Price (27-08-2017) $64.40	Fair Value Estimate $42-$47	Uncertainty Medium	Enterprise Value ~$1.5b
Consider Buy $36-$40	Economic Moat Narrow	Stewardship Rating Exemplary	Market Cap ~$1.7b

Profiting from failure for fifty years

Thesis: At the current price of $64.40, a base-case intrinsic valuation of $42 indicates a SELL. We recommend a 15% MOS for Exponent.

Lay of the Land

Within the super-sector of Business Services lies the sub-sector of Professional, Scientific, and Technical Services. Companies in this sector are ultra-specialized and provide services to clients in a variety of industries. These activities require a high degree of expertise and training. The marketplace is large and fragmented with different sources of competition for each specific service.

Business Overview

Exponent is a science and engineering consulting firm that provides solutions to complex problems. What began in 1967 as a failure analysis company now has services including analysis of product development, product recall, regulatory compliance, and the discovery of potential problems related to products, people, property and impending litigation. Exponent currently operates 19 practices under two segments, ‘Engineering and Other Scientific’ and ‘Environmental and Health.’

How has it done so far?

Exponent has a strong balance sheet and upward trends in important metrics over the last 10-years. Sales have slowly grown 1.5x at a CAGR of 4.4% entirely organically. EBIT margin has increased from ~15% to ~20%, while Net margin from ~10% to 15%. ROIC has improved from 24% to 39%, after accounting for operating leases. This is due to two factors: (1) growth in EBIT margin; and (2) reduction tax rate. FCFs have near doubled from $17m to $33m. Debt-free ROEs have grown from 30% to 41%.

Exponent has returned $306m in cash to owners, 25% via dividends and 75% via buybacks. All in all, $1 in BV/sh has grown to $3.18 today (12% CAGR).

Exponent’s performance is far better than its competitors. Companies like TTEK, GPX and CRAI have sub-par performance relative to Exponent. Their ROICs are much lower, with margins in the mid/low single digits. Most of the competitors are in debt and some have falling revenues over the last couple of years. In comparison, Exponent has performed much better.

What’s the moat?

Exponent is in the knowledge business. Solving difficult problems in efficient ways is what they specialize in. This means Exponent enjoys the moat of learning curve benefits. As Exponent works on problems, they get better at each type of case and grow their expertise for it. The more they do, the more they improve. This database of knowledge and methodology is difficult to replicate.

Exponent has also formed a long-lasting brand that communicates two key factors: Expertise and Trust. Clients rely on Exponent to have the expertise for the job and trust them to deliver a high quality service. Such trust is only built with time and a successful track record. Exponent has worked on several high-profile cases such as the collapse of the World Trade Centre in 2001 and the Deepwater Horizon accident in 2010.

Exponent often has to deal with insurance lawyers and the legal work that comes with it. It is time-saving for a client to return to Exponent for future projects instead of choosing a competitor’s service, because Exponent would already have covered much of the groundwork of knowing the legal details of their firm. This creates customer switch-cost for Exponent.

A large percentage of Exponent’s business is “reactive” in nature, meaning that customers contact Exponent to help them solve difficult situations. What is attractive about reactive businesses is that they hold the bargaining power, not the customer. Also, price is a secondary concern for a client who needs a solution immediately. Furthermore, companies face problems whether its inflationary or recessionary times. This allows Exponent to maintain its ROIC and profit margin figures during downturns.

Exponent enjoys several structural advantages. Given how asset-light the firm is, it has low depreciation expenses and maintenance costs. Exponent has needed little reinvestment for it to grow thus far. Growth has meant an increase in the number of projects from a growing number of clients. Exponent is a 50-year old player in the industry offering what is considered by the market “a premium service”. It has a strong brand that communicates reliability. Thus, without much aggressive marketing Exponent has successfully increased their clientele. Exponent’s growth has been completely organic, free of any acquisitions and debt. These characteristics are unlikely to change in the future.

Management Analysis

Management have made prudent capital allocation decisions and have proved to keep shareholder’s interests as a priority. They are transparent about their operations and honest about any shortfalls they face. As billable hours reduced in FY16, management effectively cut costs to protect margins. They are making efforts into entering markets where they have zero presence, which mainly includes developing nations. They consistently make efforts to keep the quality of their staff very high and to widen their area of expertise. Exponent is famously known to have an army of PhDs.

What does the future have in store?

Exponent claims that barriers to entry are low in its industry and that competition is increasing. One source of competition that Exponent consistently faces is their services being performed in-house by clients who have the capability. However clients may still choose to retain Exponent because of independence concerns. A sure way for Exponent to compete with this would be to make it cheaper and better for clients to outsource.

Exponent’s future is bright. As the complexities of technology grow all over the world the demand for services that Exponent provides increases. Demand from developing nations will also rise as they start to adopt newer technologies. This is key for Exponent’s growth, and management has already started making initiatives to increase their presence in these parts of the world. Major projects (e.g. self-driving cars) expecting to cause permanent shifts to the motor-industry are excellent news for Exponent, as they are likely to be heavily involved in the testing of those cars.

The biggest risk Exponent faces is an impairment to its reputation as a result of negligence or misconduct. Consequences may mean expensive lawsuits and a permanent damage to its brand. Thus, investors should require a decent margin of safety.

Valuation

Base-case assumptions below yield a value of $42 for intrinsic value per share.

• Sales growth rate: 2% for 5 years (until FY22) growing to 3% for the next 5 years (until FY27).
• Operating Margin: 20%
• Cash tax rate: 33%
• WACC in CAP-period: 7%
• WACC in steady-state: 7%
• Inflation: 1.9%
• Reinvestment trend remains similar to last 10 years.
• CAP-period: 10 years

Exponent is expecting to grow revenue between 1-5% for the next few years. The median of previous 5-year revenue growth rate is 2%. I have assumed this median is maintained for the next 5 years and grows to 3% for the following 5 years. This growth will materialize because of increasing number of projects and business from developing nations.

I believe Exponent will maintain its operating margin at 20%. Management has proven they have a tight control over operating expenses. Given these assumptions of sales growth and operating margin, Exponent would be set to earn $418m in revenue in 2027.

An intrinsic value of $42 shows that Exponent is grossly overpriced today. Exponent is in a competitive industry with a narrow moat, expecting to have slow sales growth in the future. Thus, a 15% MOS is appropriate resulting in a buy price of $36.

Best-case assumptions yield a value of $47 for intrinsic value per share.

• Sales growth rate: 3% gradually increasing to 5% by FY27.
• Operating Margin: 20%
• Cash tax rate: 33%
• WACC in CAP-period: 7%
• WACC in steady-state: 7%
• Inflation: 1.9%
• Reinvestment trend remains similar to last 10-years.
• CAP-period: 10 years

In this case, Exponent would be set to achieve ~$500m in revenue in FY27. A 15% MOS results a buy price of $40. Even at this valuation, Exponent is significantly overpriced today. Investors ought to wait for a correction in the price, instead of paying for growth Exponent is unlikely to achieve.