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GFI Group, Inc. (NYSE:GFIG)

Q3 2008 Earnings Call

October 31, 2008 8:30 am ET

Executives

Chris Giancarlo – EVP Corporate Development

Michael Gooch – Chairman and CEO

James Peers – CFO

Analysts

Don Fandetti – Citigroup

Chris Allen – Banc of America Securities

Analyst for Dan Fannon – Jefferies & Company

Chris Donat – Sandler O’Neill & Co.

Jonathan Casteleyn – Wachovia Capital Markets

Niamh Alexander – Keefe, Bruyette & Woods

Operator

Welcome to the third quarter 2008 GFI Group earnings conference call. At this time all participants are in a listen-only mode. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Mr. Chris Giancarlo. Please proceed.

Chris Giancarlo

Good morning. Welcome to the GFI Group’s third quarter of 2008 earnings conference call. We issued a press release yesterday providing the financial results for our fiscal quarter ended September 30, 2008 which is available on our website at www.gfigroup.com. We have also posted monthly revenue information for the quarter on our website under Supplementary Financial Information.

To begin this morning’s call, Michael Gooch, GFI’s Chairman and Chief Executive Officer will review our business performance in the third quarter, address some recent developments and consider expectations for the current period. Next Jim Peers, our Chief Financial Officer, will review in greater detail the financial results for the quarter. Following Jim, Mr. Gooch will conclude with a few remarks. Thereafter we will open up the call for your questions.

Our discussions during this conference call will include certain forward-looking statements. These statements are not guarantees of future performance. Actual results may differ materially from those expressed or implied from such forward-looking statements. More detailed information about the risks, uncertainties and other factors that may cause actual results to differ from such forward-looking statements are discussed in our filings with the SEC including our most recent annual report on form 10K.

Also, the discussions during this conference call may include certain financial measures that were not prepared in accordance with U.S. generally accepted accounting principles. Reconciliations of non-U.S. GAAP financial measures to the most directly comparable U.S. GAAP financial measures were included in the company’s earnings press release which was furnished on a current report on form 8K dated September 30, 2008. These reports are available on our web site under the Investor Relations section.

I will now turn the call over Michael Gooch, Chairman and Chief Executive Officer of GFI Group.

Michael Gooch

Good morning. Thank you for joining us today. We are conducting this morning’s earnings call against a very different landscape than the one we just did on August 1, the date of our last call. The change began most dramatically in September has been marked by extreme market volatility, adverse market conditions, unprecedented government intervention in the markets, consolidation in the dealer market and hedge funds forced to de-leverage or in some cases to close.

Our business was both challenged by these disruptive conditions and in other ways benefited from them. In turbulent markets the leading inter-brokers become more valuable to the dealer community providing access to ready and deep pools of trading liquidity. In assisting our business situation in September and based on our experience with past market disruptions we determined the best way to position ourselves for immediate challenges and future opportunities was to restructure our brokerage operations by closing under-performing desks and reducing headcount by 55, primarily in the front office resulting in a pre-tax charge of $14.5 million.

Several other non-recurring items are recorded in the third quarter which Jim Peers will discuss shortly. The charges resulted in a GAAP loss of $6.7 million or a loss of $0.06 per share for the third quarter. On a non-GAAP basis, however, net income and diluted EPS were $20 million or $0.17 per share.

Turning to my operations review, our total revenues in the third quarter 2008 were $243.1 million including the Lehman related charge. Our non-GAAP revenues were $252.7 million, a decrease of less than 1% from the same period last year. Trade port was a strong contributor to total revenues once again. Our brokerage revenues were 8% lower on a GAAP basis and 4% on a non-GAAP basis compared to the third quarter of 2007.

The third quarter 2007 marked the beginning of the sub-prime turmoil and led to record revenues for GFI at the time. The uneven flow of our revenues over the course of this year’s third quarter was described in our press release. It should be noted that the weakness in August revenues was also reported by several exchanges and we believe was not specific to GFI. That result was we had increased revenues from equity and commodity products that were offset by lower revenues from credit and financial products.

Nevertheless, in September our credit revenues were $33 million, up 41% over the prior September on a non-GAAP basis reflecting the high trading activity in credit in the eye of the storm. The largest change in the third quarter came from our credit product revenues which decreased 32% on a GAAP basis and 21% on a non-GAAP basis year-over-year compared with the third quarter of 2007.

In light of the strong performance in September and the extremely slow August was the major contributor to the declining credit revenues for the quarter versus the third quarter of 2007. This was partly due to the defection of a number of our New York credit brokers to a competitor in the second quarter, lower activity from counter-party de-leveraging and inter-trading in certain structure credit derivative markets in which we are a leading broker.

On the other hand, our cash fixed income business in Europe, especially our emerging market Euro bonds performed well in the quarter on a non-GAAP basis. Our bank and finance credit desk particularly benefited from the deep utilization of GFI’s credit match electronic trading platform.

Our revenues from equities products demonstrated the most significant growth in the third quarter and an increase of 18% year-over-year. That growth was driven in part by [un] volatility in global equity markets causing strong volumes in both cash equities and equity derivatives in Europe and North America. We believe that end-dealer brokers like GFI that can provide smart and effective execution to institutional market participants in the global equity markets become more valuable to their clients during periods of market turbulence.

Our commodity product revenues grew 5% year-over-year due mainly to the strength in Europe of wet freight, electric power, metals and emissions. Meanwhile we have rolled out our North American energy match electronic platform with contracts on ERCOT, the Texas Electricity grid at the end of July and the response, customer support and traction has exceeded expectations. In the next several weeks we will be launching similar electronic execution in additional energy markets. We expect these initiatives to be important contributors to our commodity product revenues going forward.

Our revenues from financial products were down 8% from the third quarter 2007 due to lower volume in various interest rate derivative products in the quarter. This was partly due to our disposal of our global U.S. dollar interest rate swaps business at the end of the first quarter 2008.

Looking at our performance in the third quarter 2008 by geography, brokerage revenues decreased 3% in Europe, 14% in North America and 5% in Asia Pacific compared with the third quarter 2007. On a non-GAAP basis, brokerage revenues were up 5% in Europe. Looking at our data, analytics and electric trading platform business I am pleased by the very strong performance of our new Trade Port subsidiary.

As you know Trade Port is the leading supplier of multi-asset class electronic trading and auto matching software for brokers, exchanges and traders worldwide. In just the past quarter Trade Port has signed long-term licensing deals with Bi-Cap Energy, Norway’s Renewable Energy Exchange (ECOMIX) and the Romanian Monetary Financial and Commodities Exchange (CYBEX). At the same time, the GFI Data and Analytics division has just signed a three year license for its Fenics FX derivatives pricing and risk management software to Bank of New York Mellon and extended its existing data agreement with Thomson Reuters to provide market participants with GFI credit derivatives FX options and energy market data for use in algorhythmic trading, risk managing, portfolio pricing and valuations. GFI and Thomson Reuters plan to extend this arrangement to equity derivatives and interest rate options early in 2009.

The new environment in financial derivatives is likely to make our data, analytics, valuation, risk management and trading platform services even more valuable on a go forward basis. The revenue from these products and services are likely to increase irrespective trading volumes in the underlying markets.

With my review of the third quarter complete, let me turn to current market conditions and GFI’s management plan. We are seeing across the board strength in equities, both cash and derivatives, and regional strength in commodities including energy, metals and shipping. We are also seeing particularly good activity in European cash bonds and CES.

Based on our revenues for October we currently expect the fourth quarter brokerage revenues will be approximately 4-7% below their level in the fourth quarter 2007 and total revenues will be down 1-4% compared to total revenues in the same quarter last year which also was record at the time.

Our restructuring initiative and the additional actions we took in the third quarter should assist us in achieving profits in an otherwise declining revenue environment. Longer term, we remain convinced the electronic trading platforms we have developed internally and will continue to develop in conjunction with Trade Port will help drive our future growth. We continue to see market automation as vitally important and plan to press forward with Credit Match in North America as well as our other electronic platforms in all regions.

We also support effective regulation to encourage greater market transparency in the OTC credit derivatives market in the U.S. and will continue our efforts to promote centralized OTC clearing of credit derivatives. The recently announced acquisition of the Clearing Corp. by ICE is actually an arrangement between ICE and the Clearing Corp. to form a New York Fed regulated bank and CDS clearing facility called ICE Trust. GFI is a shareholder in the Clearing Corp. and will be a preferred shareholder in the ICE Trust. GFI’s execution services will have open access to the ICE Trust clearinghouse.

We also believe other clearing mechanisms will also evolve as CDS in the European market where trading is far more automated and transparent than in the U.S. and GFI will certainly [inaudible] with these clearing solutions. As a leading independent, electronic alternative trading system provider for CDS, GFI welcome competition and transparency in the clearing of OTC credit derivatives.

If exchanges in listed credit futures develop, GFI intends to list those markets for execution alongside OTC credit derivatives on Credit Match, GFI’s ATS.

Our experience with energy markets post-Enron and the emergence of multiple clearing venues in both OTC and listed energy markets gives us some insight as to how credit markets will evolve in a cleared environment. A significant amount of energy trades that end up cleared with LCH, NYMEX and ICE clear across an IDB streaks. For example, we estimate that greater than ¾ of all OTC energy contracts cleared by NYMEX are generated by IDB’s such as GFI. We execute trade in both OTC and listed energy markets side by side and have a broad customer base for these energy markets.

I expect that the cleared credit markets will evolve in a similar fashion. Listed futures will enable even greater participation in the markets than currently exists. Trading opportunities and basis spread trading will evolve. Credit markets both listed and OTC will grow hand in hand and the government managed transparency will benefit the IDB’s just as it has in energy and equity markets. It may take some time but once the current de-leveraging environment completes its cycle I expect trading activity to once again grow across our markets and GFI’s investment in technology will position us to benefit tremendously.

Before I hand it over to Jim Peers I want to note briefly that we also announced yesterday the stepping down of Jurgen Bruer, a senior executive with the firm. I want to publicly thank Jurgen for his 10 years of fine service to GFI and wish him all the best.

I would now like to turn it all over to Jim Peers, our CFO, before making my concluding remarks.

James Peers

Thank you. Good morning everyone. Revenues decreased in the third quarter of 2008 compared to third quarter of 2007 by $11.6 million to $243.1 million compared to $254.7 million for the prior year. A $9.6 million charge on the Lehman unsettled trades before related reduction and compensation expenses of $3.5 million is included in revenues.

Non-GAAP revenues for the third quarter are $252.7 million compared to $254.7 million in the same period last year. Our Q3 saw strong organic growth from equities along with revenues of $8.2 million from Trade Port.

On a year-to-date basis, revenues increased by $96.1 million or 13.3% compared to the same period last year.

On a GAAP basis, the third quarter net income was a loss of $6.7 million compared to $25.9 million income in the third quarter of 2007. After backing out the non-GAAP items, which I will discuss in more detail later, third quarter net income was $20 million compared to $27.6 million in the third quarter of 2007.

On a year-to-date basis net income grew by 13% to $84 million compared to $74.3 million for the same period in 2007 on a non-GAAP basis.

Diluted earnings per share for the third quarter of 2008 was a loss of $0.06 compared to $0.22 in the third quarter of 2007. On non-GAAP basis diluted earnings per share for the third quarter of 2008 was $0.17 versus $0.23 for the same quarter last year.

For the first three quarters of 2008 diluted earnings per share on a non-GAAP basis grew 11.1% to $0.70 compared to $0.63 for the same period 2007.

Non-brokerage revenues decreased by approximately $9 million or 3.6% in the third quarter of 2008 compared to the third quarter last year. Credit was down 21.4%, financials were down 7.6%, commodities were up 4.7% and equities were up 19.1%. Brokerage revenues increased by 80.5% or 11.5% on a year-to-date basis compared to last year. Credit was up 4.5%, financials are up 2.7%, commodities are up 10.9% and equities are up slightly a [1/3] %.

Brokerage sign on bonuses paid in the third quarter of this year were $16.3 million compared to $9.1 million in the third quarter of last year. Brokerage sign on bonus expense were $14.6 million in Q3 2008 compared to $6.2 million in the third quarter of last year.

Our brokerage personnel headcount at the end of the third quarter stands at 1,082, up 61 from the third quarter of 2007. This does not reflect the 50+ brokers leaving as part of our restructuring plan. Change in broker headcount from the end of 2007 is an increase of 45.

Our year-to-date broker productivity has increased 2.5% to $726,000 compared to $708,000 last year.

Pre-tax margin for the third quarter 2008 was negative 4.4% compared to 16.7% for the same quarter last year on a GAAP basis. On a non-GAAP basis pre-tax margin for the third quarter 2008 was 12.4% versus 17.8% for the same quarter last year.

On a year-to-date basis, pre-tax margin was 10.2% compared to 16% for 2007 on a GAAP basis and on a non-GAAP basis pre-tax margin for year-to-date was 16% versus 17% for the same period last year.

In summary, our key performance drivers on a non-GAAP basis are as follows: Revenues for the third quarter are down less than 1% from the third quarter 2007. Trade Port revenues for the third quarter were $8.2 million and are included in the software licensing revenue line. Our comp costs are at 62.9% for the third quarter this year compared to 62.4% for Q3 2007. On a year-to-date basis the comp costs are 61.6% compared to 62.6% for the same period last year. Non-compensation expenses in the third quarter as a percentage of revenues were 24.6% compared to 19.8% for the same period last year. Our non-comp ratio on a year-to-date basis was 22.4% compared to 20.3% for the same period last year. The increase was mainly attributed to increased legal costs, T&E expenses and clearing fees.

GFI’s effective tax rate is currently 36.5% compared to 38% for the full year 2007.

I would now like to highlight some other areas that will be of interest to you. The number of diluted shares for the quarter ended September were 119 million shares on a non-GAAP basis. The non-GAAP adjustments were made in the third quarter. Our move to New York to 55 Water Street is complete. Accordingly the company has excluded $850,000 in duplicate rent and charged $7.8 million in costs related to the move and the abandonment of its previous premise at 100 Wall Street.

Comp costs include $21 million related to desk closing and other restructuring costs. The net charge related to Lehman unsettled trades was $6.1 million before tax and we are carrying the unsettled bonds at $3.1 million on our balance sheet. Our accounts receivable written off were approximately $600,000. We have not reflected any future recoveries in these charges. We have also written off an investment in a small unconsolidated affiliate for approximately [inaudible]. The discontinued merger talks with Tullet Prebon would also expense $1.8 million and professional fees related to the talks.

That concludes my remarks. Now I will turn the presentation back to Michael for some closing comments.

Michael Gooch

In conclusion, despite the momentous market events of the third quarter and the substantial challenges we faced in the U.S. credit markets our balanced and diverse revenue stream across products and regions served us well as has our solid financial position. We have further strengthened our company through our restructuring initiative which will help us move forward in our continued effort to improve operating leverage. We also continue to execute our hybrid brokerage strategy of melding both man and machine for its benefits to our markets and our growth.

We believe GFI is now in a better position to face current challenges as well as seize future opportunities including those presented by any further market structure changes in the global credit markets. Our board remains committed to improving shareholder value. We are pleased to have been able to declare a cash dividend of $0.05 per share for the quarter. Thank you for your time and attention today.

We are now ready to take your questions.

Question-and-answer Session

Operator

(Operator Instructions) The first question comes from Don Fandetti – Citigroup.

Don Fandetti – Citigroup

Broadly speaking and obviously there is a risk of less OTC business, more regulatory pressures and greater exchange involvement. Is the IDB model at risk here and do you feel a need to sort of morph your business over time? I just wanted to see if you could comment on that.

Michael Gooch

You are talking particularly about all of the various financial markets or are you just specifically focusing on credit?

Don Fandetti – Citigroup

I would say in general. I think the issues in credit are obviously highlighted but I think there are sort of implications in other OTC products in general, just longer term.

Michael Gooch

I think I made the point in my presentation about what happened after Enron disruption and there became the issue of counter-party risk in the energy markets and clearing of OTC energy developed and the IDB’s actually across north of 75% of all of the OTC energy markets that are then cleared on LCH, Ice Clear and NYMEX and I could imagine a similar situation is going to evolve. There is already centralized clearing in certain OTC markets including LCH and B Clear in London. B Clear is part of Eurex which is part of the NY Stock Exchange. So there is already precedent for this. What the IDB’s do is we simply send the transaction to clearing at whichever clearing entity the customer requests or in some cases we are actually paid a rebate for steering the clearing to those entities and they compete for the clearing business. The European regulators are quite keen to have very open, flat clearing mechanisms that are in competition with each other as opposed to the CME would seem to have quite a monopoly position in the interest rate futures.

I think from our perspective we will continue to be an execution broker. We operate now what is known in the regulated markets as an alternative trading system. It is regulated in ETS, electronic trading systems, we obviously do a lot of voice brokered business and a lot of that stuff is on the screens and trade side by side with the futures. I think one of the misnomers of the marketplace is this mixed comprehension that when “something” goes to the exchange somehow it is now getting crossed in a different environment when in fact a significant amount of those transactions actually get crossed upstairs at IDB’s on their trading platforms and so I think that is how this going to develop. I think we will certainly have to morph somewhat. We will absolutely find that our investment in Trade Port is going to pay off because the demand for electronic trading will increase which suits us anyway and we will need to morph with the market in order to put listed and OTC centrally cleared markets next to each other.

In the event things need to be posted on the exchange, that is just simply a mechanism that occurs on the electronic trading screen. We could in fact, relatively simply, it would take six months and $2 million to form our own exchange subsidiary where we could post trades and we are connected to multiple clearing houses now so I think you will find we are going to be extremely well positioned in this marketplace going forward.

Don Fandetti – Citigroup

On your bank line can you just remind us what the covenants are?

James Peers

Currently our bank facility loans outstanding are $232 million which the private is $60 million and the bank facility is $172 million. The private facility matures January 2013 and the bank facility matures 2011. So therefore we have an unused borrowing capacity of $93 million. We are in compliance with all of our key covenants and the three key covenants are the leverage ratio which is at 2.5 to 1 and we are actually less than 1.5 to 1. Fixed charge coverage ratio is 1.25 to 1. We are nowhere near that ratio. The other ratio is we have to have equity greater than $325 million and at the end of the third quarter we actually had $482 million. So to give you some idea, using our current EBITDA rate we could have debt outstanding of $385 million compared to the $232 million we presently have on our balance sheet. Then also I think it is worth noting the cash on our balance sheet at the end of September is just shy of $350 million and less restricted cash required for regulatory reasons and clearing we have about $172 million available unrestricted cash right now.

Michael Gooch

I’ll actually add something to that. Just to put that into some further clarity that would mean that if we wanted to we could actually reduce our debt right now to about $50 million. We are not doing that at this point. We are actually keeping cash in the balance sheet. I, needless to say, have always subscribed to the concept you should have a strong balance sheet exactly for these circumstances when credit becomes tight. Just looking back it is interesting comparison and noticed that when we went public in 2005 at the end of the first quarter 2005 our cash and cash equivalents on the balance sheet were $104 million and today it is just shy of $350 million. Our shareholders equity in March 2005 was $166 million and now it is $482 million. In terms of our balance sheet and debt facilities and cash on hand I believe we are very well positioned.

Operator

The next question comes from Chris Allen – Banc of America Securities.

Chris Allen – Banc of America Securities

Can you just give us some color in terms of how the reduction of 55 brokers will impact your comp to revenue ratio and your non-comp expenses?

James Peers

Yes. We anticipate that the annual cost savings is going to be somewhere around $18.5 million which would have roughly an impact of about $0.10 per year. From a revenue perspective the amount of revenue lost worst case scenario if you assume we were never able to get some of that revenue back would be less than 1% so it is not significant. So we will continue to monitor those costs but that is where we think we are going to be approximately. Most of those costs will start hitting the fourth quarter because almost all of these 55 people will be leaving in the fourth quarter.

Chris Allen – Banc of America Securities

If you could give us some color, when Enron happened we saw shrinkage of the energy market and kind of a re-acceleration of growth and I think your energy revenues fell about 40% once volatility settled down before they started accelerating again post-Enron. Do you see a similar scenario playing out in the credit markets here?

Michael Gooch

I think that is possible. What I have noticed is that the European credit markets have remained far more robust and I think that is partly because of the fact that the markets are far more electronic, 50-60% electronic, and there is much greater transparency in the European markets and I think that has added to user confidence in the market so I think that is one of the things that will benefit going forward when regulator mandated transparency comes to the U.S. markets it would certainly suit us if they would encourage electronic trading in North American credit in order to bring further transparency to the marketplace and to give further confidence to investors. I wouldn’t be surprised if we see similar environment we did in Europe and funny enough after Enron it was the North American market where we saw the biggest decline in energy trading. The European markets held up much better and hardly declined at all in fact. Then we saw revenues come back substantially after the introduction of various other things like centralized clearing for OTC energy and just to put it in perspective prior to Enron’s demise we had $60 million in revenue in energy and today we have something close to three times that revenue in energy. So I wouldn’t be surprised that once we sort of get through that restructuring period we see something very similar in the credit markets especially if futures on credits are introduced which will mean we can see a significantly larger amount of participants in the marketplace. There will be a lot more basis trading. I see now in some news reports that lending is now being tied to credit specs. I have been talking to traders who tell me their customer trading counter-party limits are being tied to credit spreads. So the fact of the matter is CDS is here to stay. It is not going anywhere. It is just going to become a much better, stronger, more transparent market and we are extremely well positioned to benefit from that going forward.

Chris Allen – Banc of America Securities

Obviously everyone is worried right now where trading volumes head for a variety of reasons, de-leveraging, U.S. bank consolidation, in terms of the economy. Can you give us a sense in terms of how October has held up relative to September? I know you pointed to some areas of strength. But, are you starting to see volume fall off a little bit in October and how should we think about the run rate going forward?

Michael Gooch

Basically what we have seen in October is bare in mind October a year ago was a very big month. What we are seeing for all of October now is decline of about 5% something in that region. It is tailing off a little bit towards the end of October. It certainly was more active in the first three weeks. I think this is where we are sort of coming up with our projection for the rest of the year. It is difficult to really be completely certain what is going to happen but last year in December the last two weeks of the year were virtually dead the last two weeks of December. We don’t think that is going to happen this year because there has been so much turmoil in the marketplace we think there is going to be a significant amount of year-end adjustments to balance sheets and positions just because of such significant moves in underlying positions in things.

So we expect November to be similar to October and flat to small down, could even be 7-10% down because you also have to look at the number of trading days in November with Thanksgiving and those things, but I would expect December to be better than last December. That is where we are coming up with our analysis for the full quarter of down 4-7% and down maybe 1-4% if you include our data and analytics and trading platform sales. Because data and analytics and trading platform sales shouldn’t be affected by trading volumes.

So going out into 2009, we don’t have a totally clear picture of how that is going to transpire. It is impossible really to sit here and say trading volumes won’t be negatively affected by de-leveraging. With a number of hedge funds closing down since I have always said historically a lot of our volume was being driven by the proliferation of hedge funds it would be crazy for me to say the opposite would not be true in a hedge fund de-leveraging environment. At the same time there are other wins that serve us extremely well. We have an extremely high level of volatility right now. Currency options, Sterling volatility, Euro volatility up in the high teens when we have seen it as high as 30% in Sterling with mix at 80%, these volatility levels frankly I don’t expect they will remain at those levels. I’m sure they will settle down. But there will still be pretty robust volatility there. It should be one of the counter-balances to the de-leveraging. At the same time there are still other things that are going to be occurring over the next year. We are going to have a new President. I’m sure we are going to have a few more shake outs in the equity markets. I don’t think that everything is completely done there. I think there is going to be a number of things that will keep us busy which makes it very, very difficult right now to permeate exactly how 2009 is going to come out.

Operator

The next question comes from Dan Fannon – Jefferies & Company.

Analyst for Dan Fannon – Jefferies & Company

First of all, how do you think ICE’s acquisition of the Clearing Corp. potentially impacts your order flow specifically in credit products?

Michael Gooch

I don’t think it impacts it. It might enhance it at some point. What is actually occurring, just to clarify the acquisition, is that it is a joint venture between ICE and the Clearing Corp. and so the way it is being structured is that a new entity, Ice Trust, is a subsidiary of ICE is created. That is acquiring the Clearing Corp. Then the Clearing Corp. members get some cash for their stock in the Clearing Corp., so I think we get substantially most of our investment returned to us and then we end up with preferred shares which represent our economic interest in the profitability from the Clearing Corp. So 50% of that profitability will flow to the current Clearing Corp. members who have preferred share ownership. So even though it is being described in the press as an acquisition which it technically is an acquisition of the actual entity, but it is an acquisition in a restructuring form which then gives the existing Clearing Corp. members which includes GFI, includes I Cap, it includes Mann Financial, includes Eurex, we continue to be shareholders; preferred shareholders with an element interest in the profitability of that. I spoke with Jess [Broker] yesterday with ICE and reconfirmed it is in the letter of intent anyway but reconfirmed with him in a telephone conversation there will be complete, open and transparent access to the clearing mechanism for all IDB’s on an equal basis. That will just be one of certain clearing mechanisms that will probably develop for the clearing of credit derivatives.

So, in terms of what that means for us I think it just means we are more likely to move towards a transparent, electronic environment we are ready to launch in North America any time that the regulators may mandate and we are able to from our platform go one click of multi-clearing mechanisms. We will just be trading as usual. Hopefully liquidity will grow in the marketplace once it is transparent like it is in Europe and the clearing will just click straight through to the clearing house most likely through some mechanism that uses DTTC and Slotswire and Market which the dealers own and I think from our perspective it doesn’t have significant impacts on our day to day business other than create opportunity.

Analyst for Dan Fannon – Jefferies & Company

Just assuming the credit business is somewhat slow here for the next couple of quarters, what other areas do you guys see or are you targeting for growth looking out into the future?

Michael Gooch

We are certainly targeting energy still. We don’t see any reason why energy markets shouldn’t continue to be active. We mentioned in my statements we rolled out electronic trading of ERCOT in North America, the Texas Energy Grid, and we are rolling out our electronic trading platform to other energy markets. These all have clearing mechanisms. It is electronic trading of energy in an ATS environment with trade through process in clearing. So I see opportunity in energy. I see opportunity in currency derivatives in emerging markets still. I see significant opportunity in equities and equity derivatives.

Operator

The next question comes from Chris Donat – Sandler O’Neill & Co.

Chris Donat – Sandler O’Neill & Co.

Could you give us a little color on the geographies and products that the restructuring is backing and maybe also give us a little color on you added 17 brokers in the course of the quarter if that plays into it at all, or if you are shifting people around desks or around products?

Michael Gooch

What we have done is we have had some businesses where we were attempting to grow areas where we were not particularly competitive, mostly in interest rate derivatives. It is the area where GFI’s weakest is interstate swaps. We disposed of our interstate swap business back in the first quarter of 2008. Some of these businesses were just sort of under performing. They were desks that didn’t have much revenue but we had some fixed costs associated with them, brokers that weren’t performing so we just closed them down. In terms of adding brokers, where we have been adding brokers is we have been adding brokers to areas where we have strong market share and want to continue to grow that market share.

James Peers

The other comment I would say too was that the desk closings both from the headcount and also from cost was pretty evenly distributed between the regions.

Chris Donat – Sandler O’Neill & Co.

Looking forward into the fourth quarter we have typically seen an up tick in some of the non-comp expenses. I was wondering if you have any views on that given the unusual market we are in now with things like T&E may not increase as much as it typically does in the fourth quarter.

James Speer

I think we still are spending time with our customers because of layoffs and staying close to them but also at the same time I think we have put specific spending limits on T&E so our objective hopefully is to come down from what we did in the last quarter of last year.

With regards to professional fees some of that is still being driven by the costs related to the brokers leaving the NY Credit to a certain extent and the others are sort of tracking on target. Then the other one that continues to increase in clearing and the main driver of clearing is because equities have become a major portion of our total revenue streams during the quarter in absolute dollars and as a percentage that cost goes up.

Chris Donat – Sandler O’Neill & Co.

I have to ask; in terms of I know you talked about capital and the importance of having a strong balance sheet in this environment. Any view on buying back shares under these circumstances?

Michael Gooch

One of the things is it is public information so you can pull it up but within our banking covenants we do actually have limitations on share buy backs and dividends. This wouldn’t be a brilliant environment to go ask the banks to change a covenant on a debt facility so we have been limited in our ability to do that in any case. I favor keeping a strong balance sheet in this environment.

Chris Donat – Sandler O’Neill & Co.

Are those covenants anything you are near now?

Michael Gooch

No, these are covenants against buying stock. In other words, when we have a bank facility the bank as one of its covenants says you cannot buy more than X amount of stock per annum or X dollars of stock per annum. Because they don’t want you using their borrowed money to buy your stock and worsen their position against your balance sheet without their permission. So we have limitations within our existing bank facility as to how much we can invest in the stock of our own company. So without that being changed by the banks we are somewhat limited to the extent that we can do those kinds of operations anyway. We have historically bought the stock in the market that we have given to employees in RSU’s and that would continue.

Operator

The next question comes from Jonathan Casteleyn – Wachovia Capital Markets.

Jonathan Casteleyn – Wachovia Capital Markets

I’d like to understand some information about customer concentration. I think at one point you have talked about your biggest customer being 6% of your brokerage revenues. Considering the environment has that number markedly changed considering broker dealers are in and out and consolidating, etc.?

Michael Gooch

No that really hasn’t changed. There certainly has been some flight to quality I would say banks like JP Morgan are probably getting a bigger market share right now in some of the other counter markets because they have a stronger balance sheet. But we haven’t seen any significant change in that ratio. In fact, there has been some disruption in merger and in one case bankruptcy and in one case the Bear Stearns merger into JP Morgan. In terms of what effect that has had on that business it has just sort of spread it around. In the case of your own company, Wachovia, there are areas where Wachovia was not particularly active with us and not necessarily particularly with us but the markets and well known for being active in derivatives and the merger you guys are doing hasn’t had any impact on us because Wells Fargo wasn’t even a player at all.

In some instances there is actually an opportunity out of some of these movements around the market in terms of different mergers and acquisitions.

Jonathan Casteleyn – Wachovia Capital Markets

I’m just wondering what barometers do you look at overall in the environment to kind of forecast the turn here. I understand the environment is changing now but just from your vantage point as we start on the repair and to liquefy credit markets what do you sort of look at as to when we can see a fundamental change in the business?

Michael Gooch

I think it will be when banks start lending again to corporate customers in the more normal fashion. Right now the bank to bank credit markets are open because there are various government guarantees and things and the derivative markets continue to trade because the OTC derivatives they are margined between the counter parties and they have these overall contracts that offset things. So there is a big difference between lending somebody $1 billion and trading $1 billion of OTC derivatives. You’ve only got mark to market exposure on the $1 billion in derivatives and you’ve got margin to protect yourself and you have offsetting contracts and overall contract agreements whereas if you lend someone $1 billion you are risking $1 billion.

Until the lending markets free up I would expect to continue to have concerns about growth in the business going forward. I am working under the assumption the lending markets will eventually free up. I think it is the government’s intention for that to be the case and I am pretty confident in the next 12-18 months that is going to occur.

Jonathan Casteleyn – Wachovia Capital Markets

Just so I understand the impact of any CDS clearing plan, does the CDS business internally migrate to the economics of your equity business because obviously there is a pass through of clearing fees so the margin would come down slightly I believe. Is that correct?

Michael Gooch

I think it will potentially migrate to the economics of our energy business which is a little different. We don’t actually have to pay clearing fees. We cross the trades and then send them to clearing but we are not the actual counter party. The thing about equities and cash fixed income is our clearing mechanism is actually standing in the middle of the trade and as a result of that we pay the clearing fee directly to the clearing entity whereas in the energy markets we just send them to clearing without actually paying them a clearing fee. In fact, we actually get a rebate in some instances in energy. So I think in the credit environment it is going to be similar.

I think that the margin in the business might become a little tighter for our customers. That does tend to flow down to the IDB. I would imagine though that volumes eventually will result in an increase as a result of the transparency and the centralized clearing. So it will be a balance between tighter margins, lower commissions and higher volumes.

Jonathan Casteleyn – Wachovia Capital Markets

Can you just comment broadly on the M&A environment in the sector? I understand that valuations are clearly distressed but when does it make sense to sort of think about more…I guess defensive acquisitions or strategic activities of that kind of nature?

Michael Gooch

I think right now we are obviously a very attractive merger target because we have got our share price below our book value and is barely above our cash on the balance sheet and we are very profitable other than this quarter obviously where we had the write offs. So, naturally there are individuals and companies out there that would like to have discussions. I think it would be very difficult to do M&A in this environment. I think it is going to be very difficult to do M&A whilst the banks aren’t lending. One of the reasons our Tullet deal couldn’t go forward was because it was certainly in my opinion and some others it would be very difficult to have arranged for the credit facilities because the transaction would have triggered a change in control covenants within the banking facilities and the banks at this point in this environment just don’t want to lend. So it is going to be difficult to do mergers unless they are mergers where the companies have very little or insignificant debt.

Companies that have a significant amount of debt are going to be in a very weakened position when they are trying to do mergers. I think if you are positioned like a company like GFI where the shares are trading below book value and you’ve got very little debt and a strong balance sheet I think from our perspective we are best served by waiting to see how some of the other companies that we would be interested in merging with how they shake out in this difficult environment especially if they have issues with debt on the balance sheet. I think it is going to take 6-9 months for anything really interesting to happen. Everything is frozen up and I don’t think you are going to get any significant merger activity in the next 6-9 months.

Operator

The next question comes from Niamh Alexander – Keefe, Bruyette & Woods.

Niamh Alexander – Keefe, Bruyette & Woods

Can I just get a clarification on the ICE…did you say it was 50% of the economics and then the profitability or is it kind of a revenue sharing arrangement for a few years? The other thing I just want to understand given the environment we are in and the restructuring you put through which was a quick reaction to a rapidly changing market, are there significant guarantee obligations with your producers right now? How should we think about the flexibility with respect to the cost base?

Michael Gooch

The arrangement with ICE Clearing it is only a letter of intent right now. So, they still could get a Fed banking notice. They still need a number of hurdles to be crossed. The mechanism is an economic interest, preferred stock 50% of the economic interest so the profitability will flow to the existing Clearing Corp. members. It is part of the mechanism to encourage the banks that are participants and the IDB’s and various other parties like Mann Financial that would also be a source of trading activity to send business to that clearing corp. It is an economic interest but it is forever. These are preferred shares in the new entity. What is anticipated is that is forever. Then on your second question, we have approximately 13% of revenue if you want to take into consideration total compensation and bonus commitments of GFI it represents about 13% of our revenue. In fact right now it is probably a little bit lower because we eliminated some of the non-performing desks. So in terms of guarantees, compensation guarantees and base salaries it represents a very small percentage of our total revenue. That is a good thing to say.

Niamh Alexander – Keefe, Bruyette & Woods

How do you view the risks in your business now versus six months ago? Has anything changed that drastically and if you could just share your thoughts on that.

Michael Gooch

Six months ago we would have never believed that a Lehman bankruptcy, first of all it would have been very surprising to even imagine it would occur, we always sort of looked at the street as being too big to fail or it is just unprecedented circumstances that led to that. Some of it being political. In terms of the way the British decided to incorporate the bankruptcy rules into the receivership and wind down with Lehman was surprising. So in terms of the way we look at counter party risk, we are far more cautious now in terms of concerning ourselves with how any kind of bankruptcy like that would occur. So I would say we are just certainly more cautious.

Chris Giancarlo

This concludes the GFI Group third quarter 2008 earnings conference call. Thank you all for joining in.

Operator

Thank you for your participation in today’s conference. This concludes today’s call. You may now disconnect.

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Source: GFI Group, Inc. Q3 2008 Earnings Call Transcript
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