Three Moaty Stocks Leveraged to M&A

We believe the independent, financial advisory-focused investment banks ( Evercore Partners (EVR),  Greenhill (GHL), and  Lazard (LAZ)) are some of the more growth-oriented stocks that we cover. We expect them to report record revenue and significantly higher earnings in the next two to three years. The record revenue will be driven by higher revenue-generating managing director head count, an increase in managing director productivity, and higher assets under management. An equal, if not greater, contributor to record earnings will be operating margin expansion from leveraging of expenses, decrease in legacy equity amortization, and maturing of new initiatives.

Revenue Driven by Head Count, Productivity
A company's financial advisory revenue in any particular quarter can differ materially from management or analyst forecasts based on the timing of large deal closings or nonpublic transactions, but over a longer period, financial advisory revenue is driven by the number of client-facing senior revenue producers and their productivity.

Peak revenue and head count for the majority of investment banks occurred in 2007, before the housing bubble popped and the recession ensued. While contending with several years of lackluster capital market activity, many investment banks embarked on material cost-cutting programs. While buffering margins and giving operating leverage for the eventual capital markets upturn, this cost-cutting has arguably reduced the firms' absolute revenue potential. In contrast to the majority, managing director head count at the independent investment banks is flat to significantly higher compared with 2007.

In 2012, we expect productivity per managing director to be materially below normalized levels. We believe the lower productivity is a temporary phenomenon affected by cyclically low industrywide merger and acquisition activity and geographic mix. Lower deal activity has shrunk the industry revenue pie. Aggregate deal activity should pick up when corporate executive confidence improves, as many other factors conducive to M&A activity (rising share prices, high corporate cash balances, lack of organic growth opportunities, generally positive trajectory to the economy, and access to financing) are present.

The productivity levels of the independent investment banks have recently been affected by their relative exposure to Europe. Greenhill's productivity appears to be the most affected by having a relatively high percentage of revenue coming from Europe before 2009: 43% for 2005-08. For 2006-10, just 15% of Evercore's revenue was sourced from Europe. However, the 2011 acquisition of Lexicon Partners more than doubled Evercore's European senior managing directors to 13, or about 20% of its total advisory senior managing directors at the end of 2011, which could depress or increase productivity metrics based on the European situation.

While the productivity metric that the independent investment banks--and we--prefer to use is revenue per beginning of period managing director, the material percentage of net new managing directors as a percentage of the total managing director base will affect productivity for employees who don't completely ramp in a year.

The increase in senior revenue-producing head count and productivity is a common contributor to the stories of Evercore, Greenhill, and Lazard reporting record revenue and record or near-record earnings by 2015. But each of these companies also has individual factors that need to be considered for a more complete picture.

Evercore Partners
Evercore is already reporting record revenue, but GAAP pretax income remains depressed. Three factors weighing on pretax income are equity amortization, acquisition-related expenses, and new initiatives.

Amortization of limited partnership units, IPO-related restricted stock units, and acquisition-related compensation charges have depressed GAAP operating margins by 32%-68% over the past three years. GAAP operating margins will expand rapidly and the difference between Evercore's GAAP operating margins and adjusted pro forma margins will greatly lessen as these charges run off over the next several years. Approximately $20 million of annual LP unit amortization will stop in 2014. Another $10 million-$15 million of annual Lexicon acquisition-related compensation expenses will cease in 2015.

In 2009, Evercore embarked on building up its asset management business and started an institutional equity trading and underwriting business. On an adjusted pro forma basis, we estimate that new initiatives have depressed operating margins 4-12 percentage points over the past three and a half years. Considering the inherent operating leverage in asset management and that the institutional equities business is hovering around break-even, additional new initiative revenue should come with high incremental profit margins.

By 2014, we forecast pretax operating income to be 245% higher than in 2011. We calculate that approximately one third of the GAAP operating income growth will come from the runoff of nonrecurring compensation charges.

Greenhill
Greenhill is arguably the public company that's most leveraged to an upturn in M&A activity. Among the independent financial advisory-focused investment banks, Greenhill has the highest percentage of revenue related to financial advisory, primarily M&A, although it also has restructuring and fund placement advisory businesses.

Financial advisory revenue as a percentage of total revenue will be higher at Greenhill going forward because the company exited its merchant banking business in 2010 and has been monetizing its legacy principal investment positions. While the company still has more than $90 million of principal investments that it's monetizing--largely its stake in Iridium Communications and some of its former merchant banking funds--it has more than enough equity to support the positions.

The drop in Greenhill's share price in early 2011 was primarily due to the company's deviation from its prior consistent compensation ratio of 46%. We believe that the company should be able to get back to a mid-to-high 40s compensation ratio in 2014, and that shares could react as favorably to the improved compensation ratio as they reacted unfavorably in 2011.

The increase in our forecast pretax income for Greenhill is split approximately evenly between an increase in revenue and expansion of operating margins.

Lazard
Lazard has the best risk/return profile of the independent financial advisory focused investment banks. Approximately half of its revenue comes from financial advisory, with cyclicality buffering M&A and restructuring businesses. The other half of its revenue comes from relatively stable asset management fees. Additionally, Lazard's revenue is diversified geographically and by industry. New management's target of achieving 25% operating margins in 2014 and its capital return policy give reassurance that higher revenue will find its way to the bottom line and to shareholders.

We forecast Lazard reporting record revenue in 2014, based on the company's current managing director head count and assets under management being higher than at its historical 2007 revenue peak. Additionally, managing director productivity should increase over the next several years, as it's currently being depressed by the macro environment and the company's geographic revenue mix.

We believe that management's target of 25% operating margins by 2014 is a stretch but 23% is a reasonable outcome based on our projected revenue mix for the company and variable revenue-related noncompensation costs offsetting much of the company's expense savings program. If 2014 revenue does not improve from the first half of 2012, the 25% goal would entail a material--and unlikely--decline in compensation on both an absolute and per employee basis. Over a longer time span, past 2014, we believe 25% or better margins are quite achievable.