MF Global: Repairing the Damage

This year has not been kind so far to financial stocks. From large banks recording billions in write downs to brokerage houses falling under liquidity constraints, the playing field is littered with casualties.

MF Global Ltd. (MF) is no exception. The company ran into a major issue in its fiscal fourth quarter (ending March 31) when lax internal controls allowed a broker to trade extensively outside normal restrictions, resulting in a $141.5 million dollar bad debt write down. The stock plummeted as investors feared that the event could have been repeated with other traders across the company’s platform. At one point intra-day, the stock reached a low of $3.64 after trading in the low 30’s at the beginning of the year.

Since that time, the stock has recovered much of its gains as the immediate danger was averted. Management issued several statements noting the liquidity reserves the company had available to draw on, as well as the ongoing investigation as to how this devastating event occurred and what could be done to keep it from happening again. The fact that things appear to be more contained in the overall financial sector has also added to investor confidence and allowed the stock to make back a portion of its losses.

Friday, the company pre-released its fourth quarter earnings, citing revenues of $440-$460 million, which was just a touch below analysts' expectations. At the same time, the company expects adjusted earnings of $75-$85 million, but this figure does not account for the one time loss that the company suffered. The actual GAAP earnings will recognize a loss of roughly $55-$65 million.

Despite the one time charge, the underlying business appears to have weathered the quarter well. Some analysts are concerned with a sequential decline in customer deposits, but this number is largely lower due to end of year re-balancing as customers often take excess margin from winning trades out of their accounts. Management noted that the underlying number of contracts outstanding was only down a modest amount which indicates that despite the negative headlines, traders are willing (at least for now) to continue to do business with MF Global.

Coinciding with the pre-release, the company issued a statement about its ongoing internal controls audit. There are two separate third party teams that are testing the multiple systems used by brokers and traders. After patching up the hole that was used for the loss last quarter, the reviews have yet to find any additional significant flaws. It appears that the systems are now operating securely and this type of event will not be able to happen in the future.

The company has increased the number of on-site compliance and risk management specialists at each of its company centers and appears to be taking proactive steps to rebuild its reputation. Still, reputation is one of those qualities that once lost is very hard to regain. It will likely take time for investors to be willing to pay a healthy multiple for the stock due to the perceived risk in the name.

Still, despite its stumbles, the company operates in a dynamic market that is sure to continue to grow as the need for hedging in the financial markets rises. Volatility will likely continue in the foreign exchange markets that MF Global specializes in, as well as other markets in which it is building business. Profits are likely to grow and patient investors likely to be well rewarded for the risk they are taking.

The stock traded sharply higher Friday on the earnings pre-announcement showing how good news (or lack of bad news) can propel this name. With a small pullback in the last few days, the stock appears to be in a good spot to begin initiating positions with the understanding that this name has a high degree of volatility. If trading this name, one should pay close attention to stop points as they may give a false start or two before truly beginning a solid trend back up.

Disclosure: Author does not have a position in MF.