GMP Capital's (GMPXF) CEO Harris Fricker on Q2 2016 Results - Earnings Call Transcript

| About: GMP Capital (GMPXF)

GMP Capital Inc (OTCPK:GMPXF) Q2 2016 Earnings Conference Call August 5, 2016 10:00 AM ET

Executives

Harris Fricker - Chief Executive Officer and President

Deborah Starkman - Chief Financial Officer and Corporate Secretary

Analysts

Paul Holden - CIBC World Markets Inc.

Sumit Malhotra - Scotia Capital Inc.

Operator

Good morning, ladies and gentlemen. Welcome to GMP’s Second Quarter 2016 Conference Call.

I would now like to turn the meeting over to Mr. Harris Fricker, Chief Executive Officer and President. Please go ahead, Mr. Fricker.

Harris Fricker

Thank you. Good morning, and thanks for joining us as we walk through GMP’s quarterly results. With me this this morning is Deb Starkman, our CFO.

Before we get started, I would like to remind you that this call is being webcast and will be available for subsequent replay. Today’s call may contain forward-looking information and actual results could differ materially. Forward-looking information is subject to numerous risks and uncertainties. Certain factors or assumptions applied in forward-looking information can be found in our 2015 AIF and in our second quarter MD&A. These documents are available on our website and on cedar.com.

A confluence of macro events ranging from the Fort Mac wildfires are slowing Chinese economy and the impact of the UK referendum weighed heavily on risk appetite and client activity levels again this quarter. Global markets went into a sharp short tailspin following the Brexit Vote. Confronted again with these challenges, there was a significant amount of trepidation amongst investors. Despite these ongoing challenges, our second quarter results evidenced the resilience and sustainability of our business.

Simply put, we have worked hard to build considerable operating leverage in our business model. In fact, we have managed to bring down a break-even performance quarter further than originally expected, with revenue in the low $40 million range, both our capital markets and wealth management businesses were profitable this quarter.

But this quarter’s are being overshadowed by the pending acquisition, which we announced last evening. So let’s get straight to this, as I’m sure, that’s why many of you have dialed in this morning.

Notwithstanding the current negative investment bias towards oil and gas, we continue to see these assets as incredibly important to the economy of our country and a viable part of the global energy stack for the foreseeable future. This announcement is reflective of that belief and is a strong vote of confidence in the recovery of Western Canada, particularly, the Calgary and Fort Mac communities. This is about building deeper and more enduring relationships through various market cycles, including having the will and wherewithal to seize opportunities at the bottom of the cycle, GMP has both.

This transaction will have substantial scale to our energy capabilities. In FirstEnergy, we are adding what we believe is the country’s preeminent energy franchise and an exceptional cultural fit. This partnership has been in an important part of the fabric of Canadian energy culture for nearly a quarter or century and has built significant brand recognition.

Our new partners have a deep knowledge of the energy sector and our approach will be focused on providing support to a broader platform and more efficient access to capital to help them extend their leadership and continue growing the franchise. This transaction deeply impacts our ability to fulfill our mandate at the dominant independent player in the Canadian small to mid-cap market, including facilitating the flow of capital to emerging companies that represent the future of our economy.

A dominant domestic energy franchise has long eluded the major diversified independent brokers. This announcement changes our dynamic and promises to be disruptive to the independent brokerage space.

Success and sustainability in the Canadian capital markets, given its heavy skew towards resources requires maintaining leadership in both energy and mining. We’ve always been recognized as a premier mining franchise and this transaction will add substantial energy leadership to the team. Add to these, the strong and growing franchises in non-commodities, namely healthcare, financial services, and diversified industries, and GMP has solidified its dominant competitive positioning in the Canadian capital markets.

In recognition of the strong FirstEnergy brand, our combined energy business will operate under the GMP FirstEnergy banner upon closing. Our energy business will continue to be headquartered in Calgary and incorporate best practices from both firms. We will preserve wholesale the leadership of the FirstEnergy business and look forward to their contribution to the management of the broader firm.

And although it is still early days to quantify a precise number, we also believe that as a synergistic buyer, there are considerable revenue and expect expense synergies to be extracted from the combined business.

With that, let’s turn back to our financial performance for the quarter. Total revenue decreased 48% from Q2, primarily due to a decline in investment banking fees. Partly offsetting the decrease in investment banking was a $7 million increase in principal transactions, primarily due to higher returns of principal inventories and increased U.S. client-related fixed income activity. We reported a net loss of $701,000 in the quarter and a diluted loss per share of $0.02.

Let me now discuss the financial highlights for each of our business segments. Capital Markets reported pre-tax income of $1.5 million, down from a strong performance in Q2 last year. Despite daunting market conditions, our operations in Canada were profitable again this quarter.

Revenue was $38.6 million, down 48% from Q2 last year. The year-over-year decrease was largely driven by lower investment banking and commission revenue. Partly offsetting, the decline was higher net gains on principal transactions.

Investment banking revenue decreased 68% from a strong second quarter last year. In particular, investment banking revenue in the mining and energy sector was down 82% and 77% year-over-year, respectively. You may recall that Q2 last year included record advisory revenue, including several notable mandates in the commodity sector. We continue to believe the conditions for a strong M&A cycle are still in place, namely strong valuations, historically high corporate cash balances, and a low interest rate environment.

The Capital Markets are showing renewed interest in the mining sector, as commodity prices, particularly gold continue to stabilize following several tough years of depressed and volatile prices.

Revenue from principal transactions was $8.9 million this quarter, up sharply from Q2 last year. This increase was led by improved returns on principal inventories and higher fixed income client trading revenue in our U.S. operations. And sales and trading commission revenue decreased 14% to a $11 million this quarter, driven by generally lower client activity amid ongoing equity market volatility. However, commission revenue increased 17% from the first quarter and it’s the second consecutive sequential quarterly increase.

With that, let’s turn to the Wealth Management segment, where Richardson GMP recorded adjusted EBITDA of $9.6 million this quarter. Revenue of $64.7 million was down 9% from Q2 last year, largely due to lower commissions in line with reduced client activity. We ended the quarter with AUA of $27.2 billion, 198 advisory teams with average assets per team of just over $137 million.

With that, I’ll turn it over to Deb to discuss expenses.

Deborah Starkman

Thank you, Harris. Expenses this quarter decreased 41%, or $28.5 million from Q2 last year, largely be driven by lower employee compensation expense. This decrease continues to reflect significantly lower headcount cost against entire franchise and a run-off of certain guaranteed compensation arrangements in Houston. We have reduced our total headcount by 120, or approximately 29% over the past 18 months.

Now, let’s review expenses from our Capital Market segment. Expenses of $37.1 million in the quarter were down 42% from Q2 last year. This is largely due to lower variable compensation. Additionally, fixed salaries and benefits decreased 50%, as a result of lower headcount and a run-off of certain fixed guaranteed compensation in Houston.

Lower non-compensation related expenses compared with Q2 last year also reflect the benefits of cost savings from recent restructuring initiatives. In fact, selling, general and administrative expenses this quarter are at their lowest level since third quarter 2013. We believe at this stage, our top base is effectively in line to the new normal. It’s worth highlighting that while revenues decreased 9.5% this quarter versus Q1, total expenses declined 16.3%.

Additionally, our fixed salary should continue to drop off over the next several quarters, as guaranteed compensation arrangements continue to run-off. Over the coming months, we will obviously turn our full attention to the integration of the FirstEnergy business, and we will provide greater detail on potential synergies at our next quarterly discussion.

Before I turn the call back to Harris for closing remarks, let me say a few words on the impact of this transaction to our balance sheet. There’s minimal cash outlay on close, given that consideration paid is in the form of common shares issued from treasury and a five-year promissory note.

Of course, we’ll incur integration-related costs and charges, but we expect these to be relatively modest and they will be shared with FirstEnergy. A significant portion of the shares issued in connection with the transaction will be recognized as share-based compensation over the vesting period for accounting purposes.

And now, I’ll turn it back over to Harris.

Harris Fricker

Thanks, Deb. With no question, this has been a prolonged down cycle, one that has seen many smaller independent dealers disappear from the landscape. Throughout this period, our franchise continued to demonstrate its resilience and adaptability in the phase of considerable adversity. While our performance over the past two years has not been where we would have wanted, we have both the wherewithal and the conviction to – we have had both the wherewithal and conviction to transform our business over the past 18 months to the better.

Our cost base in capital position are sound. We have surgically reduced the firms break-even and have built considerable operating to work to the up-cycle in the markets. More importantly, we have also established a new competitive benchmark in the independent brokerage space.

Following the closing of our acquisition of FirstEnergy, we will solidify our leadership position in the two largest sectors of the Canadian Capital Markets, namely oil and gas and mining. And we’ll look to continue our growth momentum in the non-commodity space through the addition of key investment banking personnel.

In the U.S., we have a first rate of profitable fixed income business based in New York. The fixed cost of the Houston initiative have dropped considerably and we expect to further refinement in the business plan there post-FirstEnergy and an accelerated path to profitability.

Simply put, we believe our competitive positioning has never been stronger. And as always, we remained a focused operator, a prudent steward of capital, and a disciplined risk manager.

With that, we’ll be pleased to take your questions.

Question-and-Answer Session

Operator

Thank you. We’ll now take questions from the phone lines. [Operator Instructions] Our first question is from Paul Holden with CIBC. Please go ahead.

Paul Holden

Thank you. Good morning.

Harris Fricker

Good morning.

Deborah Starkman

Good morning.

Paul Holden

So a few questions, and they’re all kind of related to the FirstEnergy transaction. First is, following up on Deb’s comment regarding the balance sheet impact or no balance sheet impact. Just trying to get a better sense of how the promissory note will work? Is effectively it’s just a five-year bullet payment in cash and is it contingent on any considerations?

Harris Fricker

The note is a five-year unsecured note. It will be serviced out of the profits – a share of the profits of the business over the five years, and any residual will be extinguished with the bullet payment at maturity.

Paul Holden

Got it, okay. And then in terms of again, the impact on balance sheet, based on the numbers you’re having today, once you consolidate that your balance sheets, there shouldn’t be a material impact on networking capital. Is that correct?

Harris Fricker

That’s correct.

Paul Holden

Okay. And then how do we think about the near-term impact on profitability, i.e., what I’m trying to get to is FirstEnergy’s earnings today, do they look something roughly equal to GMP?

Harris Fricker

We’re going to wait for the transaction to close, which obviously we’re – that’s more on a regulatory serious of factors. And then we will happily provide full detail on what is still obviously a private company.

But let me say a few things about their profitability. They’ve never lost money in their 20-plus-years of operation. Including in some of the most challenging years, we’ve seen in decades, they are profitable this year. Their profitability over a five-year average cycle, which includes some very challenging years is very robust. This transaction will be decidedly accretive to GMP, and we feel it positions us very competitively in the oil and gas space in Canada.

We have said consistently that despite having excellent people in Calgary who will absolutely be part of the going forward, we wanted to get stronger and what we thought was one of the critical sectors in the Capital Markets.

Paul Holden

Okay. And then given that kind of wondering, how you think about the price you’ve decided to pay for FirstEnergy? A lot of people are going to look at or try to get some kind of price to book of metric, which I’m not convinced if necessary the best way to look at it? So just wondering, Harris, how you’re looking at the price paid?

Harris Fricker

I look at it as net income after-tax and we did both the 10-year and a five-year average, applied a multiple to that. Also took during August 31 fiscal year end, also took, we’re obviously, we’re pretty close there, so took the projection for the year, but a multiple on that.

Again, we’re paying decidedly below what our multiple is. And we’re acquiring what we think is the best energy franchise independent in the country on an accretive basis. But we looked at net income after-tax as our driver. Book is not a good barometer of value for the company.

Paul Holden

Right, okay. Yes, so we can agree on that point. And then one follow-up on – if you can answer it, if then we assumed say, oil goes back to, I don’t know $80 to $100 a barrel, which will be good for us, all of you did, but so let’s take that assumption. What was your expected ROI be at that kind of price range for oil?

Harris Fricker

It would be dramatic – it would certainly be north of 30%.

Paul Holden

Okay. Okay, good. That’s all the questions I had. Thank you.

Harris Fricker

Thank you.

Operator

Thank you. [Operator Instructions] Our next question is from Mr. Sumit Malhotra with Scotia Capital. Please go ahead.

Sumit Malhotra

Thanks. Good morning. Can you hear me, okay?

Harris Fricker

Yes, we can hear you. yes.

Deborah Starkman

Yes.

Sumit Malhotra

Okay. Just one on the quarter to start. I thought, obviously, the strongest aspect was on the cost control, which has been a major emphasis of yours in recent quarters. Specifically, if we look at the fixed cost, so everything except for your variable compensation, we’ve seen a pretty dramatic decrease, it’s something like 40% year-over-year. Just want to be clear on what you’re looking at, now X of the deal, which we’re going to talk about in a second. Do you feel that you’re now at a run rate level on fixed costs, or is there still more reduction we should be looking for here?

And secondly, do you think the break-even number that you communicated before has been lowered by the progress you’ve been able to make?

Deborah Starkman

So I think with respect to cost savings, we continue to work on. And I think our fixed costs will go down even further, as the Houston guarantees continue to run-off. So the break-even, I think, probably should go down even further.

Sumit Malhotra

Yes.

Harris Fricker

Sorry, we’ve guided in the past on the – I think on the on 50%. We were comfortable at 45% as to where we need to be on a revenue run rate to see blocking [ph] kind of quarter.

Sumit Malhotra

Okay, that’s fair. Now, let’s move on to the transaction. There was a couple of interesting points that you were giving to Paul there that caught my attention. Now, you said, I know, you can’t give us too much about what their financials are. But your comment was that on a PE ratio basis you’re paying a much lower multiple than what GMP is traded at. Just so I know, because obviously, between shifting from income trust and challenges in the last few years, I’d like to know what’s the – what do you believe your PE ratio has been on average, when you say that, you’re paying a lot less than what you’re – than what you faded out?

Harris Fricker

Our PE ratio and again, obviously there’s a lot of moving parts. We always use around 10 to 12.5. And here we used 10 as our multiple – as GMP’s multiple.

Sumit Malhotra

The GMP’s multiple is 10, and you’re paying less than 10 on what you think is a reasonable earnings estimate of earnings power for FirstEnergy.

Harris Fricker

Very conservatively, yes.

Sumit Malhotra

Okay. And then secondly, I – your next call, I think, will be in November. Will this deal be closed then?

Harris Fricker

Yes.

Sumit Malhotra

Okay.

Harris Fricker

We’re strongly of the view that we’ve taken the view that we should be closed by the end of September and are obviously going to work with the regulators to get it closed as quickly as possible.

Sumit Malhotra

You’ll be able to give us a lot more in the way of numbers at that time?

Harris Fricker

Yes.

Deborah Starkman

Yes.

Sumit Malhotra

Something interesting that’s – that I want to make sure I understand that you talked about some of the consideration for this transaction running through the share-based comp. Now, I want to make sure I understand this. As – when this deal closes, will we see that – we see an immediate increase in the share count of a $11 million, or is it structured, if we will?

Deborah Starkman

Yes.

Sumit Malhotra

Okay. So the share counts going up by $11 million number on close. Now, what was that comment about share-based comp?

Deborah Starkman

Okay. So if you recall with MTR transaction part of the compensation or part of the shares issued at a treasury were treated as compensation expense over the period, which we adjusted for.

Sumit Malhotra

Yes.

Deborah Starkman

And because the shares are subject to an escrow agreement, some of the holders of FirstEnergy, which was partnership have to – for accounting purposes, some of the shares will be treated as compensation for accounting purposes, which would be recognized over the life of the escrow agreement, some of the other holders who are not employees of FirstEnergy will not be subject to do that terms.

Sumit Malhotra

And you’re going to treat that the same way you treated MTR?

Deborah Starkman

Yes.

Harris Fricker

Yes.

Sumit Malhotra

But the – yes, I think the important one is for shareholders, the share count is going up by 17%, so the denominator in your EPS calculation is going up and you’re of the view that the deal will still be very accretive, I think, was your term?

Harris Fricker

Yes, and our share counts going up 15.5%.

Sumit Malhotra

Okay. 1.5% between France, but – okay, I got you. I will check my math.

Harris Fricker

Okay, thank you.

Sumit Malhotra

Okay, let’s go into a couple other things. So maybe more strategically, you’ve pared back the Houston initiative, I think that’s fair to say, and you’ve already got a decent size commodity franchise. In fact, I think it could be argued. You made an interesting statement that it’s been difficult for independents to have a dominant energy franchise. I mean looking at some of GMP’s energy numbers over the years, I’m not sure if I would agree with that statement.

And maybe the last one that I’m going to go into this open end question, you historically as a company have avoided buying other investment banks and I think we can say it’s been difficult for one plus one to even equal to at investment banking deals. Why the change in focus here to add another broker in a sector you’ve already had success in, given some of the historical challenges?

Harris Fricker

I would say and I think we’ve said this consistently well. Well, we’ve had success in Calgary. We have not had the type of franchise and the level of success. We felt it was necessary, given the importance of that sector to the Canadian Capital Markets.

We especially noticed it and again we have some exceptional people in Calgary, who will be a big part of this, but we didn’t notice that in the trough. All of the independent broker-dealers experienced a decline in market share to the benefit of the two dominant independents in town.

That was pretty demonstrable of the strength of their franchise in the trough, so while we have had a presence in Calgary, long-term and it’s a very, very important market to us. We think there is vastly improves our franchise and positions us really as one of the dominant players in energy in the country.

Sumit Malhotra

With some of the restructuring efforts you’ve undertaken, and as you referenced the difficult environment that particularly the independent space is had, and the last number of years has been a good amount of turnover in the business. When you -- put out a decent outlay to bring another team in.

What about the cultural concerns that go into a transaction like this and that is it – we often hear the, us versus them mentality. How confident are you that you can melt or put these two units together without having that be an issue, given that there’s a new tranche of shareholders that are being made whole here at the expense of existing ones?

Harris Fricker

Well, it’s an excellent question. I don’t know or why would say the experience given its accretive, but look these things come down to two things, culture and integration. We have to get the integration right, where I worked tirelessly over the next couple months to do that.

Culture was something that we’ve assist from a distance, several other principles there are very well known to us professionally and personally. And as we got a better sense of how they ran their business, it became very clear to us that there was a very good operational and cultural fit.

Both businesses were very lean. Both businesses are very entrepreneurial, and there was – in their business an enormous amount of pride and esprit to core. If we don’t get the integration, right that it will damage the acquisition. So we have every intension of getting the integration, right. The other thing here is this is a medium term call on the price of the commodity. And if people think that WTI is going to labor $25 for the next five years, this will be a failed acquisition.

Sumit Malhotra

Yes, and listen I’m not necessarily in the business to making the call on commodities. I think my point was more and this is to the history of GMP and I’ve covered this company for a long time as you know and the acquisitions that you’ve historically done haven’t directly been in your own space. It’s been retail brokerage or it’s been private equity.

And my question to you would become if you’ve been in outlay of $100 million here, it would seem at lower levels, you could have perhaps hired individuals or teams that could build out your energy practice into a brand name of GMP that’s already quite well known. How did you approach the buy versus rebuild as far as your energy practice, especially because as a CEO, you haven’t bought brokers in the past, and I think that’s been a strategic view on your point?

Harris Fricker

I was talking with a senior person at one of our competitors and we were having a good laugh, because he was saying their Annual Strategy Meeting for the last eight years, their page on Calgary said higher rainmakers and they had hired exactly none in eight years. It’s a very difficult market to recruit from. And the thing that really attracted us is FirstEnergy is part of the cultural fabric of that city. It’s a real franchise. It’s much more than a couple people. It’s an entire operation, and we felt to be able to buy it accretively and transform our competitive position in either the first or second most important sector in the country was incredible opportunity.

Sumit Malhotra

All right.

Harris Fricker

I don’t think anyone in the independent space has demonstrated that hiring your way in Calgary is the way to build a business.

Sumit Malhotra

All right. I’ve got a couple more, I’m going to wrap up here now. I know, you’re going to share some more financials with us next time around. We were doing some of our own checks. So, I guess, I’ll ask you this question. Of FirstEnergy’s aggregate revenue stream, what percentage of it is coming from underwriting, as opposed to say, advisory or commission?

Harris Fricker

You know that waxes and wanes just like our business. So I don’t know if I could – it’s 60/40 moving back and forth.

Sumit Malhotra

Okay.

Harris Fricker

Not be similar to early.

Sumit Malhotra

I would have thought that their business would have been skewed more heavily to underwriting?

Harris Fricker

No, that’s not correct. They have a very powerful A&E business, which leads into a powerful M&A business.

Sumit Malhotra

And last question is going to come around to the capital point. You’ve been very helpful with us and saying as a standalone company around $100 million was the level that you felt was the floor and you’ve been comfortably above that for number of quarters. I think, you’re at about 150 this time around. And my question to you would be as a CEO, obviously, capital deployment is one of the most important aspects that you have to deal with.

How did you weigh spending or making this outlay to buy a competitor relative to your ability to increase the ownership position of your employees in the company, which is something that’s been very successful for GMP in the past via a major buyback. I know, especially in some of the conversations perhaps around Richardson and GMP and what happens there, the ability to increase the ownership of employees through share repurchases has been something that, I felt has been important to you. Is it fair to say that with this move today that that’s something that’s not as high on the packing order for GMP and yourself?

Harris Fricker

No, I think if you look at this transaction what we’ve done with essentially no capital outlay upfront is acquire one of the best players in the oil and gas base in Canada on an accretive basis. We will absolutely look for opportunities to buyback where those opportunities arise. And if we can do that in the material fashion, we will absolutely do it.

Sumit Malhotra

Well, thank you. Thank you for your time and I take up a lot of time, but obviously the important transactions. Thank you for that and look forward to some more financial details when we speak with you next time around.

Harris Fricker

Thank you for your questions.

Operator

Thank you. There are no further questions registered at this time. I would like to turn the meeting back over to you Mr. Fricker

Harris Fricker

Thank you. Thanks for joining us, again, today. We look forward to updating you at our Q3 call in November. Enjoy the balance of your summer.

Operator

Thank you, sir. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.

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