MF Global (MF) came public in July and the offering was a very frustrating experience as I wrote about shortly after the deal. Formerly known as Man Financial, the company was offered to the public at $31 and promptly dropped below 25 in just over a week. The most challenging headwind the stock has faced so far is that it was brought public the day after the highest close on the S&P so the overall equity environment has been quite challenging for the duration of the time MF has been public.
MF is one of the largest brokers serving the derivatives markets, offering clients the ability to trade futures, options, swaps, Over the Counter [OTC] contracts and more. The derivatives market has been one of high growth since the mid-1990s and in the past 5 years, volumes have grown an average of 22% each year. The majority of revenue for MF Global is a function of their participation in trading volume and pricing on those contracts. The largest category of revenue is cleared commissions where the company gets paid to execute trades for clients, and also charges a clearing fee to guarantee funds or security to the counterparty to the trade. The company also participates in execution only commissions but these are at much lower prices than trades which include the clearing function.
Principal transactions account for a small portion of revenue as the firm will act as a counterparty at times to clients trade. The goal of this business segment is to make money on the spread between bid and ask on contracts that may be less liquid. The company does not attempt to make money on price swings when participating in these proprietary trades - but obviously they bear risk that the market will move adversely while they are holding such securities. MF attempts to hedge such risk when they can which helps to mitigate the risk, but does not absolve the company completely. While management has been successful for the most part in keeping this portion of the business profitable and safe, investors should understand the potential for losses (and gains as well) associated with proprietary trading.
Derivatives trading is fast becoming a global phenomenon. While the US and European markets are quickly becoming mature, opportunities abound in emerging and developing markets. MF announced last week that they were acquiring Broker One which is the largest futures broker in Australia. This fits with the company’s strategy of increasing their presence in Asia Pacific, one of the fastest growing geographic areas for financial services. Broker One has primarily retail clients which fits well with MF’s current client base of primarily institutional clients. MF has been careful to keep its business diversified with a client base that consists of Banks, Broker Dealers, Hedge Funds, Asset Managers and individuals. While hedge funds and asset managers are leading the increase in derivatives trading, these two categories only make up 20% of the company’s revenue which is comforting given the negative headlines that have been so prevalent in this area.
Analysts are optimistic on Q3 numbers which should be reported in late October. Volume numbers from futures exchanges such as CME (NASDAQ:CME) and InterContinentalExchange (NYSE:ICE) show increasing summer activity due to market volatility. Since the summer is typically a slow period for trading, this will likely bode well for the company and lead to increased guidance for FY 2007. With an accretive acquisition in the works, and increasing global use of derivatives contracts, it looks like MF has a rosy outlook.
Disclosure: Author has a long position in MF