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Exponent: Investing in Bright People

August 04, 2014 | About:

Every company needs bright people, at least at the top, to create a thriving business.

Exponent Inc. (EXPO) depends on smart people on the front-lines, too. Its business is to solve complex problems, answer difficult questions, and deal with issues that demand a lot of thinking and analysis. More than half of this company's staff hold Ph.D.s, and even many of those without doctorates have advanced degrees.

What does this research and consulting company do? In his 2013 Letter to Shareholders, Exponent CEO Dr. Paul Johnston said, "...reactive services, where we investigated accidents ranging from the collapse of a major industrial facility to a home fire; evaluated potential product recalls including home appliances and food products; and assessed the health and environmental exposures for oil and gas operations." That's what the company calls the reactive side of its business.

It also has a proactive side, which he describes this way, "...we provided design consulting for products ranging from tablet computers to drug delivery systems; assisted clients with regulatory matters involving bathroom fixtures and cosmetics; and worked with clients to develop risk management programs for gas distribution systems."

This small cap came to our attention through the Undervalued Predictable screener at GuruFocus.

History

  • 1967: five Ph.D.-level researchers create a consulting business called Failure Analysis Associates® (FaAA). focusing on stress and fracture mechanics in the energy industry.
  • 1989: a holding company formed, called The Failure Group, Inc.
  • 1990: The Failure Group goes public, trading on NASDAQ under the symbol FAIL.
  • 1996: The Failure Group acquires Environmental Health Strategies (now Exponent's Health Centers).
  • 1997: The Failure Group acquires Performance Technologies, Inc., now Exponent's Environmental Practices.
  • 1998: with the broader profusion of services, beyond traditional failure analysis, the name is changed to Exponent.
  • 2002: Exponent acquires Novigen Sciences, Inc. (now Exponent's Center for Chemical Registration and Food Safety).
  • 2005: Exponent opens its first office in China.
  • 2008: opens an office in Switzerland, to service European clients (now incudes offices in the United Kingdom, Germany and Switzerland).
  • 2013: EXPO begins paying dividends, 15-cents, in the first quarter.
  • 2014: adds $35 million to the existing $19 million available for share buybacks.

Sources: company website and 10-K for 2013.

Business Model

Exponent describes itself this way in its 2013 Annual Report, "...a science and engineering consulting firm that provides solutions to complex problems." Breaking that out a bit further, it refers to a multidisciplinary team made up of:

  • scientists
  • physicians
  • engineers, and
  • business and regulatory consultants (altogether covering more than 90 different technical disciplines)

This multidisciplinary team solves "complicated issues facing industry and government today." They can perform:

  • "in-depth scientific research and analysis, or
  • "very rapid-response evaluations, to provide our clients with the critical information they need."

The company's roster, at the beginning of 2014 included 984 full- and part-time employees. Of that number, 670 had advanced degrees, including 447 Ph.D.s

As the following excerpt from the 10-K for 2013 shows, the Engineering and Other Scientific segment represented just under three-quarters of revenue, while the Environment and Health segment represented just over one-quarter.

EXPO

Growth Strategy

Exponent's management identifies the following areas in looking at its future opportunities:

  • selectively adding top talent to expand market position,
  • in-depth scientific research and analysis to determine what happened and how to prevent failures or exposures in the future

Based on information at the company's website and its Annual Report/10-K for 2013, Exponent plans no specific new growth initiatives. However, given its history of acquisitions, this mode of growth may be seen again.

Management

President & CEO: Paul R. Johnston, Ph.D., age 60, joined the company in 1981, appointed President in 2007, CEO and director in 2009; he is a Registered Professional Civil Engineer.

Chief Financial Officer (also Executive Vice President and Corporate Secretary): Richard L. Schlenker, Jr., age 48, joined the company in 1990, appointed CFO in 1999; previously a business manager, he has held several different positions in finance and accounting within Exponent.

Chairman of the Board: Michael R. Gaulke, a director since 1994 and Chair since 2007; he had been an officer and CEO between 1993 and 2009; before joining Exponent, Mr Gaulke has served in senior positions at two technology companies and had been a consultant at McKinsey & Company.

The company has five other board members, including Dr. Johnston; their backgrounds include management of tech companies, a former managing partner at KPMG LLC, a professor of economics at Stanford University, and a lawyer.

Management information from the 10-K report for 2013 and board information from the company website.

ISS Governance Quickscore: 3/10, a good score ("A decile score of 1 indicates lower governance risk, while a 10 indicates higher governance risk."). It receives one red flag, for Equity Risk Mitigation.

Ownership

Gurus: Among the gurus followed by GuruFocus, three have holdings in Exponent: Chuck Royce (Trades, Portfolio) (431,532), Jim Simons (Trades, Portfolio) (247,500), and Joel Greenblatt (Trades, Portfolio) (40,775).

Institutional Investors: 90% of Exponent's shares (institutional investors include pension funds, mutual funds, insurance companies, banks, and hedge funds).

Insiders: 4% of outstanding shares. Data from Yahoo! Finance shows Samuel H. Armacost with the single biggest holding, 95,867 shares, as of May 28, 2014. Mr. Armacost is (presumably) a former director (he is shown on the board roster for the 2013 Annual Report, but not on the current list of directors at the company's website). CEO Paul Johnston held 56,641 shares, while Chairman Gaulke is listed as owning no shares.

Short Interests: Just above 2% as the following chart shows, this is well below the almost 10% level of 2008 and the nearly 5% level reached in 2011.

1407104583143.png

EXPO by the Numbers

EXPO key statistics

Financial Strength

Exponent posts strong numbers in the GuruFocus summaries of Financial Strength (9/10) and Profitability & Growth (8/10), as the following screenshot shows:

EXPO financial strength

The following chart shows EXPO's revenue/share (green), EBITDA/share (blue), and free cashflow/share (red):

1407120532063.png

Looking at a few of the key financial statistics we see:

  • No debt
  • $156.1-million in cash and marketable securities (end of 2013)
  • $344.2-million in total assets
  • $109.1-million in total liabilities

Valuation

Exponent is an interesting case when it comes to valuation - it makes the Undervalued Predictable ranks on the strength of its 5-star predictability rating and one (of two) discounted cash flow calculation.

Speaking of the DCF results, on the Undervalued Predictable screener page it gets a value of $113, while on the DCF/Fair Value Calculator page it gets a valuation of $66.16. What's the difference? GuruFocus explains its this way, "Compared with the DCF Calculator, in this [Undervalued Predictable] page we use the EPS of the last fiscal year as default earnings, and the average of the first 5-year period and the second 5-year period as the default growth. While in the DCF calculator we use TTM EPS and 10-year compound growth rate as default."

All of the other GuruFocus valuations come in below the August 1st closing price of $70.63. For example:

  • Peter Lynch Fair Value: $42.15
  • Median P/S Value: $44.36

Being a 5-star predictable stock puts EXPO in some very elite company - only 76 of the many thousands of stocks covered by GuruFocus earn this top ranking.

According to backtesting by GuruFocus, 5-star stocks have averaged gains of 12.1% per year over the past 10 years (including the financial crisis years), and only 3% of 5-star stocks remain in a loss position if held for 10 years.

Outlook & Risks

Looking forward from the first quarter earnings release on April 23, CEO Dr. Paul Johnston said, "For 2014 we continue to expect growth in revenues before reimbursements to be in the low single digits and EBITDA1 margin to be down approximately 100 basis points from 24.6% in 2013."

In guidance with the second quarter results (July 22), Dr. Johnson reiterated his expectation that revenue growth for the year would be in the low single digits, while he expected EBITDA margin for the year to be down 25 basis points, rather than 100.

As we look through the company's 10-K for 2013, we see that the company operates in a highly competitive environment, and thus must compete for contracts, giving it limited pricing power.

To the extent that it has a moat, that would its professional reputation, and any professional misstep might erase that, making the company even more susceptible to competition.

Among the threats to its reputation is litigation; it acts as a consultant/resource in legal cases, and by the nature of its business (making recommendations based on technical studies) is exposed to legal action brought against it.

Many of the company's contracts come from governments, both in the U.S.A., and elsewhere. In the short-term, at least, spending cuts at the U.S. Department of Defence (winding down of the war in Afghanistan) will affect revenues.

And, in general its clients have less money to spend when the economy takes a turn for the worse, or when mergers and acquisitions activities diminish the size of the client pool.

Overall, though, Exponent has a strong history of growing its revenue and earnings, strong management, and for at least the immediate future, an improving American economy. At the same time, we take note of its potential entry into new markets around the world.

Finally, the company has signalled its confidence by introducing a dividend in 2013, and upping the budget for share buybacks this year.

Conclusion

Investors looking for predictable growth among small caps should take a close look at Exponent Inc. Its 5-star predictability rating suggests it will be a reliable source of capital gains in the years ahead.

The addition of a dividend and increased provision for share repurchases add incentives. While the dividend rate is a modest 1.4%, the current payout ratio is only 25% and there is room for its growth as well.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks. He’s currently exploring two potential routes to an income portfolio: First, to combine dividend challengers, contenders, and champions with covered calls, and second, to combine more volatile stocks with collars.

As a writer and publisher, Abbott explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, the first of a series of booklets on this subject, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

In an eclectic career, Robert Abbott was a radio news writer and announcer, a newsletter writer and publisher, a farmer, a telephone operator, and a construction worker. When not working, he has been a busy volunteer, which includes more than a decade of leadership roles at the Airdrie Festival of Lights, one of North America’s leading holiday light displays. He lives in Airdrie, Alberta, Canada.

Visit Robert Abbott's Website


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