Description

BGCP is one of the best plays on higher interest rate volatility and level of gross treasury issuance in the market.

We will keep this write-up brief and squarely focused on our differentiated view as there are several previous write-ups on VIC that have already done a good job discussing the nature of the inter-dealer broker business, and the competitive dynamics around voice broking.  

The bottom line is that the stock is trading at 7x consensus EPS, with potentially 30-50% upside in earnings once the Fed tapers its bond purchases, and the treasury market sustains its pace of issuance and volatility over the next 2-3 years. In the meantime, we retain the optionality that Howard Lutnick (Chairman and CEO) will monetize the fully electronic trading business (Fenics) via an outright sale to a strategic or a third-party investment. In recent conferences, he has specifically highlighted how the value of Fenics alone could be worth more than the current market cap, despite zero net earnings contribution. 

If we are right on both fronts: the earnings uplift from high rates/volatility/issuance, as well as monetization of Fenics, the stock could be worth anywhere between $11-$12 vs. $5 today.

Quick overview of the business

BGCP comprises a voice inter-dealer broker, an electronic trading business (Fenics), and an insurance brokerage business (Corant Global). Both Fenics and Corant Global are just turning profitable in 2021 following heavy investment years. The rates business accounts for roughly half of the revenues of the inter-dealer broker. Management/employees own just under half of the company.    

A look at the Treasury cash trading volumes    

The inter-dealer brokers play in the OTC cash treasury markets, while futures trading occurs on exchanges. The futures exchanges (CME, DB1) are also obvious beneficiaries of the regime change in fixed income markets, although they carry the risk of multiple compression due to a reset in valuations for growth businesses. As we see below, BGCP rates revenues fluctuate perfectly with treasury cash trading volumes. 

It is instructive to look at “churn” in the cash treasury market (both as a % of new issuance as well as overall outstanding). We adjust out the pace of monthly QE by the Fed as well as the cumulative stack of Fed ownership of treasuries in order to get to the true “float” that is available to trade. 

Churn as you might expect, has collapsed significantly ever since the Fed embarked on its first round of QE in 2008. An important factor contributing to declining churn is also an extension of duration in the market. The WAM (weighted avg maturity) of the US treasury market is now at all time highs at 6 years. It is fair to assume there is a strong inverse correlation between the level of interest rates and the weighted average tenor of issuance. 

The cash market tends to be more active around new issuance, and subsequently secondary market trading has been occurring more in the futures market. Thus gross issuance tends to be the biggest driver for inter-dealer volumes. The recent expiration of the SLR relief will also help boost inter-dealer volumes as banks will have less appetite to hold new issuance on balance sheet. 

Significant earnings upside for BGCP if churn rises into an ever-expanding treasury float

We preface with Howard’s comments on the most recent conf call with Sandler O Neil:

Q. How has the outlook for Fenics changed with volatility of UST mkt? 

Howard Lutnick: “This pandemic is a WOW and changed everything” • “Governments around the world started issuing trillions at a clip” • “We haven’t had this much as a % of GDP since WW II” • “Volumes going through the roof” • “Its the best mkts for growth of rates trading on long end” • “I mean $21 trillion of debt outstanding is WOW, it’s just WOW”

If the evolving buy-side view on inflation/interest rates is correct, and the Fed will start raising interest rates by 2022, then we think the churn in the cash treasury market could improve significantly. 

Though we don’t have a strong view on inflation, but we do believe the overall treasury debt outstanding is the best bull market in the world, where structurally (and mathematically), the compounding effect of fiscal deficits will increase the stock of government debt exponentially (globally) for many years to come. (Fiscal cliffs each year leaning into a ever larger denominator of nominal GDP)

Even if you hold churn flat at 2%, the growth in the underlying pool of treasury securities will ensure dealer volumes keep growing 20+% a year. 

If churn doubles as we expect it to post Fed exit from QE, that growth rate in underlying volumes can triple the revenue pool for BGCP within three years. So the $500mn of run-rate rates revenues could grow into the $1bn-$1.5bn range.   

Arguably such an inflationary environment would translate into higher volatility in the FX, commodities and equities markets as well. We estimate BGCP EPS could be closer to $1.20-$1.40 in 2023 vs. $0.70 this year. 

Note we are not macro investors, and don’t have a view ourselves on the distribution curve for inflation outcomes. What we are merely pointing out is that relative to the markets’ view being expressed in various other securities and asset classes, BGCP has lagged considerably despite having perhaps the one of the largest exposures to this potential regime change. 

Fenics monetization 

Fenics is BGC’s pure electronic trading business and will account for $400mn of revenues (25% of total) in 2021. The business is 50% rates, 27% FX and 21% credit. 

In the rates business, Fenics competes directly with CME, TradeWeb and MarketAxess. CME entered the CLOB rates business via its purchase of the Nex Group in 2018 for 25x+ P/E. TW and MKTX trade at 50x P/E and 17x sales today.

Howard has been investing heavily in Fenics (to the tune of $150mn annually) to improve the technology offering and expand into new asset classes. He has clearly indicated a run-rate EBITDA margin of 40%+ for Fenics if they were to stop investing in new products and/or it was acquired by an exchange. 

Having expressed frustration with his stock price more recently, Howard had the following comments in two recent conference calls (we recommend listening to the Sandler O Neil call specifically)

“I am not interested in talking about stuff that is not a homerun. Ok? Alright? I am done with that part of my life. BGCP is in the same space as MKTS and TW which have a $36 b mkt while BGCP is $2.5 b.”

“Nobody ever thought the BGCP stock would move (in 2013 after they cut the dividend post Hurricane Sandy) and then when we sold eSpeed for full value of BGCP, BGCP stock then went up (200%)”

“In an extraordinary position and maybe once in a lifetime to execute Fenics gong forward. It is the most exciting thing to me in history of company”

“It is my job to express enormous value of its assets as CEO and largest shareholder. I proved that in 2012 and this company is worth wildly more today and its Fencis assets are being underappreciated“

“I am not playing little bits here to move the need in a big way. The assets in the company are demonstrably more value than current stock price. We are working how to express the value and just like we did with eSspeed, we showed it.” 

Q. Is it feasible you would sell Fenics UST vs this or that? 

“nothing can be off the table”

“maybe a third party invests in a valuation wildly higher than where we are now?” 

“When have a third party invests, good way to great value” 

“We have the assets and built the assets” 

“We know the (SPAC) mkt clearly as a top 3 SPAC player and that is a vehicle to consider. Of course” 

Q. Can these Fenics stand-alone if separated? 

“Yes” 

Q: What is your top priority for next 3-6 months as job #1? 

“Driving asset value for Fenics for my shareholders is definitely the absolute top of my list.”

Valuation and risk-reward

In our bull case, we assume monetization of Fenics at close to $3bn (which would be 6x 2022 revenues). We think this is reasonable as it is at a discount to the Nex Group sale which occurred 3 years ago when industry-wide multiples were at least 20-30% lower (just look at the TW and MKTX charts).  

Additionally, we assume the remaining voice business will trade at 6x adjusted EPS. There has been a lot of discussion already on the value of a voice platform, but if you look at the market share of inter-dealer voice brokers they have been extremely resilient over time. Also, we assume the Fed tapering will lead to significantly higher volatility/volumes in the commodities and FX markets.

The insurance brokerage (Corant Global) is expected to build towards $300mn in revenues and 15% operating margins by 2023. We assume that this business trades for 10x EBIT, which is at a discount to peers. Note that a lot of the recent hires made in this business have been in the aviation segment, and there is significant pent up demand once travel recovers post pandemic. Over time, we expect Howard to monetize this asset as well. 

We think downside is limited given the fact that the stock still hasn’t recovered to pre-pandemic levels, but adjusted EPS is 10% higher than where it was in 2019. Howard did cut the dividend (8% yield at the time) and has now switched to a buyback weighted strategy for capital return. 

There are a lot of investors who have been disappointed by Howards actions (or lack thereof) in the past and hence the stock has traded poorly for long stretches of time. We are well aware of these issues but are purely focused on the more objective measures of differentiation in the story today (unappreciated direct exposure to the strongest macro theme in the market today and potential Fenics monetization). Whatever baseline discount the stock is reflecting already (because of Howard), we are assuming that discount will persist going forward. Our bet is mainly around the rates tailwinds and magnitude of EPS upgrades likely over the next two years.

Catalyst

Fenics Monetization

Interest rate volatility picks up

Insurance spin

This write-up is intended for informational purposes only and you should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. At any time, the author of this report may trade in or out of any securities that are mentioned in the write-up without disclosing this information. This is not an offer to sell or a solicitation of an offer to buy any security.