Charles River Associates: A Back Door Play On Litigation

Charles River Associates (CRAI) is a "global consulting firm that offers economic, financial, and strategy expertise to law firms, corporations, accounting firms, and governments around the world." CRAI offers its services in two broad areas (1) litigation, regulatory and financial consulting and (2) management consulting. Investors can think of CRAI as a publicly traded think tank. Of their 625 employee's at year-end 2012, 110 held doctorates and 140 held MBA's.

As a former management consultant in the economic damages field, I can tell readers that CRAI does have a quality reputation in the industry and puts out quality analysis.

However, the stock has underperformed over the years and I wanted to bring the company to the attention of investors.

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Litigation Services Industry

Readers are likely well aware of the growing litigation services industry, particularly with respect to intellectual property, namely patents. It seems like "patent wars" stories are hitting the news wire with greater and greater frequency. Naturally, discerning investors should ask themselves if there is a way to capitalize on this trend. In my view, buying a company entirely predicated on its patents and, in particular, potential patent damages awarded in a litigation is extremely risky.

The other way to play it is to buy the service providers in patent litigation. I am unaware of any publicly traded law firms, leaving only management consulting firms like CRAI, FTI Consulting (FCN) and Navigant Consulting (NCI) the only alternatives.

These firms benefited from the Sarbanes-Oxley Act, which disallowed public accounting firms from offering litigation services to audit clients as it was determined to potentially impair independence. Accordingly, many former partners in the management consulting arms of the large public accounting firms left to join niche players without the audit function.

In terms of the business model, litigation services is based generally two types of contracts: (1) time and materials and (2) firm-fixed price. Consulting firms, of course, prefer the former, as they have less risk in terms of managing project economics.

As a former economic damages analyst, I can tell readers that the rate per hour for these services is very high, typically between $200 and $600 per hour, depending on the staff level of the consultant. There is also a steady flow of work, as patent litigation continues at an ever increasing clip, although it is an "eat what you kill" industry. If rainmakers are not closing new work, or if the litigation pipeline dries up, the business can falter since there is a high degree of operating leverage in the business, made up of mostly fixed salaries of employees.

Based on a quick, back-of-the-envelope calculation, by taking the 2012 revenue ($270 million) and dividing it by the number of employee consultants at year-end (446), CRAI generated about $605,000 per revenue generating consultant. If we assume these consultants were 80% utilized, the blended average rate per hour was around $360, in line with what I would expect for a litigation services practice.

This brings me to the next point in the investment thesis, which is the revenue model for a professional services firm is (1) rate per hour multiplied by (2) number of billable hours. The business can only scale if rate per hour goes up and/or consultants work more billable hours.

The beauty in the professional services model, then, is that there is significant operating leverage: revenue can scale with little increase to the cost base. Of course, once consultants approach, let's say 2500 billable hours in a year, the business can only grow by adding more consultants (the cost base is semi-fixed).

In terms of growth, the other way to achieve that is through acquisitions. On January 31, 2013, CRAI announced that it acquired a niche, litigation practice comprised of 40 consultants. The company described the acquisition as non material, but it should add about 8% to its fee generating consultant line up.

Employee Retention Risk

One key risk I see in the CRAI business is relatively high concentration of its revenues (18%) produced by it's top five employee consultants. If the business were not able to retain one or more of these rainmakers, the revenue base could take a substantial hit. In my experience, it is fairly easy for employee's to leave a professional services firm, and to take with them their book of business. Professional services is a relationship driven market, and clients don't particularly care under what brand name the work is done, only that they engage the expert they know and trust.

I have no reason to believe that there any of CRAI's rainmakers have plans to leave, but it is certainly a risk worth considering in potential investors due diligence operation.

Valuation

The valuation of CRAI certainly does not look stretched. Based on its $195 million market capitalization, it trades at about 0.7x last twelve months' sales, 7x LTM EV/EBITDA and 15x projected 2014 earnings. However, I'm not convinced that CRAI is grossly undervalued at the current quote.

Sure, revenues were up 13% in Q3 year-over-year, and adjusted EBITDA grew at a faster pace (on account of the operating leverage described herein). Utilization rates are approaching 80% which are about in line with industry norms. While there is room for utilization improvement, I wouldn't want to model any more than about 80-85% company wide utilization rates.

With those factors in mind, I'm not particularly bullish or bearish on CRAI at the current valuation.

Conclusion

I left the economic damages consulting field for a reason. And that reason is simply that I do not think it adds value to the economy. Sure, litigation consulting is a well paid profession, but that is only because it comes at a cost to the wider economy: litigation services firms are able to extract a princely sum when clients are backed up against the proverbial wall.

I'm not saying CRAI is a bad business, quite the contrary. It is one of the best firms in the litigation services field. I do, however, believe that there are better investment opportunities, particularly because professional services can't scale as well as other businesses (particularly CRAI, who is effectively limited to hiring PhDs). There is also increasing competition which should have keep billable rates per hour subdued.

From a strict investment perspective, I think that investors capital is better allocated elsewhere, to businesses that create products and services, not on writing erudite research reports. If you want to invest in a PhD, go to university.

Source: Charles River Associates: A Back Door Play On Litigation

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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