Litigation Is Good News for Navigant and FTI Consulting

We believe both event-driven consulting firms we cover-- Navigant Consulting  and  FTI Consulting (FCN)--are attractively priced and provide investors with an opportunity to benefit from the current economic recovery and increased financial crisis related litigation activity. While we understand the reasons behind investors' past aversion toward these stocks (Navigant in particular), we believe the underlying demand environment has and will continue to improve. These two stocks currently offer attractive investment opportunities, in our opinion.

Poor Results Enticed Investors to Stay Away from Consulting Firms During the Recovery
Navigant and FTI derive a significant portion of their revenue from pro-cyclical businesses, so when the broader economy faltered in mid-2008, their performance also started to slip. However, the reverse didn't hold true when the economic environment began to improve in the second half of 2009. While part of this was due to the typical lag between the recovery and the pickup in demand for discretionary consulting services, the other part could be blamed on firm-specific issues: Navigant's performance declined due to internal restructuring issues, while FTI faced headwinds from its counter-cyclical restructuring practice. We also think that the fear of a double-dip recession forced many companies to delay their discretionary investments, which in turn hurt the results for these firms.

However, recent indicators point to a recovery in demand for both litigation and business consulting services, which we believe will drive top-line growth for these two firms in the future.

Litigation Consulting Will Allow Both Firms to Benefit From the Recession
FTI and Navigant derive a large portion of their revenues from litigation consulting; this exposure played some part in pulling down their performance when litigation activities slowed down during the recession. As the economy continues to pick up, the total number of class-action filings should increase helped by an expected increase in the number of traditional commercial litigations. While class-action filings related to the financial crisis dominated the landscape in 2008 (45% of total filings) and 2009 (33% of total filings), they weren't strong enough to offset the decline in other filings.

In fact, 2009 turned out to be one of the worst years as the total number of litigation filings fell about 25% compared to the previous year (168 in 2009 compared with 222 in 2008). The poor 2009 numbers could be attributed to companies opting to delay the filing of claims and the growing backlog of commercial litigations. This trend continued into the first half of 2010, though the situation started to improve during the second half of the year, driven by a notable uptick in a broad range of filings. This dynamic was confirmed by encouraging commentary and better litigation-related results from FTI and Navigant in the fourth quarter of fiscal 2010. While we don't want to rush to any judgment based on two quarters of data, it is highly likely that we have seen the worst of the slump in litigation filings. Thus, the litigation consulting operations of both companies should see a continual acceleration in requested customer projects over the foreseeable future.

Finally, we would like to note that although the pace of credit-crisis filings has declined, we still expect them to continue to provide a tailwind to Navigant and FTI over the medium term. Our expectations are strengthened by a report from the National Economic Research Associates Inc. that states about two thirds of credit-crisis-related class actions filings still remain unresolved. We believe it may take years before all of these cases are ultimately closed.

Discretionary Consulting Will Allow Both Firms to Benefit From the Recovery
FTI's relatively strong performance during 2009 and Navigant's relatively lackluster results during the same period could be attributed to their business mix. FTI has a more balanced mix of pro-cyclical and counter-cyclical practices, while Navigant's portfolio is heavily tilted toward cyclical businesses. FTI derives about 70% of its revenue from cyclical businesses, while this proportion jumps to 90%-plus for Navigant. As the economy struggled mightily during the recent recession, FTI's counter-cyclical restructuring practice flourished and made up for a weak showing from the company's cyclical businesses. The crisis opened up tremendous opportunities for the company's restructuring practice, and FTI didn't let these opportunities slip away. On the other hand, a cut in discretionary spending by companies negatively impacted Navigant's business segments. Additionally, Navigant reorganized its business in the midst of the recession, which further dragged on its results. As a part of its restructuring process, the company exited certain practices that made up about 9% of its operations in 2009.

However, with the overall economy gaining positive momentum, we believe Navigant is in a better position to take advantage of the recovery. The company's decision to focus on the health-care and energy industries should work in its favor as the underlying demand trends in these two industries remain strong. The disruptions caused by the health-care reform bill and an expected increase in investments by health-care institutions to improve their operational efficiency should keep Navigant's consultants busy for the foreseeable future. The company's energy practice continues to find good traction in areas including smart-grid-related projects, clean energy technologies, and energy efficiency. With oil prices continuing to inch up, we expect demand to remain strong going forward for Navigant's cyclical business lines.

FTI should also benefit from an anticipated ramp-up in demand for its cyclical businesses. FTI derives more than one fourth of its revenue from capital-market-related activities (such as M&A deals and IPOs), and a pickup in these activities should work in FTI's favor. Overall, we expect FTI to perform well but its growth could be hindered by its counter-cyclical restructuring business. Nevertheless, these trends should benefit both firms and bolster their results.

How to Play This Situation?
The recent recession has challenged both Navigant and FTI, and both stocks have underperformed the market during the ensuing recovery. However, we think both companies are well-positioned to capitalize on an increase in discretionary consulting spending as the economy continues to rebound. Additionally, both companies' litigation consulting businesses should benefit from the lingering troubles of the financial crisis. Augmenting these positive trends are the decisions made by both Navigant and FTI to beef up their respective consultant workforces. We believe these factors will lead to improved results for both firms over the near term and will solidify their long-term competitive advantages. It is our strong opinion that investors are presented with an opportunity to buy two high-quality narrow-moat companies at attractive prices.