If you think filing bankruptcy is tough, try making a living at it these days.

As the economy has finally shown signs of life in the past six months, public companies that service the bankruptcy industry have mostly gone Chapter 0, as in the price toward which their stocks are headed.

Epiq Systems ( EPIQ), a provider of software and support for bankruptcy attorneys and trustees, has seen its shares plunge to $14 from mid-2003 highs around $23. FTI Consulting ( FCN), which built a big part of its business around helping large corporations restructure and emerge from bankruptcy, has sunk to the $15 area from mid-2003 highs around $32.

Both stocks have stabilized in recent weeks as short-sellers have paused to catch their breath. The question now is whether renewed fears that the economy may falter in the next six months will yield a positive revaluation of these companies' prospects, sparking a rebound in their shares.

The Case for a Rebound

It's not as unlikely as you might think. The Economic Cycle Research Institute's Weekly Leading Index, which has accurately forecast the last several recessions, has persistently turned down since the fall, but it has started to sink in a more pronounced way over the past three months.

The Weekly Leading Index is on the lookout for changes in the pace of U.S. economic activity on the six-month horizon, which is one reason the market may have struggled since the start of the year. Indeed, it was interesting to see first-quarter U.S. GDP figures cut last week from the high level originally reported.

A good recipe for an improvement in the shares of bankruptcy-related companies is one in which the economy stumbles at the same time interest rates and the price of energy are rising. Companies that are on the edge financially can find themselves pushed over a cliff in this environment, as expenses go way up and sales flatten or decline.

This view requires a contrarian stance, however, because business bankruptcy filings are not on the rise right now. Craig Richard, an analyst at brokerage Stifel Nicolaus & Co. in Denver, contends that filings are highly cyclical. His analysis of total filings, of which personal bankruptcy accounts for 95%, indicates that over the past 12 years, there have been four peak-to-trough cycles lasting 10 to 12 quarters each. The rising half of the cycles have been stronger, averaging year-over-year filing increases of 12% to 17%, while the declining cycles have averaged year-over-year filing decreases of 4% to 6%.

Richard believes that the peak of the last cycle occurred in the second quarter of last year. The fourth quarter of last year showed a 1% decline in the number of total filings. And data from the federal court system showed total filings declined 1.3% in the first quarter of this year. The back-to-back declines lend credence to the notion that bankruptcies may be starting the downslope of a cyclical decline.

Richard concludes that while consumer credit and household debt burdens are high, better economic conditions combined with relatively low interest rates will result in fewer total bankruptcy filings in 2004.

The recent economic recovery has not followed most historical precedents very well, though, so it would not be a huge surprise to see another divergence from the normal pattern. Let's take a closer look at the two companies that would probably be the best investments if complex corporate bankruptcies increase in the next year, rather than decrease as most believe.

Epiq Profits From More and Bigger Bankruptcies

Epiq Systems primarily provides software and hardware to attorneys, trustees and companies that help them manage the myriad documents, assets and funds associated with a major bankruptcy. Its CasePower software, for instance, enables Chapter 11 bankruptcy trustees to manage debtor payments, creditor distributions and government reporting. Through an acquisition made in January, Epiq also provides the same sort of software and support to participants in class-action, mass tort and other complex legal proceedings. Over the 12 months ending March 31, the company earned $8.1 million on sales of $79 million.

Unlike most ordinary software companies, however, in addition to site licenses, Epiq earns a monthly fee from financial institutions based on a percentage of total liquidated assets on deposit and on the number of trustees. It also gets monthly fees based on the number of cases that a client has in a database, as well as the number of claims in a case.

So the bigger and more numerous the corporate bankruptcies, in other words, the more Epiq earns. The number of new bankruptcy filings each year varies based on the level of consumer and business debt, the overall economy and interest rate levels. Epiq management told investors in the company's latest 10-Q report that it believes the level of consumer and business debt is among the most important indicators of future bankruptcy filings. It then noted that the most recently available Federal Reserve Flow of Funds Accounts of the United States, published June 10, reported increases in both consumer and business debt outstanding as compared with the same period of the prior year -- the first increases after two quarters of decreases, as shown in the table below.

U.S. Debt Growth by Sector
Quarterly figures are seasonally adjusted annual rates
Date Households Business
2000 8.8% 9.4%
2001 9 6.1
2002 9.7 2.9
First-quarter 2003 10.8 3.8
Second-quarter 2003 11.7 5.9
Third-quarter 2003 10.2 3.2
Fourth-quarter 2003 7.3 3.9
First-quarter 2004 10.9 4.1
Source: Federal Reserve

If a rise in bankruptcies surprises investors, it will come at a time when Epiq rests at its lowest valuation in years. Since 1997, the company has sported a price-to-sales multiple ranging from 4.5 to 9.2 and a price-to-earnings multiple of 23 to 47; the multiples now are down to 1.9 and 16.4 on consensus forward sales and earnings estimates.

Economic skeptics with a taste for risk could consider the shares at the current level with an initial target around $17 -- a 20% move if it happens. If a gloomier mood on the economy takes hold, the stock should be able to get back to the $19 to $20 range over the next six to nine months, which would be a 40% move from recent levels.

FTI Consulting: Cheap (and Getting Cheaper?)

Likewise, FTI Consulting also looks cheaper than it has in years, now that most believe bankruptcies are on the wane. This is another provider of services to the bankruptcy and legal industries, though FTI provides higher-value services such as forensic accounting, corporate refinance and restructuring, economic consulting and litigation support.

Billing hours is the name of the game here, and in the last quarter they were higher. In its last report, the company reported $110.2 million in revenue and earnings per share of 27 cents -- 7 cents below estimates. The culprit was significantly higher expenses due to the sudden departure of numerous consultants.

FTI has been rebuilding itself to become less reliant on bankruptcy and other complex financial consulting business. Its other lines are not as profitable, but they are more consistent from year to year. In the 12 months ending March 31, the company earned $51.5 million on $384 million in sales.

If the company can retain more bankruptcy-related business than generally believed while at the same time improving its other lines, then the stock should be revalued upward. If not, then this already cheap stock -- P/E and price-to-sales multiples are near historic lows -- could get a lot more inexpensive.

Insiders appear to be betting on a rebound, as they have bought 250,000 shares on the open market since November, at prices ranging from $16 to $19. (There was also one very large sale, of 5 million shares, by a major shareholder around $14 in early February.)

FTI would not be an easy stock to buy, and may require a lot of patience, but the skepticism and negativity surrounding the company would probably reverse if the economy begins to visibly weaken in the coming months. The first target would be $18.65. If that is breached, then bulls will set their sights on $22.

I'll watch both Epiq and FTI over the next six months and let you know how they are either weathering an economic recovery or exploiting a new downturn.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Epiq Systems to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, Markman had positions in no stocks mentioned in this column. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at sm@jonmark.com; please write COMMENT in the subject line.

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