Why Kroll Is on a Roll


By Alex Salkever Michael Cherkasky has never shirked difficult assignments. A former New York County district attorney and mob prosecutor, in 1995 Cherkasky served as the adviser to an Orange County, Calif., grand jury charged with examining allegations of derivatives fraud that brought the well-heeled county to near-bankruptcy. In 1997, he helped monitor a hotly contested Teamsters Union election. When he accepted the top job at Kroll Inc. (KROL) in May, 2001, he had accepted yet another rough gig. The troubled risk-management consulting and security-services company was losing money and struggling to capitalize on a disappointing merger.

Flash forward, and Cherkasky has Kroll on a roll. In the fiscal year ending Dec. 31, Cherkasky managed to bring in Kroll's first net profit since 1998. And he has promised great things for 2003 -- a pledge based mainly on the early success of an ongoing corporate renovation that expunged poorly performing divisions and two key acquisitions. Investors are eating it up, bidding Kroll skyward 25%, to $20.45, over the past four weeks.

Wall Street's consensus is quite bullish. Five of the 10 analysts covering the stock call it a strong buy, and four others rate it a buy. "I like these guys. I like the story. I like everything that they're doing. And I like the direction they're headed," says David Gold, an analyst at independent small-cap research company Sidoti & Co. (Neither Gold nor Sidoti owns shares of Kroll, and the firm does no business with Kroll.)

IMPRESSIVE NUMBERS. It's easy to see why Gold is enthused. In fiscal 2002, Kroll posted net sales of $289.2 million, up 39% from $207.9 million in 2001. Despite two acquisitions that powered much of this growth, Kroll's cost of sales increased by only $22.3 million, less than half of the additional revenue coming from the acquisitions.

All told, Kroll bagged $16.4 million in profits for the year, vs. a loss of $21.4 million in 2001. In the key metric of continuing operations, Kroll clocked $19.4 million on the plus side, vs. a loss of $11.4 million for 2001. Those are impressive numbers, considering that benchmark stock indexes have fallen all year, and corporate profits have looked anemic at best (see BW Online, 4/7/03, "Organically Growing at More Than 15%").

Founded by Jules Kroll, this small shop has grown into a global provider of investigative and risk-consulting services. It now has five separate units. Consulting offers business investigations and forensic accounting. The corporate advisory and restructuring unit advises troubled companies. Technology covers electronic discovery and data recovery for legal cases. Background screening offers employee checks and other due diligence on key personnel or partners. Finally, the security unit provides corporate-security consulting and secure facility design services.

MANY FINGERS, MANY PIES. It has taken longer than many observers thought for Kroll to benefit from the upsurge of homeland-security concerns triggered by September 11. Many analysts figured it would chalk up major gains from reactions to the terrorist attacks. Ironically, new business was slow in coming, as Kroll -- along with the bulk of its rivals -- got sandbagged by a stumbling global economy. But thanks to two deft acquisitions in 2002, Kroll morphed from a merely healthy company to a growth machine.

In June, Kroll paid $150 million in stock to purchase Ontrack Data International. Ontrack has proprietary technology and a consulting team that helps law firms and law enforcement recover data and sift through it for court cases. In September, Kroll paid $153 million in cash and stock to buy Zolfo Cooper, a boutique provider of corporate-turnaround and restructuring-consulting services. Stephen Cooper, the firm's founder, is the now acting CEO of failed energy giant Enron.

Ontrack is highly profitable and growing quickly, while Zolfo Cooper has operating margins higher than 30%. That's significantly higher than the 19% operating margins for the whole of Kroll. Collectively, those two units accounted for the lion's share of Kroll's growth in 2002.

SYNERGISTIC GROWTH. It might sound like Kroll is buying growth, a dicey game that can spook investors. But it had respectable growth before these deals came along. "If you throw out all the acquisitions, they [grew] internally 16% last year and will grow at that same rate this year. They're able to put north of 20% to the bottom line," says Brian Ruttenbur, analyst at Morgan Keegan & Co. (Neither he nor his firm own the stock, nor has Morgan Keegan done investment-banking for Kroll.)

Cherkasky says the development of synergies between his business units will generate new growth. If Kroll sells forensic-accounting services to a law firm that also needs someone to pick apart subpoenaed computer hard drives, Kroll can help. And if a company Kroll is aiding with fraud investigations ends up slipping into Chapter 11, Kroll can offer restructuring services.

"We think we have some scalable businesses here," says Cherkasky, who believes Kroll can push operating margins to 20% by the end of 2003 and above that in subsequent years. Since no single client is responsible for more than 5% of revenues, Kroll isn't overly dependent on any one kind of work.

ATYPICAL SHORTS. By some accounts, Kroll may be headed for a sell-off. Short-sellers, who borrow shares and hope to benefit from their decline, hold nearly 15% of Kroll's outstanding stock. Most of the time, short-sellers have a good reason to dislike a stock.

However, Gold says 3 million or so of those shorted shares are held by two large institutions hedging the Kroll convertible-bond issues they hold, which makes them atypical. In fact, aside from those two big short positions, most holders of the borrowed shares are reversing their positions -- a bullish sign.

Gold points out that the number of shorted shares fell by 300,000 during the latest reporting period. He's optimistic enough to have a $29 target price on the stock. That would be a 42% jump from where it closed Apr. 4, which is perhaps a bit ambitious considering the uncertainty surrounding the economy and when the war in Iraq will end.

SOME SKEPTICS. Not everyone thinks Kroll is poised for a big run. The recent 25% gain may be all it sees -- at least for this year, says Goldman Sachs equities analyst Chris Hussey. On Apr. 1, he downgraded Kroll to market-perform, the equivalent of a hold rating in Goldman-speak. (Goldman has done investment banking work for Kroll in the past. Hussey owns no shares, and he doesn't know if Goldman owns any shares or is currently doing any investment banking with Kroll.)

Nothing is wrong with the company's performance, he says, but shares have become too dear in the near term, trading at 18.6 times future earnings.

Hussey may have a point, but for now he's in the minority. And if the consensus outlook on Kroll is on target, this stock could outperform the market in 2003. SalkeverSalkever is technology editor for BusinessWeek Online


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