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Executives

Bradley Wright - EVP and CFO

Eric Billings - Chairman and CEO

Rick Hendrix - President and COO

Analysts

Eric Bertrand - Barclays Capital

Dan Fannon - Jefferies

FBR Capital Markets Corporation (FBCM) Q3 2008 Earnings Call Transcript October 22, 2008 9:00 AM ET

Operator

Good morning. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the FBR Capital Markets Third Quarter 2008 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Bradley Wright, Chief Financial Officer, sir, you may begin your conference.

Bradley Wright

Thank you, and good morning. This is Brad Wright, Chief Financial Officer of FBR Capital Markets. Before we begin this morning’s call, I’d like to remind everyone that statements concerning future performance, developments, events, market forecasts, revenues, expenses, earnings, run rates and any other guidance on present or future periods constitute forward-looking statements. These forward-looking statements are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These factors include but are not limited to the effect of demand for public offerings, activity in the secondary securities markets, interest rates, risks associated with merchant banking investment, the realization of gains and losses on principle investments, available technologies, competition for business and personnel and general economic, political and market conditions.

Additional information concerning these factors that could cause results to differ materially is contained in FBR Capital Markets annual report on Form 10-K and in quarterly reports on Form 10-Q.

I’d now like to turn the call over to Eric Billings, Chairman and Chief Executive Officer of FBR Capital Markets. Also joining us this morning is Rick Hendrix, President and Chief Operating Officer of FBR Capital Markets.

Eric Billings

Thank you, Brad. Good morning. In today’s call we will cover third quarter results, the progress of our cost reduction activities, some franchise building steps taken during the quarter, the state of our balance sheet and the outlook going forward.

The environment continues to be as challenging as any we have ever seen. What we are experiencing and in terms of the nature and severity of the dislocation in the financial markets as well as the impact on an increasingly interconnected global economy is significant. We expect that the duration of the downturn will be prolonged and will continue to have a negative impact on banking and the securities industry.

Our third quarter results are clearly a reflection of the difficult capital markets environment. The firm reported a $28.6 million or $0.44 per share third quarter loss compared to what was essentially a breakeven third quarter in 2007.

Our loss for the quarter includes non-operating charges of $3.7 million for severance costs and $11 million for valuation adjustments merchant banking and other long-term investments. Excluding these charges and $5.5 million of non-cash equity compensation, the operating cash loss would have been approximately $16 million after tax.

In response to the increasingly difficult economic climate, we undertook a second headcount reduction in August, and implemented an aggressive cost-cutting program which, when fully realized, will reduce our annualized breakeven by approximately a $125 million over our second quarter run rate, creating a cost structure, where we expect to break even in spite of these historically low levels of banking revenues.

During the third quarter, we achieved approximately 20% of the fixed cost reductions that we have targeted to get us to our reduced breakeven. The initial impact of these reductions was sufficient to achieve cash break even for the month of September. We expect to achieve 60% of the target savings in the fourth quarter with the full savings to be realized in 2009.

Some of them more significant cost reduction initiatives being taken include; reductions in domestic and international headcount, decreasing scope of FBR sponsored events and marketing activities, consolidation of facilities and elimination of certain technology costs. Overall, we are targeting a $30 million reduction in annual fixed costs and additional improvement in our break even through adjustments to our variable costs.

Subsequent to the quarter’s end, the company repurchased 6.7 million shares at an average cost of $5.02. As a result of this repurchase activity which includes 1.5 million shares seta [set aside] for potential employee purchase; book value per share now stands at $7.13.

Investment banking revenue was $12.8 million compared to $8.2 million in the second quarter. Clearly, primary capital markets continue to be challenged – challenging. In this type of environment our focused equity markets model has always exhibited volatility as evidenced by the quarter’s results.

Conversely, during the market downturns, fast moving capital raising capabilities, one of the primary strengths of our firm are paramount important. We believe that with the platform we have today and because of the severity of the economic climate, as soon as conditions permit, we are likely to participate in significant numbers of recapitalizations across various industry segments, and in particularly, in financial services, an area of historic strength for our firm.

Our institutional brokerage business maintained its strong upward trend during the quarter, as we were able to take advantage of the dislocations in our industry. Brokerage revenues were $36.4 million compared with $34.8 million for the second quarter of 2008, and $27.2 million for the third quarter of 2007, a year-over-year increase of 34%. For the first nine months of 2008, institutional brokerage revenues were $103 million, 20% above the same period in 2007.

As we assess the competitive landscape, the totality of the recent changes are so significant and dramatic, it is difficult to fully comprehend. What we do know is that our top four equity capital markets competitors going into 2008 were Bear Stearns, Lehman Brothers, Wachovia, and Banc of America. And what we also know is that this picture has changed for ever.

Our objective is to take full advantage of the current turmoil to be in the market and make sure we are fully engaged with all of our clients and prospects in a way that maximized our chances of capturing more than our fair share of business now and as the market turns.

As we have said in the past, we will continue to make strategic hires, having added 30 plus professional in the last six months and acquire or fund businesses that are additive to our franchise, like a new convertible unit that we announced last quarter and which began trading at September.

At the same time, however, as evidenced by our cost-cutting actions, we are preceding with caution as we believe the breaks in the financial markets are likely to persist for some time.

As history has shown, difficult market conditions present opportunities for us to take advantage of our unique strengths and capabilities. With regard to our balance sheet, first and foremost it remains relative to our size the strongest in the industry. As mentioned in our release, at the end of the quarter we reported $450 million of capital all equity.

FBR Capital Markets is a firm that has historically performed well in challenging environment with substantial balance sheet strength, our franchise is as strongest it has ever been. The execution of the previously outlined activities to reduce cost and expand our capabilities along with our flexibility and adaptabilities of firm will lead to reduced volatility and to return to significant profitability as we take advantage of the environment in the evitable recovery.

We will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Eric Bertrand of Barclays Capital.

Eric Bertrand - Barclays Capital

Meaningful display in the recapitalization of the bank sector. How do you think about that opportunity given the context of the TARP Capital Purchase Program where the treasury actually directly investing in banks.

Eric Billings

So Eric, obviously that’s a good question and I think it's not clear to anybody at this time what the exact ramifications will be in this regard. Having said that I would tell you from my perspective I think it will probably in some ways enhance the ability to raise capital for many of these companies. And the reason I say that is two fold. Number one, this capital remember is trust preferred, or a preferred capital. It is long-term financing. It is not common tangible equity. When this companies all of them when they loose money they loose money through their common tangible equity.

So, in point of fact what the government is doing the TARP program is increasing the funding of long-term debt on these balance sheets. It is not in fact increasing the tangible common equity. And this is a paramount and important. I think there is going to be opportunities to talk to many of these companies and to do potentially transactions that can be simultaneous take downs of the government plan and simultaneously increase, I mean raise equity capital at prices that are maybe half, may not be a severe as they otherwise would and still will enhance the value of the franchise and create a great investment opportunity as people functionally or buying into great funding sources, deposit basis which obviously is the greatest value they ever have had because of the break in the capital markets.

So I think it's is going to be, there are going to be many hundreds of sales banks, the TARP program is not going to prevent that under any circumstances from our perspective and the opportunity to capitalize and recapitalize financial institutions will go and will be very, very significant.

Eric Bertrand - Barclays Capital

Okay. Thanks. The investment securities portfolio looks like about $11 million losses versus pretty much nothing last quarter and little bit the prior quarters. Is there any specific securities in that portfolio that generate loss to this quarter, how should we be thinking about the positioning of the whole portfolio?

Rick Hendrix

Eric, this is Rick. We don’t disclose the individual securities that we write down or take gains on until the Q is out. So, everybody live and update can see where that portfolio stands when we file, but we don’t disclose prior to that.

Eric Bertrand - Barclays Capital

Okay. Could you say whether there were any exposures to the GSEs or the sales broker dealer last quarter?

Rick Hendrix

There were no exposures to either -- neither of those activities. We actually did have and we kind of alluded to this in the press release. We had one floating rate agency mortgage security that was on repo at Lehman, when it failed, because as you know run a lot and cash and low leverage, we were able to assess it by the security back during the week between when the holding company filed and when the subsidiary filed the following weekend. And then held the security and cash over quarter end and refinanced it with another repo party in early October. So, that was the only potential exposure to Lehman and we didn’t have any negative impact from it.

Eric Bertrand - Barclays Capital

Okay, fair enough. And then one more question before I hop back in the queue. On the asset mentioned this actually, you talk about the flows during the quarter and kind of strategic initiatives in the business. Seems like the business continues to be performing whether low level, we are looking for some sort of element there?

Eric Billings

Sure. So again in terms of flows we are any different than any other mutual fund firm and in the sense that we had negative flows in the aggregate. Most of that has come in kind of our biggest fund, which is the FBR focused fund and inside of those number we have actually seen positive flows into our financial services bonds, particularly of late. As investors are looking at that as an opportunity.

And the relative performance of all of the funds continues to be in the very high percentiles of their peer group. So, while this is a difficult environment and nobody should be pleased with negative returns just because you are in the top percentile, some of these funds are new as we have talked about and are getting ready to reach the three year point and in their performance is going to generate very high rankings within mutual fund group and so we think we will see positive flows when they return to the industry overall.

But we certainly are not immune to the overall outflows that have taken place in the industry, and we do have some opportunities that we are pursuing for organic growth in that business overall and ride and get into each of those individual I think those are things hopefully we can talk about in coming quarters.

Eric Bertrand - Barclays Capital

Okay, fair enough. I will hop back in the queue. Thanks.

Operator

(Operator Instructions). Your next question comes from the line of Dan Fannon of Jefferies.

Dan Fannon - Jefferies

I wanted to talk a bit about the areas of strength when you say the market comes back, if you guys see I think you are well positioned, I think the banks would make sense in terms of what we are seeing for capital raises. But what other areas do you see that when you talk to your clients you think when the capital markets do open up when you are well positioned to benefit from activity you are in?

Eric Billings

So Dan, I think that the backlog of the activity that we have is building in a very robust way. Obviously, one of the things that people should keep in mind is that the capital markets have been now for months. Equity capital raising has been almost shutdown. I mean virtually unprecedented, and small cap companies, growth companies that we obviously focus on they are users of capital they need equity capital.

And so the fact that they have not had access, it doesn’t mean that they suddenly don’t need it, it means that it's been delayed but when they have access again they are going to robustly access the equity capital markets. And so, whether it's the entire figure for sure banks, structure finance the opportunity I think it will be enormous. I think that certainly we're seeing in our diversified industries area, our insurance area, our energy area we have -- it's a little bit different because of certain circumstance but we have numerous active -- transactions that we're looking at there.

And so I'd say really it's quite pervasive and I think we will see activities across the board, and I think you will see that our ability on things like the National Bank Holding company vehicle that we're creating. These vehicles will allow us to raise capital sooner than the markets actually come back and reopen on the general basis and which is certainly our history. But so I think will be other access and more quickly and then I do believe as the markets are open more broadly will have a very broad amount of capital raising activities.

Dan Fannon - Jefferies

And given some of the struggles in what were used to be your competitors are with the general have investment banking market. Are your dialogs changing? Are you used to talking to bigger companies? Are your the doors being open to people that you necessary want seeing or talking with before?

Rick Hendrix

You know Dan, this is Rick. I would say it's not so much or talking to people that we weren't talking to before. Although, I think that probably is a longer-term development that would be the case. But all the sudden we are having a different level of competition and in a lot of cases different dialog with our existing clients. And so, whereas -- we did a deal on the third quarter that we would have co-booked with one of the both record firms, just kind of based on history with that client and prior to some of the extreme dislocation with that particular company, the client had so book the transaction.

And we have transactions where we would have been a co-manager clearly where we are now a book running manager. And in some cases we are moving to the last of the biggest names in the industry and that is -- because when number things, it's because of concern -- specifically with some of the guys that met with the most the kind of severe disruptions. But it also as a function of the fact that we are getting our most senior resources in front of these clients and kind of the remaining large firms -- in our opinion are meaningfully distracted and so we think we are getting better resources, better ideas in front our clients and clients responding to that now.

As Eric said, the market is clearly not open, but our backlog is very solid, it's very solid across all of our history groups. We clearly need as everybody does, kind of a window to be able to execute but our relative positioning with our existing client base is in about to change, it has changed. And I don’t think will be so unique in that. I think other of the mid sized Peer firms should benefit from same kind of activity.

Dan Fannon - Jefferies

Okay, great. Thank you.

Eric Billings

Thanks, Dan.

Operator

(Operator Instructions) And there are no further questions at this time. I would now like to turn the call back over to Eric Billings, CEO for any closing remarks.

Eric Billings

Thank you everybody for joining us, we appreciated, and look forward to speaking with you next quarter.

Operator

This concludes today's conference call. You may now disconnect.

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Source: FBR Capital Markets Corporation, Q3 2008 Earnings Call Transcript
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