This report was originally published on 5/29/09.

To say the Securities and Exchange Commission (SEC) has been embarrassed over the past few years would be an understatement. It is hard to imagine a worse period for the SEC than what the agency has experienced over the past 12-months. Bernie Madoff, Bear Stearns, auction rate securities, Pequot Capital, Lehman Brothers, Allen Stanford, the list goes on and on. In many respects, the inability of the SEC to prevent, or at least identify some of the glaring examples of malfeasance in the financial sector over the past 2-3 years was a result of an agency with bureaucratic impediments, resource constraints and a general decline in the overall level of investigative and enforcement activity. According to NERA Economic Consulting, the number of SEC settlements with companies (a final outcome for an investigation) declined from a peak of 242 in 2004 to 157 in 2008.

Additionally, a recent Syracuse University study based on Department of Justice data concluded that the number of prosecutions for securities fraud declined significantly for the first eleven months of 2008. The study argues that there has been an 87% drop in prosecutions from 2000 to 2007.

It is almost impossible to believe, but as the credit crisis was unfolding the actual number of full time equivalent employees (FTE’s) working in the Enforcement division of the SEC actually declined! The chart below outlines the number of FTE’s that actually worked in the SEC compared to the amount that was enacted by Congress and requested by the SEC. Perhaps worse than the actual decline in FTE’s from 2005 to 2008 was the request for less manpower. Each year from 2007 to 2009, the Chairman of the SEC, Christopher Cox actually requested a lower level of FTE’s for its enforcement division as part of its annual budget request. All we can say is: WOW.

The good news is that there are growing signs that the SEC is ramping up for increased activity. Outside of the request for more FTE’s in 2010, as show in the chart above, new commissioner Mary Schapiro had this to say at her Senate confirmation hearing in mid-January:

“The first thing I will do is take the handcuffs off, get investigations started immediately…. there will be no sacred cows.”

On the heels of the credit crisis, the SEC is not the only source of rising scrutiny. On top of increased activity from the SEC, investors should be aware that the number of securities class action suits has started to grow and other regulating bodies are looking at corporate accounting policies more closely.

n February, Deputy Director of the FBI, John Pistole indicated that there are more than 530 corporate fraud investigations underway. Clearly we are entering a period of greater legal and regulatory oversight.

As investors at PAA Research we strive to identify investment vehicles for a particular secular theme. In this case, there are several publicly traded companies that would directly benefit from increased securities litigation and SEC enforcement activity, including: CRA International, FTI Consulting ,Navigant Consulting and Huron (HURN 23.25 ↓0.26%) Consulting. Of these companies, we find HURN to be the most compelling investment opportunity for the following reasons:

1. The SEC has been shamed into action, securities class actions suits are mounting and the FBI has launched a record number of corporate fraud investigations.  Huron’s Financial and Accounting consulting division is uniquely positioned to benefit.  There are growing signs that the SEC has started to become more active and vigilant.  For the first time in several years, the SEC has requested an increase in full time equivalent employees (FTE’s) for its enforcement and compliance, inspections, and examinations divisions.  According to NERA Economic Consulting, the number of settlements by the SEC increased 16% YOY in 1Q09.  In addition, the number of securities class action suits has continued to rise.  Finally, Deputy Director of the FBI, John Pistole recently indicated that there are more than 530 corporate fraud investigations underway.  Revenue growth for HURN’s financial and accounting consulting practice has historically been driven by regulatory inquiries and securities class action suits.  Typically, a company will be required to hire a third-party consultant to review its accounting practices or to settle a dispute with the SEC immediately once an investigation has been launched.  Over the past 2-years, utilization rates for this practice have been depressed due in part to a dearth of SEC investigations and enforcement actions.  However, the growing backlog of securities class action suits and increase in SEC activity should result in higher utilization rates for this practice within the next 12-months.  We anticipate this could boost HURN’s operating income by as much as $20-$30MM and EPS by $0.50-$0.75 on an annual basis.
2. Demand for HURN’s healthcare and education services is acyclical, if not counter-cyclical.  The company has just started to scratch the surface of synergies between these two practices. HURN’s healthcare and education practice has become the “bread and butter” of the company.  Financial distress in the hospital sector and substantial funding issues at higher education institutions has created strong demand for HURN’s consulting services.  The company has an unrivaled track record in improving operating performance at hospitals and has secured major contract engagements from some of the leading university systems in the world.  The acquisition of Stockamp & Associates in the second quarter of last year broadened HURN’s service offering and should enable the company to forge closer relationships with large university systems.  The company has a growing pipeline of engagements for this division and organic revenue growth should continue to exceed 15% YOY for the rest of 2009.  This division is HURN’s stable growth engine, representing more than 50% of operating income.
3. Activity for HURN’s ediscovery business, V3locity, should rebound in the second half of 2009.  Following 2-years of substantial growth, HURN’s legal consulting division witnessed a 9% decline in revenues for 1Q09.  This was due in large part to a delay in many ediscovery projects during the past 3-6 months as law firms try to curtail costs.  The good news is that these projects cannot be delayed indefinitely and the legal process will eventually create a need for the work to be done.  HURN has quickly established itself as a leading service provider in the $4.5 billion edsiscovery marketplace.  The company continues to sign master service agreements with leading law firms and corporations through its V3locity service offering, which should boost demand over the next 6-12 months.

Risks to Our Investment Thesis

The risks to our investment thesis are the following:

1. The number of SEC investigations does not increase and/or the rise in securities class action suits does not yield a meaningful amount of work for HURN’s financial and accounting consulting practice.  This would likely lead to utilization rates at or below 60% for that division for the foreseeable future.
2. Demand for HURN’s more economically sensitive consulting services wanes.  We estimate approximately 30-40% of HURN’s revenues come from service offerings that are driven by more procyclical demand factors.  Weak demand for these services has largely been reflected in the lower utilization rates witnessed in 4Q08 and 1Q09.  We expect performance to improve from these depressed levels
3. HURN has significant leverage.  As of 1Q09, HURN had approximately $321 million in bank debt outstanding, which implies total leverage of 2.2x on a total debt/EBITDA basis.  We do not view this as an unreasonable debt load for a company with HURN’s free cash flow generation characteristics.  We expect HURN to generate approximately $100 million in FCF in both 2009 and 2010, which should enable the company to pay down a significant portion of its outstanding bank debt.

Brief Company Description and Trading History

HURN is a leading specialty consulting firm, with approximately 1,500 hundred consultants.  HURN operates in four major segments: 1) Health and education, 2) Financial and accounting, 3) Legal and 4) Corporate consulting, which includes restructuring advisory.  Over the past 5-years, HURN has completed 8-acquisitions to diversify its business model beyond the legacy franchise in finance and accounting consulting.  Health and education is HURN’s largest and most profitable division.

Health and Education Consulting – HURN is a market leader

HURN’s health and education division now has more than 900 FTE’s, of which approximately 250-300 are in the higher education practice.  HURN’s higher education practice focuses on helping large universities improve financial management, resource optimization, regulatory compliance, sourcing and procurement.  HURN’s healthcare practice is a combination of Wellspring and Stockamp, both of which were acquired.  The company is one of the leading providers of consulting services to hospitals.  The healthcare practice provides performance solutions for hospitals and healthcare systems including: compliance management, patient flow improvement, non-cost labor management, interim management, clinical quality and revenue cycle improvement.

Financial and Accounting Consulting – Disputes, SEC, Litigation Driven

Through its Financial and Accounting division HURN assists companies with complex accounting and financial reporting issues.  Securities class actions and SEC investigations are often drivers for revenue opportunities for this division.  The company’s service offerings include: 1) disputes and forensic accounting, 2) economic consulting, 3) accounting and finance advisory, 4) valuation, and 5) corporate governance.

Legal Consulting – eDiscovery and Traditional Consulting to Law Firms

HURN’s Legal Consulting division can be divided into its traditional operational consulting to law firms and the company’s eDiscovery practice.  Through its V3locity service offering, HURN provides fully streamlined ediscovery services including: processing, hosting, review and production.  The company has a number of review facilities where it subcontracts lawyers on a temporary basis to complete specific project assignments on a cost per page basis.

Corporate Consulting – Restructuring Advisory, Traditional Strategic Consulting and Utilities Consulting

HURN’s corporate consulting division can be subdivided into three separate practices: restructuring advisory, traditional strategic consulting and the company’s utilities franchise.  HURN’s restructuring advisory is not nearly as large as that of FTI Consulting, but the company has had better success recently in securing engagements.  The company has recently secured some restructuring engagements in the auto sector.

Company History and Trading Background:

Huron Consulting was founded in 2002 by a group of ex-Arthur Andersen LLP partners and professionals.  The company initially started out offering financial and accounting services, particularly in forensic accounting. Over the past 5-years, HURN has completed 8-acquisitions, which have diversified the company’s service offerings into healthcare consulting, restructuring advisory, and ediscovery solutions.

HURN’s stock peaked in the fourth quarter of 2007 at just over $80/share, following a 12-month period during which revenues and operating income for the company’s finance and accounting division were boosted by the options back-dating scandal.  As utilization for that division fell from 85%+ to less than 60% the company’s operating performance suffered and the stock followed suit. Prior to the acquisition of Stockamp & Associates, the company’s healthcare and education division was not large enough to completely offset subpar utilization at HURN’s finance and accounting division.  The stock rallied recently following 1Q09 results that were not as bad as feared, even though several of the company’s core practices continue to have depressed utilization levels.

Short Dynamics

The short interest in HURN stands at 2.2 million shares, which represents approximately 10% of the float and a short-interest-ratio of 7.6 days.  The short interest in the stock has decreased by almost 40% since the fourth quarter of 2008.

Investment Thesis in Detail

Our investment thesis is predicated on the following:

The SEC has been shamed into action and securities class actions suits are mounting.  Huron’s Financial and Accounting consulting division is uniquely positioned to benefit.

It is hard to imagine a worse period for the SEC than what the agency has experienced over the past 12-months.  Bernie Madoff, Bear Stearns, Auction rate securities, Pequot Capital, Lehman Brothers, Allen Stanford, the list goes on and on.  In many respects, the inability of the SEC to prevent, or at least identify some of the glaring examples of malfeasance in the financial sector over the past 2-3 years was a result of an agency with bureaucratic impediments, resource constraints and a general decline in the overall level of investigative and enforcement activity.   According to NERA Economic Consulting, the number of SEC settlements with companies (a final outcome for an investigation) declined from a peak of 242 in 2004 to 157 in 2008.

Additionally, a recent Syracuse University study based on Department of Justice (DOJ) data concluded that the number of prosecutions for securities fraud declined significantly for the first eleven months of 2008.  The study argues that there has been an 87% drop in prosecutions from 2000 to 2007.

The SEC is Ramping Up for Increased Activity, Other Government Agencies are Getting Involved

To use the agency’s own words:

“The past year has been immensely challenging for investors, public companies, and the U.S. and global financial markets.  American families have seen their retirement plans and savings plummet in value.  Faith in the U.S. system of capital formation has been severely tested with the economic crisis, the turmoil in the markets, and the revelations of illegal and ill-advised investment schemes.  It is against this backdrop that the SEC works to restore investors’ confidence in the U.S. markets by refocusing its efforts on deterring and detecting fraud and reengineering its internal process to work more efficiently and effectively.”

SEC Congressional Justification Report 2010

It is almost impossible to believe, but as the credit crisis was unfolding the number of FTE’s working in the enforcement division of the SEC actually declined!   The chart below outlines the number of FTE’s that actually worked in the SEC compared to the amount that was enacted by congress and requested by the SEC. Perhaps worse than the actual decline in FTE’s from 2005 to 2008 was the request for less manpower. Each year from 2007 to 2009, the Chairman of the SEC, Christopher Cox actually requested a lower level of FTE’s for its enforcement division as part of its annual budge request.  Wow.

An examination of the number of FTE’s working in the SEC’s Compliance, Inspections and Examinations division paints a similar picture.  The actual number of FTE’s declined from 2006 through 2008 and the number requested also decreased.  Perhaps investors should not be surprised there was a glaring lack of oversight.

All of this occurred during a period in which:

1. Since 2005 the number of investment advisers registered with the SEC increased by 32% and their assets under management have jumped by over 70% to more than $40 trillion
2. The size, complexity, and geographical diversity of broker deal operations greatly expanded, with the number of broker-dealer branch offices rising to a current total of 174,000
3. The dollar value of average daily trading volume in stocks, ETF’s and futures was approximately $251 billion daily in February 2009 compared to $87 billion a day in February 1999

In defense of those that work at the SEC, there are simply too few people employed to oversee an ever-growing abundance of trades and financial statements.  The goods news is that the SEC now appears committed to improving the effectiveness of oversight through a combination of increasing the number of FTE’s in enforcement and removing some of the bureaucracy that hindered enforcement agents from pursuing penalties for violations. In addition to renewed vigor from the SEC, FBI Deputy Director John Pistole indicated in testimony before the Senate Judiciary Committee in February 2009, stated that the FBI has a bulging case load of corporate fraud cases with 530 investigations currently underway. Those cases focus on financial statement manipulation, accounting fraud and insider trading.

Securities Class Actions Suits Continue to Mount, More Are Being Filed and Few Have Been Resolved

In addition to a rejuvenated SEC, there is a growing backlog of securities class action suits that have yet to be resolved, which should provide a good tailwind of work for HURN’s financial and accounting consulting practice.  According to NERA Economic Consulting, 255 securities class actions were filed, up from a 12-year low of only 131 filings in 2006 and 195 in 2007.  Of these filings, approximately 110 were related to the credit crisis.  The number of filings is still well below that seen in 2001.

Securities class action suits do not necessarily result in an immediate revenue opportunity for HURN, although over time, many typically require a third party to be engaged by the board or executives of the company to exonerate their accounting practices. This is where HURN would typically be engaged.  Securities class action suits typically take a long period of time to be resolved.  To put this in perspective, according to Cornerstone Research 41% of the securities class action suits filed in 2006 were still ongoing and only 22% of those filed in 2007 had been resolved through settlement or dismissal. We anticipate the backlog of class action suits will become a driver for HURN within the next 6-12 months.

Increased Activity from the SEC and Others Could Boost EPS for HURN by as much as $0.55-$0.80 in 2010

In 2007, HURN generated $156 million in revenues and $61 million in operating income from its financial and accounting consulting practice. At that time utilization rates for the division exceeded 80% due to strong demand stemming from options back-dating investigations and general work related to valuation, internal audit and economic consulting.  Since that time, utilization for that practice has plunged and has remained below 60% for five consecutive quarters.

Based on increased activity from the SEC, a large number of FBI investigations related to accounting fraud and a growing backlog of securities class action suits, we think utilization rates are poised to increase sharply.  We estimate that this could increase operating income by as much as $20-$30 million in 2010.  This equates to approximately $0.55-$0.80 in EPS.  It is important to note that the magnitude of the investigations and the class action suits are considerably larger than those related to options back-dating, so the revenue opportunity could be even larger for HURN.  We would argue that HURN shares do not reflect this huge revenue opportunity and will not until investors see tangible evidence in an uptick in utilization.  We think that is likely within the next 3-6 months.

Variance vs. Consensus

We think HURN is a “meet” story for the rest of the year, which is to say the company only needs to meet consensus estimates for the stock to trade higher. Our estimates for 2Q09 are slightly higher than the street, based on our view that utilization will improve sequentially in both the legal and finance and accounting divisions. Overall we expect HURN to meet street consensus for FY09 EPS.

For 2010, we have assumed that the utilization rate for HURN’s finance and accounting division increases approximately 10% YOY. Additionally, we have assumed utilization rates for health and education remain above 75% for the entire year. As we mentioned earlier, the swing factor in operating income based on improved utilization at HURN’s finance and accounting division could be as large as $20-$30 million. Based on our analysis, it does not appear that the street has fully factored in an improvement in profitability for this practice into their estimates for FY10.

Catalysts

We would establish a full position in HURN shares at current levels.  There are not many clearly identifiable catalysts for the stock, outside of 2Q09 earnings which will not be announced until late July/early August.  It is difficult to predict, when, or even if the SEC will start to ramp up enforcement, but that would be viewed as a major positive catalyst for the stock.  If a regulatory matter, similar in scope to the options-back dating scandal were to arise, we anticipate HURN shares would trade meaningfully higher.

Probability Weighted Return

Upside Conviction Level:  80%

A quick look at valuation: HURN shares currently trade at approximately 14x consensus 2009 EPS.  Historically the stock has traded between 12x-30x+ on consensus 12-month forward EPS. The company’s peer group of specialty consulting firms has typically traded at 15-20x 12-month forward EPS.  Companies that are executing and have a strong tailwind of regulatory activity or a practice with robust demand (FCN’s bankruptcy franchise) have typically traded as high as 20-25x 12-month forward EPS.  We think any upturn in utilization for the company’s finance and accounting division will lead to positive estimate revisions AND multiple expansion for the stock.  In the interim, HURN is also a steady FCF generator with a 10% yield. We anticipate the company will use FCF to pay down debt for the remainder of the year.

We think HURN shares could trade to $55 by the end of the year, if things remain status quo:  At $55, HURN would trade at 17-18x our FY09 EPS estimate.  Should utilization rates pickup company-wide then we think HURN shares could trade to 17-18x our FY10 EPS estimate of $4.16, which would imply a stock price in excess of $70.

Total Probability Weighted Return: In order to better allocate capital from a timing and sizing perspective, we think it is important to look at each position on a probability weighted return basis.  Overall, we think there’s an 80% chance that HURN shares will trade higher over the next 6-9 months.  We expect management to reiterate guidance on its 2Q09 earnings conference call and speak to the strong cash flow potential of the business as it is currently constituted.  We anticipate shares could trade as high as $55 per share in the next six-months as investors gain comfort with the stability of demand for HURN’s healthcare and education consulting services.  Any uptick in activity for the company’s other divisions would lead the stock to trade in excess of $70, in our view.  Overall the probability adjusted return is 31.3%, which we think is compelling for a 6-9 month trade.

At 14x consensus FY09 EPS, we would argue that HURN shares do not reflect the huge revenue opportunity that could come from increased litigation and regulatory oversight. Once investors see tangible evidence that utilization rates in HURN’s financial and accounting consulting practice are improving, shares could trade considerably higher. We think that is likely in the next 3-6 months.

As always, please act accordingly….