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Executives

 

Paul Beattie – Director of Investor Relations

Richard J. Hendrix - President and Chief Operating Officer

Eric F. Billings - Chairman and Chief Executive Officer

Bradley J. Wright - Chief Financial Officer, Executive Vice President

Analysts

Eric – Lehman Brothers

Daniel Fannon - Jefferies & Co.

FBR Capital Markets Corporation (FBCM) Q2 2008 Earnings Call July 23, 2008 9:00 AM ET

 

Operator

 

Good morning, my name is Mary Anne and I will be your conference operator today. At this time I would like to welcome everyone to the FBR Capital Markets Second Quarter 2008 Earnings Conference Call. (Operator Instructions)

Paul Beattie

This is Paul Beattie, Director of Investor Relations at 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 not limited to the effect of demand for public offerings, activity in the secondary securities markets, interest rates, the risks associated with merchant banking investment, the realization of gains and losses on principle 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 Markets 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

 

In today’s call we will cover the second quarter results, franchise bidding steps we took during the quarter and the outlook going forward.

I said last quarter that I couldn’t recall a market as challenging as the one we are currently experiencing and that certainly continues to be true. We believe that the duration of the downturn will be prolonged and will have a continuing negative impact on the securities industry, something I’ll come back to in a few minutes.

Our second quarter was also clearly a reflection of the difficult capital markets environment in which we are working. The firm reported a $25.2 million or $0.39 per share second quarter loss compared to a net after tax earnings of $21.8 million or $0.34 per share in the second quarter of 2007.

Investment banking revenue was $8.2 million, the lowest level in over seven years and clearly primary capital markets continue to be challenging. In this type of environment our focused equity capital markets model has always exhibited volatility as evidenced by the quarter’s results.

Our institutional brokerage business maintained its strong upward trend during the quarter. Brokerage revenues were $34.8 million compared to $31.8 million for the first quarter of 2008 and $32.7 million in the second quarter of 2007.

For the first six months of 2008 institutional brokerage revenues were $66.6 million, 14% above the first half of 2007. As history has shown us, difficult market conditions present opportunities for us to take advantage of our unique strengths and capabilities.

Our strong, highly liquid capital structure gave us the flexibility in the second quarter to hire a number of talented production professionals in investment banking and institutional brokerage and to launch a convertible securities unit, which will be headquartered in our New York office. The addition of this convertible securities origination and trading capability is an important new service offering for our banking and institutional brokerage clients and a significant step in the fulfillment of our mission to become the preeminent global investment bank serving middle market companies and those who invest in them.

Our new convertibles team, the leadership core of which came from Bear Stearns, brings us strong and active buy side accounts and relationships with potential issuers which compliment and extend our network. Not only will be able to work together to offer these products to our existing institutional clients and corporate clients, but we will also have the opportunity to open new doors and form new avenues of distribution.

As we said in our release, we will continue to make strategic hires and acquire or fund businesses like the convertibles unit that added to our franchise. At the same time, however, we are continuing to proceed with caution because we believe the break in the financial markets, which is curtailed capital markets activity both here and overseas, is likely to persist. In light of this difficult economic climate we are deepening the cost reduction plan initiated in the first quarter in order to position all of our businesses for this market environment.

It is our intent to accomplish this while continuing to selectively enhance revenue generating capabilities and new and existing businesses. Further, as the US economy rights itself and adequately recapitalizes its financial structure, the country will come out of this type process with far healthier financial institutions that are more competitive globally and with financial markets that are better controlled from a regulatory standpoint.

In this environment fast moving, thoughtful, capital raising capabilities, which are one of the primary strengths of this firm, are of parallel importance. We believe that with the platform we have today and because of the severity of the economic climate, we are likely to participate in capital raising opportunities created by the environment. FBR Capital Markets is a firm that has historically performed well in challenging environments, our franchise is strong, we have substantial balance sheet strength with $480 million of capital filed equity and more than $300 million in cash and cash equivalents.

The execution of the previously mentioned activities along with our flexibility and adaptability as a firm will lead to reduced volatility and greater profitability as we take advantage of the environment and the inevitable recovery.

 

Question-and-Answer Session

Operator

 

(Operator Instructions) Your first question comes from Roger Freeman of Lehman Brothers.

Eric – Lehman Brothers

On the capital raising backlog, could you give some color as to what sort of deals you have on the road, if any at all, in the third quarter. What sort of pipeline you’re starting to see developing for the back half of this year.

Richard Hendrix

In terms of backlog, as you know we don’t give specific guidance on the backlog, but we are active in all of our [indiscernible] groups in banking right now. We have several transactions that are either right at the front end of being on the road or will be on the road within a week or two. We’re not lead manager on all those transactions, but there are some transactions where that is our role and we obviously, like many financial institutions [indiscernible] spokesman financial institutions are spending a lot of time in dialogue with mid-size banks about recapitalization opportunities; so that clearly is part of the backlog, but beyond that we’re not going to give a whole lot of detail specific guidance.

 

Eric – Lehman Brothers

 

Okay so you definitely characterize the financial sector as probably the largest part of the backlog at this point.

Richard Hendrix

Yes I think that’s fair. I mean as I said we’re active really in all the groups, but certainly in terms of revenue opportunity that’s the biggest near-term piece of the business.

Eric Billings

I’d just like to say in addition to that Eric, you know while our backlogs all have activity, diversified industries has a very significant activity, but I think the receptivity from the buy side of the US capital, world capital markets is much more significant in the financial services industry and particularly obviously wrapped around these recapitalizations or creation companies which take advantage of the difficulty in the environment and so that clearly is where we are allocating a lot of resources and focus.

Eric – Lehman Brothers

 

Okay, on the investment portfolio we know that a lack of meaningful P&L in the investment portfolio actually was a positive number versus the prior losses in the past couple of quarters, but we’re trying to compare and contrast that with the significant declines in broader financial stocks over the past quarter. Could you help me with a couple of things?

The first question is when we get to the queue, how will the per unit prices on the merchant banking portfolio compare to the program [ph] prices in FBR plus, would you care if pricing was largely consistent.

Second, if you’re not actually marking to the FBR plus prices, how do you mark the portfolio?

Eric Billings

 

There are a couple questions in there. Number one, as you know, we did have write-downs in both the fourth quarter and the first quarter in that portfolio. We evaluate each of those positions every quarter and did not have any write-downs the second quarter, because we don’t believe they’re impaired beyond where they’re marked currently.

Each of the securities themselves, depending on whether it is a public security or whether it is a private security, gets treated differently, but if we had a mark in FBR plus or trading value in FBR plus that was meaningfully below our cost basis and it persisted there, that would more likely drive a write-down and that’s part of what drove fourth quarter and first quarter activity. That is one parameter that we use as we look at deposits. Obviously in the public securities we looked at the public market and what I would tell you is that we don’t have securities in the portfolio that are marked meaningfully by or above at all kind of where the trading prices are in portal.

Eric – Lehman Brothers

 

Beyond the expense management you talked about efforts to reduce expenses. Could you give a little more color as to what areas you are looking to reduce expenses, be it head count, non-personnel expense, what sort of time frame are you looking at there?

Eric Billings

The time frame is right now. As you know we did reduce a head count in the first quarter and yet we have continued to hire where we thought we could add really talented people to the franchise and we’re going to continue to do that, but at the same time as we build the business we are going to focus on our fixed expenses and are looking to have a meaningful reduction in fixed expenses that will be initiated here just in the next couple of weeks and in all likelihood a reduction in variable expenses as well. Through the combination of those we intend to get our break even down into the mid-200s from a revenue standpoint.

Operator

 

Your next question comes from Dan Fannon of Jefferies & Co.

Daniel Fannon - Jefferies & Co.

 

Can you talk about the balance sheet for a second, just kind of help us understand the mortgage securities you own and how their funded and the risks associated with those assets?

Eric Billings

All of the mortgage securities that are on the balance sheet are agency floaters and so there is no interest rate risk in that portfolio and we have, to the extent that they’re caps in those floaters, we had just taken the caps off. So they’re an average spread of about 92 basis points and they’re funded through repo agreements, but the term repo agreements, we have three counter parties and I believe the weighted average term of those financing commitments is about 13 months currently.

Daniel Fannon - Jefferies & Co.

 

Then you look at your capital, you have been sitting on a sizable amount of cash for a while which you are losing money, and you, I think, announced a buy back program several quarters ago. Is the buy back off the table for a while just given where we are and kind of the revenue stream we’re at and is it something where we could see you using this capital to take advantage of, from growing the asset management business at all, or has that also, kind of, been dialed back in terms of priorities?

Richard Hendrix

 

Definitely we wouldn’t say that buy backs are off the table. We look at it and view it under different circumstance and obviously as we’re contemplating different activities it makes you more or less able to buy back stock and so many things get reflected in that activity, but obviously with our stock trading where it is now as we have opportunity that is definitely something that we would consider.

The asset management business is something that we are focused on. We absolutely intend to continue to allocate resources and to build that business. Having said that, we’re going to be very focused in cutting costs there as well, but we are building that business and if we had an opportunity with our capital to do something very accretive we would consider it, but there are numerous factors involved there, but we are really comfortable having a very liquid balance sheet and having that strength as a core character of our company at all times in all environments.

It’s not as if we have $350 million in cash and we’re feeling anxious to put that to work in some way that would deplete the cash, we actually by design want to maintain a strong, highly liquid balance sheet all of the time. But, we will certainly try to advantage of opportunities that are significant and buying back stock, absolutely is one of the things that we are looking at very actively.

Daniel Fannon - Jefferies & Co.

 

Then lastly, in terms of your dialogue with clients is the 144A products still at the forefront of what you guys are pitching or given the liquidity associated with that and maybe dwindling investor appetite for those types of securities, has your pitch changed?

Richard Hendrix

Our pitch hasn’t changed. I mean the 144A market is not even, to describe it that way is probably unfair. It is not a separate market, it is part of the equity capital markets and we happen to be able to execute those transactions very quickly and in a way that is real attractive to both issuers and investors; so it’s always part of the pitch in terms of alternatives to raise capital. There are circumstances where it’s more relevant and circumstances where it’s less relevant, but our approach hasn’t changed.

Our approach is to get issuers the most attractive capital that we can in the fasted time frame and if that’s a public execution it’s a public execution, if it’s a private execution it’s a private execution. In this environment I would tell you that I don’t think that a public deal is any particularly easier to execute than a 144A.

Eric Billings

 

In fact I would point to the Thornburg transaction which was a private, private and as you know was a $1 billion $400 million transaction and/or specifically in the middle of June we had functionally completed a $450 million recap on the Southern California Savings Bank that unfortunately just prior to actually formally completing the transaction it was acquired by another bank. But that also was a private transaction and both of those were received very well.

I think I would say that while your observation to liquidity is a good one and in difficult markets, as you rightly point out, liquidity becomes more important; nonetheless right now often times speed is even more important and obviously that’s something that has always been a great strength of the company, as you know, and when were back in the early 90s in a fairly similar circumstance recapitalizing banks in respect [ph] and taking advantage of the unique ability to move with speed and creativity, which we’re doing now. In that capacity the 144A type execution, I think, actually becomes paramount. So, in that regard I think you’ll continue to see a mix of activities.

Operator

 

Your last question is a follow up from Roger Freeman of Lehman Brothers.

Roger Freeman – Lehman Brothers

 

On the cash on your balance sheet is $300 million, how much of that would you characterize as excess above what you would need for regulatory requirements, working capital needs, that sort of stuff?

 

Eric Billings

 

In reality it’s all excess. We have $480 million of capital and so for regulatory purposes, we’re in capital compliance substantially with the capital weight from that cash; so it is really all cash that we have the ability to utilize in ways we think best and prudent and to take advantage of opportunities that could come up.

 

Roger Freeman – Lehman Brothers

 

On the asset management business, could you let us know what the flows were in the quarter of the net new assets, one way or the other?

Richard Hendrix

 

Yes the asset management business was down in terms of AUM by 10% in the quarter and about half of that were negative flows and half of that was performance.

Roger Freeman – Lehman Brothers

 

And the advisory business, could you talk about the backlogs there separately from the capital raising backlog and are you seeing increased activity there? How is the receptivity to that business?

Richard Hendrix

 

The short answer is yes, we are seeing increased activity there. This quarter was actually like the capital raising activity was a light quarter for us in the advisory business. Our expectation is based on pipeline and as you know that’s a longer tilt business and so we’ve got a little bit better feel for what revenues will be in that part of our business in the third quarter.

We would hope that we’ll do at least double those revenues in the third quarter.

Roger Freeman – Lehman Brothers

 

My last question would be on the tax rates, a little detail question. The effective rate was close to 28%. Where would you expect the tax rate kind of on an ongoing basis to be? Is there something happening in there because of the low income?

Bradley Wright

 

Yes, Eric this is Brad Wright. We look at the projected tax rate for the whole year and then get to where we need to be on a year-to-date basis and I would expect for the full year to be closer to 40%, but we did have some permanent differences that we took into effect and got us down to around 28 this quarter.

Eric Billings

 

We appreciate everybody joining us and are optimistic that next quarter will be better than this one and will be better than this one and we’ll be looking forward to taking advantage of different opportunities, but thank you all for joining us and we look forward to speaking to you next quarter.

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