MF Global Ltd. (MF) F1Q10 Earnings Call August 6, 2009 8:00 AM ET
Jeremy Skule – Chief Communications Officer
Bernard Dan – Chief Executive Officer
Randy MacDonald – Chief Financial Officer
Niamh Alexander – KBW
Christopher Allen - Valley Capital
Patrick O'Shaughnessy - Raymond James
[Chris Dennett] - Sandler O'Neill
[Alex Cram] - Barclays
Ken Worthington - J.P. Morgan
Howard Chen - Credit Suisse
Mike Carrier - Deutsche Bank
[Jillian Miller - Unidentified Firm]
Good day, ladies and gentlemen, and welcome to the fiscal first quarter 2010 MF Global earnings conference call. My name is [Erica] and I will be your conference coordinator for today. (Operator Instructions)
I will now turn the presentation over to your host for today's call, Jeremy Skule, Chief Communications Officer. Please proceed.
Good morning and thank you for joining MF Global's first quarter conference call.
With us today are Bernie Dan, CEO, and Randy MacDonald, CFO.
The information made available on this conference call contains certain forward-looking statements that reflect MF Global's view of future events and financial performance as of June 30, 2009. Any such forward-looking statements are subject to risks and uncertainties indicated from time to time in the company's SEC filings. Therefore, the company's future results of operations could differ from historical results or current expectations as more formally discussed in our SEC filings. The company does not undertake any obligation to update publicly any forward-looking statement.
The information made available also includes certain non-GAAP financial measures as defined under the SEC rules. The reconciliation of these measures is included in the company's earnings release, which can be found on our website or in our SEC filings.
With that, I'll now turn the call over to our CEO, Bernie Dan.
Good morning and thank you for joining MF Global's first quarter fiscal year 2010 earnings call.
Today I'll start out with a broad overview of our performance in the quarter. I'll also spend some time talking about our business plan for 2010 and how it fits with our long-term strategy and vision. From there Randy will get into the details of our results.
If you turn to Slide 3, about nine months ago we began an extensive effort to reposition our company for the future. I'm very happy to share with you that our organization's internal realignment is near completion. The changes we've made throughout our company - improving risk management, tightening operational efficiency, optimizing our capital structure, and strengthening our talented team - have created a competitive advantage. Now we expect to move into the next phase of our transition, a period of growth and great profitability.
In our last call I mentioned that this transition will likely take some time before we realize our full potential. As we move forward we're committed to increasing the size of the market through activities such as leading the OTC to clear transition and by facilitating access to products that are in high demand across Asia. At the same time, we're working to grow our market share to increase the profitability of our business and deliver great shareholder value.
Slide 4 highlights that while we remain in the transition period, our results pointed to the resiliency of our company, with both revenue and EPS rising from the prior quarter. Of course, our performance was influenced by the current macro environment, and although we're starting to see some improvement in the broader business climate, which I'll discuss in greater detail in a moment, interest rates still are near zero, industry balances in the quarter were at their lowest level since December of 2007, and volume remain well below peak levels. We decided several months ago to focus on the elements of our business we can control. This approach has been highly successful at maximizing results for shareholders in the current business environment.
As we mentioned in previous calls, we're working very hard to grow our business and Slide 5 illustrates that during the quarter three of four revenue streams increased from the prior period. In particular, our fixed income, interest rates, equities, ag and metals product lines performed well. At the same time, we kept our cost base relatively flat. I attribute this progress to the extensive positive changes we've implemented throughout the organization.
Turning to Slide 6, we saw an encouraging trend in the VIX as it fell to a nine-month low at the end of the quarter. This decline in risk aversion helped drive our exchange traded volume, which grew 11% sequentially. Increases in our interest rate product volume in Europe and North America and equities volume in Europe and Asia helped us to gain share in the quarter. While we find these trends encouraging, it's unlikely that volume will grow consistently in the coming months. It looks as though the broader industry will experience a typical seasonal slowdown in July and August.
Turning to Slide 7, revenue from our matched principal business was the only line item that experienced a pullback sequentially. FX and energy declined from last quarter on narrowing spreads; however, certain commodities, such as metals, performed well during the quarter. Volume on the London Metal Exchange reached an eight-month high and base metals experienced continued volatility.
At the same time, turning to Slide 8, revenue from principal transactions within fixed income was up slightly over the prior quarter, largely driven by an increase in our securities lending business. In addition, overall fixed income performance was up again sequentially, but obviously was impacted by narrowing spreads.
Finally, looking at Slide 9, although interest rates are near zero, revenue from interest income from client balances grew 26% sequentially. Our talented professionals continued to find opportunity in the market, extending duration and expanding into various approved instruments. In addition, industrywide segregated fund balances were at an 18-month low in June, yet MF Global gained a larger share of those assets. Our share of U.S. segregated funds reached their highest level since November of 2008, which we believe is further evidence of clients embracing the unique value we offer.
Turning to Slide 10, the push for legislative and regulatory changes from Washington is another development that could be beneficial to MF Global. As the slide illustrates, we believe that the majority of the changes under discussion would be positive or of minimal impact to our business.
One such proposed change is to mandate centralized clearing of OTC transactions. We have extensive experience and knowledge of both OTC execution and centralized clearing, so we're uniquely qualified to be a leader in this shift, should it occur. In fact, we've already begun to lead this transition. For example, we're a participant in IDCG, a clearinghouse for settling swap contracts. We're also in the process of engaging with CME on opportunities to participate in the evolution of the CDX market on their CMDX platform.
Another potential development out of Washington is an increase in the adjusted net capital requirements for FCNs. We believe that the existing margin-based requirement of 8% for customers is more than adequate, evidenced by the fact that over the years it has provided sufficient protection. Regardless of the outcome of this proposal, we're extremely well capitalized and don't believe it would have any material impact on our capital base or structure; however, we do think that capital requirements for the non-customer business, primarily the proprietary trading activity of large global banks, should be raised at least to the customer level of 8%.
Right now there's also heightened debate on the long-standing issue of fungibility. There are really two issues at play here. One item under discussion is mandating fungibility of OTC contracts on exchanges. Another component being discussed is shifting the exchange clearing model from a vertical to a horizontal environment. While we don't believe any change in exchange model is imminent, MF Global has thrived in both vertical and horizontal clearing environments, so we believe we're well prepared for any outcome.
Finally, establishing speculative position limits for energy products is another proposal on the table in Washington. Restricting market participation to control prices and/or volatility will likely have the exact opposite of the desired effect. Further limiting the diversity of market users will ultimately reduce liquidity and increase the cost of trading. That said, we believe that speculators will continue to seek market opportunity either in the U.S. or abroad. We're leaders in markets globally, so we will serve speculators wherever they're active.
At this point it's far to early to know the full impact of the many proposals under consideration in Washington. Wherever possible and appropriate we're working with regulators and lawmakers to educate them about our markets and weigh in on impending changes.
In order to best support our business and growth strategy, specifically our continued focus on diversifying our business within financial services, MF Global has begun an initiative to move its corporate domicile from Bermuda to the United States. We believe this change will best position our company from a regulatory and competitive standpoint and better align our governance framework with today's evolving market landscape. Further, the vast majority of our revenue currently originates in the United States. We feel strongly that clients will view this shift positively and it will increase our ongoing flexibility in handling the potential outcomes of proposed regulatory changes.
This step is still in the planning change and, accordingly, we can't give any assurances as to when or whether such a move will be completed or what its impact on the company will be.
Of course, positive market structure developments would be beneficial to our business, but as I've mentioned, we're focused on delivering results in any environment. As illustrated by Slide 11, our strategy has three main components - to expand our global footprint we're targeting areas of the world where MF Global has an established presence and where it makes sense to build one. As we've discussed in the last couple of quarters, expanding in Asia-Pacific is one priority. We're already seeing success in the region, with revenue there up 20% sequentially. Part of our plan in Asia is to meet demand for low cost efficient access to contracts for difference or CFD products. We've already begun to gain a strong foothold, adding 1,600 CFD accounts in Asia during the first quarter alone.
In addition, we believe Japan represents an excellent opportunity for expanding our successful equity research model. Institutional clients active in the Japanese equity markets are demanding a non-conflicted, unbiased point of view. We believe meeting this need will further strengthen our existing relationships and attract new clients.
As we increase our presence globally, we're also focused on growing our client base of both retail and institutional market users. Last month we successfully launched Lind-Waldock, our premier U.S. retail brand in Canada. As for our retail business in Europe and Asia, we're currently working to consolidate around one brand in both regions. Once this initiative is fully implemented, two-thirds of our retail business would operate under a single brand name.
At the same time, we've taken important steps to grow our share of business with large financial institutions. During the quarter we hired one of our industry's most experienced institutional sales group from UBS. While at UBS, this four-person team helped build one of the leading FCMs in terms of U.S. segregated funds. They're now representing MF Global's comprehensive offerings to institutional market participants and are responsible for helping drive growth in this area.
Hiring top talent to MF Global has been helpful in furthering our third objective of expanding our offerings to clients. We've added about 20 new professionals to our fixed income team to enhance our leadership in the product and to help capitalize on increasing global debt issuance. These new hires contributed to a near-term increase in compensation costs, which Randy will discuss in detail; however, the additions to our team are part of our plan to invest in high-growth, high-margin opportunities.
We also continue to pursue the opportunity of becoming a primary dealer. We believe this designation would increase organic growth and enhance our credibility, aiding our efforts to attract new clients and retain existing ones. We're hopeful to have completed the process by the end of calendar year 2009 or shortly thereafter. This process requires approval from the New York Federal Reserve, so the outcome and timing remain uncertain.
Importantly, while we've delivered solid results this quarter, we stayed true to our appetite for risk and philosophy of balancing risk and reward. Turning to Slide 12, our strong belief is that the best risk managers will be the leaders in this industry, and part of our commitment is evident in our liquid and transparent balance sheet. Similarly, our track record in managing credit and counterparty risk remains exceptionally strong, with errors and bad debts at 1.4%, well within our historical range. We believe that our clean balance sheet, along with our successful risk management track record, will continue to make MF Global an extremely attractive counterparty.
I believe that as we continue to demonstrate the effectiveness of our growth strategy, the soundness of our business model, and the financial strength and transparency of our balance sheet, our investors will be rewarded. During the last few months we've addressed our challenges head on and positioned our company to capitalize on opportunity over the long term. I'm very confident that if we continue to remain focused on growing our business by geography, clients and product, we'll be successful in driving greater shareholder value.
With that I'd like to turn things over to Randy.
Okay, thank you, Bernie.
I think what you heard from Bernie is very consistent with the message we've been communicating over the last several quarters and that is (1) we've achieved greater accountability and efficiency by moving to a globally managed model, (2) we've reallocated resources to make the most impact on our value proposition with our clients and our shareholders, and (3) we've achieved greater management focus by utilizing our five key filters of growth, profitability, scalability, the appropriate risk versus reward and optimization of capital.
And all of this just enhances our market-leading position. In addition, we've seen another quarter where a diversified, predominantly agency only model delivered results in an otherwise challenging marketplace.
So looking at Slide 13 and beginning with the IPO back in July of 2007, MF Global had utilized the concept of non-GAAP EPS. Items like stock compensation awarded at the IPO or IPO-related costs were used to adjust to GAAP EPS. And then adjusted non-GAAP was layered in and that was to call out things that might be aberrant or nonrecurring for the quarter so we could do analysis and modeling.
And in an evolution to make our financial results easier to understand and provide our investors with a better understanding of the company's earnings power, we have subsumed the non-GAAP adjustments and other adjusted items into a single continuous presentation, and that would be the columns on the far right side of this page titled Fully Diluted. So the last set of columns contains all the information you've always had, but it's without differentiation between it being non-GAAP or adjusted non-GAAP. The two columns that precede Fully Diluted are entitled Basic and the difference between these two columns and the last two columns is strictly due to the number of shares used. Again, starting with the IPO, MF Global elected to add back the expense of stock compensation, but then include the dilution from the shares issues.
Now, we've historically used the fully diluted comps to speak to our continuing results. The Fully Diluted columns assume all the shares from the Series A and B preferreds, the convertible notes and the restricted shares issued at the IPO are outstanding whereas the Basic columns do not.
Now, there are five rows or adjustments that we want to call out this quarter. The first two relate to the U.S. dollar weakening and its impact on translation accounting. As a matter of fact, we have historically disclosed in our Form 10-K that a 10% adverse movement in the pound versus the dollar or the euro versus the dollar would create respectively about $25 million [to $30 million] in translation losses. And actually in the quarter there was a 13% adverse movement in the pound versus the dollar and a 6% adverse movement in the euro versus the dollar.
So for the first adjustment that's listed, the significant movements in exchange rates caused the company to record a $12.2 million translation loss for net liabilities in currency. Primarily it's bridge pound and euros that needed to be translated back into the local or functional currencies of their respective subsidiaries. The movement in these currencies in just one month was the inverse of the movements we saw cumulatively over the last 12 months of last year.
Now the second adjustment listed was a bit of an oddity resulting from the accounting for the Parabola judgment in May. I should remind you we recorded this additional liability on the balance sheet in the March quarter for a judgment issued by the courts in May that was equal to 22.2 million pounds sterling while the insurance proceeds were in U.S. dollars, for a net loss of about $8 million. Now that liability was recorded in the March quarter; however, the translation of that liability for the period between March 31st when it was recorded retrospectively and late May when the judgment was rendered by the courts was an additional $4.1 million currency translation loss recorded in the June quarter. So under the accounting rules, we could not move forward that translation loss to the March quarter to align it with the related liability.
Although nothing could have been done to avoid the anomalous accounting for a translation loss that occurred with the recording of the Parabola liability, we have revisited the company's policies and processes with regard to the other sizeable loss due to currency swings, and in order to reduce the volatility in our P&L we've now taken steps to guard against future significant currency moves.
We will be more actively hedging our most sizeable net assets or liabilities for currencies that are other than the local company's functional currency. Of course, with any hedging program, our ability to mitigate exposure is not 100%, but I'm confident that the steps we've taken will greatly reduce translation gains or losses from running through our P&L. As a result of our efforts, we believe that our translation gains or losses will be significantly less than the movements we have historically experienced.
The next adjustment listed is consistent with what we communicated last quarter and that is the $9.7 million write-off of unamortized debt issuance costs following the early retirement in April of our $240 million term loan.
Now, the other two adjustments are for things that we have historically called out to you, like severance or IPO-related costs. They totaled another $0.01 and the details are disclosed in the footnotes. In summary, other than severance, none of these items had any impact on cash or liquidity. Adjusting for the dilutive impact to our share count, together with these adjustments, gets us to $8.8 million of net income or $0.05 of EPS.
Lastly, let me remind you that GAAP reporting companies must adopt two new accounting pronouncements this year that require companies to have a technical restatement of their historical financials. The first, the impact to us is simply to geographically move the location where minority interest gets reported in our financials. And the second is to gross up interest on borrowings to a market rate coupon on our convertible notes.
We will be filling an 8-K immediately after we file our 10-Q for this quarter. Mann Group asked us to file a registration statement, so this 8-K helps complete that registration statement.
Now turning to Slide 14, let's review the key financial metrics for the quarter, which are adjusted for the items noted on the previous slide.
Net revenue was up $14.4 million or 6% from the previous quarter. And, as Bernie mentioned, we're beginning to see the signs that our strategic initiatives are gaining traction and we're encouraged not only by the revenue growth but that virtually all of our businesses participated in the performance.
As we invested in high-growth, high-margin businesses, our compensation expense in the quarter increased. It moved from 55.9% of net revenue in the sequential quarter to 62.9%. The reason for the increase is twofold - one is timing, the other is geography. First, with regard to timing, as we mentioned last quarter, we took advantage of market dislocations to hire many highly skilled employees into key production areas. Although this effort is focused on growing net revenues, it takes time to ramp up the business, transfer over the clients, and [inaudible] the revenue, whereas the costs were immediate. So as these initiatives gain traction we'd expect the compensation over the course of the year should come back more in line with the prior year.
The second driver of the increase this quarter is really geography on the income statement. As Bernie mentioned, we have significantly decreased the cost of consultants around the firm and replaced them with lower-cost full-time employees. This also stops the brain drain of consultants leaving with the institutional knowledge that should be resident with our employees. And you see this by examining the decline in professional fees in the quarter.
Now, I'll address non-compensation expenses in more detail on our next slide, so let's move down to interest on borrowings.
The interest on borrowings excluding the accelerated amortization of debt issuance costs was 24% lower this quarter than in March, and that was mainly the result of two factors - a decrease in LIBOR and the $240 million term loan was paid off in April, eliminating interest on this loan.
The effective adjusted tax rate was 45% this quarter; however, we expect the ongoing rate for the full year to be more like 41%. This is higher than the 39% we experienced in fiscal 2009 and this is because we expect the mix of our pre-tax earnings to remain consistent, with more than three-quarters of our pre-tax earnings coming from high tax jurisdictions like the U.S. The reason this quarter's rate was higher than 41% was due to some discrete tax items primarily arising during the quarter; it gave us additional tax benefits. Looking forward, if we change the company's domicile to the U.S. we believe our effective tax rate would only increase a nominal amount as we are already effectively a U.S. taxpayer.
So now let's take a look at non-compensation expenses on the next slide, Slide 15. On an adjusted basis they were $92 million and below the expected range of $100 million that I mentioned in previous quarters. This is even as we continue to invest in engineering efforts for scalability and efficiency. In anticipation of some engineering of new systems, we are not yet ready to move off our stated expectations of $100 million a quarter.
On a sequential basis excluding foreign exchange loss, every non-comp line item is down. We continue to focus on cost rationalization and an enterprise-wide commitment to being as efficient as possible with shareholder money. As Bernie mentioned earlier, we did a good job in managing risk as measured by our errors and bad debt expense, which represented just 1.4% of net revenue for the quarter.
So now let's drill down on the revenues. Turning to Slide 16, while the industry continues to face challenging macro conditions by performing at off-peak levels of volumes and client balances plus near zero interest rates, our net revenue this quarter is a great indicator of two things: (1) the positive impact of internal realignment as well as the strategic initiatives begun last fall, and (2) the diversification of our model across geography, product and client.
Now, as evidence, three out of four major revenue streams are up sequentially and most of our businesses contributed to the growth in the quarter. Let's drill into the details, starting with the increase we experienced in commission revenue.
In Row 12, Commissions This Quarter, $196.7 million, were 5% higher than in the March quarter.
In Row 13, Column A, the volume was 430 million contracts, which was an 11% increase from the March quarter. These volumes exceeded the growth in exchange deposit volume, which experienced a 6% increase. As a matter of fact, we grabbed market share on the seven largest exchanges in the world.
Going back to Column B and Row 11, the net execution only commissions were virtually unchanged from the March quarter at $57.7 million. Volumes related to this in Row 13 increased to 123 million trades or 16%. Offsetting the increase in volume is a decrease in the yield per contract.
In Column B, Row 15 the execution only yields were $0.47 this quarter, which was down from $0.56 in the March quarter. One of the main reasons is we experienced strong growth in our equities direct market access business, which is high volume and lower touch, so are lower commission rate.
We also experienced a significant increase in interest rate product volumes as many of the banks and broker-dealers reengaged with the market. These market participants have strong buying given the amount of volume they can add, so the mix shift created downward pressure on our execution rate per contract.
In Column C, Row 11, net cleared commissions were $111 million, up 3% from the March quarter; volumes, though, were up 9% to 290 million contracts.
Yield from clearing, which is Row 15 was $0.38 this quarter, which was $0.03 lower than the March quarter as this was primarily a shift in mix to higher volume but lower yielding professional trader volumes.
Now moving over the Matched Principals section, Column A we'll speak to in another slide. Let's jump to Column F. Rolling up in Column F would be energy, metals and foreign exchange. Principal transaction net revenues totaled $40.5 million. That was down from $44.9 million in the March quarter. Our commodities businesses, particularly metals, experienced growth in the quarter as volumes and spreads on the LME widened due to the volatility in many of the base metals. Foreign exchange and energy experienced tighter spreads.
So now let's jump over to the Net Interest section. In Column G, Rows 3 and 4, you'll notice that the sum of the interest income and principal transaction revenue totaled $33.5 million this quarter. That represents a return of 99 basis points on the average client company funds of $13.5 billion. That's a 27% increase from the 78 basis points for the March quarter.
And we were able to increase the yield even though balances and interest rates remain the same by doing two things. One, we've now extended approximately $3.6 billion or approximately 27% of our average balances into longer data maturities that are approved by the CFTC, with an average maturity of 15 months, which means the blended portfolio duration is extended to six months. Now, most economists are predicting that interest rates will not increase before Christmas, so we feel comfortable with the life of this portfolio.
And, two, we've been able to see efficiencies in our Treasury team's global approach under our new governance model and they've redeployed monies that were inefficiently invested. A simple example is substituting cash deposits at exchanges with collateral and then investing the cash.
So now let's drill down on the fixed income business on Slide 18. In Column E, in spite of decreasing LIBOR and narrowing credit spreads, our fixed income revenues were up by 1% to $47.8 million. As we have ramped up our product offering and skill set in fixed income the average balance has increased approximately $10 billion from the March quarter.
As I mentioned last quarter and as Bernie mentioned in his remarks, we expect the balance sheet to grow in line with expectations and with growth in our fixed income business as we continue to focus on high-growth, high-martin opportunities. Importantly, the balance sheet expansion is consistent with our risk profile, which was only marginally increased as most of the fixed income business is cleared through the FICC.
Turning now to Slide 19, we've created a summarized version of our balance sheet. These are average balances and not [inaudible] to give you a better idea of trends. Although our client balances remain level from the March quarter, as Bernie pointed out earlier, we have grabbed more market share of these balances.
The growth in fixed income I just discussed; however, I should note that the fixed income business added 144 new accounts this quarter, which is 63% more than we opened in the March quarter.
Average shareholder's equity decreased $74 million. Again, let me remind you these are average balances. Having said that, almost the entire change occurred in the March quarter and was comprised of two things: (1) We wrote off $82 million of goodwill, and (2) we reclassified nearly $30 million of receivable from Mann Group from liabilities to shareholder's equity.
The company's free cash decreased $280 million from March 31st since the company paid off early its $240 million term loan in April.
So let's see how this translates into the company's liquidity position on Slide 20. On Slide 20 you can see a detailed breakdown of our liquidity and the long-term capital structure. In looking at the first row, here you can see that we have $1.9 billion of capital in regulated companies, which consists of $1.4 billion of required capital and $447 million of excess capital. The comparable slide for the March quarter is in our appendix, but there is $106 million less excess capital. As we have ramped up the balance sheet by an average of $10 billion and about $20 billion of period ink, the increased usage of capital opposite the increase in balance sheet represents about 1% of those balances, which reflects the low-risk nature of this business.
Looking at the second row, we also have $211 million of free cash at June 30th. This decreased $280 million, primarily due to the repayment of the term loan for $240 million in April. We also paid the preferred shareholders their dividends and placed additional regulated capital into Asia. Looking at the last row, the available liquidity is about $3 billion and this is the sum of the Excess Capital and Free Cash columns.
So now let's look at this liquid balance sheet in relation to our stock price. On Slide 21, as you can see from the right side of the slide, MF Global is still trading at a significant discount to the tangible book relative to our competitors. And then on the left side you can see the trend line for our liquid equity per share. And for the most recent quarter, if we took all the assets and liabilities and liquidated the balance sheet, we'd return to our common shareholders approximately $1 billion in cash. Assuming approximately 120 million of outstanding shares, that's $7.99. And the decrease from last quarter was primarily the result of the foreign currency translation loss and amortization of debt issuance costs.
So in the first six months of this calendar year we've imposed a lot of change on the organization; however, we think the organization has responded in a very positive way. Some of the secular trends have clearly helped our business, but the recent initiatives seem to have helped us grow in organic fashion above and beyond the secular growth.
With that, I'm going to turn it back to Bernie.
We'd like to, Operator, open up the call for questions.
(Operator Instructions) Your first question comes from Niamh Alexander – KBW.
Niamh Alexander – KBW
Where I'm concerned with going forward just in terms of our model is the comp ratio date increase. I know you hired in some teams and you're looking to primary dealer status, but also, Randy, if you could just go back to these adjustments. Are they all kind of very much nonrecurring or the FX-related translations, surely that's something, you know, the fairly new hire we should expect to flow through into next quarter as well. So I'm just trying to get a good proxy for how we should think about the expense rate going forward and the compensation ratio.
I think the purpose of calling them out is we do think they are aberrant. We can never sort of predict what will happen with exchange rates. The risk disclosure indicated that it would be much bigger than it actually was, and I think what we've decided is to try and mitigate even the exposure we did see. It is primarily an accountingism, but we've decided that in each of the local jurisdictions whatever the functional currency is, if it's not that currency we're going to go out and hedge it. So we would expect that to be much less than its been.
I would note that in May you had a seismic shift in the sterling versus the dollar and basically it wiped out each of the monthly gains that we had last year. If you took and added up all the gains that we had last year every month, it was about $12 million. So in one month you had a reversal of that and that's what we're looking to eliminate as much as we can from the P&L. We just think the volatility, especially given the size of the company, is something we're not thrilled with.
And I think the other things are pretty much one-time things or nonrecurring things or at least things that we want to call out to you. I'd say the translation loss - certainly the debt issuance cost is truly one-time. So if you look at just those two items, it's almost all of the change; it's really just two items.
The others are this convention that we've had since the company went public. I didn't want to change that, but I am giving you the information for you to use.
We are clearly driving our strategic plan and in doing so ramping up on skill sets that this company had lacked to fulfill some of those goals. And so clearly we're going to have a timing issue with bringing in talent and then following up on that as they get acclimated for them to drive revenues. So as Randy mentioned and I'll affirm, we would expect by the end of this year to be at a ratio similar to the one we closed last year on.
Niamh Alexander - KBW
If you could dumb it down for me, Randy, with respect to the non-comp expenses, assuming no change in the exchange rates going forward - which, you know, is not realistic, but let's assume there's no change in the exchange rates going forward - from here how should we think about a good range for that non-comp ratio? Because, I mean, is it at an absolutely higher level now or was that kind of a one-time jump that you had to make?
Well, I would say we're going to. We've been talking about engineering all of our systems, our processes, and we're at that phase now where we're going to start spending some money to actually get that scalability for profitable growth.
So the reason I've pointed out that going forward I think $100 million a quarter is still the right number is that we're going to be doing things like in the back office we have to have an Oracle general ledger or we have to have in HR a worldwide system that self-serve so that we can have that scalability, that efficiency, or for the front end systems, rationalizing all of them and the databases that go with them and the reconcilements.
So we're going to spend some money over the next few quarters, and I think we're comfortable saying that if we're spending money it's not going to be more than $100 million unless we come out and tell you that, but that's the guidance that I would give you on the non-comp.
Your next question comes from Christopher Allen - Valley Capital.
Christopher Allen - Valley Capital
I just wanted to ask the question on, Bernie, you brought up the fungibility debate and you said that it's not going to happen anytime soon, but do you think there's a decent probability that fungibility is changed at some point down the line?
Chris, let's just be clear. The fungibility debate was really brought up by the legislators in Washington and the real focus is on OTC clearing, which we're basically supportive of.
With respect to the exchange model there was some reference to that during the quarter, and my comment is look, personally I think it's not imminent at all, number one. Number two is with respect to the U.S. market structure I don't agree with it all. And the point I'm making from an MF Global perspective is that we operate around the world with vertical and horizontal market models and we can respond to either of them or any of them.
Christopher Allen - Valley Capital
And then just on the balance sheet, it went up a little bit more than probably most would have expected this quarter. How should we think about that going forward? Is that, as you guys discussed, going up in line with your risk philosophy and opportunities for growth?
Yes, Chris, I think this relates to the fixed income business. All of the increase is really, again, the matched book. If you go to that one slide where I show you the fixed income business and their returns, it's opposite their matched book. It's all FICC qualified.
One of the reasons that the balances are on our books is we're actually rolling out a lot of new teams. In Bernie's remarks he talked about hiring 20 - 23 people into fixed income. Well, we're doing different types of assets. We're getting into high-grade corporates, high-yield agencies, and we're doing it across the globe. We've ramped this up in the U.K., so it's ramping up regionally as well.
However, the risk profile, the type of business we're doing is the exact same thing we were doing all along. It's just more asset classes and more geography, but it's the exact same thing we've been doing.
And if you'll look at the capital that is then increasing associated with the business, it's not even 1%. So that should give you an idea and comfort about the type of business it is.
So I would say we'll continue to see that increase, but in a fairly paced way. The reason it increased as much as it did, we brought some really talented folks on board in the fixed income arena. The U.K. in particular is really ramping up. And I think we're very pleased with the results and we should start seeing that in the next few quarters, the results of that.
Christopher Allen - Valley Capital
You mentioned that you'd be filling an 8-K after the 10-Q. Is that the last thing that Mann Group needs for the registration statement or are there other things they're waiting on from the SEC side?
The SEC has basically declared the instrument effective. The only thing that's left to do is to file the 8-K.
Your next question comes from Patrick O'Shaughnessy - Raymond James.
Patrick O'Shaughnessy - Raymond James
I wanted to see if you could help me differentiate between the last few quarters when you talked about shrinking the balance sheet and then this past quarter you're talking about kind of building it back up for your fixed income business. Can you kind of differentiate what was taking place before and why you wanted to shrink it versus where you've moving towards now.
When the balance sheet was shrunk earlier, you know, six, seven, eight, nine, 10 months ago, it was in response to activity that wasn't driving sufficient risk-adjusted returns, okay? And that's kind of backdating back into the March kind of '08, June '08 sort of period. So what we focused on in that period is to enhance the systems, the capabilities, the risk systems, etc., so that we can scale fixed income.
So what Randy had just clarified is that in addition to bringing in 25-plus highly talented fixed income professionals, we've not only scaled our existing operation of Treasury and agencies, but we've brought in product - high-yield corporate debt, high-yield agencies - and we've expanded this activity into Europe as well.
So the combination of both of those is what's driving the increase in the balance sheet, and I think there's frankly two important points to make - the risk profile associated with this increase in balance sheet has not changed, number one. And number two, the timing associated with these people starting, all really within the last 60 to 90 days, we expect them to kind of reach their full potential in the next couple quarters so that the return associated with that increase in balance sheet will look far more positive than it does today.
I think in closing - we'll see if Randy has any other comments - this is part of the transition you have to go through when you're trying to diversify your revenue streams. We are ramping up in some areas to diversify. We have to make investments. There's going to be timing issues associated with cost spends and balance sheet and, frankly, at the same time as we right size the historic operation.
So we're right in the midst of that, and I think what we're really focused on is the revenue growth, the strong cost containment and the fact that the diversity in our revenue model for this particular quarter is validating the steps we've been taking the last six to nine months.
Randy, I don't know if there's anything you want to add to that?
No, I think that was well said.
Patrick O'Shaughnessy - Raymond James
And then I guess a follow up question would be as far as kind of adding employees to lower your consulting expenses, you employee comp went up by $19 million quarter-over-quarter, your consulting expenses went down by around $1 million or so, $1.5 million maybe. I know there's probably some noise in there from the currency translation, but should we expect the professional fees to continue to go down further or was most of the increase in employee comp not necessarily because you're replacing consultants but because you're adding on new people incrementally?
The vast majority, Patrick, are production people coming on. Bernie mentioned just in fixed income 23 new people.
If you think about some stats on the Street, I think most people would say a good salesman should be producing somewhere between $1 million and $2 million of net revenues. These folks are costing us anywhere between $250,00 and $354,000 - $400,000 on average. There are sign-on bonuses, things that we expense upfront, so there is some front end loading of that plus, as I mentioned in my remarks, the expense shows up day one; the revenues don't.
So I think the ratio that I would focus on is - this is very much in contrast, to some of the other businesses that we've historically been involved in where you could have payouts for guys somewhere between 50% and 70%. So the numbers I just gave you are well below that. In terms of risk profile and the ability to generate revenues, it's just a much higher-margin business and a higher-growth business, and just further diversifies the whole business model, so we're very confident.
With regard to the folks in the support areas, there has been pretty much a 1:1 relationship. I think if you look at professional fees for the sequential quarter, not for the fiscal year, you have seen a pretty significant ramp down in professional fees. And there it's been an effort, a very disciplined effort. Everyone who hires someone has to go through either myself or the head of HR and provide us with a business case of what the savings are of hiring that person. And in every single case there is a business case that makes total sense to one of the two of us.
Your next question comes from [Chris Dennett] - Sandler O'Neill.
Chris Dennett - Sandler O'Neill
Hopefully one quick last one here on the compensation issue. I know you've given us a lot of quantitative information about your expectations, but just qualitatively where do you think you are in terms of hiring and bringing on new people? Are we sort of toward the end of a rapid hiring period or is there more hiring to come?
I'd say in terms of the focus the last three to six months of recruiting, in terms of a significant net add we're basically at the end of that period. We're clearly going to be opportunistic if we can identify producers or teams, but in terms of getting ramped up properly for our fixed income expansion, we're basically done. But we'll on an ad hoc basis identify and, if required, bring on more talent.
Chris Dennett - Sandler O'Neill
And then in terms of competition, you talked about gaining share in terms of U.S. seg funds. Can you give any color on where you think you're gaining share from at this point?
I think a couple things. We've seen kind of two or three areas. One is in the retail area globally, and I think that focus, particularly in Asia, is one point. Two, within the U.S., with some risk aversion kind of abating a little bit, some traditional users that might have been on the sidelines, asset managers, hedge funds, the investment bank that we execute for, all of them have come into the end of this quarter a lot strong. And three is that we're starting to basically increase the amount of cleared assets on our books from commercial hedgers and recognizing the clean balance sheet, the strong risk management of this company.
So it's fairly diverse and it's representative of, frankly, our product lines. And what we're motivated by is that the short-term phenomenon associated with TARP banks and some of those institutions paying back money to the government is, frankly, leveling the playing field for a company like MF Global, and clients are now focusing on other risk associated with our competitors, specifically the toxic assets on their balance sheets and the inability for a lot of these banks to price them. And everybody recognizes that with the suspension of the marked-to-market rules there's still some uncertainty associated with those balance sheets, and that's why we've highlighted it in the manner that we've done. So we're benefiting from that. And I think as time goes on this model is going to emerge as a preferred counterparty model.
Chris Dennett - Sandler O'Neill
Any potential downside to changing your domicile from Bermuda?
Right now we're at the early planning stages. In my comments, you know, it's difficult for us to give any judgment today. What I wanted to do for the public is just notify them that this process had started. As we get certainty or not in terms of this process and clarity of what it means, at the appropriate time we'll start to communicate it.
Your next question comes from [Alex Cram] - Barclays.
Alex Cram - Barclays
My question on the compensation - I know it's been discussed at length; hopefully there's something else to add - but two prongs. First, all you said the whole timing issue is totally understandable but wondering, given that you have done some hiring now and we're past the quarter and maybe even some stuff came on during the quarter, are you actually seeing evidence that these new hires are producing and are grabbing market share and maybe bringing on old clients?
And then second of all, related to this is obviously earlier this year when the [inaudible] firms had a lot of dislocations it was pretty easy for you to make your value proposition, but the hiring markets have changed dramatically over the last couple of months and we see firms paying guarantees again and certainly a lot of competition in certain areas, so I'm just wondering do you have to pay up? Has it changed a lot in terms of getting people to come on board? And any additional color you have on that.
First off, we're already seeing production from the new hires which is why three of the four product lines - specifically, fixed income and others - are up for the quarter. So we're seeing that, number one.
Number two is our overall revenues, which we're probably one of the few financial services companies in this reporting quarter that had higher revenues than the sequential quarter before, so we're seeing that benefit now and we're reporting it in this quarter, and on a few of the slides that Randy highlighted I think that should be clear.
Two is it's clear that our approach for identifying people is a combination of three things. It's kind of the operating model and the environment and the fact that we're largely an independent, non-directional sort of trader is appealing to the institutional user in terms of a preferred counterparty. And so that's appealing to highly successful people that want to serve the client and the client order only. That's point one.
Point two is in every market that we operate in we are competitive in terms of securing people.
And then three is it's clear that now that some of the confidence maybe in Wall Street and some of the focus of the banks is about retaining some of this talent their comp ratios are significantly higher, frankly, as they seek to retain and/or re-hire some existing teams. And I think what we feel really comfortable about is the folks that we hired are long-term committed to this organization, embrace the model and are positioned with us to continue this rebuild and reposition of MF Global.
And so I think like any other sort of opportunity we're cognizant of the markets we operate in, what it takes to get good people, and it's all factored into how we view risk-adjusted returns and the amount of money we're willing to spend to get it.
Alex Cram - Barclays
And just along those lines again, for Randy, because you mentioned earlier that 50% to 70% payout, did I understand that right? Did you say these new hires are actually below your typical payout ratios in other businesses?
What Randy was talking about in that range of 50% to 70% is really kind of the traditional execution-only, high-volume, lower-margin transaction business. And what Randy was commenting on is in the fixed income with the recent hires is the diversity that these folks offer in terms of multi-product, create a higher-margin opportunity for MF Global, and the payouts associated with that activity are lower than that traditional model.
Alex Cram - Barclays
Then coming back to market share, you gave a lot of color on the market share you've gained on the traditional businesses, but do you have any tangible evidence you can share already how you're making inroads in the fixed income business? I know you mentioned some new accounts and things like that, but looking at, obviously, a lot of [inaudible] firms having very, very strong fixed income quarters as well. Just any evidence that you are really grabbing market share here?
Well, a couple things. I don't know if I said it or Randy or maybe we didn't, but in the quarter there was 144 new fixed income accounts associated with the new hires, which basically has translated into the net revenue. That's something that we're monitoring, so not only are we successful in onboarding new employees but the measurement of that success is our ability for the clients to follow and we think with most of these folks hired within this past quarter to already have 144 active clients that are [inaudible] is an internal barometer that we're really focused on and positive about.
I think the other thing is Slide 8. We foreshadow how we internally think about the marketplace and our participation in it for fixed income. And it very much has to do with notional values of the issuances, and I think you've got a good pie chart there of the opportunity. So even if we're a small slice of that pie, it's a very, very enormous market.
Alex Cram - Barclays
In terms of the trading loss you had last year, I think you said before there might be some insurance recoveries down the road. Do we have any visibility on anything like that actually happening in the future?
This is all part of a broader process, so the only visibility we have is what we previously gave, that we have a claim file and when we have more news on the status of that we will advise accordingly.
Your next question comes from Ken Worthington - J.P. Morgan.
Ken Worthington - J.P. Morgan
First, for Bernie, derivative volumes have suffered materially over the last, I don't know, three, four quarters due to deleveraging. In your opinion, has that deleveraging ended and how does the releveraging [break in audio] kind of start to look like? And then are any particular regions ahead or behind others in that or do you think that they will be ahead or behind in the releveraging process versus other regions?
That's a great question, so let me make a couple comments.
What we've been watching as kind of one data point is the interest rate - Treasury and euro dollar [break in audio] - and what has happened from March to June and then June into September - is the open interest has fully rolled and increased, and those are two quarters in a row that we've seen that happen. The three or four quarters prior we saw it decline, so that's kind of one big data point. And open interest, as you're aware, is kind of a leading indicator of liquidity and future volume as clients begin to take that risk off.
Two is we've also seen in June CME have combined, their strongest month since, like, whatever it was, October of 2008, and our participation in that was very, very significant. And so notwithstanding the seasonal slowdown that we kind of anticipate for July and August, that's a very good sign.
The third data point is we've just completed earnings seasons for all the large global macro banks and it was clear that what drove a lot of their earn up was increased risk taking and higher VARs. So that's the other data point that's, frankly, out there.
The fourth thing we really monitor closely is VIX. And as VIX has kind of settled down we've now seen asset managers, hedge funds and others that might have been a little bit on the sidelines or activity clearly off peak levels of the last two quarters entering this marketplace.
So when I say that some of the macro drivers are showing signs of stabilization, those are the kind of things that I point to. And I think that that's obviously been very strong and bullish for the MF Global model and that's why our revenues in this quarter were up sequentially.
In terms of region, I'd say in the U.S. - I'm sorry to interrupt, Ken, but just on the second part of your question - we think in the U.S. those banks are far more active and aggressive in the marketplace than they had been and so we're seeing most of this increased activity and risk taking come from the U.S. side of the equation right now.
Ken Worthington - J.P. Morgan
And then you talked a lot about building up the fixed income business. We also hear you're hiring in equities. What does the equity build out look like for MF.
Well, Ken, we have a very strong research-based equity model in Europe that covers the top 200 European stocks. And what we've identified in Europe is that institutional users like the unbiased kind of objective view of MF Global because we don't have [inaudible] product, we don’t have any IPOs, we don't have any other conflicts. And so that model's been very successful within Europe.
There are opportunities in Asia in certain of those markets to replicate some of that activity, and so our focus is to scale the core infrastructure in Europe and focus on five or six Asian markets where that same sort of market segment creates an opportunity for us. And that's really where we've been focused of late and that's why I made some comments specifically on Japan.
And then, finally, we've been very active in India. We're going to slowly in the coming months give more color on that country and some of the activities in that part of the world because we are a leader in India within retail and institutional equities, and it's something that I think as we continue to develop our Asia footprint we're going to give more color. But they clearly contributed to that 20% sequential revenue increase that I referenced in my comments.
And so we're going to focus a little bit more in coming quarters on that. In fact, Ken, I'm going to be in Asia-Pacific for most of September kind of focusing on this topic and working with our strong management team in that part of the world.
Ken Worthington - J.P. Morgan
On the FX side for Randy, the $12.2 million, are there any FX-related mitigating factors that may be offsetting that $12.2 million this quarter? Like, for example, I think you mentioned that the revenue grew 6% sequentially. Was that benefited by FX translations as well and maybe what would that have been on a currency neutral basis?
They're really mutually exclusive. I mean, it's things like in the U.K. you accumulate liabilities, Parabola being a good example [break in audio]. Your liability is in sterling but the functional currency there is actually the U.S. dollar, so you have a translation loss.
So what we're going to do going forward is look at those net assets or those net liabilities in each of those subsidiaries, look at what the functional currency is, and say okay, we don't want to be exposed to a currency other than that functional currency because we don't want to have the volatility gain or loss be significant to us. It's a lot of noise. One could argue either side of the point theoretically about whether to hedge those or not, and I think, frankly, the world is divided on whether it makes sense to hedge currencies like pounds in the U.K. even though your functional currency is the dollar.
So we're going to go out and hedge net assets, net liabilities, in each of those subsidiaries the best we can.
Ken Worthington - J.P. Morgan
And on an income statement basis, was there a benefit at all either included or not included in that $12.2 million?
No. No, it all went one way. It was sterling, euro, and it all - there was a mammoth move in May.
(Operator Instructions) Your next question comes from Howard Chen - Credit Suisse.
Howard Chen - Credit Suisse
What drove the outsized growth in the repo balances this quarter?
This is, again, the fixed income business ramping up their matched book. To the extent that everything is matched and on the FICC, it does not show up on our balance sheet. But to the extent that the guys are doing repo and the collateral is not exactly matched, that's the opportunity they create for themselves. Then it all comes on our balance sheet and it's all grossed up.
Howard Chen - Credit Suisse
Okay. And then just a quick follow up to that, Randy. As we anticipate more new hires ramping up and installation of new human capital here, should we just anticipate that trend continues in terms of the growth of that side of the fixed income business and the balance sheet?
We said in previous calls as we ramp this up we do expect the balance sheet to grow. We've also been very conscious of operating within our risk appetite, which we've clearly documented, communicated to the Board and this team, and so what we're seeing here is just the affect of new products and new geographies expanding on an already very successful fixed income base.
And so we continue to monitor it and as these guys ramp up we'll continue to inform you guys as it happens, but this is something we anticipated and this is part of growing this business activity. And to Randy's point, it's just a reflection of the mismatch of those trading opportunities that we're grossing up on the balance sheet at a point in time.
Your next question comes from Mike Carrier - Deutsche Bank.
Mike Carrier - Deutsche Bank
Real quick, just on the pricing, usually when you see an increase in the volumes like you did it has to do with mix, but I just wanted to see if there was anything else going on there on the product side?
You've got to remember, Mike, what's going on here is as kind of the banks have refocused their own efforts of managing risk, what they've done is they're focused on cost savings as well, so they've approached a number of brokers about let me consolidate more volume with less intermediaries and then do so trying to extract out some ranges.
So some of it's mix, some of it's a reflection of the new risk taking or increased risk taking on the part of the banks, and the consolidation of their activity with global leaders like MF Global, supporting that activity.
So we're going to wait quarter or two and see how that mix settles down and then we'll give some more comment on that, but that's really the big change. And until you get kind of a full complement of profiles trading in the market at the same time, we don't really want to touch some of the historic guidance we've given on yields. We just want to see if the mix comes back. We'll make comments in the future on it.
Mike Carrier - Deutsche Bank
And then one follow up on the matched repo book. I understand in terms of the risk level, relatively low. I guess just from kind of the risk management in terms of the leverage that it does increase and then the income or the earnings that you're generating off of that, I guess if you saw an increase you'd expect that there were opportunities there; you would have some benefit on the revenues. But you didn't see much, although you could say just spreads came in. How do you look at that?
Look, you're thinking it the same way that we manage it. Spreads are narrow, so clearly in this particular quarter or period they have the increase in the balance sheet without the revenues, given those spreads, is frankly not a long-term risk-adjusted return we want. But it's also just a reflection of the opportunity within this period.
So in terms of the long-term plan, clearly, as the balance sheet increases, the risk-adjusted returns are going to reflect that, okay? So that's kind of point one.
Point two is we're trying to get the full complement of this team up and ready so we can properly model for you guys the ongoing run rate of this, so as we ramp up it's going to appear to be deficient on the revenue side even though some of the positions are there, but some of it's just the timing of these trades and when we recognize some of that income.
So I think it's a very good question. Randy and I totally understand what you're after. It's exactly how we communicate it to our Board and we're going to be monitoring the development of these teams and ensure that not only the risk profile, we're operating within the risk appetite, but that the revenues we drive from the increase in balance sheet is representative of that risk.
I think one of the things that we have on Slide 8 on the right side is LIBOR OIS spread. And if you look at the fixed income stock VAR loan yield, I mean, there is a high correlation. So the opportunity is not just balances but the opportunity is spreads, and we did see narrowing spreads. So not unexpectedly last quarter, where you had anomalous spreads, again, we did well. And the quarter before that they were even more anomalous, but that was frankly the Treasury group taking advantage of buying into the agency portfolio when everybody was fleeting to Treasuries.
So I guess the point is every quarter what we have to do is a good job of staying within our risk appetite, yet going after those opportunities. But it is on an agency basis. I mean, if you look at our VAR relative to people who take principal risk, we're a very different business. We really are non-directional proprietary. We are agency only client driven.
So I think the yields actually are pretty reasonable given the risk appetite and the amount of capital committed to it.
Your next question comes from [Jillian Miller - Unidentified Firm].
Jillian Miller - Unidentified Firm
Are you having any new discussions on freeing up more regulatory capital in the London market.
We recently named James Rowsell as our MD of Europe and we've now kind of completed that management structure. I think we named James in May or June, I forget. So James now is working with all the functional heads in that part of the world and getting his arms around that broader operation.
And so I think our kind of next approach in the [inaudible] in the U.K. is to establish James locally and at the appropriate time we will continue to basically say, look, what's our capital needs and how much do we really need there? And it's just a matter of timing, but we have to go through this stuff with James and get him comfortable with that.
And would you like to make closing remarks?
We just wanted to thank everybody for their interest in MF Global. I appreciate your questions, and we look forward to speaking to you in the not-too-distant future. Thank you.
Ladies and gentlemen, thank you for your participation in MF Global's fiscal first quarter 2010 earnings conference call. This concludes the meeting. You may now disconnect and have a good day.
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