ICAP (OTCPK:IAPLF) is the largest inter-dealer broker. Inter-dealer brokers act as intermediaries between major dealers, such as investment banks, in the financial markets.
The majority of inter-dealer broker revenue comes from the Over-the-Counter (OTC) Market. OTC trades differ from trading on a standardized exchange like NYSE or Eurex. OTC trades are characterized by low volume, very large deal size and non-standardization.
ICAP facilitates trades in many different asset classes. The largest class 'Rates' (Repos, government bonds, interest rate derivatives and financial futures) accounts for about 40% of revenues. FX is the second largest and accounts for about 20%. Other asset classes are commodities, credit (corporate bonds and credit derivatives), equity derivatives and emerging markets. ICAP also sells information and risk mitigation services.
ICAP's revenues and share price have fallen hard over the last few years because of a decline in trading volumes. ICAP's revenues fell 3% from 31st March 2011 to 31st March 2012 and they have continued to decline since then. Like an exchange, ICAP's revenues are directly linked to volumes on its platforms. Higher the volumes traded, the more commission it earns.
ICAP has suffered from the fallout and lower volumes following the financial crisis. The situation has got even worse in the last year. Quantitative easing and low interest rates around the world have restricted trading in FX, repos, fixed income and interest rate derivatives. The LTROs (Long term refinancing operation) introduced by the ECB have had a particularly negative impact on the repo market, since banks have been able to borrow from the ECB almost for free.
Economic weakness and an environment of de-risking and regulatory uncertainty have all also contributed. Michael Spencer, ICAP's CEO, has said this is one of the toughest trading periods he has have ever seen. The entire industry has been struggling against this cyclical decline. In November, ICAP released poor results for the first half of the year with revenue falling 14% year-on-year.
I believe ICAP is a stock to own for the long-term investor not overly worried about short-term results.
Volumes will Return in Time
The low interest rate and low risk environment has hurt ICAP. At some point, this situation will change, confidence will return and interest rates will rise. When this happens, ICAP will benefit. Volumes are well below peak levels. History shows us that they have always recovered in the past.
There are already some positive signs. ICAP has just announced (On February 5th) that volumes on its Broker Tec and EBS platforms were up 17% in January compared to last year. Spot FX volumes were up 22%. ICAP has probably benefited from the on-going currency wars. ICAP saw higher secondary repo volumes as the second LTRO was repaid early. The repayment of LTROs should increase repo volumes in the future.
ICAP gets most of its revenue from a small number of major banks. These banks are doing better and this should benefit ICAP as they start to do more trading and take on more risk.
The fall in ICAP's share price means its dividend now yields just under 7%. ICAP has increased its dividend every year since it introduced it in 2004. The pay-out ratio was 55% last year. Despite a fall in revenues ICAP has cut costs effectively and this has helped sustain the bottom line and it continues to do this. This is a long-term play paying you to wait.
Best of Breed
ICAP has better technology particularly in electronic trading, which gives it a competitive advantage over its competitors, Tullet (OTCPK:TULLF), BGC (NASDAQ:BGCP), Tradition and GFI (NYSE:GFIG). I believe the recent decline is due to decreasing trading volumes across the industry rather than company-specific issues. Since the beginning of 2008, ICAP's share price has fallen 51.36%, which compares to a 54.09% fall for Tullet Prebon and 65.33% fall for BGC.
ICAP has better scale (which is important for its infrastructure and compliance costs), better diversification and better flexibility than its competitors. ICAP has market leading post trade and risk products which have grown well even whilst the rest of the business has suffered. They now make up a significant and growing portion of overall revenue. ICAP's recent acquisition of the PLUS exchange is positive and furthers its advantage.
Risks - the LIBOR Scandal
Anyone considering investing in ICAP should be aware that one of its subsidiaries is currently under investigation by the FSA because of the LIBOR scandal. In February 2012, ICAP suspended one of its employees and put two more on administrative leave. According to the Financial Times, seven of the fifty people working on the LIBOR investigation are focusing on ICAP. ICAP has been under investigation since March 2012. On February 7th 2013, CEO Michael Spencer said the firm's own investigation didn't find any evidence of 'wash trades' and that no employee had been fired as a result of the scandal. ICAP has not made any financial provision for the matter and the FSA investigation continues. It is a major overhang on the stock and it is almost impossible to predict the outcome but potentially it could be very negative.
Regulation is changing the industry. This may be a positive and a negative for ICAP. Regulation has created a lot of uncertainty, which has depressed trading volumes in the short term. Increased transparency and greater clarity should increase volumes in the longer term, but for now uncertainty has had the opposite effect.
The Volcker Rule and Basel III have resulted in a lower risk appetite in the credit and equity derivatives market. New regulations will force greater central execution and central clearing rather than bilateral execution and clearing. This should benefit ICAP. Regulatory reform is driving volumes from voice to electronic markets. Given ICAP's advantage in electronic platforms this may enable them to gain market share.
Regulators are also pushing for increased risk mitigation and this should benefit ICAP's post trade risk mitigation services. TriOptima, is the market leader in risk elimination and risk mitigation solutions for the OTC derivatives market.
There is a risk that regulation will attract new participants to the industry. The exchanges might start to push in on the inter-dealers business. Regulation may facilitate them in this process, as it encourages more trading on exchanges. This is partly why ICAP went out and bought the PLUS exchange, so it immediately had an exchange and the requisite license.
The exchanges have been struggling to grow organically and they are looking for any way to increase revenues. We have seen a lot of mergers and M&A activity already by the exchanges. The LSE has just taken over LCH.Clearnet.
The exchanges would probably not become a major threat without taking over a competitor. They would not be well suited to move into the very different OTC market by themselves. It is possible an exchange could take over a competitor of ICAP and use their own scale and resources to move aggressively to take market share. They might also take over ICAP itself. ICAP has the best technology and therefore they represent the most attractive, if also the most expensive takeover target.
ICAP is a cheap stock with a high solid dividend which is paying you to wait until macro factors become more favorable. It has a competitive advantage over its competitors and there are a number of other catalysts which could drive the stock price higher in the future. There are some big risks to it, most notably the uncertainty over new regulation and the potential for a large fine over the LIBOR scandal. I think it's an excellent stock for the patient investor.
Disclaimer: This article intended as general information only, and is not intended to provide specific advice, or due diligence to be relied on. As such, the information presented in any article does not consider any reader's personal investment objectives or financial situation; therefore, no article makes any personalized recommendations. See full disclaimer here.
Disclosure: I am long OTCPK:IAPLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.