06/17/13 10:04:14 AM FOCUS STOCK OF THE WEEK

LAZARD LTD. (LAZ)

LAZARD LTD. : (LAZ)



INVESTMENT THESIS



This week's Focus Stock of the Week is Lazard Ltd. (LAZ: $33), which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy. We believe LAZ has the right business mix and size to grow its franchise, realize wider margins to drive higher EPS, and to return excess cash to shareholders through dividends and share repurchases. We have a favorable view of management having defined financial goals and utilizing investment bankers across many disciplines of the business. In addition, we believe LAZ's geographic reach, asset management business, new employee hiring, and compensation guidelines will benefit its results.



In keeping with its goal of widening operating margins, LAZ management has been selectively, rather than aggressively, increasing headcount for investment bankers and other professionals. Widening operating margins is an important part of LAZ's new strategic plan, in our opinion. It was also cited by a shareholder activist for its investment rationale in ownership of LAZ common shares. During the market downturn, LAZ said it was only selectively hiring investment bankers where it needs to fill gaps in industry or geographic coverage. The energy sector has been a recent area of focus for the company, and new hires are expected with better market conditions.



The company's growing asset management business offers high recurring fees and stable conditions for cash flow generation. More specifically, LAZ's percentage of total revenue from investment banking advisory and underwriting services ranks highest among its peers. LAZ also has the highest rank among peers in our coverage for revenue contributions from asset management services. We think relatively less volatile asset management fees will provide some stability to more volatile investment advisory revenues. Meanwhile, new fund introductions should help grow its asset management fee base, and strong relative performance has drawn investor assets.



In our opinion, LAZ's advisory services and asset management areas have more potential for revenue growth in the next two years than brokerage commissions from equity customers, both retail and institutional, and possibly trading and principal transactions for fixed income, commodities and foreign exchange activities.



BUSINESS PROFILE



Lazard Ltd. is one of the world's preeminent advisory investment banks, with offices in 16 countries around the globe. With origins dating back to 1848, the firm provides advisory services, including merger and acquisition (M&A) advice, asset management, and restructuring for corporations, partnerships, institutions, governments and individuals. Lazard Ltd. began trading on the New York Stock Exchange on May 5, 2005, under the ticker symbol LAZ. Immediately prior to completing its initial public offering, Lazard spun off its capital markets and some of its merchant banking businesses.



We think Lazard has an interesting mix of businesses, with financial advisory contributing 54% of operating revenue in 2012, asset management 45%, and corporate the remaining 1%. We also believe Lazard is well diversified by region, with a significant portion of its operating revenue generated outside North America.



In the 2013 first quarter, LAZ moved up 5 notches to rank 7th in the M&A league tables for announced transactions. Most of the leading global investment banks and investment bank boutiques have moved up in the league tables taking market share from European banks. LAZ realized $62.5 billion in 55 announced transactions in the first quarter, up 2.3% from the year-earlier period, and representing 11.5% market share, according to Thomson Reuters. We believe that LAZ did particularly well in the real estate and consumer staples sectors in the first quarter. It realized $20.9 billion in completed transactions, whose exact closing dates are often difficult to project. Financial advisory operating revenue in the first quarter of 2013 was down 39% versus the same period in 2012 and declined 46% from fourth-quarter levels as we think many transactions were pushed up to the fourth quarter on worries about potential negative tax legislation.



Asset management is a stable and growing business, in our view, and we see single-digit growth ahead. We think LAZ's asset management business should benefit from an improving equity market in 2013, with the S&P Capital IQ Equity Strategy team forecasting a 12-month target price of 1780 for the S&P 500 Index. Assets under management (AUM) were $167 billion as of December 31, 2012, up from the $141 billion level at year-end 2011. Management fees in 2012 were $806 million, 1% lower than 2011 levels. LAZ's asset management has a mostly institutional client base that is nearly 80% of total AUM and represents sovereign wealth funds, public pensions and corporate pensions. Winning significant new mandates from institutions like public and private pensions or sovereign funds is a key driver in boosting AUM for the asset management segment. Total asset management fees in the first quarter of 2013 were down 2% versus the fourth quarter, but up 14% from the same period a year ago.



INDUSTRY ANALYSIS



We believe CEO Confidence levels, as tracked by The Conference Board, should move higher in the future, based on M&A announced transactions in the first quarter. The April 25 quarterly news release from The Conference Board showed its measure of CEO Confidence improved again in the first quarter of 2013, after increasing in the 2012 fourth quarter. The first-quarter reading of 54 (a reading of more than 50 points reflects more positive than negative responses) was up from 46 in the previous quarter. As for the global outlook, CEOs were positive on the current economic conditions in the U.S., China, Japan and Brazil, but pessimistic about conditions in India and Europe. Over the next six months, the survey of CEOs showed expectations for improvement in economic conditions, with the exception of Europe where cautiousness remains.



In 2012, we had seen CEO hesitancy to do M&A deals, and regulatory uncertainties may have clouded valuation views and perhaps delayed debt funding for some proposed M&A transactions. In 2013, we think the key potential drivers for improved M&A are increased cash levels at multinational companies, availability of credit on favorable terms, expanding consumer spending, opportunities in emerging markets, improving equity markets, and private equity firms putting available funds to work. We believe the challenge of driving organic revenue growth in a slow-growing global economy may incentivize managements and their board of directors to look more closely at strategic acquisitions. We are also seeing record new funds flowing to private equity firms from large state and employee pensions looking for above-average returns on investment versus the public equity markets.



Exit strategies are another key M&A factor for deciding the sale of a company, as well as market conditions. According to a 2013 M&A Outlook Survey by KPMG, the response to which exit strategy would be preferred was: 65% would be in favor of selling to a strategic buyer, 18% would choose to sell to a financial buyer, 13% would choose to refinance or raise debt capital, and only 3% would prefer an IPO.



Announced merger and acquisition deals have been posting positive results, and we see increased activity ahead. According to Thomson Reuters, announced worldwide M&A totals in the 2013 first-quarter were up 10.4% to $542.7 billion in deal value. We believe this is a positive start for M&A in 2013 despite geopolitical risks in Europe and U.S. fiscal policy issues that are worrying investors. Thomson Reuters tallied M&A in the Americas at $313.0 billion, up 48.5%, followed by Europe at $125.7 billion, down 23.9%, and Asia/Pacific at $71.9 billion, down 13.9%. We have seen a major pick-up in North America announced M&A transactions, partly offset by a 24% decline in cross border deals to $134 billion, which still represented 25% of total announced transactions. Thomson Reuters noted that the three leading industry sectors for M&A activity were energy & power, real estate and information technology. These three industries represented nearly 40% of total announced M&A in the first quarter.



EARNINGS OUTLOOK



We project EPS of $1.80 in 2013 and $2.25 in 2014.This compares to the Capital IQ consensus estimates of $1.74 for 2013 and $2.34 for 2014. Our forecasts are 3.4% above the consensus for 2013 and 3.8% below for 2014. The key drivers we see for EPS growth in 2013 are a continued rebound in the M&A market for investment advisory services; 11% revenue growth from the asset management unit; a decline in the compensation ratio to the mid- to upper-50% level, from low-60% levels in 2012 as a percentage of total net revenues; and improved cost controls on non-compensation expenses. Following 8.5% revenue growth in 2012, we see largely flat growth in 2013 mostly tied to a weak first quarter, followed by upper-single-digit growth in 2014, with an improving market for financial advisory services.



LAZ management is steadfast in its goal of reaching 25% operating margins in 2014. The 25% operating margin target is well above the Capital IQ consensus of 20% in 2013 but in line with 2014's. We are targeting operating margins of 22% in 2014, as we assume the firm will reinvest in the business. Compensation cost is a material part of the margin story, and LAZ reduced discretionary bonuses by 20% last year. We are forecasting compensation and benefits expense to be about 58% of total revenue in 2013 and 57% in 2014, compared to 63% in 2012. The longer-term goal is to get awarded and GAAP compensation costs in the mid-50% range as a percentage of total revenues.



VALUATION



Our 12-month target price of $40 is based on applying a forward P/E multiple of 17.7X, near the midpoint of LAZ's five-year historical range and near peers, to our 2014 EPS estimate of $2.25. Most small to mid-size investment banks are currently trading at higher multiples than LAZ, and LAZ's peak multiple range for forward earnings is in the upper-teens. We caution that results for LAZ's investment banking unit are difficult to forecast quarter to quarter, but the M&A advisory pipeline should improve going forward, in our view. Strong operating cash flow generation is supporting a dividend that yields 3%, and a stock repurchase plan that is in effect.



CORPORATE GOVERNANCE



In October 2009, chairman and CEO Bruce Wasserstein passed away unexpectedly, leaving a leadership void at the firm. He was a high-profile dealmaker with extensive relationships, which he used to not only bring business to the firm, but also to expand its roster of investment bankers. The company named Kenneth Jacobs as its new chairman and chief executive. He was previously the head of the firm's North American operations. We view favorably the increase in the number of independent directors and some streamlining of the company's complex ownership structure. Today, 80% of LAZ's board of directors is independent, including its Lead Director. We note that the Compensation Committee is made up entirely of independent directors.



Management's capital goals are to reduce excess cash, manage debt levels, and increase returns to shareholders through dividends, and also provide for share repurchases. The company bought back $354 million in shares in 2013 and $206 million in 2012 from varied authorized share repurchase plans. Common dividends paid in cash were $107 million in 2013 and $71 million in 2012. In addition, LAZ paid a special dividend of $28 million in 2012. No new stock or debt has been issued in the last few years and $134 million of long-term debt was repaid in 2011. Total cash interest paid in 2012 was $78 million, down from $93 million in 2011.



In June 2012, Trian Fund Management, led by Nelson Peltz, accumulated nearly 5% ownership interest in LAZ shares. Trian put out a press release that highlighted its views that LAZ is significantly undervalued and that the firm supports LAZ's strategic plan. Also, Trian's press release favorably cited that LAZ has become shareholder-friendly to corporate governance and shareholder transparency. Additionally, LAZ is committed to return excess cash to shareholders. We believe accumulation of LAZ common shares by a shareholder activist brings wider attention to the company. LAZ management stated it has continued discussions with Nelson Peltz along with other shareholders.



INVESTMENT RISKS



We see investment risks tied to potential negative macroeconomic headline news. Risks to our opinion and target price include further weakening in the capital markets, including M&A activity, downward moves in equity and fixed income markets, and fewer contract renewals from significant customers in the asset management business. U.S. and European regulatory regimes also pose potential risk to the global capital markets. We caution that results for LAZ's investment banking unit are still difficult to forecast, but the advisory pipeline is improving, in our view.



CONCLUSION



Despite disappointing first-quarter results for the company's investment advisory unit, we remain confident of improved M&A advisory fees as evident by a growing backlog of announced transactions for LAZ and, in our view, improving business drivers likely to spur M&A activity for the second half of 2013. We believe the company is likely to gain market share as demand for advice grows and world economies rebound, but we caution that realized revenue from its advisory business remains difficult to forecast, especially the timing when announced transactions become closed deals. With our target price indicating appreciation potential of 20% from current levels, our recommendation is Strong Buy.



S&P Capital IQ's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.