An Interesting Opportunity in FCStone Group

Nov. 6.08 | About: FCStone (FCSX)

FCStone Group, Inc. (FCSX) has found itself in quite an embarrassing predicament. The company issued an announcement Monday that it would set aside $25 million for bad debts in the first quarter of this year (the company’s fiscal year end is August). According to the release, there are three accounts in question, an energy trading account and two smaller accounts dealing with renewable fuels and foreign exchange.

It is somewhat ironic that the company is facing such challenges considering the fact that the company specializes in risk management for clients. Many different firms from varying industries hire FCStone as a consultant to review practices, and develop procedures to mitigate risks associated with fluctuating costs, revenue streams, or production levels. It certainly does not bode well for such a company to have so many in-house risks that it has been unable to properly manage.

In fairness to FCSX, one should understand that its business is inherently risky and unprecedented dislocations in many markets has presented enormous challenges. FCStone operates as a clearing agent for many contracts its customers use for risk management purposes. As such, FCSX essentially takes on risk by providing an exchange for these contracts to be traded on.  FCSX will require customers to put up a reasonable amount of collateral in order to mitigate this risk, but when markets move well outside normal ranges, that collateral only goes so far.  Typically a clearing agent would offset its risk by demanding more capital or selling a customer out of a position but since many of these contracts are illiquid and not standardized this is nearly impossible.

Still, investors obviously didn’t respond positively to the news. The stock lost another 39% of its value on Tuesday trading to a new low since its March 2007 debut.  While the stock rebounded a bit during Wednesday’s session, it still closed below $4.00 and is less than a quarter of the IPO value from 20 months ago.  Management stated that it now expects its provisions to be adequate for the bad debt.  It also stated that the company has beefed up its risk management staff and has conducted a complex review of all its accounts.  While this may be true, it will still take quite a bit of work to regain credibility in the eyes of investors.  One of the metrics that the press release pointed to was the fact that on May 31, shareholders equity was $217 million.  That is nearly double the current market cap, but one can hardly put any faith in a number from May in this environment.

Although the series of events have been disappointing, the opportunity in the stock is now quite interesting.  The company will report earnings on November 13.  Investors will expect (and even demand) a comprehensive analysis of the company’s financials.  This event will likely have one of two outcomes.  Either management will be able to assuage investors’ fear and the stock will trade substantially higher, or the market will lose any remaining hope for the company and all bets will be off.  I realize that this scenario does very little to instill confidence in the stock at this point, but I believe there is an opportunity for a measured speculative trade on this name.

Imagine someone offers you a chance to roll a dice and agrees to pay you $100 if the number is odd, and will take $50 if the number is even.  As long as you could live without the $50 (and as long as the dice is not loaded) you would be a fool not to take his bet.  Essentially the FCSX scenario looks like a similar bet.  Now that the stock is trading for $4.00 there is little hope that the company will return to its previous state anytime soon.  But FCSX is not likely to declare bankruptcy in the next few months (if that were true it wouldn’t have survived through the last month).  The stock could take a bit of a shot if the earnings call does not go well, but the potential for it to rally sharply (100% or more) seems a reasonable possibility.

Now I would not suggest throwing a large sum of money at the stock right now.  The uncertainty is simply too great.  But similar to a call option, the potential reward seems to offset the risk for a small amount of capital.  I find the idea of purchasing the stock before the earnings announcement to be a very interesting trade.

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FCSX Notes

Disclosure: Author does not have a position in FCSX.