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FBR & Co (NASDAQ:FBRC)

Q2 2013 Earnings Conference Call

July 17, 2013 9:00 am ET

Executives

Richard Hendrix – Chairman, Chief Executive Officer

Bradley Wright – Executive Vice President, Chief Financial Officer

Shannon Small – Senior Vice President, Corporate Communications

Analysts

Zach Pancratz – DRZ

Mark Patterson – MPW Investments (ph)

Albert Jones – Jones Capital Management

Operator

Good day ladies and gentlemen and welcome to the FBR & Co. Second Quarter 2013 Earnings call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session with instructions to be given at that time. Should anyone require operator assistance, you may press star then zero on your touchtone telephone. As a reminder, today’s conference is being recorded.

I would now like to turn the call over to your host for today, Shannon Small, Senior Vice President. Please begin your conference.

Shannon Small

Thank you and good morning. This is Shannon Small, Senior Vice President of Corporate Communications for FBR.

Before we begin this morning’s call, I would like to remind everyone that statements concerning expectations, future performance, developments, events, market forecasts, revenues, expenses, earnings, run rates, and any other guidance on present or future periods constitute forward-looking statements. These forward-looking statements are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These factors include but are not limited to the demand for securities offerings, activity in secondary securities markets, interest rates, the realization of gains and losses on principal investments, available technologies, competition for business and personnel, and other general economic, political and market conditions. Additional information concerning these factors that could cause results to differ materially is contained on FBR’s annual report on Form 10-K and in quarterly reports on Form 10-Q.

Joining us on the call today is Brad Wright, Chief Financial Officer of FBR. I’ll now turn the call over to Rick Hendrix, Chairman and Chief Executive Officer.

Richard Hendrix

Shannon, thank you, and good morning. Last night we reported 46.5 million in net income for the second quarter, or $3.52 per diluted share, on 67.2 million of revenue. As noted in the release, these earnings include pre-tax operating income of 14.6 million, net income from discontinued operations of 2.3 million, and an income tax benefit of 29.6 million. For the first half of 2013, the Company’s net income was 81.8 million or $6.24 per diluted share on revenue of 185.2 million.

On both a revenue and a net income from continuing operations basis, our 2013 first half performance was our strongest since 2007. From my perspective, more important than the numbers themselves is the confirmation that we’ve been doing a great job for our clients. By delivering truly differentiated executions and exceeding expectations, we are both developing important new relationships and enhancing existing ones. It is our ability to make money for these clients that always has and always will determine our success.

In investment banking, following one of the best quarters in our history, momentum continued through the second quarter with revenue of $52 million compared to $19 million in the second quarter of 2012 and $101 million last quarter. This $52 million in revenue from 16 client engagements was earned from a variety of transactions, large and small, public and private, and across industry groups. During the quarter, we maintained our substantial lead as the number one book runner of initial common stock offerings over the last 12 months across all industries for market caps of 1.5 billion and under, and we are ranked number eight with a 5% market share for all common stock offerings for companies in this category. As mentioned in the release, we will work to build on the momentum we’ve established and to enhance our position as a top 10 underwriter in U.S. small cap equities.

During the first half, we had a number of notable successes. We were the sold book runner on the best performing U.S. IPO of the year. We completed the first equity capital raise in the mortgage origination industry during this cycle. We led the way in raising capital for home builders with a series of three headline issues. We did the first initial capital raise in the property and casualty space in a number of years for a company owned by an important long-time client. And recently, our team delivered great result for a large coal company in arranging the sale of certain mining assets in a very tough market. These are just a few of our banking successes this year, but each are good examples of executing and making money for clients.

In addition to our banking work, our trading businesses have shown year-over-year improvement. Institutional brokerage for the quarter generated net revenue of 13.1 million compared to 12.3 million and 13.7 million in the second quarter of 2012 and first quarter of 2013 respectively. Cash equity trading commissions were up for the third consecutive quarter and represent a 12% improvement over the second quarter of 2012.

Our continued investment in quality differentiated research is an important ingredient in this improvement. With a combination of increased marketing days and active new issue calendar, improved consistency of coverage, the addition of new relationships, and gains in market share from existing clients, we are well positioned to achieve higher year-over-year revenue in this part of our business. In addition to an improving revenue picture, we had materially lowered our execution costs year-over-year, providing further improvements in our profitability profile.

Our credit trading business has also experienced a good first half of the year as we have focused on the off-the-run opportunities where we can make a difference for clients. Our business in credit is very complementary to our equities franchise and has allowed us to extend and enhance relationships with buy-side accounts in a number of instances.

In addition to our operating businesses, we deploy capital in our principal investing business in both proprietary ideas as well as with select third party managers. For the quarter and for the half, we have generated very good returns on our own invested capital, earning 1.2 million and 3.3 million respectively. We are optimistic about continuing to grow the contribution from this area of the business as we carefully allocate capital among a number of diverse strategies.

We continued to effectively manage expenses and reported lower non-comp fixed expenses during the quarter of 10.2 million compared to 10.8 million in the second quarter of 2012 and 11.1 million in the first quarter of this year. We expect to realize some modest additional savings this year and into 2014, particularly in the areas of occupancy and technology.

Head count increased during the quarter to 265 primarily due to the addition of first-year analysts and associates, and we continued to manage compensation and net revenue in line with our 56% target. It is important to note that annualized revenue per head has been close to or above $1 million for the last three quarters, and since our major restructuring in the fourth quarter of 2011 has consistently averaged more than 800,000 per head.

In the second quarter, we recognized an additional 2.3 million of net income from discontinued operations for a total of 3.1 million for the first half of 2013. These amounts reflect the impact of increasing assets under management in the mutual funds business that we sold in the fourth quarter of 2012. A final payment for the business will occur in the fourth quarter of this year based on AUM on the one-year anniversary of the transaction closing date.

As a result of the Company’s recent results and our outlook regarding future operating performance, we have determined that the release of a significant component of the valuation allowance on our deferred tax assets was appropriate under GAAP as of June 30. Therefore, the Company’s net income from continuing operations for the second quarter include the $29.6 million tax benefit reflecting the valuation allowance reversal and the Company’s utilization of its net operating loss carry-forwards. The Company continues to maintain a valuation allowance of approximately $26 million. By the end of 2013, the reserve we expect to retain will mostly relate to capital loss carry-forwards due to the less certain nature of their realization.

Also during the quarter, we repurchased 150,000 shares at an average price of 21.33 per share. This was in large part accomplished through open market purchases. Since 2010, we have repurchased 5.4 million shares or approximately 30% of shares outstanding at an average price of $13.29 per share, for a total of $72 million. The Company has 778,000 shares remaining under its previously disclosed repurchase authorization.

Shareholders equity was 315 million as of the end of the quarter, up from 267 million at the end of the first quarter and 240 million at the end of last year. As of June 30, the Company held 227 million in cash and its tangible book value per share was $25.82, an increase of 35% from the beginning of this year and 63% since the end of 2011.

Clearly we are off to a strong start in 2013 with the first half being one of the best in our history, and certainly the best in the last five years. We have been and remain very active in areas related to the housing recovery and are seeing increased activity in our industrial, energy, and specialty finance investment banking groups. Clients are increasingly taking notice of our success in helping issuers and investors achieve their respective goals. We are winning large mandates in head-to-head competition with many of our largest competitors. We are enhancing and building our brand each step of the way as the sum total of our recent accomplishments begin to tell their own story and help position us for future successes.

As we cautioned last quarter, however, while our numbers demonstrate growing momentum and validate that we have established a very efficient and productive operating platform, we are well aware of and focused on the significant risks that remain in the current environment. The global macroeconomic conditions, the continued uncertainty surrounding Fed policy, U.S. budget and legislative deliberations, and the slowly evolving but significantly changing regulatory environment all continue to underpin the risk profile of this market. This cautious outlook will continue to influence our day-to-day decisions surrounding controlling costs and growing our platform, even as we enjoy increasing success in winning banking mandates and delivering successful outcomes to clients.

I’m proud of the work our team has done this year and over the last several years as we have consistently worked to fulfill our mission of doing big things for clients. I’m confident our focus will remain on our client success as we work to build on our recent track record.

Thank you for joining us, and Operator, you can now open the call up for questions.

Question and Answer Session

Operator

[Operator instructions]

Our first question today comes from the line of Zach Pancratz from DRZ. Your line is open. Please go ahead.

Zach Pancratz – DRZ

Good morning, Rick. Congrats on another great quarter.

Richard Hendrix

Good morning, Zach. Thank you.

Zach Pancratz – DRZ

I wanted to ask – you know, the tenders that you have guys have tried to come out with, they seem like no one’s really willing to sell you their stock. Going forward, how do we think about returning excess capital to shareholders? Is dividend really your only option, or what are some of the other things out there that you guys can do to return that excess capital?

Richard Hendrix

Well, we’ve had success with some of the tenders, but clearly this most recent one was not subscribed at all, and I think that’s a reflection of the fact that there are not a lot of sellers. We have been able to buy shares in the open market, as we mentioned in the script and as you can see in the numbers, and we’ve done that a couple times this year in size. But as the stock trades above book value, it may be more efficient if we’re going to continue to return capital to do it in ways other than buybacks, and so we’re going to continue to look at where we are from an overall capital perspective. We’re going to look at opportunities that come to us. I think we may still see some select buyback opportunities, and we will consider a dividend potentially as we go forward. We’ve not made any determination that that is going to be in the best interest of shareholders at this point, but certainly if the stock is trading at a level where its no longer accretive to book value to be buying it, a dividend starts to become something that might make more sense.

But we’re always going to buy back at least enough stock to offset dilution from employee shares that are granted in vest, and I do think we may continue to see select opportunities to buy shares. So we’re very focused on managing capital in an efficient way. I think we’ve done a pretty good job of that over the last few years, and sort of all of those tools are at our disposal and we’re going to do what we think is going to be most valuable and create the most value for shareholders.

Zach Pancratz – DRZ

All right. Okay. Would you guys be more inclined to do a one-time div, or would this be some type of a recurring as you think about going forward?

Richard Hendrix

We honestly haven’t made a determination that we’re going to do anything specific from a dividend perspective, so I think it’s premature to talk about how we would do it when we haven’t decided to do it. But obviously companies will pursue both those paths from time to time with special dividends or regular quarterly dividends, and that’s just a decision that we haven’t gotten to yet and we haven’t really done the work to be able to communicate anything along those lines.

Zach Pancratz – DRZ

Okay, that’s helpful. And then looking at the DTA going forward, first of all, how much do you guys have left on that, and then how do you see that progressing throughout the remainder of this year?

Richard Hendrix

So there’s about $26 million left, and most of that is related to capital loss carry-forwards. It’s not likely, at least in our opinion right now otherwise we would have brought it back, that we’ll be bringing that back in the near term. Capital gains are just more difficult to forecast than operating profit; and so it’s there, it’s available to us, and I think we’re optimistic and believe we’ll find ways to use it and to be able to shelter gains as a result. But we’re not planning at this point to bring it back onto the balance sheet.

There is an additional 4 million that is likely to come back through the balance of the year as we report earnings, and that’s not capital loss carry-forward related so there’s a little bit more that we’ll benefit from in 2013; and then the capital loss carry-forwards, we’re going to have to actually generate capital gains to be able to recognize that.

Zach Pancratz – DRZ

Okay. All right, well that’s it for me. Thank you and, again, congrats on a great quarter. We like everything you guys are doing.

Richard Hendrix

Great. Thanks, Zach.

Operator

Thank you, and once again ladies and gentlemen, if you’d like to ask a question, please press star and then one now. Our next question comes from the line of Mark Patterson of MPW Investments. Your line is open. Please go ahead.

Mark Patterson – MPW Investments

Hey there, thanks you guys. Rick, you and your team have done a tremendous job. Really appreciate it. I wanted to follow up a little bit on the DTA. So the 26 million left, that’s 22 of capital loss carry-forward and then the additional 4?

Richard Hendrix

Brad, is that how it breaks down?

Bradley Wright

Yeah, that’s dead-on, Mark.

Mark Patterson – MPW Investments

Okay. And then on the FBR funds, with the discontinued income, do you expect to dribble some more of that through over Q3, Q4 until that final payment is made?

Richard Hendrix

If AUM holds exactly where it was at the end of June, there is an additional couple million dollars that we would likely recognize, probably primarily in the third quarter because the date for determination of the final payment is actually in October, and so we’ll know by the time we report earnings again sort of where we are, so we’ll have a reasonable degree of certainty with which to estimate. But it’s a couple million dollars if AUM stays at the same level it was at the end of June.

Mark Patterson – MPW Investments

Okay, great. I guess a little bit of a follow-up from Zach’s question related to the—I guess I’ll call it a high-class problem of excess capital. Do you see opportunities that would be economically appropriate to take for the firm right now with that capital, as opposed to the return to shareholders?

Richard Hendrix

We do, Mark. Number one, we are actually generating really attractive returns in what we’re doing from a principal investing standpoint. We’re not in a big hurry to deploy certainly all of our cash, or even a really high percentage of our cash, into less liquid alternatives, but where we have done that, we have generated really attractive returns, so we see opportunities there. We also believe that there are developing opportunities in some of our trading businesses, not for us to take big desk positions that look like prop trading but to support higher levels of trading revenue. And so I think both those things are interesting opportunities for us.

But in addition, as you know and as Zach and I talked about, we’ve been very focused on returning capital to shareholders along the way, and I do expect that we’re going to continue to do that; but I don’t think any of these things is an absolute. The only answer isn’t return every dollar of capital that we’re not using tomorrow to shareholders immediately, and we certainly aren’t going to rush to put on a bunch of risk that probably, while we’ve generated great returns with it, might raise the risk profile beyond where we think it ought to be in this environment.

So we’re going to continue to be sort of thoughtful about how we do it. We’re going to continue to invest in the business, both the operating businesses as well as our principal business, and we’re going to continue to find ways to get capital back to shareholders. I think that’s been a good approach for us over the last couple years and one we want to continue to follow.

Mark Patterson – MPW Investments

Okay. Moving to the expense side, obviously the restructuring you guys have done has been very helpful for the operating leverage of the Company. I’m looking at non-comp expense down a couple of million dollars year-over-year when your revenues have more than doubled. But that 10.2 million of fixed non-comp, is that pretty much a floor now that we should expect?

Richard Hendrix

Well as we mentioned in the script, there is some more to come. We’re going to be relocating our Arlington headquarters in 2014, and I expect that we’re going to have savings associated with that move. We also have some changes that we’re making to our technology infrastructure that has saves that are going to be coming with them, but each of those things is going to take longer than some of the other steps we’ve taken over the last couple years. So I think we’re running about at the level we’ll run at going forward. There’s probably another 5 to 6% in cost saves available off of that $40 million run rate, and I think we’ll capture some of those; but we may also grow areas of the business where we add some expense. So 40 million, I think is a pretty good number to think about in terms of a full-year non-comp fixed, and I would tell you there’s a little bit of opportunity beyond that.

Mark Patterson – MPW Investments

Okay, great. Last question for you, last topic, I think – in the investment banking line, again looking at your numbers, three of the four best quarters you’ve had in the last five years, back-to-back-to-back. I know that you’ve been painstakingly letting the shareholders know and the investors know that you have lumpiness from quarter to quarter, but do you feel like with the traction momentum that you’ve got over the last few quarters, that this is kind of more of a new plateau or level of revenues that you can see on a quarterly basis? Not that you’re going to make $50 million every quarter, but that you’re probably at a 50 million a quarter average type of pace?

Richard Hendrix

Well, 50 million in banking on average is probably a little bit above where we feel we’re running, so I guess I’d say a couple things. As you said, we’ve been careful to caution people, and I’m going to do it again – we are really lumpy quarter to quarter, so if you just look at individual quarters its difficult. But if you look at sort of a trailing 12 months or a forward 12 months, I think that investment banking revenues of between 150 and 200 million a year is very achievable against the platform we have today in a decent environment. It doesn’t have to be the best environment we’ve ever seen, but it obviously can’t be something that looks like the back half of ’11 or the first half of ’09 when there was almost no capital markets activity. So in a normal environment, I think 150 to 200 banking is achievable for us with the way we’re positioned today.

And then our trading businesses should run in the aggregate between 50 and $60 million, and then when you add in some principal revenue, if you look at our trailing 12-month revenues for each of the last two quarters, it’s sort of in a 230 or $235 million range. And look – that’s a good performance, so I don’t want to suggest that that’s easy for us, but I think it’s achievable for us.

Mark Patterson – MPW Investments

Okay then. And then the final question, then – the 150 to 200 million a year achievable, that averages out to something under 50, obviously. Would you expect quarters where markets aren’t really open or accommodative to—I mean, it’s not likely it’s going to take place during a whole quarter, but maybe it does. Is there a floor level of revenues you think you guys have kind of achieved – I mean, maybe you won’t have quarters below $15 million, or--?

Richard Hendrix

Well, I think in investment banking, that would be at the low end of what we would hope we would ever see; but we had a quarter that looked a lot like that, maybe even a little bit below that, last year in the third quarter. And the third quarter is always seasonally tough for us, just because there’s a lot less deal activity in the back half of August, and you’ve got some holidays in the beginning of July and so forth. So I think that is the low end of what we should ever do, but we’ve done it – we did in the third quarter of last year. So while we hope we don’t repeat that, what I would tell you is that we are structured in such a way that even if we put up a really light revenue quarter like that, we should be profitable. I think that’s been the goal through the whole repositioning and transitioning of the business, was let’s get in a position where in good environments – and I’ll certainly call the first half of 2013 a good environment – we deliver a lot of operating earnings and a lot of return to shareholders, and in a tougher environment – call it the third quarter of ’12 – we don’t lose money. I think we’re structured in such a way where that’s the case.

Now, the third quarter of ’12 was really light – it was 24 million in total revenue, and at that level we’d probably still lose a little bit of money. I think we lost about 4.5 million pre-tax last year in that quarter. We would do better than that, but we’re definitely structured in such a way where I have a hard time envisioning us with the business we have today, losing money for a year or even having one of those really tough quarters that we did in ’10 and ’11.

Mark Patterson – MPW Investments

And is it too early to talk about third quarter of ’13, just what you see, what’s in your pipeline?

Richard Hendrix

Well, it’s definitely too early to talk about revenue. I can tell you from a pipeline standpoint, we have a deal on the road right now that is going very well. It’s a real thin IPO that we feel great about. We have a number of other deals that are either about to launch or we have high confidence about launching in the next few weeks. But I would tell you that whether the third quarter turns out to be a great quarter or a lighter but still okay quarter will probably be determined mostly in September, just based on the calendar and sort of what’s in the pipeline.

But we continue to have a very solid pipeline. I feel great about the fact that our teams have been to capitalize on the momentum that we have right now, so as I look through the balance of this year, we feel really good about where the business is positioned. But just because we’re so volatile and because—you know, if things slow down and a couple of deals move from September to October, it can really influence results. It’s hard to be predicting what third quarter is going to be at.

Mark Patterson – MPW Investments

Great. Thanks again.

Richard Hendrix

All right, thanks Mark.

Operator

Thank you. Our next question comes from the line of Albert Jones of Jones Capital Management. Your line is open. Please go ahead.

Albert Jones – Jones Capital Management

Congratulations on a very nice quarter. Just a quick question on the IPO market – are you seeing any sectors there open up quite a bit from last year and earlier this year? Anything in that environment that’s changed where things for certain areas, you’re starting to see more opportunity?

Richard Hendrix

Well, we’re seeing opportunity, really, in every one of our industry groups. I probably shouldn’t comment on groups where we don’t compete from a banking standpoint because we’re just not as as focused there, so I’ve got probably less direct feedback about what investors are thinking. But in energy and industrials, and in financials and in real estate, we see opportunities in every one of those groups and we have a pipeline that would suggest that we’re going to be executing important transactions in every one of them.

You know, the first half of 2013 has actually been a very good period, from my perspective, for the IPO market. We’ve had short windows where things have slowed down a little bit, and with all the taper talk a couple weeks ago, that certainly gave the market pause and you saw a bunch of the real estate names in particular sell off pretty hard. But most of that has come back and the market’s recovered, and I think it feels pretty constructive as we look to the second half of this year.

So I don’t see any of the sectors in which we compete where I don’t think we can execute sort of a well structured and high performing company from an IPO perspective. So that’s why I mentioned to Mark we do feel good about the back half of this year.

There isn’t any particular sector where I would say it’s opened up versus not having been available to issuers, because the first half was a really good period. So I think our view is that that strength is going to continue, and we’re certainly seeing it in the reception of the deals that we have on the road right now.

Albert Jones – Jones Capital Management

Okay, thanks. My next question was actually going to deal with that taper talk slowdown issue. You answered that, so that will be it for me. Thanks, guys.

Richard Hendrix

Great, thank you.

Operator

Thank you, and with no further questions in queue, I’d like to turn the conference back over to Mr. Hendrix for any closing remarks.

Richard Hendrix

Great. I’d like to thank everyone for joining us, and we look forward to talking to you in October with regard to our third quarter results.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may all disconnect. Have a great rest of the day.

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