Dividend

At a 3% dividend yield right now based on the most recent quarterly dividend, EVR's yield is as high as it has been since late 2012.

Data by YCharts

Ordinarily, this would signify a good buying opportunity, but given the likelihood of a revenue drop in a potentially ensuing recession, the rising yield is understandable. I think it is likely that investors will be able to buy in at an even higher yield in the next year or so.

What about dividend coverage? I'm pleased to see that, despite the regularity of one weak quarter of FCF per year, EVR's dividend is regularly covered by cash flow.

Data by YCharts

And that coverage, when FCF is considered on the whole, is ample. In the last twelve months, the dividends per share have only amounted to 19% of FCF per share.

Data by YCharts

FCF per share even covered the dividend — by a wide margin — during the recession. From Fall 2008 to Fall 2009, the worst twelve-month period for EVR, dividends paid still amounted to only 31.5% of FCF per share.

I could see EVR's payout ratio based on FCF jumping up as high as 50-60% during the next recession, but I don't see a dividend cut as likely.

10-Year Yield-On-Cost Calculation

What about target 10-year yield-on-cost (YoC)? As a dividend growth investor with a long time horizon until I will need to tap into my investment income stream, it matters less to me what a stock pays today than what it will pay many years from now. The 10-year YoC projection is my attempt to quantify, to the best of my ability, the amount of income that will be thrown off from an investment ten years from now.

Let's assume that competition for advisory deals heats up in the next decade and it becomes harder for EVR to secure the lucrative bookrunner roles. Let's also assume a recession will occur in the near future, leading to a few bad years for EVR. The likelihood of continued 15-20% dividend growth (as witnessed over the last few years) is highly unlikely going forward, then. Let's consider three scenarios: a base case in which dividend growth averages 12%, a conservative case in which dividend growth averages 10%, and a pessimistic case (relatively speaking) in which dividend growth averages only 8%.

At a 3% starting yield, base case (10%) average annual dividend growth would result in a 9.3% YoC after ten years. Conservative case (8%) dividend growth would result in a 7.8% YoC in a decade. And pessimistic case growth would result in a 6.5% YoC in ten years' time.

I like to aim for at least a 7% target YoC. Assuming I'm relatively pessimistic about EVR's forward growth prospects, at what starting yield (and entry price) would I need to by EVR in order to achieve a 10-year YoC of 7%? In that case, I would need to buy the stock at a 3.25% starting yield, or $71.35 per share. That price (and lower) was hit during the Christmas selloff in 2018.

Honestly, I'm not that pessimistic about EVR, especially given its quality personnel and proven ability to generate strong growth during bull markets. But I believe caution is still warranted currently.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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