Pick-and-Shovel Plays for Rising Mergers and Acquisitions

The papers have been abuzz with merger and acquisition news. There's been the drama of the financial exchanges, with  NYSE Euronext  announcing a merger agreement with  Deutsche Boerse DB1 and subsequently twice rejecting  NASDAQ OMX Group (NDAQ) and  IntercontinentalExchange's (ICE) unsolicited higher bid for the company.  Berkshire Hathaway (BRK.A) (BRK.B) was put in the spotlight after its acquisition of Lubrizol and related resignation of Berkshire CEO heir apparent David Sokol due to a conflict of interest issue. Megamergers have also resurfaced, with  AT&T's (T) $39 billion bid for  Deutsche Telekom DTEGY's T-Mobile USA unit.

The string of high-profile acquisitions and headlines provides evidence that we've entered into a new M&A cycle. Commonly touted interrelated factors conducive to overall M&A activity that appear to be present are rising share prices, senior management confidence, a positive trajectory to the economy, and access to financing. Certain company- or industry-specific factors such as high cash balances, low organic growth prospects, and shifting industry dynamics are also present.

If you want to place your bets on M&A, there are at least two ways you can do it. One, you could speculate on the highest-potential acquisitors and acquisition targets. Or you could invest in the pick-and-shovel investment banks that are providing and booking revenue for M&A financial advisory services.

Below is a table of some of the boutique financial advisory and larger investment banks that we cover along with their proportion of revenue related to financial advisory:

As can be seen from the table, the financial advisory boutiques  Evercore Partners (EVR),  Greenhill & Co. (GHL), and  Lazard (LAZ) are best positioned to ride a wave of M&A deals to superior earnings growth. The dominance of trading, underwriting, and other activities at the more diversified investment banks such as  Goldman Sachs (GS),  Jefferies , and  Morgan Stanley (MS) make them less than optimal investments to express an opinion on growth in M&A activity.

Moaty Lazard Has Downside Revenue Protection and Upside Potential
Of the three boutique-ish investment banks, we are partial to Lazard for three reasons. First is that Lazard has the largest geographic footprint of the three: Evercore has offices in three countries with strategic alliances in three more, Greenhill has offices in six countries, and Lazard has offices in 26 countries. A global geographic footprint and local expertise are a competitive advantage in a world with increasing amounts of cross-border M&A. A larger geographic footprint could also fortify revenue if economic recoveries across various countries are uneven.

Second, Lazard has the greatest downside protection in any possible double-dip recession scenario. All three firms have countercyclical restructuring advisory services to complement their M&A services that should do well in a double-dip. That said, Lazard is considered one of the preeminent names in the restructuring field. The difference in ability to weather a double-dip is evident from the cyclical 2007 advisory revenue peak to the 2008 trough for Evercore or 2009 trough for Greenhill and Lazard. Evercore and Greenhill's advisory revenue fell 39% and 41% respectively, while Lazard's investment banking and other advisory revenue only decreased 20%.

Moreover, Lazard has a fairly stable, sizable, and profitable asset management business that will soften the company's total revenue decline in any potential economic downturn and grow along with asset prices during an upturn. Lazard's asset management business, of which over 80% is in U.S. or global equity funds, contributes approximately one third to one half of net revenue. Being heavily focused on equity means its asset management revenue correlates with the economy and stock market. However, the majority of Lazard's asset management business revenue comes from base management fees and not incentive fees, so barring a stock market crash, asset management fees won't significantly contract and the segment should remain profitable.

Of the other firms, Evercore has a nascent and rapidly growing asset and wealth management business under new CEO and former  BlackRock (BLK) co-founder Ralph Schlosstein. Evercore's asset management business recently became profitable, but it is currently not a material contributor to the bottom line. Meanwhile, Greenhill recently wound down its merchant banking fund management business at the end of 2010, so outside of some principal investments, the company's revenue is solely tied to financial advisory.

Evercore Partners and Greenhill Are the Most Leveraged to M&A
Even though we're partial to Lazard due to its strong business model and downside protection, Evercore and Greenhill arguably have more potential upside in an economic expansion. We estimate that Evercore has increased its investment banking senior managing director head count by over 70% since the end of 2007, while Greenhill has increased its managing director and senior advisory head count by nearly 100% in the last several years. On the other hand, Lazard's financial advisory head count decreased 7% from the end of 2007 as Kenneth Jacobs selectively pruned managing directors after taking over the CEO reins in late 2009. Growth in managing director head count can be a leading indicator of potential revenue, as each managing director generally translates into high-single-digit to low-double-digit millions of revenue annually during healthy merger and acquisition volume years. In 2010 Evercore broke its prior 2007 annual advisory and investment banking revenue record, and we expect Greenhill will also break its 2007 record in a year or two.

All three of the financial advisory focused investment banks' earnings are likely to outperform more diversified investment banking peers in the intermediate term. The market has factored increased financial advisory revenue into their stock prices, however, and Lazard has gone from a top Morningstar 5-star rating a year ago to a fairly valued 3-star rating. If Lazard's stock price were to have a moderate pullback, we would be eager buyers due to its strong business model and would even contemplate making it a core holding. It's also our opinion that Evercore Partners is fairly valued, and it is rated 3-stars. However, Greenhill & Co., whose shares we believed were overvalued for much of the last two to three years, has taken a beating due to its relatively lower employee productivity and higher than historical compensation ratio in recent quarters. It's our opinion that it's the most undervalued of the three at current prices and consequently has the most potential upside; we rate it 4-stars.