02/12/15 07:12 AM EST

LAZ - As Good As It Gets - Modeled for Secular Not Cyclical Growth

Jonathan Casteleyn

@hedgeyejc

Josh Steiner

@hedgeyefig

Takeaway: Lazard is priced for perfection, but we see $3 in earnings vs. the current expectation for

$4. Complacency has created a lot of risk.

Quick Summary:

1) Rising VIX and sinking EM are a recipe for disaster for Lazard.

2) The strong US dollar is weighing on their asset management business.

3) Cost cutting initiatives are now in the rear view mirror, but the Street is modeling

further efficiency improvement.

4) Tax rate dynamics are a material headwind going forward.

5) The Street assumes strong growth from here, despite 2014 being a record year.

6) Sentiment (aka Expectations) is unbelievably high on Lazard.

The Bar is High

Lazard (LAZ) is undoubtedly a leading Financial Services firm with a unique position in

low capital, high return Financial Advisory and Asset Management businesses. That

being said, the Street is now modeling top-of-cycle business activity growing in a

secular fashion. This is unrealistic considering the slow start to M&A, the declining and

negative outlook for Emerging Markets, and the positively trending U.S. dollar. Our 2016

earnings estimate is $3.11 per share, more than 20% below the Street, and we think fair

value is $39-$41 per share. Lazard shares have very low short interest and very high

sell-side sentiment, which historically has resulted in intermediate term losses according

to our proprietary sentiment monitor.

Exposures are currently negative for LAZ:

The combination of a slow start to mergers and acquisitions (M&A) activity in both

Europe and the U.S., an ongoing price decline in Emerging Markets, and a positively

trending U.S. dollar are all trends that historically have negatively affected the

fundamentals of Lazard. Starting with M&A, announced mergers and acquisitions in

both developed geographies of the U.S. and Europe has started 2015 much lower both

sequentially and year-over-year. The important U.S. market is most worrisome with a -

25% decline in year-over-year activity through the end of January. The sequential

decline in U.S. announcements is more drastic with running 1Q15 activity down -38% vs

4Q14 activity. While a sequential decline into 1Q is not uncommon as there is a

seasonal rush to complete deals into year end, the rate of decline into 2015 is

noteworthy. Importantly, European activity levels have also ticked down with announced

advisory work down -2% year-over-year with a -20% sequential decline vs 4Q. Only

Asian activity, which is a smaller percentage of Lazard's advisory revenues, is comping

higher into 2015.

The important developed markets are starting 2015 with lower levels of announced

M&A activity:

Volatility

While seasonality is one reason for the domestic M&A decline in 1Q, another is the

elevation in volatility. Historically there is a noticeable fulcrum point in M&A

announcements with the VIX at 20, a level which was surpassed in the middle of

January of this year. Historically there are measurable differences in M&A activity in

high volatility environments versus periods of low vol. U.S. M&A has averaged over

$400 billion per quarter with a VIX below 20 compared to just a $230 billion announced

activity level in quarters with volatility above 20. This sensitivity is important for investors

to understand with the VIX still in an uptrend and still threatening to push through the 20

level threshold currently.

We think a rising VIX is most to blame at this point for a slow start to M&A in 2015. With

volatility in a continued uptrend, the market is not out-of-the-woods yet:

Emerging market weakness coupled with a strong dollar are sensitivities that impact

Lazard's other main business, asset management. With nearly 40% of its assets-under-

management in Emerging Market strategies, the continued price appreciation of EM

assets complemented by a weak or flat U.S. dollar is the best scenario for Lazard Asset

Management. Currently, however, the market setup is negative in both of these regards.

While Lazard Asset Management revenues have temporarily grown through these

headwinds for the better part of 2014, a longer term picture of these inputs shows

measurable impact. With the U.S. dollar on a course to discount even a small rate hike

into the middle of this year, there is likely no slowing the ascent of the U.S. currency. In

addition, our Macro team continues to flash caution on the trajectory of EM assets with

a bearish outlook for Emerging Market proxies (see Hedgeye Macro research).

Despite a divergence starting in 2012, a strong dollar has historically kicked off a

weaker revenue opportunity for LAZ Asset Management (note DXY axis on the right

scale is inverted):

The trajectory of Emerging Markets via the EEM is also a good general beacon for top

line results of the firm's asset management business:

Charts are Telling But Numbers Don't Lie:

While the charted exposures of these top down variables are a good starting point for

LAZ investors, we think the histogram or correlation tables are more useful. We have

run the relationships between the drivers of M&A activity and also the data sets which

most closely correlate to Lazard's stock price. Interestingly, while Lazard's management

discusses how low financing costs are a strong driver of U.S. M&A activity, both grades

of Moody's Credit Indices have only a slightly negative correlation to U.S. M&A and

instead the S&P 500 is a more important driver of M&A activity (as higher stock prices

can be used for M&A currency). For LAZ stock specifically, U.S. M&A has the highest

R-squared value to its stock price at 0.57, with the aforementioned VIX having the most

negative relationship at -0.35 (with an R-Squared between M&A announcements and

the VIX at -0.43).

Causation or just correlation? These are the relationships between quarterly M&A

announcements and the LAZ stock price on a quarterly basis:

Looking to Lazard's asset management business, the direction of the EEM Emerging

Markets ETF has the strongest positive correlation on LAZ's asset management's

revenues with an R-squared of 0.64. Both the Dollar Index (DXY) and 10 Year Yields

have negative R-values with R-squared's of 0.34 and 0.46. A rising U.S. currency

impacts Lazard's asset management business with both lower AUM translation and also

more skittish demand for EM assets.

The EEM ETF is the biggest independent proxy of the impending trends within the asset

management business with the Dollar Index and 10 Year Yields also being relevant

variables:

Cost cuts in the rear view mirror and a substantially higher tax rate mean growth

is going to be harder to generate:

The Lazard story is one of excellence with solid management and a leading position in

some of the most desirable areas of financial services. We are arguing, however, that

the story and the stock is already modeled that way, which sets up for more downside

than upside. Specifically we note that a good time to buy LAZ stock was in late 2012,

upon the announcement of its ambitious cost cutting plan. In the second quarter of

2012, the firm targeted cost cuts of $125 million and a pretax margin target of 25%.

What seemed aggressive at the time has actually made its way through Lazard's

financials with $150 million by our count actually having been taken out of the cost

structure (we have avoided using the recently printed fourth quarter numbers as year

end seasonality in comp and beyond is usually never a good indication of on-the-run

costs).

These efficiencies are already baked into the firm's operating structure:

With the the cost-cutting program now in the rear view mirror, this leaves the plight of

the stock to more cyclical top-down machinations. For example, on the firm's higher tax

guidance alone into 2015 (the firm has guided to a "mid-to-high" twenty percentage tax

rate with the burn off of prior tax NOLs), Lazard would have to grow revenues by

anywhere from +3% to +9% to even start growing earnings from 2014 levels.

The firm's new tax guidance translates into the firm having to grow revenues by +3% to

+9% to even start growing earnings on its 2014 base of earnings:

Consensus estimates assume continued operating leverage and an ongoing

trending M&A market:

While consensus estimates are not in jeopardy just yet, they reflect a best case

scenario for Lazard creating an asymmetric setup to the downside. We estimate that

despite 2014 being the best M&A environment since 2007, the Street is saying that

2015 and 2016 will be even better with higher M&A revenues for the company, margins

accelerating to over 28.0%, and asset management setting new records for AUM and

revenues. These assumptions get the Street to $3.95 for 2016.

In contrast, we outline that the firm's cost cutting program is largely complete and that

the tax rate guidance alone raises the onus on management to work even harder just to

tread water in 2015 off a $3.02 base from 2014. Based on a more realistic hand off

between pro-cyclical M&A advisory and defensive restructuring and more muted

operating leverage, our model produces $3.11 in EPS for 2016.

Our specific assumptions versus Consensus are below. The earnings opportunity for

the company for 2016 outlined by the Street is the best case scenario in our view:

What's the catalyst? We are highlighting the macro setup for now but the AT&T

deal bears watching too:

Every investor wants the point-to-point exit and entry on every idea and we are not

foolish enough to think that even a slow start to M&A or adverse exposures to EM

assets or the U.S. dollar is enough to unwind the substantially improved environment for

both the advisory and asset management franchises. At this point, we are highlighting

that several important macro indicators are setting up negatively for the company and

that consensus is assuming the all-clear on all fronts for the story. In addition to the

macro setup we have outlined, we are also watching the important, pending $66 billion

for Direct TV and AT&T. Lazard is the sole advisor to the acquirer AT&T. Most M&A

deal fees are "success" and not "retainer" based and thus with substantial regulatory

approvals needed (including Hart-Scott Rodino and also an FCC greenlight) we are

keeping an eye on this transaction. At a 10 basis point fee, Lazard stands to realize

over $66 million in revenue which would be 22% of our advisory fee estimate for the

firm's second quarter. While we don't sit in the board room or have an angle on pending

regulatory renderings, we do find it interesting that the annualized merger arb spread on

the deal is the highest amongst all transactions over $10 billion currently. This implies at

least some caution for all associated parties including the M&A advisors involved.

The annualized implied merger arb spread sits at over 30% on the T/DTV deal which

translates into some caution from investors:

The deal is targeted for completion by April 30th if regulatory approvals from several

bodies are attained:

We see fair value on Lazard shares in the $39-to-$41 per share range which accounts

for a more realistic earnings opportunity including a more challenging macro setup and

accounting for the completion of the main benefits of the firm's cost current program and

a more normalized expense base. The Street is too complacent on Lazard in our view

with the stock screening as one of the highest rated in the sector. In our proprietary

sentiment monitor (Hedgeye Sentiment Monitor), sell side ratings and short interest

scores compute to a 96 level, the second highest rating in the Financials sector. In 10

years of back testing sentiment scores, stocks rated 90 or higher have averaged a -

10.3% decline on average in the 12 month forward period. Simply put, Lazard is a great

company but is already priced that way. We see risks in the current complacency on the

Street.

The current Lazard score of 96 in sell side sentiment is second highest in the sector to

the reading of 98 on NNI:

Stocks that start exceed 90 in the sentiment scorecard have averaged over a -10%

decline 12 months forward:

The Basics - Revenue Splits...Segment Info...and Geographic Exposures oh boy:

Lazard's top line revenues are almost evenly split between Financial Advisory and Asset

Management:

Operating margins however are quite different with Asset Management over 50% more

profitable than advisory:

North American and European M&A activity predominates Financial Advisory

comprising over 90% of revenues:

Emerging market assets are the most important class in Asset Management totaling

nearly 40% of top line:

Moelis (MC) Pre-IPO Black Book

GHL - Removing Greenhill From Best Ideas list

GHL - The Best Way to Capitalize on an Improvement in M&A

Hedgeye Black Book - M&A Market to Positively Inflect in 2014

Jonathan Casteleyn, CFA, CMT

203-562-6500

jcasteleyn@hedgeye.com