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Cowen Group, Inc. (NASDAQ:COWN)

Q2 2008 Earnings Call Transcript

August 5, 2008 9:00 am ET

Executives

Greg Malcolm – President and CEO

Tom Conner – CFO

Analysts

Patrick Dubae [ph] – Merrill Lynch

Devin Ryan – Sandler O'Neill

Horst Hueniken – Thomas Weisel Partners

Operator

Good morning, ladies and gentlemen, and thank you for joining the Cowen Group Incorporated conference call to discuss the financial results for the first half of 2008.

By now, you should have received a copy of the company's earnings release, which can be accessed at the Cowen Group Inc. website, at www.cowen.com. If you do have Internet access and would like a copy of the press release, please call Nicole Keeler at 646-562-1796.

Before we begin, the company has asked me to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties described in the company's earnings release and other filings with the SEC. Cowen Group Inc. has no obligation to update the information presented on the call. A more complete description of these and other risks, uncertainties and assumptions is included in the company's filings with the SEC, which are available on the company's website and on the SEC website, at www.sec.gov.

Also on today's call our speakers will reference certain non-GAAP financial measures, which the company believes will provide useful information for investors. Reconciliation of these measures to GAAP is consistent with the company's reconciliation as presented in today's earnings release.

Now, I would like to turn the call over to Mr. Greg Malcolm, Chief Executive Officer, who is joined today by Mr. Tom Conner, Chief Financial Officer. Please proceed.

Greg Malcolm

Good morning and thanks for joining our conference call. I'm going to start today with our results for the second quarter and for the first half of 2008 and then spend a few moments discussing each of our business areas. I will then turn the call over to Tom, who will review the financial information for the quarter and the half in greater detail. Then we will take your questions.

For the second quarter of 2008, revenue was $62.7 million, a decrease of $8.5 million from the second quarter of ’07 and an increase of $7.7 million from the first quarter of ’08.

It should come as no surprise that the year-over-year decrease was due primarily to a reduction in revenue from capital raising transactions. The quarter-over-quarter increase was due to improvements in both capital raising and strategic advisory revenue.

We reported an adjusted net operating loss of $300, 000 for the second quarter, which represented a $2 million decrease from adjusted net operating income of $1.7 million in the second quarter of ’07 and an improvement of $300,000 from the first quarter.

On a GAAP basis we reported a net loss of $700,000 for the period a $900,000 decrease from net income of $200,000 in the second quarter of ’07 and a $1.4 million decrease from the first quarter. Our GAAP results as you may recall for the first quarter included a $5.1 reversal of stock compensation expense.

For the first half of 2008 revenue was $117.7 million, a decrease of $27.1 million from the prior year period. The year-over-year decrease was again due primarily to a reduction in revenue from capital raising transactions as well as a reduction in revenue attributable to the firm’s warrant positions. As an aside [ph] the firm receives warrants in connection with price [ph] in private placements this warrant portfolio was mark-to-market every month and those marks resulted in gains in the first half of ’07 compared to losses from marks in the first half of ’08. During the first half of ’08 the firm recognized $1.1 million in losses on its warrant positions. In the first half of ’07 the company recognized $6.5 million in gains as a result of the successful IPO of certain companies in the portfolio and the overall market depreciation throughout the period.

Now, returning to the first half we reported an adjusted net operating loss of $1.7 million down $6.2 million from adjusted net operating income of $4.5 million in the prior period. On a GAAP basis we reported a net loss of $100, 000 for the period down $2.8 million from net income of 2.7. During the first half our performance was obviously impacted by the lack of equity capital markets activity both industry-wide and in Cowen’s target sectors.

Underwriting revenue was $5.8 million for the first half a decrease of $22.7 million from the prior period. The underwriting revenue of $4.3 million in the second quarter increased $2.8 million sequentially.

The growth sector equity new issue market is an important part of our business and as a result depressed capital raising activity has a significant impact on our overall results. During the first half of 2008 only 10 growth sectors IPOs priced down 85% compared to 65% in the prior year period. Similarly growth sector follow on offerings during the first half declined 64% to 38 transactions compared to 106 in the prior year period.

As an aside if I would back over the post bubble period of the past 5 years, the $1.5 million of underwriting revenue in the first quarter of 2008 was the worst quarter since the first quarter of 2003 when we had $1.4 million of underwriting revenue. I would note that our best underwriting quarter during that period was $31.5 million. These swings give you a clear indication of the cyclical nature of this part of our business. However, our public equity backlog remains strong with 14 filed transactions of which 5 were booked around our lead management. Like our peers, we look forward to improved market conditions, however, I am not confident that the market window will open this quarter or next.

On a more positive note, our strategic advisory revenue for the first half of 2008 increased 50% year-over-year to $24.5 million. Since our IPO we have taken significant steps to strengthen our advisory practice and our first half results illustrate the progress we have made. We were particularly pleased with this performance in the face of a 10% decrease in first half growth sector M&A activity as measured by deal value and a 13% decrease as measured by the number of transactions completed.

Entering the third quarter our M&A pipeline was robust having increased 24% from the end of the first quarter. Core brokerage revenue for the six months was flat compared to the prior year period. Overall brokerage revenue in the first half decreased $8.6 million compared to the first half of ’07. The decrease was primarily related to the mark-to-market adjustments in the firm’s warrant positions, which I described earlier. Historically, we have outpunched our weight in the cash equity business due to the caliber of our research and sales and trading professionals as well as a very disciplined asset allocation model.

We continue to take steps that we believe will allow us to maintain this superior performance. As an example we expanded our middle market’s coverage effort during the first six months of a year with the addition of a talented team based out of Atlanta. During the first half, we made significant progress towards expanding our geographic footprint. In the first quarter, we announced that we have entered into a definitive agreement to acquire Latitude Capital a boutique investment bank headquartered in Hong Kong with additional offices in Beijing and Shanghai. I am pleased to report that we received formal regulatory approval at the end of last week. Cowen Latitude Asia represents an important opportunity for us to enhance our activities internationally and expand our sector focus to investment banking platform across the region.

Both Cowen and Latitude personnel have been working diligently to lay the logistical foundation necessary to ensure a speedy integration and we expect to close the transaction in the third quarter. We continue to work closely with our latitude partners and we are confident that we have taken the necessary steps to ensure that we get the ground running.

Cowen’s efforts to build up an alternative asset management practice have already yielded significant results. As you have likely seen, two weeks ago we announced the closing of Cowen Healthcare Royalty Partners first run with capital commitments in excess of $500 million. This represents one of the largest first time healthcare focused private equity funds ever raised. At the hard capital of $500 million the fund substantially exceeded its initial target of $350 million. CHRP has already deployed approximately $80 million of capital and its pipeline is robust. This effort expands further our already leading franchise in healthcare and life sciences. The healthcare royalty team has exceeded our expectations and we look forward to their continued success. I am pleased to note that we booked over $8 million in revenue from CHRP in 2008.

Our development of the traditional asset management business is also on schedule. Both the US and UK based teams have been managing assets since the beginning of the year and are developing successful track records as part of Cowen. In point of that as of the end of second quarter all 8 funds, 2 in the US and 6 in London were outperforming their respective benchmarks. We have assembled two teams of talented investment professionals and we looked forward to their contributions in the coming years.

Let me turn for a moment to our non-compensation expenses. We also continued to identify opportunities for savings and greater efficiencies. We always seek to contain our non-comp cost but we have redoubled our efforts in the face of challenging market conditions. During the first half of 2008 non-comp expenses decreased 5% compared to the prior year period. Included in this decrease was a one-time charge for the placement fee related to the Cowen Healthcare Royalty Partners’ fund. Excluding this one time charge of $2.2 million non-compensation expenses for the first half decreased more than 9% compared to the prior year period. This is both an effort and a result of which I am extremely proud. Believe me, we will continue to seek ways to appropriately reduce our non-comp expenses.

Now let me spend a moment addressing head count. During the first half we reduced total head count by 9% from 535 people to 485. This is in addition to an overall reduction of 3% in 2007. While we have reduced overall head count in 2008 we remain pleased with our ability to attract highly talented professionals. In view of the current employment market there is an opportunity to selectively add exceptional professionals across our businesses. In fact this year we have added key hires in all of our principal divisions, research, investment banking, and sales and trading.

You will also note that we continue to accrue comp at 60% of revenues. We like others are uncertain about what our compensation ratio will ultimately be. Where we end up will depend on market conditions over the remainder of the year and the overall street environment as we come closer to year-end.

During the first half, we had significant accomplishments in many areas of our platform that were perhaps overshadowed by the lack of new issue activity and its impact on our overall results. We continue to take steps to diversify our business, however, our sector focused platform remains highly correlated to growth sector capital raising activity. Although we cannot predict when the market environment will turn, I am confident that Cowen is well positioned to capitalize when conditions do improve.

I would now like to turn the call over to Tom Conner to review the financial results in more detail.

Tom Conner

Thank you, Greg. For the quarter June 30, 2008, total revenues were $62.7 million compared to $71.2 million during the same quarter of 2007. For the six months ended June 30, 2008, total revenues were $117.7 million compared to $144.8 million in the first half of 2007. Investment banking revenue for the second quarter of 2008 were $20.5 million, a decrease of $9.6 million compared to $30.1 million during the same period in 2007. For the six months ended June 30, 2008, investment banking revenues were $34.4 million down 38% from $55.5 million in the first half of 2007. As Greg mentioned the decreases for both the quarter and the first half of 2008 compared to the same periods in 2007 reflect lower transaction volumes in both our public and private capital raising activities partially offset by an increase in our strategic advisory fees.

Brokerage revenues for the second quarter of 2008 were $37.1 million, a decrease of $1.4 million compared to $38.5 million in the second quarter of 2007. For the six months ended June 30, 2008, brokerage revenues were $75.2 million down 10% from $83.7 million in the first half of 2007. The decreases for both periods resulted primarily from activity related to certain warrant positions. All of our warrant positions as we mentioned earlier were received in connection with investment banking transactions. However, the mark-to-market changes in value and as well as well as realized P&L are required to be reflected in the brokerage line item.

Our core brokerage revenues for the second quarter of 2008 were $37 million, an increase of $0.4 million compared to $36.6 million in the same quarter of 2007. For the six months ended June 30, 2008, our core brokerage revenues were $76.7 million compared to $76.8 million in the first half of 2007.

Revenue from interest and dividend income for the second quarter of 2008 was $0.9 million compared to $1.9 million in the same period last year. For the six months ended June 30, 2008, revenues from interest and dividend income were $2.1 million compared to $4 million in the first half of 2007. The decrease in both periods resulted primarily from lower average interest rates during both the second quarter of first half of 2008 compared to the same periods in 2007.

Other revenues in the second quarter of 2008 were $4.1 million, an increase of $3.5 million compared to $0.6 million in the second quarter of 2007. For the six months ended June 30, 2008, other revenues were $6 million an increase of $4.5 million compared to $1.5 million in the first half of 2007. The increases in both periods resulted from an increase in fees from managing the assets and investments of certain private equity and alternative investment funds.

Turning to expenses, our employee compensation and benefits expense was $38.9 million for the second quarter of 2008, a decrease of $4.9 million compared to $43.8 million for the same quarter last year. For the six months ended June 30, 2008, our employee compensation and benefits expense was $67.7 million down 24% from $89 million in the first half of 2007. The decreases in both periods resulted from the application of our compensation to revenue ratio to lower revenues in 2008 compared to the same periods in 2007. This decrease was partially offset by an increase in the compensation to revenue ratio to 60% in the first half of 2008 compared to 58% in the first half of 2007.

Employee compensation and benefits expense for the second quarter of 2008 also included $1.3 million of expense associated with the initial grant of equity to our employees in connection with the IPO compared to $2.5 million of expense in the prior year period. The expense associated with the IPO awards is excluded from our compensation ratio. For the six months ended June 30, 2008, employee compensation and benefits expense included a net reversal of $2.9 million of expense associated with the initial grant of equity in connected with the IPO compared to $5 million of expense in the prior year period. The reversal in the first half of 2008 relate to amounts previously expensed in 2006 and 2007 associated with the IPO award that was forfeited by Mr. Fennebresque in connection with his resignation.

Non-compensation expenses were $26.1 million for the second quarter of 2008, a decrease of $0.9 million or 3% compared to $27 million in the same quarter last year. For the six months ended June 30, 2008 non-compensation expenses were $50 million down 5% from $52.8 million in the first half of 2007. Both these decreases were primarily due to reductions in our floor brokerage and trade execution related expenses, employment fees, communication related expenses, maintenance costs related to our information technology infrastructure and consulting costs. These decreases were partially offset by an increase in service fees related to a change in our trading and order management system and placement fees which we mentioned earlier related to closings associated with Healthcare Royalty Partners.

Excluding the royalty fees, total non-compensation expenses decreased $2.9 million or 11% during the second quarter of 2008 compared to the same quarter last year. For the six months ended June 30, 2008, excluding the placement fees total non-compensation expenses decreased $4.9 million or 9% compared with the first half of 2007.

We recorded a tax benefit of $1.7 million for the second quarter of 2008 compared to a provision for taxes of $0.2 million for the second quarter of 2007. For the six months ended June 30, 2008, we recorded a tax benefit of $0.1 million compared to provision for taxes of $2.1 million for the first half of 2007. The higher effective tax rates in both periods of 2008 were the result of certain non-deductible expenses including the placement fee mentioned earlier.

For the quarter ended June 30,2008, we reported a net loss of $0.7 million or $0.06 per share compared to net income of $0.2 million in the prior year period of $0.02 per diluted share. Excluding the compensation expense related to employee stock awards in connection with our IPO, our adjusted net operating loss for the second quarter of 2008 was $0.3 million compared to adjusted net operating income of $1.7 million in the prior year period.

For the six months ended June 30, 2008, we reported a net loss of $0.1 million compared to net income of $2.7 million for the first half of 2007. Net income in the first half of 2007 included the effects of a one-time $1. 8 million gain related to the sale of our membership fees on the Chicago Board Options Exchange.

Our adjusted net operating loss for the six months ended June 30, 2008, was $1.7 million compared to adjusted net operating income of $4.5 million in the prior year period.

Tangible book value per share at June 30, 2008, based on common shares outstanding was $10.92.

This concludes our formal remarks. Greg and I will now take questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Patrick Dubae [ph] with Merrill Lynch. Please proceed.

Patrick Dubae – Merrill Lynch

Good morning guys. I assume you know if you were to market another fund like the healthcare fund that would result in another placement fee. Do you have kind of a plan to raise another one or is there any idea – so we that we can get an idea of maybe how we should model maybe what that expense would be next year if you decided to do another one?

Greg Malcolm

Well, you know if I could be paying those placement fees once a quarter, I would be a happy guy.

Patrick Dubae – Merrill Lynch

Yes, I understood.

Greg Malcolm

We continue to look at other venues or opportunities where we see the same sort of synergistic play that we saw with the royalty team but there are frankly difficult to find. It took us quite some time to accomplish this. We think it is an absolutely fantastic outcome for all involved, but I am not sure I would be modeling an additional fund in 2009 at this point in time.

Patrick Dubae – Merrill Lynch

Okay, that makes sense. And in the other revenues can we get an idea of how much of the pickup was related to the new fund and you know what the fee structure is going to be there, I assume that is running through other.

Greg Malcolm

Yes, that is where it is located. About half of the quarter, the revenues for the quarter relates to the pickup associated with the fund.

Patrick Dubae – Merrill Lynch

And the fee structure.

Tom Conner

Well, the fee structure is – how we are dealing with distribution of the fee income the management fee income is we haven’t discussed publicly. It is revenue to us as any other revenue is and the expenses that grow from it are incorporated inside our comp lines or inside our non-comp expenses. Obviously, at some point in time there will be carry, but I think we are away from that at the moment [ph].

Patrick Dubae – Merrill Lynch

And you said it will generate $8 million of revenue this year and that is included in the $2 million or so that was in the second quarter right.

Tom Conner

That is correct.

Patrick Dubae – Merrill Lynch

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Devin Ryan with Sandler O'Neill. Please proceed.

Devin Ryan – Sandler O'Neill

Hi, good morning guys.

Greg Malcolm

Good morning.

Devin Ryan – Sandler O'Neill

I just got a follow-up on the Healthcare Royalty Partners fund. Can you remind us what Cowen’s investment was in the fund. Did you disclose that?

Greg Malcolm

We did not disclose it. I don’t believe we have made a $25 million investment.

Devin Ryan – Sandler O'Neill

Okay, and just in terms of the carry obviously it may take some time, but you know are these funds typically volatile or how should we think about kind of the performance of the funds. Can you get a sense of what the performance is going to be after a certain period of time like some kind of recurring fee structure or how should we think about that?

Greg Malcolm

It is different than a more traditional private equity leveraged buyers business. Obviously, when you invest in royalties generally speaking the cash flows start relatively immediately and continue over a period of time. So, the money comes back quite quickly, and as a result we anticipate – what we anticipate fine returns and the multiples on your investment are probably a little lower as a general matter then they would be in for a same IRR in a private equity fund. So, we will see returns immediately in this fund and we will see carry 3 or 4 or 5 years down.

Devin Ryan – Sandler O'Neill

Okay that is helpful. And then just on the warrant portfolio, it has created a fair amount of volatility from quarter-to-quarter and obviously its additional banking fees are paid in warrants in the portfolio, I would assume would grow. Is there any way to economically hedge the portfolio or hedge the volatility here and what are your thoughts on that?

Greg Malcolm

Well, we have looked at it a lot because it does create more volatility that we would like. You know we get these warrants as a result of our price in private placement activities and we like them, but we sure don’t like the accounting for them because we would like to see them as a longer held asset to look forward to nice returns and the mark-to-market creates some problems for us. The portfolio is not big enough to really create a substantive hedge nor is it big enough to hedge around in terms of the particular warrant positions. We have had discussions with people, we have thought about it and to date we can’t see a way to successfully lay a hedge on that that either reduces the accounting volatility but also takes away from the economic – potential economic impact of the portfolio when it works well as we saw in the first half of 2007.

Devin Ryan – Sandler O'Neill

All right thanks guys.

Operator

(Operator instructions) And your next question comes from the line of Horst Hueniken with Thomas Weisel Partners. Please proceed.

Horst Hueniken – Thomas Weisel Partners

Good morning. I see that you have another good quarter on your strategic advisory business and your backlog is looking pretty strong entering into the third quarter, could you just comment on the sustainability of the strategic advisory business, typically it is a lumpy business, but you seem to be bucking the trends. I am wondering what you ascribe that to.

Greg Malcolm

Well, actually we are paying quite a lot of attention to that business and I think we fundamentally over the last few years have changed how we look at the business and changed how we thought about the business. So, we are hopeful that we are smooth enough to (inaudible). You know I will make a couple of comments. Our business is not for the most part dependent upon leverage. So, the decrease in M&A activity that we are seeing across the street has been impacted obviously or affected by the credit markets. The majority of our transactions end up being strategic to strategic and so the availability of credit is not generally necessary to see our business move forward. So we have been able to – if we are bucking a trend I think that is a principal reason for it. Basically we have focused across the board in our investment banking business on improving our strategic dialog with all of our customers and clients and opportunities and we are confident in seeing the continued success and results of that if that is going to an ongoing issue for us. We believe our strategic advisory business is just simply going to continue to get better and everything that we see in front of us indicates that that is in fact what is going to happen.

Horst Hueniken – Thomas Weisel Partners

Okay that is very helpful. Thank you.

Operator

(Operator instructions) And you have no further questions at this time.

Greg Malcolm

I just want to say thank you everyone for taking the time to be with us this morning. We are pleased with our results in the context of some very, very difficult market conditions that we all understand and see daily. We look forward to a return of more robust equity new issue business and we think we are very well positioned to take advantage of that market when it comes and we appreciate all your support. Thanks very much.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Cowen Group, Inc. Q2 2008 Earnings Call Transcript

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