LECG (XPRT)

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suman singh

LECG (NASDAQ: XPRT) is a consulting firm that provides specialized services such as expert witness testimony, economic, financial and statistical analyses, and litigation support. LECG completed its IPO in November 2003. Since its IPO, demand for the company's services has grown rapidly due to Sarbanes-Oxley, which restricts public accounting firms from providing their clients with consulting services. From 2003 to 2006 the company's revenue grew at a CAGR of nearly 30%. ^[1]

Despite this impressive revenue growth, poor management of consultant compensation and intense competition have shrunk operating margins from over 13% in 2002 to under 10% in 2006. ^[2] In response to investor demands for change the company has initiated restructuring plan to reduce operating costs.

Aside from its restructuring efforts, LECG's future success depends on its ability to compete with larger and more diversified consulting firms. While other competitors have focused on diversifying into different consulting arenas, LECG has focused on recruiting experts that have advanced degrees and significant experience in their field of practice. Many of these experts are professors with the reputation of being one of only a handful of people qualified to deliver expert testimony on their chosen subject. Much like a specialized retailer competing with Walmart or Target, it is unclear whether LECG's depth can compete with its competitors' breadth.

Business Financials

As of December 31, 2006, LECG employed 379 consultants that provide independent expert services to Fortune 500 corporations, law firms, and local, state and federal government agencies in the United States and other countries around the world. ^[3] LECG provides litigation support services and expert testimony in several consulting arenas:

• Government Competition Regulations (Antitrust Legislation)
• Intellectual Property Disputes
• Forensic Accounting
• Electronic Discovery

LECG's revenue growth is largely the result of an acquisition-based growth strategy. Since 2002, LECG has acquired multiple companies that have contributed approximately 40% of total revenue growth. The depth of LECG's client relationships and the non-discretionary nature of its expert services has also contributed to strong top-line growth. However, a reputation of giving large bonuses to lure new consultants and retain strong performers has hurt LECG's operating margins. ^[4]

The following graph demonstrates LECG's revenue and operating income growth from 2002 - 2006:

The utilization rate of consultants is a fundamental operating metric that gives insight into a firm's ability to generate consistent demand. A demonstrable trend in either direction may foreshadow under or over performance by the firm. In LECG's case, poor utilization from 2002 - 2005 is evidence to the difficultly of integrating consultants. As LECG has grown through an acquisition-based strategy, it must constantly integrate new consultants into the existing business. This process inevitably reduces the amount of time current and new consultants can spend working on cases. However, the spike in utilization in 2006 is evidence that absent these integration demands, the strength of LECG's relationships with clients and the unique services provided by its experts does create sustainable work flows.

The following graph demonstrates LECG's consultant utilization rate over the past five years:

Key Trends and Forces

• Growth of the Legal Industry Expands Consulting Opportunities: The legal industry has seen strong growth as the volume and monetary stakes of litigation cases have risen dramatically over the past decade. Due to LECG's focus on providing litigation support services and expert testimony, its primary clients are often national and regional law firms. As the volume and monetary stakes continue to grow, Legg should experience continuing growth in demand for its services.

• Consulting Firms Needed to Help Companies Navigate Increased Regulatory Complexity: As a result of increased regulatory complexity, firms engage consulting firms to provide objective and independent expertise. Indeed, according to Glass Lewis & Co., an institutional investor advisory firm, the number of financial restatements by U.S. public companies reached 1,195 in 2005, an increase of 95% from 2004.^[7] LECG's strong reputation and track record in addressing regulatory compliance has positioned the firm to take advantage of increased regulatory activity.

• Heightened SEC Activity Drives Demand for External Advisory Services: The heightened focus on corporate mismanagement, fraud-related investigations (following the Enron and WorldCom scandals), and ongoing SEC regulatory activity drive demand for external advisory services. For fiscal 2008, the President’s budget request for the SEC is $905.3 million, a 3.2% increase over the $877.1 million funding level in 2007.^[8] Specifically, LECG's forensic, litigation, and economic practices have seen tremendous growth as increasing SEC activity requires firms to focus on better managing fraud-related risks.

Competition

Market Overview

External consulting services brought in approximately $125 billion globally in 2006, and over the last several years spending on these services in the U.S. has grown at an annualized rate of nearly 7%, significantly outpacing GDP growth. ^[9] The consulting industry is loosely divided into four categories that feature highly fragmented competitive landscapes:

• Human Resources Consulting: Mercer International, Hewitt Associates, Towers Perrin, Deloitte Consulting.
• Information Technology (IT) Consulting: Accenture, BearingPoint, IBM Global Business Services.
• Outsourcing / Staffing Consulting: Robert Half International, Manpower, Korn/Ferry International.
• Operational and Financial Consulting: McKinsey, Boston Consulting Group, Bain, Booze Allen Hamilton, Watson Wyatt, Huron Consulting Group, FTI Consulting, CRA International, LECG, Navigant Consulting, Exponent, Corporate Executive Board Company.

LECG's closest peers are the independent consulting firms that provide similar financial and operational consulting services to many of the same clients. As the "Big 4" accounting firms continue to bleed market share in the financial and operating consulting market, a tremendous opportunity exists to become the dominant provider of these advisory services. This market has several unique characteristics:

1. Demand is typically non-discretionary and insensitive to economic cycles, but is highly volatile quarter to quarter, as the work is largely case or project-based.
2. Price is typically not relevant in a firm's decision in choosing a consulting firm, as these fees are rounding errors in high stakes litigation cases or restructuring efforts. Moreover, seeking the cheap option in forensic investigation of financial records can be seen as a failure of due diligence for boards of directors. Thus, clients choose consulting firms based on organizational or individual consultants' reputations.
3. Consulting requires little capital investment or working capital requirements, thus resulting in low levels of debt and strong free cash flows , which provide important performance and valuation metrics.

Relevant Peer Group

• FTI Consulting is a global consulting firm that addresses financial, legal, and operational issues for a diverse range of clients. As of December 31, 2006, it employed 1596 consultants and generated annual revenue of $707.9 Million. ^[10]

• CRA International is an economic, financial and management consulting services firm. As of December 31, 2006, it employed 733 consultants and generated annual revenue of $349.89 Million.^[11]

• Navigant Consulting is a provider of regulatory, financial and operational advisory services. As of December 31, 2006, it employed 1,760 consultants and generated annual revenue of $681.75 Million.^[12]

• Huron Consulting Group is a consulting firm that provides financial and operational advisory services. As of December 31, 2006, it employed 344 consultants and generated annual revenue of $321.92 Million.^[13]

Competing Cost Structures

Demand for financial and operational consulting services is non-cyclical and has shown no signs of slowing down. Thus, the key determinant of these firms' future success is their ability to contain costs, especially costs related to consultant hiring, compensation, and retention. These firms operate under two distinct organizational structures that determine how consultants are paid:

• The Star Model (LECG, CRA International,Inc. ): In this model, consultants receive a majority of their hourly billing fees as direct compensation. This, combined with a decentralized structure and minimal hierarchy, gives consultants significant independence and autonomy. This model creates an attractive environment for top talent, and allows the firm to provide unique services that are difficult to imitate. However, compensation is based on individual work, not firm profitability, and thus there is no collective effort to build organizational brand equity or realize economies of scope.

• The Partnership Model (FTI Consulting, Huron Consulting Group , Navigant Consulting): In this model, consultant revenues are pooled and distributed based on partner status. This, combined with a bureaucratic hierarchy designed to maximize operational efficiency, forces consultants to work to improve overall firm performance. Revenue becomes less case-driven, as demand is not tied to individual consultants but to firm reputation. However, this organizational standardization can lead to a commoditization of services, and the extra layers of management can dissuade top talent from joining the firm.

Relative Performance

The following graphs compare the relative revenue growth, operating margins, free cash flow levels, and consultant utilization rates of these competitors:

References

1. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
2. ↑ . LECG 2007 Annual Report, Selected Financial Data, Page 26
3. ↑ LECG 2007 Annual Report, Busines, Page 12.
4. ↑ LECG 2007 Annual Report, Busines, Page 10.
5. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
6. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
7. ↑ Huron Consulting 2007 Annual Report, Industry Background, Pages 9 - 10.
8. ↑ Huron Consulting 2007 Annual Report, Industry Background, Pages 9 - 10.
9. ↑ Royston Greenwood, Roy Suddaby; Professional Service Firms.
10. ↑ Reuters. [1]
11. ↑ Reuters. [2]
12. ↑ Reuters. [3]
13. ↑ Reuters. [4]
14. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20 ; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; [[stock:LECG_%28XPRT%29/Filing/10-K/2008/F5590664 | LECG 2007 Annual Report, Selected Financial Data, Page 25 ]]
15. ↑ [| FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65]; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; CRA International 2007 Annual Report, Selected Financial Data, Page 22;Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16 ; . LECG 2007 Annual Report, Selected Financial Data, Page 25
16. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; CRA International 2007 Annual Report, Selected Financial Data, Page 22; Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16 ; . LECG 2007 Annual Report, Selected Financial Data, Page 25
17. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; [[stock:Huron_Consulting_Group_(HURN)/Filing/10-K/2008/F2622622#tx68267_8 | Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20]]; [[stock:Celera_Corp_(CRA)/Filing/10-K/2008/F3751031#tx51698_23 | CRA International 2007 Annual Report, Selected Financial Data, Page 22]]; Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16; . LECG 2007 Annual Report, Selected Financial Data, Page 25

Notes

1. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
2. ↑ . LECG 2007 Annual Report, Selected Financial Data, Page 26
3. ↑ LECG 2007 Annual Report, Busines, Page 12.
4. ↑ LECG 2007 Annual Report, Busines, Page 10.
5. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
6. ↑ LECG 2007 Annual Report, Selected Financial Data, Page 26.
7. ↑ Huron Consulting 2007 Annual Report, Industry Background, Pages 9 - 10.
8. ↑ Huron Consulting 2007 Annual Report, Industry Background, Pages 9 - 10.
9. ↑ Royston Greenwood, Roy Suddaby; Professional Service Firms.
10. ↑ Reuters. [5]
11. ↑ Reuters. [6]
12. ↑ Reuters. [7]
13. ↑ Reuters. [8]
14. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20 ; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; [[stock:LECG_%28XPRT%29/Filing/10-K/2008/F5590664 | LECG 2007 Annual Report, Selected Financial Data, Page 25 ]]
15. ↑ [| FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65]; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; CRA International 2007 Annual Report, Selected Financial Data, Page 22;Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16 ; . LECG 2007 Annual Report, Selected Financial Data, Page 25
16. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20; CRA International 2007 Annual Report, Selected Financial Data, Page 22; Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16 ; . LECG 2007 Annual Report, Selected Financial Data, Page 25
17. ↑ FTI Consulting 2007 Annual Report, Financial Statements and Supplementary Data, Page 65; [[stock:Huron_Consulting_Group_(HURN)/Filing/10-K/2008/F2622622#tx68267_8 | Huron Consulting Group 2007 Annual Report, Selected Financial Data, Page 20]]; [[stock:Celera_Corp_(CRA)/Filing/10-K/2008/F3751031#tx51698_23 | CRA International 2007 Annual Report, Selected Financial Data, Page 22]]; Navigant Consulting 2007 Annual Report, Selected Financial Data, Page 16; . LECG 2007 Annual Report, Selected Financial Data, Page 25