Before Penson Worldwide's (OTC:PNSN) IPO this month, Bill Simpson wrote a detailed analysis of the company and offering. PNSN shares priced at $17--the high end of its range-- on May 17th. The text of Mr. Simpson's original writeup follows.
PNSN, Penson Worldwide plans on offering 7.5 million shares (1.2 million from insiders) at a range of $15-$17. JP Morgan and Credit Suisse are lead managing the offering. Post-offering PNSN will have approximately 24 million shares outstanding for a market cap mid-range of $384 million. About 1/3 of the IPO proceeds will be utilized to repay all long term debt, the remaining 2/3's will be used to grow capital base allowing for increased margin lending. Executives/ Directors will own 50% of PNSN outstanding shares post-offering.
From the prospectus:
We are a leading provider of a broad range of critical securities-processing infrastructure products and services to the global securities and investment industry. Our products and services include securities and futures clearing, margin lending, facilities management, technology and other related offerings to broker-dealers, hedge funds, banks and financial technology firms.
Think of PNSN as the back office for direct access brokers, online brokers and retail brokers. They handle clearing and margin lending so that brokers do not have to devote hefty resources in that area. Note too that PNSN has recently bulked up their information services area, although primary revenue driver is back office operations, primarily clearing and margin lending. Still revenues consist primarily of transaction processing fees earned from clearing operations, interest income earned from margin lending activities and from investing customers' cash. Clearing fees and interest accounted for 85% of 2005 revenue.
PNSN was founded in 1995 and currently operates in the U.S., Canada and the U.K. Principal clients are direct access and online brokers, PNSN has a current total of 220 active clients. Direct access brokers accounted for 27% of '05 revenues, traditional retail brokers15% and online brokers 22%.
PNSN is a play on the return of the individual to the market. The stronger trading volumes are and the more margin is utilized, the better results PNSN will post. It is pretty much that simple. A key here is also are lending rates. A large component of PNSN's income is derived from interest on margin lending/ cash, PNSN has benefited past 2 years from rising interest rates. Interest revenues alone accounted for over 50% of 2005 overall revenue.
Unlike most other major clearing providers, PNSN is not affiliated with a large financial institution and generally does not compete with clients in other lines of business. This is a niche characterized by similar operations being affiliated with a larger entity such as Goldman Sachs, Bear Stearns, Fidelity, Merrill Lynch etc.... PNSN is leading independent provider in the niche market segment and feels it gives them an advantage as differentiating factor. Note that this is not the same as making a market in a security. PNSN does not participate in actual market making, placing orders for clients or proprietary trading.
Technology and information services: PNSN has made a few purchases the past few years to bulk up their technology platforms and also provide a wider variety of information services to customers. Currently PNSN offers customizable trading platforms for direct access brokers as well as comprehensive historical equity and option chain prices. In addition to their clearing and margin lending services, PNSN offers these additional services to broker clients. For the most part they're offered on a private label basis so the broker can slap their own name on the service available to brokerage clients. While this niche accounted for just 4% of overall '05 revenue, PNSN feels adding extra services helps them grab and retain more clearing business.
PNSN's goal is to handle data services, trading platforms and all back office clearing and margin lending for brokerage clients.
Note that immediately prior to IPO non-core business segment know as SAMCO is being removed from PNSN. SAMCO is up for sale and will be listed as 'discontinued operations' until it is sold.
Ten largest clients accounted for 31.8% of '05 revenue.
In addition to various brokers, customers include CBOE and Nasdaq.
$3 1/2 per share in cash post-offering, no debt. 2.4 X's book at $16. Revenues have benefited from the increased use of brokerage margin the past few years, notably 2005. As noted above, margin interest accounted for about 50% of PNSN's revenues in 2005 and is primarily responsible for overall revenue growth. Clearing fees actually declined in 2005 due to the loss of PNSN's largest client. The decline was minimal as increased business from others nearly made up the loss. Clearing fees, the largest % of revenue until 2005, have been pretty flat overall the past 5 years. PNSN has become a margin lending growth story the past 2 years. Fueled by margin interest, 2005 revenues (even with the flat clearing fee intake) were up 51% in 2005 to $174.5 million. PNSN exists in a low margin highly competitive sector. Employee compensation and benefits have grown a little too fast for my taste -- Clearing fees have been stagnant, yet employee fees/ compensation have grown at a pace similar to margin interest, up 50% in 2005. I'd much rather see more restrained operating expenses here, especially with revenue growth coming from a tangential area. PNSN already had the infrastructure in place to handle the clearing fee flow; I feel that the huge margin increase to revenues did not need to see a similar % increase to employee expenses. It appears to me to be a little too much fat on that expense line in 2005. Note that much of the increase is due to employee bonuses and performance based compensation. Note too that margin income is a much thinner margin business for PNSN then clearing fees. Margin income must be shared with the initiating broker and other entities. Expenses for margin income have routinely meant 50% returned to other originating/ partner entities. When you factor in the huge increase in employee expenses, PNSN's operating margins actually shrank in 2005 even with the 50%+ revenue increase. Passing on increased revenues to employees is fine however, as a public company PNSN will need to rein that huge increase in quite a bit. In 2005 they essentially passed through to executives nearly all of the increased interest intake. Shareholders will not stand for that and if PNSN continues this practice the stock price will stagnate. Operating margins in 2005 were 3% in 2005, down from 7% in 2004. Not ideal. Again I'm fine with revenue increases being fueled by a lower margin driver, however PNSN can control employee expenses and not pass on ALL interest revenues to executives. Net earnings [ after taxes and eliminating debt servicing] were 22 cents in 2005. At a $16 pricing PNSN would be coming at 72 X's trailing earnings. PNSN had a monster first quarter 2006. They booked record quarterly revenue from each: Clearing fees, interest collected, technology fees. Based on first quarter numbers clearing fees are on pace to grow 30% in 2006, margin interest is on pace to grow 66%, and technology/ service revenues are on pace to grow 50%. Wow. PNSN obviously benefited from a pleasant and increased trading volume environment first Q of 2006. Overall revenues, taking into account seasonality, still look to grow 40% for PNSN in 2006. That is being conservative and assuming there will be one quarter in 2006 in which margin income is curtailed significantly. Employee expenses continue to grow swiftly. Fortunately they appear to be growing just a little slower than anticipated revenue increases. My feeling again is that it is too much. This line in 2006 looks as if it will grow 30% over 2005 levels, I'd be more comfortable in the 15% area. Based on first quarter and some seasonal slowdown, net margins for 2006 do look to improve to the 7 1/2% range. Based on similar assumptions PNSN could earn 80- 85 cents a share in 2006. At $16 PNSN would be trading 19 X's 2006 earnings.
Note that these earnings are in part based on a simply blowout first quarter 2006. I slowed down the remainder of the year however, when a company books a quarter that is completely outside any other operating quarter in history, forecasting is difficult.
Risks -- the overriding risk here is a trading volume/ margin slowdown leading to a sharp quarterly decrease in PNSN's revenue. They've ramped employee count and compensation to the point of relying on the recent quarterly revenue increases. That can be dangerous and is a very real risk. One made more so due to PNSN's lack of restraint on employee compensation. The hope obviously is that PNSN as a public company will run operations with more of an eye to shareholder value and earnings. I do not know how this will play out. A 2005 IPO with a very strong core business DLB is still sitting around aftermarket open levels due to hefty expense lines, they've not managed to curtail. If PNSN continues to operate as they have the past 15 months, similar could occur.
For a clearing and margin firm in which executives will own 50%+ of outstanding stock post offering, this is a very clean deal with no off-balance sheet arrangement or odd loans etc....In other words I don't see a RFX type situation here at all.
Conclusion - Will PNSN perform going forward similar to the blowout first Q 2006? Good question. If so, this offering represents a good opportunity in range. As alluded to, I do not like the swift rise of the employee compensation expense line. If as a public company they manage with more of an eye to the bottom line, '06 results could top my forecasts. Public companies relying on increased trading volume and/ or capital market expertise have performed very well in the past year. PNSN fits into both categories. Factor in as well that with the IPO cash influx PNSN will be able to loan out for margin a significantly larger amount of capital. I think due to the absolute blowout Q1 '06, and other positives in the sector, PNSN is worth the risk in range and $1-$2 above.
This 'reco' comes with a few words of caution - Keep an eye on those expense lines as well as overall market trading volume. If market trading volume and margin lending pace slow significantly in any quarter in 2006, PNSN will need to quickly rein in expenses or the stock will get hammered upon quarterly earnings report I like this one in a good market climate, I would not want to hold PNSN through a quarterly report in which the market struggled and trading volume and margin levels decline. Recommended, however in a negative market climate/ trading volume decrease PNSN's bottom line will evaporate quickly. Thus far they appear to be a company that can grow top line quickly in pleasant conditions.
Synopsis - Recommended based on absolute blowout 1st quarter 2006 earnings. As a public company PNSN will need to rein in employees bonuses a bit and display an ability to filter revenue to the bottom line a bit better. However the 1st quarter 2006 performance was so far outside anything PNSN had previously compiled it is worth the oft mentioned above risks.