Description

BGCP is a beaten down stock in a beaten down sector that currently yields over 12% and trades under 7x earnings.  BGCP is perceived by investors as a secularly declining business with substantial regulatory risk, complicated accounting, and a convoluted ownership structure that recently cut its dividend and may have to do so again.  This perception has resulted in the stock trading near all-time lows and near its lowest valuation levels ever.  Contrary to conventional wisdom, we believe regulatory noise, industry complexity, and BGCP's structural complexity has created an opportunity to buy a collection of decent to good businesses at cheap multiples of trough earnings, ahead of several meaningful catalysts over the next several weeks.  Furthermore, we believe that there are signs that volumes and revenues are poised to rebound meaningfully in 2013 and that the dividend is sustainable and may actually increase from here.  Although there are some secular pressures in certain aspects of the business, we note that 55% of profits LTM (and growing) are from healthy, growing businesses with no secular pressures.  We further estimate that less than 5% of revs and 4% of profits are at substantial risk from regulatory change in 2013 and that it is quite possible that regulatory changes are actually a meaningful positive, rather than a negative.  We think the whole IDB sector is cheap and attractive, but think that BGCP represents the most compelling risk/reward over the near-term (next 3-12 months).  We expect the company to meaningfully outperform consensus earnings for Q1 and for the stock to be rerated within when it becomes clear that the business is at a cyclical inflection point and not going away.  We believe upside should be 40-85% from here, with 12% (tax efficient) dividends while we wait. If we are wrong, we think downside is only about 10% (assuming stock trades at a 15% dividend yield, sub 6x earnings, and we collect 1 year worth of dividends).

Business Overview:

BGCP is one of the largest inter-broker dealers in the world.  An inter-broker dealer acts as an agent between various counterparties (typically large Ibanks) that trade in over-the-counter financial products (e.g. interest rate swaps, credit default swaps, FX derivatives), as well as in certain cash traded assets, such as US government bonds.  There are 5 large inter-broker dealers (all publicly traded), each of which trade in over 200 products in mostly illiquid markets with non-standardized products.  Most IDBs take on no unusual balance sheet risk - they don't make bets with their own balance sheets or do proprietary trading - they merely act as an agent between to parties and take a fee for facilitating the trade.  All the IDBs survived the 2009 financial crisis - the worst thing that happened to BGCP is they lost 30M when Lehman Brothers went bankrupt, but were subsequently made whole by Barclays due to the importance of the relationship.

BGCP operates in these markets in 3 different ways - through voice transactions (broker facilitated trades), electronic (purely electronic transactions with no broker input), and hybrid (broker assisted electronic transactions).  BGCP's electronic revenues and products carry 50%+ operating margins and should grow high single to low double digits absent cyclical headwinds.  Although BGCP has electronic capabilities in most asset classes, their primary strength is in the cash treasuries market, where their Espeed platform is one of two primary platforms.  In most other markes, the bulk of BGCP's revenues are either voice or hybrid.

Danconia17 provided an excellent overview of BGCP and the IDB space in his 2009 write-up, most of which is still relevant today.  Rather than replicate his excellent work, I would encourage you to read through his write-up for additional details on the industry.  The rest of this piece will focus on why we believe the cyclical pressures that have caused double digit revenue declines may be turning, and why the three primary concerns about BGCP (Regulatory, Secular, and Structural) are overblown.

BGCP also a large commercial real estate brokerage business that it bought out of bankruptcy (Grubb Ellis) and has added to this platform with further acquisitions.  Most revenues in this area are derived from advising on strategic real estate transactions, collecting a commission on sales or leases of commercial properties, and property management services.

The diversity of BGCP's business operations is part of the opportunity; whereas BGCP competitor ICAP, for example, clearly calls out where their profitability comes from, BGCP does a less good job.  Below are our estimates of revenues and profits from each business unit, based on company disclosures (see analyst day presentation) as well as conversations with industry participants:

Bolded categories are those that should have no impact or a positive impact from legislation or secular pressures.  Italicized categories are those where legislation may have an impact, but likely not until 2014 or later.  We estimate that approximately 50% of EBIT in FY12 and closer to 60% of EBIT in 2013 has little to nothing to do with highly publicized regulatory or secular risks.  Further, if we include Asia voice (which we probably should), those numbers would increase to 60% and 70% respectively.

Background on BGCP situation and how we got here:

BGCP, the other IDBs, as well as many exchanges saw very tepid volumes for a variety of macro reasons (QE, low interest rates & rate volatility, low FX volatility, sovereign debt crisis in Europe, etc.).  On November 2nd, 2012, BGCP announced disappointing earnings and suspended guidance for Q4, 2012.  Further, they announced a dividend cut from $.17 to $.12 a share, and noted that given the devastating impact of hurricane Sandy, they had little visibility into Q4 or 2013.  In cutting the dividend, management said it did so based on October volume levels, and believed it could continue to fund the dividend even at levels 10% lower than those experienced in October.  It's important to have context for management's decisions in October - their HQ in the US had 12 feet of water in the lobby - many employees couldn't get to work and, if they could, they had nowhere to go (BGCP subsequently relocated employees to Cantor Fitzgerald offices).  Industry volumes the last few days of October were horrendous, and management was unsure when or if things would get better.  Although Sandy is at least in part to blame for results, industry volumes were also incredibly tepid even before Sandy.  Below is a look at volumes reported by comparable exchanges that typically correlate to BGCP's own volumes and what they were looking like when management reported earnings & cut the dividend:

Cycle Finally Turning?

Based on conversations we've had with multiple industry participants, as well as futures exchange volumes and other metrics that are usually a good proxy for IDB volumes, we believe industry volumes likely bottomed in October last year and are starting to improve.  Although many of the same issues remain (especially subdued rate volatility and QE purchasing), increased debt issuance, increased FX volatility, and less soveigrn concerns in Europe are driving increased activity in volumes for the IDBs.  Below are the same metrics for Q4 and for January 2013:

Nearly every metric got better on a sequential basis in Q4 (namely due to a strong December nearly across the board) and this has continued into January.  Our conversations with market participants suggest that this strength in volumes has also extended to the IDBs.  Considering that most analysts still call for down industry volumes in the first half of the year, we expect BGCP and the rest of the IDBs to surprise to the upside over the next couple quarters.  To the degree this happens (while at the same time very little bad happens to you with regulatory or secular pressures) we believe the sector and BGCP specifically will be re-rated to a more appropriate multiple and yield.

Why is this cheap?

After several years of declining volumes and increased regulatory noise, many investors are convinced that the traditional Voice IDB is going away.  Their customers are de-levering, Dodd Frank & EMIR (Europe legislation) are coming, collateral requirements will increase, Basel III is structurally driving down volumes across the board, markets will go electronic or become futurized, and the IDB will be unable to compete with exchanges and others as these changes occur.  Although there are some aspects of these arguments we believe are valid, we think that these arguments are only true for relatively small parts of the market and that these reforms will take years to make a meaningful dent in BGCP's voice volumes.  We would also point that, relative to the other IDBs, we believe BGCP is the second best diversified away from voice after ICAP (which trades at a 2-turn premium to the rest of the sector).  In the meantime, volumes of the products BGCP trades will determine revenue trends and, for the reasons cited previously, we believe those are turning positive. 

Regulatory Concerns

We believe less than 5% of BGCP's revs and 4% of operating profits are at risk from Dodd Frank in the foreseeable future.  US Voice revenues (which are what are at risk) are only 10% of consolidated revs at 8% of profits.  Dodd Frank legislation is, for now, only going to impact interest rate swaps and credit defaults swaps, which we generously estimate to be 50% of that 10% (although it’s probably closer to 30%).  This fact is lost in the debate over what Dodd Frank legislation will do to the IDBs and BGCP specifically.  I actually don't even believe this issue is particularly material, but since it seems to be causing all the IDBs to trade where they do, it's worth discussion.  Dodd Frank was passed over 2 years ago and, in part, was an effort to regulate the opaque swaps market.  The CFTC (the main regulatory body overseeing swaps) wants to make sure swaps are centrally cleared, offer more transparency (including transparent pricing).  The CFTC issued draft rules in November that would create SEFs, which would act as clearing houses for interest rate & credit default swaps.  These rules are likely to be finalized in mid-February and we believe they will be largely perceived as positive relative to what some people fear.  I am happy to talk more in the Q&A about specifics, but the main concern people have is that voice trading will not be allowed and that the CFTC will mandate, either explicitly or through various restrictions, that the bulk of interest rate swaps & CDS trade electronically.  Our conversations with multiple lawyers and others following this legislation, including several people who spoke at SEFCON, suggest that, within industry, it is widely expected that voice will continue to be allowed under Dodd Frank.  Although there are other potential restrictions that could be negative, this is generally the one that has most people concerned.

A separate concern people have is the potential "futurization" of swaps, as happened in the energy markets, in large part due to proposed collateral rules for swaps that would be much higher than what is required for futures.  The CFTC had a hearing January 31st on this matter and we believe recognizes that the collateral requirements they drafted would make swaps potentially less attractive than futures.  It is our belief that updated collateral requirements (when they do come out, perhaps mid year) will be better than the draft requirements.

We would also point to the potential massive positive associated with Dodd Frank, namely that ALL interest rate swap & CDS trades will need to go through a SEF.  Right now, many banks cross trades internally, bank to bank, or through other intermediaries that are not IDBs.  Under Dodd Frank, all these transactions must be required to go through a SEF, which are likely to be the 5 large IDBs, and potentially a couple futures exchanges.  There are no firm numbers on how much trades this way, but we estimate it is at least 2-3x current volumes that flow through IDBs (some IDBs have said it's up to 10x).  People do not give the IDBs any credit for this potential massive benefit and instead are focused on the negatives.

Frankly, we just don't think regulation of voice in the US for the specified products is enough to matter.  EMIR, the EU regulation, is at least 1-2 years behind Dodd Frank.  Conversations we have had suggest that it is likely to be much more benign and less restrictive when it eventually comes, so at this point we think UK revenue is largely safe from regulation.  Regulation in Asia and elsewhere are years behind Europe.

Secular Concerns

Much of the IDB industry still conducts voice trades.  There are certain markets that have transitioned electronic but, despite the technology being around for many years, most markets have not gone electronic.  Products that lend themselves to electronic trading are typically standardized and liquid.  Most swap transactions are not.  We've heard estimates that the entire swaps market is composed of on a few thousand trades a day, in average sizes of $50M or $100M.  Products go days without trading.  Multiple forays to try to electronicize markets have failed - Ibanks, who control most of the flow, don't want markets to go electronic because their fees would decline substantially.  Most markets also aren't deep enough for electronic markets to work well.  Markets that have gone electronic or are going electronic successful (e.g. rate swaps in Europe), do so reasonably slowly, and are likely to only get 40-50% total penetration.  Bottom line, there will always be at least some parts of the market that trade through voice.  The transition of markets from voice to electronic (where it makes sense) will be slow and not without failure.  We would point to ICAP's electronic futures platform as a great example of an electronic exchange that has run into substantial trouble (and lost share to voice recently) over concerns that algo traders have been gaming the markets.  We assume modest pressures in certain products and certain markets but, again, we don't believe any one product in any one geography is big enough to move the needle to much.  Because BGCP trades so many products in so many geographies, and electronic exchanges need to be developed product by product and geo by geo, it's just going to take a very long time before the secular pressures are big enough to outweigh the cyclical ones.

Structure Concerns

BGCP's ownership structure creates complicated GAAP accounting and other issues that scare investors.  Although there are negatives to some of the structure, we believe these issues have been true of the stock since it became public, and have been reflected in the historical multiple and stock price.

 BGCP has 3 classes of shares:  A shares, B shares, and LP units:

The A shares are publicly traded and have 1 vote.  The B shares are owned entirely by Cantor Fitzgerald and have 10 votes.  The LP units are not publicly traded and owned entirely by employees of BGCP and Cantor Fitzgerald.  The company pays a substantial portion of it's compensation in stock comp - absent acquisitions, the company expects to issue about 20M LP units a year, which would result in annual dilution of about 6%.  Annual dilution has run a bit higher than that, primarily due to acquisitions.  Although this is a clear negative (and reflected in our / analysts estimates), there are a couple positives associated with the structure.  Employees and management have a strong vested interest in the performance of the business.  Also, the LP units are typically subject to long vesting periods - if an employee leaves BGCP for another firm, they typically forfeit their LP units, which creates meaningful barriers to employees leaving their employment.  It's also worth noting that LP units can also be sold by being exchanged into A shares - the company and employees have a strong vested interest in the stock price of the A shares, which helps to protect you from the company taking actions on behalf of the LP units at expense of the A units.

The CEO of BGCP is also the CEO of Cantor Fitzgerald, there are substantial related company fees and the possibility of value transfer from Cantor to BGCP over-time.  Although this is a risk, we believe BGCP’s substantial employee ownership (as well as Howard’s) limit the risk of this issue.

The structure also creates very complicated GAAP accounting.  The company reports distributable earnings (cash available to be distributable to common units).  This number is, essentially, earnings ex-stock comp.  Although this is a real ongoing expense (which we reflect in increasing sharecount over time), it is a non-cash expense and, thus, is not an issue in terms of the dividend being sustainable.  We would note that FCF has approximately this distributable earnings number over the last several years.

Conclusion:

Ultimately, the thesis here is very simple.  BGCP faces a slew of uncertainty, fear around which has been heightened due to sharp cyclical pressures and a recent dividend cut.  We believe these pressures are misunderstood and that a cyclical uptick is on the verge of overwhelming these fears.  When businesses perceived as being secularly declining begin growing again, the fears take a backburner and the stock re-rates.  We believe that this will happen this year, potentially as soon as Q1.

BGCP has historically traded at a 9.5% dividend, with a range between 6% and 15%.  If BGC trades at the average of its historical yield a year from now, the stock should trade at $5.05 plus $.48 of dividends, yielding upside of 40% over the next year.  If this goes back to trading at a 7% yield (which it did as recently as mid 2011), we see upside of 80%+ from here.  Neither of these scenarios contemplate an eventual dividend hike, which we believe is possible depending on how volumes shape up this year.  In most scenarios, we do not envision the dividend needing to be cut absent a meaningful further cyclical downturn. If the yield blows out again to 15% over the next year, we think the stock could go to $3.20 plus $.48 of dividends, which would be about 10% from here.

Catalyst