Research Note – Heidrick & Struggles International, Inc.

Heidrick & Struggles International, Inc. is a leadership advisory firm with a global footprint. The company has over 450 consultants in cities around the world. The company’s main business is Executive Search, where they partner with clients to identify, contact, evaluate, and onboard prospective executives for the clients’ leadership teams. The company establishes a contract with the client at the beginning of the engagement. The contract typically includes a retainer for the company’s services in the amount of 1/3 of the prospective candidates expected first-year compensation. If a placed candidate earns more than the amount estimated in the contract, Heidrick & Struggles typically can bill the client for 1/3 of the difference. Revenue is driven by the number of engagements that the company performs throughout the year and by the average revenue per engagement.

Heidrick & Struggles also provides consulting services. These services may include leadership assessment and development, executive coaching and on-boarding, succession planning, team and board effectiveness, organizational performance acceleration, workforce planning, and culture shaping. Revenue is generated through fees billed to the clients based on the size and scope of the project. Consulting generally accounts for less than 5% of Net Revenue.

The business in which Heidrick & Struggles competes does not require physical assets to operate. The company only needs its people and it’s IT systems to operate its business. It leases all of the office space that it uses. The capital expenditures go to leasehold improvements, office furniture and fixtures, and computer systems.

The above numbers are from the company’s most recent 10-K. Through the end of 2019, Heidrick & Struggles was growing revenue and income for the past five years other than when they booked impairment and restructuring charges in 2017. In general, the company performs well when the labor market is tight and executive compensation is increasing. As it has been for most businesses, 2020 was a difficult year for the financial results of the company. Far fewer corporations were searching for new executives during the past 10 months than they had been previously.

The Executive Search industry is highly fragmented and competitive. The company’s competitive advantage lies in its global footprint and institutional knowledge of the space. There are five large global players, of which Heidricks & Struggles is one. The company has been public for 21 years and has been in business for over 60 years. It has grown into a company that does over $700mm in revenue by nurturing client relationships and providing quality service.

Bull Case for Heidricks & Struggles

Since its IPO in 1999, Heidrick & Struggles has a history of maintaining a conservative balance sheet. There is little to no risk that this company will be knocked off by an exogenous shock. It has cash and marketable securities to weather at least a full year with zero revenue. The marketable securities are in Treasuries, so there is little risk of loss due to market fluctuations. It is well positioned to weather the COVID-19 crisis and continue to compete once business picks back up.

Because the business does not rely on physical assets to generate revenue, the return on invested capital is high. The company could grow much larger with little-to-no further investment. In a highly competitive and fragmented space, it is impressive that the company has been able to generate profit and grow revenue for its 21 years as a public company. The company has demonstrated that it can provide quality service to other corporations in their Executive Search business.

With about $249mm in cash and marketable securities and no debt, the company has an enterprise value around $385mm on a market cap of $634mm. Earnings took a hit in 2020 due to business conditions amid the COVID-19 pandemic. But with federal stimulus and pent-up demand driving the economy through 2021 and 2022, it is reasonable that the company can return to earning $40mm per year in net income and about $50mm in free cash flow on net revenues over $700mm like it was in 2018 and 2019. If it can do this and maintain or grow its revenues for the next few years, the stock is underpriced at $32.78. Under these conditions, the fair value of this stock is closer to $40.

Bear Case for Heidricks & Struggles

The Executive Search industry in which Heidrick & Struggles competes is highly fragmented and competitive. There are four other firms that also have global scale in the Executive Search business. Because there are no capital requirements to compete in this industry, new firms could enter at any time. While they might not have the expertise or the brand to compete at the same scale, they can take share from the company. The company also must compete for the consultants themselves. Compensation is often over 70% of net revenue. While much of this is variable and tied to performance, the fierce competition for talent makes it difficult to pay money out to shareholders. In order to grow the business, the company must attract and retain quality consultants. The only way to do that is to throw more money at them because they can easily leave and join one of the other Executive Search firms for a higher salary if Heidrick & Struggles is not giving it to them.

The business model is not one that performs very well during poor economic conditions. Heidrick & Struggles does have a conservative balance sheet and a history of keeping it that way, but that is because its revenue and income are more variable than most companies. The company must stay conservative and flexible so that it can weather the storms that the company knows are on the horizon.

With the uncertainty in economic conditions due to the COVID-19 pandemic and the difficult market in which the company operates, the current price does not provide an adequate margin of safety. Each time business gets tight due to macroeconomic conditions, the stock has dropped to around $20 per share. It was 50% cheaper than it is today less than 4 months ago. Right now, a new investor is getting a large enough discount to make this company a better investment than a market index.

Conclusion

Heidricks & Struggles is healthy financially now and has been that way historically. It has institutional knowledge that make it hard for an upstart to come and knock it off. This business has little or no risk of obsolescence in the next 10 years. I think it will be around for a long time unless it starts executing poorly.

               Four months ago, when shares were under $22, I think you were getting enough discount to intrinsic value to justify investment. There has been a huge run up in the past four months up to $32.78 on Friday. While there is a better chance of stimulus with President Biden in the White House and Democrats in the majority in both houses of Congress, it is far from certain that the market for executive-level talent will rebound to 2018-2019 levels quickly. The price of the stock, at this moment, does not leave enough margin of safety for me to invest. $HSII will go on my watch list and I will continue to follow it, but it is not going into the portfolio today.

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