Focus Financial files a shelf registration as debt swells above critical '4X' level then its shares dropped to new low in after-hours

Rudy Adolf is learning how to play Wall Street's numbers game one year into Focus Financial Partners' initial public offering (IPO), but he's paid a high price for 30% revenue growth and a 38% bump in adjusted earnings per share year-over-year.

The stock is tanking, down 39% from its IPO price of $33 a share only five quarters ago and 60% from its 52-week high of $49.52, according to its latest closing price. The stock ended the day, Friday (Aug. 30) at $20.52, roughly a buck off its 52-week low of $19.61.

The haircut has left the company's market cap at around $1 billion, down from $1.54 billion after its July 2018 IPO and $2.3 billion at its 52-week high water mark, based on 46.68 million shares outstanding, the latest reported figure.  

If the stock falls any lower, it could put the company in play as a takeover target. Institutions hold 82% of the stock. 

The disconnect between earnings and fading investor confidence apparently can be summed up in a word... debt.

In the company's fiscal Q2 conference call Aug. 8, Chief Financial Officer Jim Shanahan revealed that Focus ended the quarter with about $1.1 billion in outstanding debt and a net leverage ratio of 4.05 times. Shares closed at $25.07 that day but have since slid about 20% to the $20 level.

Typically, a debt-to-equity ratio of around 1 to 1.5 is considered financially sound, although the ratio can vary depending on the industry. The upside of debt is that it averts the need for owners to dilute their ownership by selling equity to raise capital.

The ratio is significant because it indicates potential financial risk, especially now, when the economy keeps throwing off signals that a business slowdown and possible recession lie ahead.

The more alarming aspect of the ratio for Focus Financial is that it represents a habit -- borrowing -- that is proving hard to break even in a buoyant economy, according to Matt Crow,  president of Mercer Capital in Memphis, Tenn.

'Trouble is...'

"Year to date they invested $200 million, only a quarter of which was from operating cash flow.  They aren’t carrying much cash, but have plenty of room on their line of credit.  Trouble is that [tapping that line of credit] expands their debt ratios unless EBITDA grows."

The firm's potential to get caught in a death spiral of needing to madly do deals to pay for old deals wasn't lost on analysts taking the call who asked whether the debt ratio is as high as it appears.

"Yes, we're over four times," Shanahan acknowledged in response to one question. But he called the number manageable given growth opportunities.

Focus has already exceeded one self-imposed debt ratio limit, causing Goldman Sachs analyst Alex Blostein to ask the question that begged an answer.

"I guess [I'd] just [like to hear] thoughts around any alternative funding sources [that are being considered] to de-lever [the debt-laden balance sheet] since it doesn't sound like you guys are willing to kind of slow down the pace of M&A," he asked. 

"We don't have current imminent plans to issue equity," Adolf replied.  "We only issue equity in the context of specific set of transaction, or transactions, where we have a clear understanding that this is accretive ultimately from a shareholder perspective."

"So unless we see this type of opportunities we are going to stay where we are today, but, of course, if we see some of these types of transactions, we would be willing to tap into the equity markets," he added. 

Hedging bets

Even so, Focus appears to be hedging all bets. On Friday (Aug. 30), the company filed a shelf registration covering a potential offering of class A common stock, preferred stock, depositary shares, warrants, subscription rights, and/or units.

The statement contained general corporate boilerplate. The proceeds are slated for "general corporate purposes," including working capital, repayment of debt and other obligations and the financing of capital expenditures, acquisitions and "investment in existing and future projects."

The registration is good for up to three years and allows a company to move quickly to raise capital when conditions become favorable, according to SEC regulations. 

The company said the move was "standard procedure" following the one-year anniversary of its IPO. The market saw it differently.

Shares slipped another 1.6% in after hours trading to below $20 following the announcement. Focus may gain some respite from the long Labor Day weekend.

When markets, reopen on Tuesday (Sept. 3), however, the stock is almost certainly headed for another decline, and possibly another 52-week low. 

Crow sees a clear reason why Adolf is reluctant to pull the trigger on a secondary offering. 

"Would you sell stock at $21 when you went public a year ago for $33?  Hard to justify."

Robust growth

The hope for Focus rests in performance numbers. At least, they appear well ahead of the game.

Revenue of $301.5 million was up 30.3% from the same period a year ago, and net income was $3.1 million, or 2 cents a share compared with a loss of $7.6 million a year earlier. Adjusted earnings per share were 55 cents, up 38% year-over-year.

Eight new partner firm acquisitions that closed during the 12 months, ended June 30, were responsible for about $28.6 million in revenue growth, Shanahan said. 

"Our revenues increased 30.3% year-over-year and our ANI [adjusted net income], per share grew 37.5%. This is our fifth quarter reporting as a public company. And in each of these quarters we have achieved year-over-year revenue and ANI, per share growth in excess of 30%," he said.

"Wealth management fees were the primary driver of that revenue growth. Our fee-based and recurring revenues remain in excess of 95%, of our total revenues," he added. "As such, an important differentiator of our business is that, we earn virtually all of our revenues from fee-based and recurring sources."

Of note, however, about 70% of  Q2 revenues were correlated to the equity and fixed income financial markets, which could leave the firm vulnerable to an economic downturn. The remaining 30% came from non-correlated sources, Shanahan said. 

Organic growth

Another key economic metric, organic growth, rose 18% year-over-year, despite a "substantially larger revenue base." But much of that was driven by merger activity, according to the company.  

Focus has completed 27 mergers since July 1, 2018. The largest, Loring Ward's merger into Buckingham, contributed $12.8 million of revenue in Q2 2019, Shanahan said. 

Over the last 10 quarters the average quarterly organic revenue growth rate was 13.4%.

"Based on our visibility, due to the advanced billing by our firms, we expect another strong quarter of organic revenue growth in Q3 with a year-over-year growth rate in excess of 15%," he said. 

"Year-to-date through August 8th, acquired base earnings for the six partner firms we closed were $35.1 million," he continued. "We also closed 24 mergers of which nine were in the second quarter and six to-date in the third quarter.

The Williams Jones  deal, which closed Aug. 1, is expected to contribute an estimated $42 million in annual revenues and $16.5 million in acquired base earnings, or about $7 million in revenue and $2.7 million in EBITDA in Q3, he noted. 

"The 24 mergers we completed were done on behalf of 14 partner firms and half of these firms were executing their first merger," he added.

Sink or swim? 

Tellingly, Focus doesn't anticipate "any additional new partner firm closings in Q3."

Even so, Shanahan  said he was confident the firm had "meaningful downside protection in the event of market volatility."

He cited a "high level of fee-based and recurring revenues [and] our variable expense base." 

"In aggregate, these factors would limit the adverse effect of a market decline on our EBITDA, and therefore our leverage," he explained.

A market decline would barely budge the needle on the company's debt to equity ratio, he noted. 

"For example, had our Q2 market correlated revenues declined by 10%, our Q2 reported net leverage would have only increased by 0.1 times. Had our Q2 market correlated revenues declined by 20%, our Q2 reported net leverage would have only increased by 0.2 times."

Of course, there was one caveat. Except for management fees, which are tied to the profitability of partner firms, the analysis holds all other revenues and expenses constant.

But how many deals like Williams Jones exist in the market? The question is critical to Focus's business model. With its current debt load, the company will sink or swim based on its deal flow. 

A company dependent on M&A for growth is vulnerable, warned Jamie McLaughlin, principal of J. H. McLaughlin & Co. of Darien, Conn., in an interview a year ago leading up to the IPO. See: Focus Financial files for IPO to raise $100 million, with 'interesting' timing

"This is what they know how to do, and it has value," he says. "But is it simply a financial transaction (i.e. an asset play) or a strategic transaction that can strip out redundant expenses and may add other intrinsic value."

"[But] there has to be more, or the deal-making is like a drug you need to keep taking.  What happens when the pipeline runs dry or the deals become too rich?"

Focus on mergers

"We are not acquiring simply for the sake of accelerated growth," Shanahan insisted during the call. 

"We invest the operating cash flow that we generate into the growth of our business. But to the extent, there are less attractive opportunities in the market. We will use that cash flow to delever. We have always operated our business this way."

That said, mergers are a major focus of Focus. Nearly 60% of the 46 firms on its platform have completed mergers, and they're returning nearly twice the the average compound annual growth (15%) of the firms that haven't merged (7%).

"Our pipeline is robust, but not at the expense of being selective in the firms we acquire. We only pursue transactions that are accretive to deal-specific return hurdles or that meet a strategic need," said Adolf. 

"We're not simply aggregating a collection of assets or solving succession planning issues." 

Bank of America analyst Mike Carrier popped the question during the call. 

"You guys mentioned like the number of deals being up, I think about 20% year-over-year, but any other color in terms of like the types of deals, like earnings contribution... just so we have some context on the types of deals that you guys are seeing in the market."

 Value proposition

Focus General Counsel Rusty McGranahan, who also sat in on the call, jumped in with an answer. 

"Quite frankly we ourselves, we are surprised by our ability to grow way above guidance since the IPO... These are absolutely the quality firms that fit into our portfolio and it all comes down  to the essence of our value proposition."

Focus, founded in 2004, has been riding the growing migration of wirehouse broker dealers to registered investment advisers. 

The company has been particularly strong adding so-called "tuck-in" firms. A tuck-in acquisition refers to a company that is acquired by a platform company.

Focus has made 30 deals year-to-date versus 25 deals full-year last year. Six of the deals were direct acquisitions of new partner firms, while 24 were mergers, in which RIAs combine with existing Focus Financial partners, according to Q2 financials.

Focus CEO Adolf attributed the uptick to "simply more platforms," a market that  "is very, very attractive" and, of course, the firm's value proposition. 

"We firmly believe and the results are demonstrating [our model] is simply superior to the monolithic one-size-fits-all models that really seem to be dominating some parts of this industry.

Size matters

But "when you’re the size of Focus Financial ($100-plus billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals," noted Crow, in a prescient RIABiz article earlier this month. See: Focus Financial IPO marks an RIA milestone one year on, but year two hinges on how Rudy Adolf handles the millstone around his neck--mounting debt

KBW Analyst Kyle Voigt picked up on that point during the call. 

"Are you finding more competition for these deals more recently or the acquisition prices moving higher and nudging higher at all?" he asked. "Just if you could kind of talk about the competitive dynamics for the deals that you're closing?"

"Quite frankly we firmly believe we are the only game in town," Adolf responded. 

"You can get swallowed up by some mega institution, you can join in monolithic platform where basically the culture and the way of doing business disappears," he explained. 

"You may get private equity involved, which really ultimately means significant loss of control in particular a private equity per definition is temporary capital versus Focus being a permanent capital. So in other words, this thing will be on the block again, which particularly in the ultra-high net worth basis market is very unattractive.

The company will continue to pay multiples in the "mid to high single-digits" for firms "almost independent of size."

Debt monkey

Deals also require cash, and Focus has had no qualms about diving deeply into debt to keep the deals flowing.

The company was laden with $1 billion-plus in debt in 2017 and the amount swelled to $1.246 billion going into its IPO. Even then, Focus was "highly vulnerable to a market downturn," according to David DeVoe, a principal in the management consulting firm DeVoe & Company.   See: The Case for Debt Over Equity for RIAs in Need of Capital

As a result, the bulk of the $532 billion raised through the IPO  -- about $393 million, or 71% of proceeds--was earmarked to pay down loans, according to Autonomous Research. See: Focus Financial IPO pays off for KKR and Stone Point, after all, by hitting price mark, plus an investor 'pop.' Now, on to the less glamorous task of paying down debt

But this past July, Focus jumped into the debt pool, again.

In a shuffling of deck chairs, the RIA aggregator boosted its $803 million first lien term loan by $300 million to $1.103 billion to pay off $300 million on the revolving credit facility it uses to fund acquisitions, according to Citywire. The loan matures in July of 2024.

Then, it was back for another debt injection shortly afterward. On July 26, the company disclosed in an SEC filing that it added another $50 million to its first lien term loan. RIABiz first reported the change.

The move boosted its term loan to $1.153 billion. In contrast, it owed $797 million on the loan at the end of Q1 2019. The company's term loan quarterly amortization payment jumped 45% from $2.0 million to $2.9 million, according to its financial statement. 

With $3.1 million in quarterly net operating income, Focus has a 1.07 debt service coverage ratio--.a red flag for credit worthiness in a soft economy. 

Generally, lenders are looking for ratios of 1.25 or more. In some cases — when the economy is doing great — they might accept  as low as 1.15. But when the economy is tightening as it is now, ratios can be set as high as 1.35 or even 1.5, according to financial references. 

How high? 

After blowing through the initial debt-to-equity ratio ceiling, analyst Voigt wanted to know just how far Focus executives were willing to push the dial. 

"Going forward how should investors think about kind of an absolute max on where you're willing to take leverage before you'd want to hit the pause button on acquisition activity or switch to equity consideration for new acquisitions. Is it five times, is it four and half times; is there any clarity you can provide there?" he asked.

The short answer was no.  

"We're not providing any specific guidance to the leverage will be at in Q3. But as I said we're very comfortable with where we are today," said Shanahan. 

But the chief financial officer noted that financing deals out of equity and cash flow was always an option, although not a preferred one. 

"This business is extremely cash generative. Our cash flow generation in the last 12 months Q2 is $124 million. And so that's something we either deploy back into the next level of transactions or we use to de-lever," he said. 

"De-levering" would signal imminent death to Focus Financial because it would be tantamount to admitting the growth model was broken, said one competitor who asked not to be named

Shanahan made certain to emphasize Focus is doing anything but de-levering and that the July term offering to banks was "well received, which is why we upsized it."

"It's just a tremendous reaffirmation that is very attractive and so we moved it up to $350 million. Our total capacity now is roughly about close to $500 million [for acquisitions] with the new facility in place."

Maybe so, but the market didn't quite see it the same way. 

Sharks bite

Short sellers began moving in on the company's stock shortly after the July debt deal. By Oct. 2018, 1.9 million shares were short against an average daily volume of 184,000 shares, according to the NASDAQ, which tracks short positions. 

That pushed the days-to-cover ratio to 10.5, its first foray into double digits. A “days to cover” above 10 indicates extreme pessimism in the market, according to financial references. The ratio hit 11.7 before the shorts began to cover, sending the ratio back into the mid-single digits.

Then, in early 2019 it jumped again to a high of 12.8 in January before peaking at 14.1 in mid-February, partially due to lower trading volume. 

Ironically, during that time, share prices trended higher, rising from $35.90 at the end of July to its 52-week high in Sept. 2018. The period was marked by a huge spike in trading volume in excess of 3 million shares on Sept. 21. 

After that, share prices began an inexorable slide. They last traded in the $40 range in October and had fallen below $30 for the first time in early December.  They rallied this past February and climbed past the $33 IPO price at the end of the month.

Shares peaked at $38 in early March and have been on a slow slide ever since. They slipped below $30 in mid-May and have been trading in the $20s to high teens ever since. 

Market gyrations may have had something to do with it, but the iShares U.S. Financials ETF, which tracks the sector, is actually up 18.8% on the year. 

The stock's short position has held steady between 1.65 million and 1.2 million shares against fluctuating trading volume. The days-to-close ratio has been hovering between 8 and 4. As long as it stays below,10, it's considered out of the danger zone. 

Meanwhile, analysts are sticking by the stock. Of the nine who are following the company, four have a "hold" rating on shares and three have a "buy" rating. No analyst has flashed "sell" in the last three months, despite its steady decline. 

Keefe Bruyette & Woods actually upgraded its rating to "outperform" in July in line with Oppenheimer and BMO Capital. Both have held steady with "outperform" ratings throughout the year.