GFI Group: Loss Reported in Murphy’s Law Quarter

Investors weren’t expecting much in the way of good news as inter-dealer broker GFI Group (GFIG) reported earnings on Thursday, after the bell. Shares are down 80% YTD and over 60% in the past month, as several of the company’s core markets - OTC derivatives trading - experienced massively lower volumes, and many industry watchers wonder if OTC derivatives are going the way of the dodo bird.

General de-leveraging activities have reduced the amount of money sloshing around the derivatives markets, so it’s impossible to tell just what the new average trading volumes will be for credit derivatives, forex, and equity derivatives. Going in, I was expecting the worst for the third quarter, while volumes in certain areas have been high (such as equity derivatives), the “work stoppage” in the credit markets was too steep to ignore.

Is There 80% Business Deterioration Here?

Overall, I was pleasantly surprised that total brokerage revenues were only down 8% in the third quarter, to $226 million. GFI reported a net loss of $0.06/share, but several one-time charges affected the results. Management is cutting 55 brokers to help cut costs (some of their isolated credit products may never get back to prior volumes), which added a pre-tax expense of $14.5 million. The company also recorded $9.6 million of charges related to the Lehman bankruptcy. Non-GAAP EPS came in at $0.17, which is $0.02 below estimates.

The growth trends within GFI’s brokerage business speak volumes about our market. Credit market revenues were down 32% YoY, while equity market revenues were up 18%. Commodity product revenues were up 5%, and the company’s nascent data/analytics segment posted strong growth of over 200%, adding $14 million to the top line during the quarter.

Even more telling was how volatile derivatives trading has become for the institutions. Within the third quarter months, July was roughly flat, while August saw trading revenues down 29% year-over-year. Then in September (when the financial crisis first struck blood), trading revenues were up 30% YoY. If uncertainty in the markets continues to lead to higher hedging activity, GFI should see overall growth in equity, forex, and commodity-based revenues. Credit product revenues will continue to fall, and many will likely end up on a regulated exchange by this time next year.

Guidance & Prospects

For now, management is guiding towards total fourth quarter revenues down 1% - 4% from 2007’s $243 million. I see this quarter as proof that the company can stabilize itself in any environment, and absent further restructuring charges, the company should be able to deliver between $0.10 and $0.15 EPS in the fourth quarter. The current estimates are closer to $0.20, but these will be coming down swiftly as the analyst community digests the quarterly guidance and results.

If I can draw up any reasonable earnings run-rate from the current (depressed) levels, I can get to annual EPS of $0.50 to $0.75 pretty easily. This puts the forward P/E of GFI at between six and eight times with a lot of upside potential (God forbid the speculators come back - this company was chugging along at 30% growth before the credit collapse of the past year). There is ample downside protection with a 0.8 Price/Book ratio and a dividend yield over 5%, making this a compelling growth/value hybrid stock.

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Disclosure: None

Comments

[Elliot Eise...:]

Believe you are on the right track.

The bad news is that disappearance of Lehman and Bear Stearns means fewer true brokerage customers for GFIG in its role as 'street broker.'

The good news is that what were once street brokers are becoming more and more important as anonymous intermediaries between large -- and not so large -- funds.

The agency business model of street brokers is very appealing. Ie, after showing anonymous bids and offers, matching trades, in most cases GFIG doesnt get in between the buyer and seller. In one of several ways, it 'gives up' one side to another, allowing them to settle directly. GFIG then sends one side, usually the seller, an invoice for putting the trade together.

How the two sides settle up is changing. Gooch points out that rather than writing a broker-to-broker ticket on each side, increasingly such trades are being sent to an exchange or other similar platform. He adds that for $2 million and six months' time, GFIG could establish its own exchange.

That may make GFIG an acquisition target. He says:

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.


At another point, Gooch says:

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.

2008 Nov 03 09:39 AM