Greenhill - a great franchise, buy at $60

Greenhill (Ticker: GHL)

Who they are: Greenhill is a NYC-based investment bank that focuses on Corporate Advisory (both M&A and restructuring), Merchant Banking and a newer Funds Placement business. As of 3/17/2009, they have 52 managing directors around the world.

Investment Thesis:
-M&A is cyclical and will return in the future, at which point investors will pay 20x estimates for this high quality pure-play.
-Unlike bulge bracket rivals, Greenhill has remained a low-capital-intensive business. Advisory has almost no capital requirements, and merchant banking has low capital requirements (which are not levered up).
-Greenhill's boutique business model is in favor and will gain prominence given the tarnished image of the bulge brackets and fewer conflicts of interest when working with Greenhill.
-They are attracting the best and brightest amid the market turmoil.
-They have won some very high profile assignments that bolster their industry standing among corporate chieftains.
-I have tremendous respect for Bob Greenhill and Scott Bok, and think they have built a differentiated culture that will serve clients, employees and shareholders well.
-I like this stock under $60 per share.

Catalysts/Risks:
-Need to hire about 10 top-notch MDs in 2009 or investors will be disappointed.
-Merchant Banking will try to raise GCP III this year and was hoping for $1b; +/- will be noted.
-GCP II is 80% invested since being raised in 2005. While it appears they were more prudent with leverage than the industry, there is mark-to-market risk at a minimum.
-Additional high profile assignments in advisory. Getting the lead role to Roche on its Genentech merger was a big deal. Investors will be looking for signs it wasn't a one-timer.
-Can their culture survive and thrive as they grow? I think so, but this is a risk.

Math/Assumptions:
-I assume that at the end of 2010, investors will pay 20x for a normalized earnings power estimate because the M&A cycle will be re-accelerating and Greenhill is a high quality way to get pure-play exposure to that cycle.
-I assume they will start 2011 with 63 managing directors which can each generate $8 million in revenue, and that on a normalized basis, merchant banking will contribute 15% of total revenue. (I assume no interest income for conservatism sake)
-I assume compensation expense ratio of 46% and a non-comp expense ratio of 15%, for an operating margin of 39%.
-With a 35% tax rate, that gives me $150 million in net income for normalized 2011 ($5 in EPS with a 30m sharecount)
-That implies the market will pay right around $100 per share at the end of 2010 and I want a 30% CAGR to that price. Discounting back to today means I like this stock at about $60 per share.

A note on culture:
Culture is a tricky thing to analyze because it is inherently subjective, but it is often very important. I think Greenhill is an example of a company where they have been very deliberate about their culture and where I think it is a competitive advantage. Most i-banks have cut-throat environments where the MDs bring in the business and operate at a very high level, but leave most of the execution and detail to their subordinates. Compensation is often opaque and there is very little collaboration among MDs.

Greenhill has built a culture of collaboration, execution and meritocracy. MDs at Greenhill routinely help each other find contacts in the course of completing and sourcing deals. As Scott Bok said, if an MD turns out not to be a team player, they will be drummed out of the firm. Additionally, a rival firm might send ten people to a board meeting, each of which is competing for air time to demonstrate their sliver of knowledge on the deal. Greenhill sends a couple people with the MD knowing the whole story because they have been involved in the execution. Greenhill looks for MDs that want to be involved with completing deals, not just golfing with CEOs to source deals. Finally, every MD knows the compensation for every other MD. This creates a culture of meritocracy where the new hires know they can be paid for their performance and the veterans know they have to justify their compensation in the eyes of their peers. Maybe I'm drinking the corporate cool-aid, but I can see why a CEO would prefer to work with Greenhill.

Word of caution:
I think buying GHL at $60 or less will provide a nice return by the end of 2010, but recognize that the fundamentals in the M&A and Merchant Banking business are at the bad part of their cycle right now. It is probable that there will be bad news between now and the end of 2010. I guess I'm trying to warn investors that the fundamentals could be extremely volatile on this stock and therefore the stock price may be extremely volatile as well. When I try to model this company I don't even bother to forecast an EPS number for 2009 or 2010 for the reasons I just mentioned. Just understand the type of investment this is before you buy it.