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With every quarter that passes, investment banks are finding it more and more difficult to turn a profit. Headcounts are being slashed, major restructurings are taking place, and entire divisions are being shut down at some of the largest banks in the world in an attempt to return to profitability. While many businesses have been decimated by multi-year low trading volumes, others have suffered at the hands of stricter capital requirements.

Dodd-Frank has led to more intense oversight and transparency of banking operations, while the Volcker Rule will look to ensure banks are not taking too much risk by engaging in proprietary trading. Meanwhile, regulations like the Basel Accords continue to be implemented, seeking to make banks safer investments by forcing them to hold higher amounts of capital against their positions. These regulatory changes have forced investment banks to rethink how they generate revenue, as industry standards begin to shift. The old days of taking big bets and in-turn, enjoying hefty paydays are long gone, as banks are now required to generate the majority of their revenue from commissions and fee-based client activity rather than risk. As a result, revenue is harder to come by, while resources are becoming more valuable as cost constraints continue to take hold. This changing landscape means that banks are going to have to take a long hard look at their client lists, determine which relationships are most profitable, and dedicate their limited resources to expanding those relationships in order to drive profitability. Although larger, more profitable institutional clients will not experience many noticeable changes in coverage, many institutions that are smaller and have less profitable relationships are going to see a considerable reduction in business from the industry leaders, while some may be shut out altogether.

A Shifting Industry - Middle Markets Expand

So what will happen to the institutional clients that ultimately have their access to bulge bracket banks limited or removed altogether, simply because they cannot offer enough business to make their relationships worthwhile? Hundreds of hedge funds, pension funds, insurance companies and money managers aren't going to simply shut down solely because a handful of the world's largest investment banks limit their business with them. Instead, they're going to search for the best-in-class banks that are willing to service their needs, a class of banks that operate in what is known as the middle markets. "Middle markets" is a relative term used to describe the typical size of deals, clients and geographical reach that mid-size banks have and generally do business with. The middle market client base sits just below the group of clients that bulge bracket mega banks will prefer to serve, and just above the client base of smaller boutique firms. The middle markets also just happen to be where many of the institutional investors who are shunned by the larger banks will end up, causing the segment to significantly expand in the coming years.

As many institutional investors begin to fall out of favor with the large banks, they're going to end up in the middle markets arena, offering significant revenue growth opportunities for banks that operate in this segment and that are best positioned to take advantage of this shift. The upper echelon of these banks offer the same type of services as the larger banks, including debt and equity capital markets, sales and trading as well as M&A advisory services. Many of them also have a global reach, although they tend to be stronger domestically than in other regions, which may actually prove to be a strength rather than a weakness as many banks look to exit certain businesses, especially in Asia. Piper Jaffray (PJC) is one of these leading banks, and although it has been forced to make tough decisions in terms of cost reductions along with the rest of the industry, over the past year it has also steadily ramped up some of its more strategic businesses. These strategic moves were first highlighted in Piper Jaffray's Q3 earnings release this past October, and represent the company's attempt to take advantage of the flight to the middle markets phenomenon previously mentioned. Although still a relatively new initiative, Q3 results were fairly pleasing, while Q4 and year-end results, which were just released last week, were very impressive.

News From Within

On October 17, 2012, Piper Jaffray released its Q3 earnings. Chairman and CEO Andrew Duff credited the company's pleasing results to robust fixed income institutional brokerage revenue, solid market share in public finance and equity offerings, additional cost reductions and its decision to exit the Hong Kong capital markets. It was reassuring to see that while PJC was delivering flat to higher earnings as a result of strategic costs savings just as other banks, it was also expanding revenue in many of the businesses that will be vital to its success in the future, businesses that are struggling to turn a profit at some of the world's largest banks. Fixed income trading businesses have suffered extensively across the industry due to stricter capital requirements, and as a result, many banks are drastically downsizing and even completely eliminating their fixed income departments. Despite these adverse conditions, Piper Jaffray was able to drive revenue in its fixed income brokerage business, with client-related revenue being up 22% compared with the second quarter. This is a great sign since client revenue can be steadily grown and is more predictable relative to risk-based revenue that can fluctuate depending on market conditions. Another positive signal of increasing client business was Piper Jaffray's equity institutional brokerage results. Revenue increased 8% despite market wide trading volumes being down drastically for some time now. These improvements further highlight the shift of client business to Piper Jaffray, and confirm its position as a middle market firm set to take advantage of larger banks limiting access to its resources for tier 2 and 3 clients. After Q3 earnings and formal remarks, Piper Jaffray CFO Debra Schoneman was asked by an analyst if she could elaborate on the firm's fixed income results. Schoneman answered with "…the client-related revenues were up 22% as well. Maybe a way to answer it is, if you set aside the strong MBS performance in the quarter, client-related revenues represents a majority of that fixed income institutional brokerage line. So that maybe gives you some sense of how much is strategic trading versus clients' flows." CEO Andrew Duff added by saying "And I would just add that we would expect the majority of revenues in our fixed income brokerage would be related to client activity."

Just last week Piper Jaffray released its 2012 Q4 earnings. The stock received a considerable boost as the company posted exceptional overall results, with Q4 revenue jumping 50% to $141mm from $93mm and EPS rising to 88 cents from 11 cents in Q4 2011. These results outpaced analyst expectations of $131mm and 69 cents respectively, according to FactSet.

PJC's investment banking and M&A advisory businesses lead the firm for the quarter, with IB revenue climbing 69% to $82mm and advisory revenue posting a record $45mm, which was up 173% compared with Q3 2012. Equity institutional brokerage revenue came in at $20mm, which was flat versus Q4 2011 but up 12% compared with Q3. Fixed income brokerage revenue was $24mm, up 112% relative to Q4 2011 but down versus Q3 2012 due to an exceptionally strong third quarter.

CEO Andrew Duff elaborated on his company results by saying, "Our strategy served us well as we focused our resources on our businesses where we are strongest, working to generate higher margins and improving our return on equity. Key execution steps in 2012 included adding resources in public finance, fixed income and M&A, creating more flexibility with our lenders, reducing costs, and exiting businesses that lacked sustainability or did not contribute meaningfully to our results. These efforts contributed to an improvement in ROE to 5.7%(6) in 2012 compared to 2.3% in 2011."

The Fundamentals

Given management's statements, Piper Jaffray has certainly positioned itself well to take advantage and profit from the changing environment in the investment banking industry. But what about the fundamentals? The company's quarterly revenue growth is 42%, which easily outpaces the industry average and has it in a close race with direct competitor Jefferies (JEF). Earnings growth also resembles Jefferies, however as we move to the balance sheet we see that Jefferies carries a massive amount of debt relative to Piper Jaffray, as the two companies come in with debt-to-equity ratios of 436 and 77 respectively.

Piper Jaffray also posts attractive price-to-earnings and price-to-sales ratios relative to the industry average. PJC's P/E is 18.4 compared with 25.5 for the industry and its P/S is 1.2 versus a 4.6 industry average.

According to Yahoo! Finance, while PJC currently trades around $40 per share, the four analysts covering the stock have a median one-year target of $42, with a low of $40 and high of $44. However, the company displays a book value of $47.58 per share, and while analyzing the current P/E ratio and forward looking earnings, you can derive a two-year target of $52.

Conclusion

As previously mentioned, middle market banks that are positioned correctly will be set to experience incredible revenue growth in the coming years due to an influx of client activity from large banks, as those banks are forced to closely monitor the profitability of each of their client relationships, and shed those relationships, which no longer make sense. Back in October, as part of Piper Jaffray's Q3 earnings release CEO Andrew Duff said, "In 2010 and 2011, fixed income institutional brokerage revenues totaled just under $80 million annually. During that time frame, we expanded our middle-market distribution and ramped and diversified our strategic trading business…" and then, "…we would now expect that fixed income institutional brokerage on average could generate approximately $25 million in revenues per quarter. We continue to believe that investing in targeted and defined strategies that leverage our intellectual and financial capital is a key component of our strategic direction and financial performance." I believe this is a perfect example of how Piper Jaffray's management was able to obtain a position as an earlier mover in 2010 and 2011, ultimately setting itself up for success as additional business comes its way. This is also a testament to Duff's commitment to the firm's strategic initiatives, initiatives that were proven to be successful as part of last week's Q4 earnings release.

Like most financials, Piper Jaffray has seen considerable price appreciation since bottoming out a couple of years ago. In addition, the recent bull market, along with PJC's better-than-expected 2012 Q4 results have given the stock an added boost in recent weeks. Although I believe there is considerable upside for Piper Jaffray in the coming months and years, it may be worth waiting for a small pull back before you jump in as investors take profits off the table. With that said, I think PJC is priced at a discount given its current price and position as well as its growth potential.

(click to enlarge)

Chart courtesy of Yahoo! Finance

Link to PJC '12 Q4 Results

Link to PJC '12 Q3 Results

Link to PCJ '12 Q3 Earnings Call Transcript (pdf)

Source: Pied Piper: Piper Jaffray Will Lead The Banking Industry Into The Future

Additional disclosure: Piper Jaffray may at times engage in business with my firm.