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FBR Capital Markets Corporation (FBCM)

Q1 2008 Earnings Call

April 23, 2008 9:00 am ET

Executives

Eric Billings - Chairman and Chief Executive Officer

Rick Hendrix - President and Chief Operating Officer

Brad Wright - Chief Financial Officer.

Paul Beattie - Director of Investor Relations

Analysts

Roger Freeman - Lehman Brothers

Dan Fannon - Jeffries

Terry Babe – ThinkEquity Partners

Operator

At this time, I would like to welcome everyone to the FBR Capital Markets first quarter 2008 earnings conference call. (Operator Instructions) Mr. Beattie, you may begin your conference.

Paul Beattie

Thank you. Good morning. This is Paul Beattie, Director of Investor Relations of FBR Capital Markets. Before we begin this morning’s call, I would like to remind everyone that statements concerning 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 limited to the effect of demands for public offerings, activity in the secondary securities markets, interest rates, the risks associated with merchant banking investments, the realization of gains and losses on principal investments, available technologies, competition for business and personnel and general economic, political and market conditions.

Additional information concerning these factors that could cause results to differ materially is contained in FBR Capital Market’s Annual Report on Form 10-K and in quarterly reports on Form 10-Q.

I would now like to turn the call over to Eric Billings, Chairman and Chief Executive Officer of FBR Capital Markets. Also joining us this morning are Rick Hendrix, President and Chief Operating Officer of FBR Capital Markets and Brad Wright, FBR Capital Markets’ Chief Financial Officer.

Eric Billings

Thank you Paul and good morning.

Before I comment relative to our specific first quarter results, I would like to take a moment to comment on the environment. In my years of the business through numerous market upheavals, closures and disruptions, I can't recall any market as challenging as the one we are now experiencing. Never within such a short period of time have any of us seen the likes of a bulge bracket banking firm bail-out, a high profile mortgage company liquidation and broad-based write-downs and recapitalizations across the financial services industry. This is clearly a very difficult market. To predict what’s next would be impossible, however in this environment, our capital structure and overall liquidity will provide significant strength to our market position and allow us to prudently pursue market opportunities.

Now to our results. As you have seen from the release, FBR Capital Markets had a net after-tax loss of $10.2 million or $0.16 a share on the quarter. These results include expenses and charges primarily severance costs, business development expenses and a non-cash tax charge relating to past grants of restricted stock that are higher than normal along with write-downs on merchant banking investments. These items which I will discuss in detail in a few minutes totaled approximately $16 million and absent these items, the Company would have generated an operating profit for the first quarter.

Our capital markets revenue were $102 million, about $40 million higher than in the fourth quarter of 2007. We had record institutional brokerage revenues of $31.8 million for the quarter and raised $2.9 billion in nine transactions, four of which we lead managed and we completed five merger and acquisition advice assignments. Of the transactions the $1.35 billion private debt offering we led managed for Thornburg Mortgage underscores the characteristics that are most reflected of the strengths of our firm.

Because we are to sell or lead the quarter on the majority of our equity transactions and because we more than any other investment bank have a proven distribution platform that can provide access to investor capital through large institutional private placements or 144A’s we have a distinct competitive advantage during times of market dislocations. Challenging markets don’t mean that there are compelling and worthy transactions, particularly recapitalizations that need to get done and because of the capabilities I have just mentioned we believe we will see, compete for and win more than our share. Even in the small number of such transactions can generate significant revenues.

The Thornburg recapitalization for which we acted as the lead placement agent and financial advisor is clearly a case in point. We continue to believe that 2008 is going to be a low growth year with curtailed capitals market activity both here and overseas and while we feel that we are well positioned to whether this upheaval, in January and February we took steps including a 10% work force reduction to eliminate fixed costs not directly in support of either 2008 revenue productions or targeted growth initiatives. While $3.1 million in severance costs were expensed in the first quarter the full impact of the associated staff reduction and other cost management steps will not be seen until the second quarter and beyond.

In addition to this severance expense the first quarter end results also included approximately $5 million of business development expenses that are high relative to the reminder of the year and $5 million of write-downs on merchant banking and other long term investments. We also incurred a $2.6 million non-cash tax charge related to past restricted stock grants which in large part offset a $3.4 million tax benefit. At the close of the quarter we had 11 merchant banking portfolio investments with an investment value of $54 million compared to $58.3 million at the close of the fourth quarter of 2007. These impairment charges related to four investments in company’s in the specialty finance sector.

Our backlog continues to be relatively strong given market conditions and as a firm that has historically performed well in challenging environments, we are well positioned with $500 million in equity more than $300 million in cash, note that to capitalize on the kind of situations that arise in times of market dislocation. While we will continue as noted earlier to manage cost levels appropriate to expected business volumes, we will also take every advantage of this market environment by being aggressive and adding and upgrading talent that supports future growth. We indicated in our February call that the annual results included a relatively small contribution from the Company’s liquid available for investors. We continue to evaluate opportunities for the profitable deployment of that capital. As we have emphasized before, historically, FBR Capital Markets has managed to do well through difficult times and while we have confidence that we will do that again by taking advantage of our core strengths and our capital structure, we foresee that will undoubtedly continue to be in an extremely challenging environment for an extended period.

We will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Dan Fannon.

Dan Fannon

Hello.

Eric Billings

Hi, Dan.

Dan Fannon

Okay. Sorry about that. What is the fee you guys earned from the TMA deal? Just broken that out separately and then --?

Eric Billings

Dan, we earned about $44 million -- $44 million of revenues I should say from the TMA transaction.

Operator

Sir, are you ready for the next question?

Eric Billings

Is that it? Did he get cut off? Dan is that it?

Operator

Mr. Fannon?

Brad Wright

Maybe he can re-prompt, maybe he can re queue

Operator

Okay. The next question comes from Roger Freeman of Lehman Brothers.

Roger Freeman - Lehman Brothers

Hi, good morning. Can you hear me?

Eric Billings

Yes, Roger we can.

Roger Freeman - Lehman Brothers

Alright. So I just want to clarify, the Thornburg transaction is in the first quarter revenues, is that correct?

Eric Billings

Correct.

Roger Freeman - Lehman Brothers

Okay. Can you give us a sense -- a flavor for the current environment? What is in the backlog in terms of maybe industry concentrations? I know you have been trying to expand your overall industry exposures. Is it predominantly finance related given refinancing activity right now?

Eric Billings

I would say Roger that our backlog is reasonably broad. Having said that, I think the transactions that have the highest likelihood of being done effectively are in the financial area and areas of recapitalization or creation companies that are an essence of starting from cash and taking advantage of the opportunity to invest into some of the difficulties and the disarray in the credit markets. So I think those are likely in the near term to be where we will do most of our activity. I think the markets are most receptive to these kinds of opportunities.

Roger Freeman - Lehman Brothers

Have you -- I mean do you feel pretty well positioned for recap activity and what kind of reception has your work on Thornburg gotten you? Has it generated incoming calls from clients?

Eric Billings

Roger, it has and I think Thornburg was a very good recent example of some of the things that we do particularly well, but I think beyond just that transaction particularly in the sales and services sector there is kind of a broad recognition of our ability to execute on recapitalization transactions and there is going to be I think a much higher number of those transactions across the industry than people fully appreciate yet. There have been obliviously a number of very high profiles, very large deals that have gotten done over the last two to three weeks, but there is as much more to come and they’re not all are going to be $8 billion and $10 billion and $15 billion deals. They are going to be a lot of transactions that are in the $200 million to billion range because this is a problem for the financial services industry that is not narrowly sculpt.

Brad Wright

Just a couple of things in it. Roger I think the first round of this break in the capital markets has been visibly seen and born by the largest institutions but I -- certainly in our opinion that it is very likely to spill over to the mid size and even smaller institutions and we will require a need for capital and many different types of companies and to provide an opportunity to create companies that can invest in the Ellington Financial Company that we helped Ellington create last summer. These kinds of opportunities I think should be quiet significant. Our history as you probably know Roger we started the Company back in 1989 in the last reasonably comparable break in the credit markets and obviously we had very good success back then recapitalizing the largest banks interests, savings banks interests in the United States. In the early 2001, 2002, 2003 time frame coming out of a down turn not as severe as this for sure but coming out of a down turn we also had similarly very good success. So, I think our history votes quiet well for our ability to take advantage of these kinds of situations and obviously our balance sheet puts us in a position where as we all know there are many highly very talented people that are going to be available to potentially bring into the Company and to help build and take the Company to a better higher level than we have been historically, that our history. We are optimistic we can continue do that but again want to stress that it is a very difficult environment and so it as always will be bumping.

Roger Freeman - Lehman Brothers

Yeah, and as you think about the -- in the environment, the types of deals you will do. How should we think about those from a key perspective because the Thornburg was debt; that’s a lower spread obviously was a large transaction but if we are talking about smaller ones and sort of non 144A types of transactions right, I guess the expectation would be that the under writing fee percentages would go down, but they are a assumption.

Eric Billings

Roger for the public deal, we are inversely all case is going to have co-managers and we will end up with a lower percentage of the overall fee but I think you are going to see transactions that are part of it are public and I think that given the nature of this market these are going to be full fee transactions.

Brad Wright

The other point that I’d make to that Roger is again remember speed is a great importance in these circumstances more typically and those obviously would lend themselves very, very significantly to the 144A execution or the private execution because of the need for speed and those will much more typically be full fee execution. When you think about our business, basically, we need to raise somewhere around $500 million to $600 million -- I mean $500 million to $700 million a quarter to get to our breakeven level. Obviously, that can be one transaction for a company or two of our average size transactions in a quarter and so it’s not an enormous past but it’s one we are going to have to work very hard to do and to exceed but again I will have the Thornburg transaction. I think our ability -- demonstrated ability in a very short timeframe, in a matter of weeks to structure that transaction, a very complex transaction and to be raised, that’s going to be a capital with over 50 institutions around the United States and Europe really speak very, very loudly to our abilities to do these things and I do believe the market and corporate clients do recognize that.

Roger Freeman - Lehman Brothers

Okay. What was the total private placement revenues in the quarter, out of your $65 million in total capital raising?

Eric Billings

It was a high proportion of the -- it was about $58 million of the $65 million.

Roger Freeman - Lehman Brothers

Okay. And last question and I’ll get back in the queue. Have you done any of these perpetual 144s that you have been trying to develop that markets --?

Eric Billings

The longest one we have done Roger is a three year registration period. In a not particular case, the investors actually have a right to vote on whether or not they want to have the shares registered. So, I think while there is still interest in going that direction as we have talked about the past, there is a higher premium on liquidity today than in most markets and so while I clearly believe that that as a market is going to continue to develop, I don’t think you are going to see perpetual 144As in the next couple of quarters.

Roger Freeman - Lehman Brothers

Right. Okay. Alright, thanks. I’ll jump back in

Eric Billings

Thank you Roger.

Operator

Your next question comes from Dan Fannon of Jeffries.

Dan Fannon - Jeffries

Hi, I’ll try this again here. In terms of the TMA deal, did you guys invest any of your own capital in that transaction?

Eric Billings

We did Dan but it was a modest investment. We invested $5 million in the transaction.

Dan Fannon - Jeffries

Okay and then, just turning to your balance sheet here, it seems there is a bunch of mortgage backed securities that showed up which is in your $400 million funded through some repos. Can you talk about that a little bit?

Eric Billings

Sure. Those are agency floaters and that’s simply an effort to enhance kind of the return on our cash and accounts management vehicle and you can see it’s a small investment relative to the overall balance sheet and we have term financing against those assets and we think it will bump our overall yield on the cash by about 1% over the course of the year.

Dan Fannon - Jeffries

Okay. And just in terms of the capital in here your tangible book is 765, around there. What is your thoughts towards buyback programs towards using that capital, towards share repurchases, or other investments?

Eric Billings

Well, clearly share repurchases are one of the things that we constantly evaluate but in particular in an environment like this with the stocks trading and overall liquidity that is one of the real opportunities we have in front of us and there are always a lot of considerations that needed to be taken into account regarding A share repurchase, but that clearly is an opportunity for the Company today and we will evaluate it against our other investment opportunities. I will say that we feel very good about where the balance sheet is right now and while we clearly want to take advantage of opportunities in the market regarding our own stock. We would not want to meaningfully change the capital structure of the Company.

Daniel Fannon - Jefferies & Co.

Okay, and then the business development expenses, the $5 million what -- can I get a little more color on to what those were and why it’s one time versus ongoing expenses?

Eric Billings

Yeah, it’s not Dan that it’s one time. It has a much higher proportion of business development in the first quarter to tune of about $5 million and that has to do with our branding costs, our skewed in that direction because of the timing of the FBR open.

Daniel Fannon - Jefferies & Co.

So, this is not -- I mean if you were to go on a -- next year you are going to have $5 million more in the first quarter than normal?

Eric Billings

Yeah, on a full year basis that’s accurate, that’s why. It’s not really non-recurring, it’s just much higher in the first quarter than it is in the following quarters and so to get a sense for where our overall expense load will be in the coming quarters, it’s just important people understand that number won’t be there in second, third and fourth quarters this year.

Daniel Fannon - Jefferies & Co.

Okay, so but are you anticipating some of these other -- will severance costs be there in the second quarter.

Eric Billings

Severance costs should be much lower in the second quarter. We did a 10% work force reduction in the first quarter and we don’t anticipate a similar type of activity and so that would not be there in the second, third and fourth quarters.

Daniel Fannon - Jefferies & Co.

Okay, alright. Thank you very much.

Eric Billings

Thanks Dan.

Operator

Your next question comes from Terry Babe – ThinkEquity Partners

Terry Babe – ThinkEquity Partners

Thanks, good morning. Just a couple of questions here. So, in terms of I guess where you are at with the severance and the head count reductions expecting and probably around the middle of the year to reach kind of a run rate basis, where does the break even stand? Can you update us on that?

Eric Billings

Yeah, I think Terry on a cash basis we are looking at kind of mid 70’s. We do have some other mid $70 million on the capital markets revenue. We do have some other non-cash costs in terms of stock compensate that might drive that towards AE.

Terry Babe – ThinkEquity Partners

Okay, and then I guess just thinking about the non-comp items as we progress throughout the year. I mean how should we think about that as kind of a percentage of a your revenue on a fixed dollar basis.

Eric Billings

On a fixed cost basis? I would say fixed costs probably running we are looking at something in the 30% range.

Terry Babe – ThinkEquity Partners

Okay, that’s all I have thanks.

Eric Billings

Thanks

Operator

(Operator Instructions) your next question comes from Roger Freeman of Lehman Brothers.

Roger Freeman – Lehman Brothers

Hi, just a couple of follow ups, so I think that there was a comment in the prepared remarks about the taxes; you call that the charge being -- offsetting gain. Is that -- can you just walk through that again?

Brad Wright

Yeah, the non-cash charge relates to investing of grants done a couple of years ago where the distribution actually is in lower stock price, so the tax expense is a lower deduction than the original book cost. What we are seeing as offsetting is just the tax benefit from the operating loss.

Roger Freeman - Lehman Brothers

Okay, got it. Okay, and in your advisory business, can you tell us what kind of a headcount you have in there now? I think the last we had was six or so. You obviously have been building out that business, but I was just wondering if that got reduced in the firm line reductions earlier in the year.

Eric Billings

When you say six or so, Roger --

Roger Freeman - Lehman Brothers

I think six as MDs.

Eric Billings

Yeah, six managing directors. We are at the same level but the headcount reductions do not involve any managing directors in our project business.

Roger Freeman - Lehman Brothers

Okay and then just on the comp expense, so you said that there was I believe $7 million of severance in the number?

Eric Billings

No, $3.1 million of severance in the number.

Roger Freeman - Lehman Brothers

Oh, $3.1 million, okay. So if I back that out, we are basically what, $68 million into 1/04. So that’s 65% contra revenue? I guess the way that -- that’s running above, you call it at the mid-50’s target just because of the absolute level of revenues at this point, right? I mean that’s the way you --

Eric Billings

Yeah. It’s the absolute level of revenues but there is some other as there always are in the numbers. So for instance when you have a write-down in the merchant area or we also had losses in some of our investments in our own mutual funds which is a seed money and that totaled about $5 million and when you look at that versus kind of the investment income let's say in the first quarter of ’07 where we actually did run 54% composite revenues, those are a sort of non-compensable revenues or they are compensable at very low level and so when those things move around -- when the investment earnings move up or down, they also have a big impact on the confident revenue number. So there are a number of things that are going on in there but we actually are running where we would expect to in terms of both fixed and variable compensation and the absolute rep level of revenues also do have an impact on that.

Roger Freeman - Lehman Brothers

Okay. Speaking of asset management, can you just talk a little bit about what’s going on there in flows. It looks like mutual funds I think are down 17% or so in AUM and obviously a big chunk of that is market performance but it looks like it was still out closed there, can you talk about where those were?

Eric Billings

Sure. They were primarily in the mutual fund area and there have been flows out of equity funds generally. We have a particular focus and great track record in some of the financial services funds and obviously given the market dislocation, investors have pulled back with regard to financial services exposure. The focus fund which is our biggest fund which had very significant inflows a year ago because we reopened that fund, has had some outflows and so it’s a function of the overall market and we would expect that to reverse from a flow standpoint as performance starts to move in the other direction.

Roger Freeman - Lehman Brothers

Okay, last question is I guess the bigger picture again. May be Eric how do you think about market volatility and sort of corporate client views towards capital raising right. So, in down markets, the volatile markets, there’s a lot of uncertainty, so they tend to not want to pursue equity capital raising transactions; now we have seem some improvement in the markets over the past month or so. Have you seen an increase in client engagement around doing deals and how do you think about -- like how long you need to see market stability before you start to see say a backlog rebuild?

Eric Billings

So Roger, it’s obviously it’s a great question and really it is difficult to answer because every market is different. I think we would look at this and say that the sort of the damage in this kind of a market is many times companies have no choice. They have to raise capital and that -- and the relevance there is that valuation really doesn’t matter.

Roger Freeman - Lehman Brothers

Right

Eric Billings

This is really an important consideration because in these kinds of environments the ability to raise capital quickly, effectively and very importantly with a high certainty of success is becomes much more paramount and I think that’s where we are really focusing our people and are again as we said consciously optimistic. We will see continued opportunities of some significance in those regard. I think that the other side of it though obviously as where companies do not have to raise capital. It is the ongoing challenge between evaluation and in difficult tough markets, valuations are tougher. Having said that, look these markets are down but they are not really down very much given the pain and the disarray and the chaos in many respects that’s taken place in the United States and to some degree in the world. The stock market actually continues to act with incredible resilience in history, I would say whether it’s right or wrong; history would say it’s likely to continue to do that, to hang in there through this and therefore valuations they don’t need to be terrible to get done but in small, mid cap arena world where liquidity is very important, valuations clearly do suffer and to be successful in executing transactions which is the reason we have less activity more broadly and I would expect that to continue in a general sense.

Roger Freeman - Lehman Brothers

Okay, that’s helpful thanks.

Eric Billings

Thanks.

Operator

There are no further no questions at this time.

Eric Billings

Thanks everybody for joining us, we appreciate it. We will talk to you next quarter.

Operator

This concludes today’s conference call. You may now disconnect.

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