FXCM: Profiting From Foreign Exchange Volatility & Financial Regulation

| About: Global Brokerage, (GLBR)
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Over the past month, shares of FXCM (FXCM) have risen over 8%, versus a fall of over 3.5% for the S&P 500, driven by increased volatility in the foreign exchange markets, both here in the United States and around the world. And as debate over the Federal Reserve's direction and the need for increased regulation continues, FXCM is poised to benefit from both debates. With a solid balance sheet, FXCM is poised to continue its expansion, both domestically and internationally, thereby continuing to create value for its shareholders, both in the form of long-term earnings growth, as well as return of capital. Unless otherwise noted, financial statistics and management commentary cited will be sourced from FXCM's Q1 2013 earnings release, its Q1 2013 earnings call, or its latest 10-Q.

Q1 Review: Setting the Stage for Continued Expansion

For the first quarter of 2013, FXCM posted record results across a variety of metrics. Revenues rose 20% to a record $122.864 million, but missed consensus estimated by $4.7 million (more on this a bit later). Pro forma EPS of $0.23 matched consensus estimates, rising 35.29% year-over-year, as FXCM's operating margin expanded from 18.28% to 24.33% on the back of tight SG&A, compensation, and advertising cost controls (these 3 items accounted for 33.61% of revenue in Q1 2013, down from 46.57% a year ago). FCXM saw continued growth in Q1 across a variety of metrics, even when including the impact of 2 less trading days in Q1 2013 than Q1 2012. Total daily trading volume rose 6% to $1.041 trillion, even when accounting for a 7% decline in institutional trading volume to $373 billion (on its earnings call, FXCM's management team suggested that weaker than expected trading in its institutional business, owing to weakness in foreign exchange funds). However, institutional trading accounts for less than 23% of FXCM's revenue, meaning that weakness in this segment can be offset by strength in the company's retail business. Although retail revenue per $1 million traded (a key industry metric) fell by 6% to $88, this slide was more than offset by a rise in daily trades, which jumped 15% year-over-year to 437,813, even though active accounts grew just 1% to 173,265. This implies that FXCM's customer base is becoming more active, a long-term positive for the company. The company notes that the slide in retail revenue per $1 million traded was mostly caused by volatility in the yen/dollar cross, which has led to above-average trading volumes for FXCM in Japan. However, FXCM's Japanese business has lower retail revenue than the company's other markets (FXCM does not disclose retail revenue by market), and lower pip conversion rates also impacted consolidated retail revenue. CFO Robert Lande also stated that the loss of 2 trading days in the quarter also played a role in depressing retail revenue. However, FXCM's management team noted on the company's earnings call that it does not foresee retail revenue per $1 million traded falling below $88, and expects that in time, it will recover to its long-term normalized range of $92-$100.

On the company's earnings call, CEO Drew Niv has committed FXCM to educating its customer base that it is not in the principal business, noting that there is still suspicion amongst the company's customer base, particularly in international markets, that the company trades against its customers, something that runs counter the core of FXCM's no dealing desk strategy. CEO Drew Niv freely admits that the company could easily boost profits by becoming a principal, thereby trading against its customers. But that would erode a core aspect of FXCM's competitive advantage, as well as damage its goal of growing account balances and its customer base. On the company's Q1 earnings call, CEO Drew Niv stated that,

"If you think of what that does to customer compounds is today, many of our customers sort of doubt that we're because we're in anomaly in our industry and most of our - most of our competitors are in the principle business. Customers know that you make more money on trading against the customer than trading on agency basis with a customer. So, a lot of customers are somewhat suspicious and other outright don't believe us that we're in agency business. We think that making that a mandatory, a legal thing in certain jurisdictions and all in all especially in all the major ones, we'll give a lot of customers the confidence to educate and I think we'll grow those balances pretty significantly when that happens. So, I think there is enormous amount of room to do that not to mention obviously does regulatory changes do come the amount of decreased competition in the major jurisdiction should be pretty substantial. I don't see most of our principle competitors while some will convert and will be fine with it the bigger ones I don't see a lot of the other surviving."

This is just one aspect of FXCM's ability to profit from increased financial regulation, and should regulators push to make FXCM's model more prevalent across the industry, we believe that the company's competitive position will be meaningfully strengthened, for it will have an extensive track record of successfully operating a non-principal business model. Although new market regulations, specifically Basel III, have forced many financial institutions away from "capital-intensive" instruments as FXCM calls them, the company notes that this could steer companies towards more "vanilla" foreign exchange products, something that could help the company's institutional business keep pace with the growth seen in FXCM's retail business (FXCM's continued migration of its institutional business to in-house platforms can also help that segment of the company's business recover. In Q1 2013, over 50% of FXCM's institutional trading volume was conducted on the company's ECN/FastMatch platforms, and FXCM is set to continue migrating more of its institutional customers in the quarters to come) However, increased regulation can also benefit FXCM in its retail business as well. As the company noted on its Q1 earnings call, the reforms included in Dodd-Frank have affected multiple over-the-counter capital instruments, but not retail foreign exchange trading. CEO Drew Niv noted this glaring oversight, stating that, "retail FX is the only retail asset category, where a single-dealer principal model is currently permitted without any of the benefits of multiple (court rule) as with over the counter trading in SEC regulated environment." Should the S.E.C. (alongside regulators international regulators) move to impose stronger rules on the retail foreign exchange market, FXCM will be presented with a large opportunity to capture market share and trading volumes from principal dealers. Another potential benefit of increased regulation could be a rise in foreign exchange trading due to increased margin requirements for futures trading; FXCM noted that new Commodity Futures Trading Commission rules [CME (NASDAQ:CME) raised margin requirements for futures accounts in May] could push more active traders into foreign exchange markets.

The 2nd Quarter & Beyond: Profiting from Volatility & New Ventures

FXCM is building on a successful first quarter with continued growth in its business, as well as the launch of new ventures. Trading and activity figures for April and May highlight FXCM's growth across both its retail and institutional businesses. The table below charts FXCM's monthly metrics of April and May, with month-over-month and year-over-year growth rates included in parentheses.

FXCM Monthly Metrics, April & May 2013

 

April

May

Retail Trading Volume

$366 Billion (+15%/+48%)

$390 Billion (+7%/+28%)

Average Daily Retail Volume

$16.6 Billion (+9%/+41%)

$17 Billion (+2%/+29%)

Average Retail Trades

498,808 (+18%/+54%)

498,089(-0.1%/+37%)

Institutional Trading Volume

$183 Billion (+46%/+78%)

$191 Billion (+4%/+39%)

Average Daily Institutional Volume

$8.3 Billion (+38%/+69%)

$8.3 Billion (+0%/+39%)

Average Institutional Trades

22,851 (+27%/+68%)

39,364 (+72%/+139%)

With the return of volatility to the foreign exchange markets, FXCM recorded record trading volumes in both its retail and institutional businesses in May, and the company's average daily institutional trading volumes have also rebounded sharply from their weak levels in Q1, reaching a new record of $8.3 billion. FXCM is seeing meaningful benefits from a return of volatility, with debate over the direction of United States monetary policy intensifying, we believe that FXCM's June metrics, set for release in early July, will show new records in both retail and institutional trading, setting the company up for a solid second quarter and second half of 2013.

FXCM is also expanding its "white label" business (in which FXCM provides its platform, systems, and back-office services), and has recently signed an agreement with Charles Schwab (NYSE:SCHW), building on its existing agreements with E*Trade (NASDAQ:ETFC) and Barclays (NYSE:BCS). The integration of FXCM's foreign exchange trading into Schwab's optionsXpress platform is set to fully launch in Q3 2013, and on FXCM's Q1 earnings call, CEO Drew Niv noted that further agreements are pending. Although it is early, these agreements are beginning to contribute to FXCM's financial results. That being said, the fact that FXCM does not control the marketing of its foreign exchange solutions in its white label agreements means that FXCM's ability to profit off of these agreements depends in part on the level of marketing investments made by its partners. We expect more color on these white label agreements on FXCM's Q2 earnings call.

Financials & Valuations: Deploying Capital to Create Shareholder Value

FXCM has a solid balance sheet, and it has shown no hesitation in using it to create shareholder value, both through return of capital as well as acquisitions. The company ended Q1 2013 with $170.517 million in net cash (inclusive of $102.867 million in debt), and based on FXCM's 37,067,596 currently outstanding shares, the company's net cash balance is equivalent to $4.60 per share, or more than 29% of its current market capitalization (based on FXCM's closing price of $15.83 on July 21). And FXCM has not been hesitant to deploy capital. In June 2012, FXCM took control of British-based Lucid Markets, acquiring a 50.1% stake for $176 million, giving the company a new foothold in the institutional foreign exchange market. And on April 8, FXCM attempted to acquire Gain Capital (NYSE:GCAP) for over $210 million, which FXCM estimated would result in $50-$70 million in EBITDA synergies, and the release of $80-$100 million in restricted cash at the combined company. However, Gain rebuffed FXCM's offer, choosing instead to acquire Sydney-based Global Futures & Forex, thereby draining its cash balances, and causing FXCM to withdraw its proposal on April 25. However, this setback does not mark the end of FXCM's acquisition hunt. In late May, FXCM closed a $175 million offering of 2.25% convertible notes due 2018 (with net proceeds of $166.3 million), and explicitly stated that the proceeds of this offering may be used for acquisitions, as well as the repayment of existing debt.

In addition to deploying its capital on acquisitions, FXCM has also been returning it to shareholders, via the form of a 6-cent quarterly dividend, which results in a current yield of 1.52%. FXCM has not raised its dividend since it was initiated in March 2011, but that may soon change. On the company's Q1 earnings call, CFO Robert Lande stated that although FXCM wants to reduce its debt levels in the near term, investors should expect FXCM to increase its return of capital "shortly," via both a potential dividend increase as well as a share repurchase program. In our view, FXCM will have ample resources to not both reduce debt and return capital to shareholder, due to the company's continued earnings growth. Consensus estimates call for EPS of $0.87 in 2013, up 50% from 2012 EPS of $0.58, outpacing estimated revenue growth of 18.81%. And for 2014, consensus estimates call for EPS to rise 27.59% to $1.11, once again outpacing estimated revenue growth of 10.04%. 2014 EPS is set to reach a record for FXCM (the previous record was set in 2010 at $0.92), as the company's strategic investments in its business begin to pay off, and 2015 EPS is set to continue that trend, with estimates calling for EPS to rise 18.02% to $1.31. These growth rates make FXCM inexpensive at current levels; shares currently trade at 18.2x 2013 EPS, 14.26x 2014 EPS, and 12.08x 2015 EPS. However, this does not take into account the ample cash balances that FXCM currently holds. When the company's $4.60 per share in net cash is included, FXCM's multiples become even more compelling. When this cash is taken into account, the company's multiples fall to 12.91x for 2013, 10.12x for 2014, and just 8.57x for 2015.

Conclusions

FXCM is poised to benefit from a return of foreign exchange volatility, as well as any increase in foreign exchange market regulation. The company's institutional business has staged a solid recovery in April and May, and its retail business continues to operate at record levels. Backed by a solid balance sheet, and a management team committed to deploying it for the benefit of investors, shares of FXCM are set to rise. In our view, FXCM's best days are ahead of it, and we believe that investors should add to or initiate positions in FXCM ahead of what we believe will be a solid 2nd half of 2013, from both a financial and operational perspective.

Disclosure: I am long FXCM, CME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.