Description

Description

 BGC Partners, Inc. is a full-service, inter-dealer broker (IDB) specializing in the trading of over-the-counter (OTC) financial instruments and related derivative products. The company is active in the global fixed income (corporates & sovereign cash and swaps), interest rates, foreign exchange, equity derivatives, credit derivatives, futures and structured product markets.

 As of Sept 30, 2009 BGCP employed 1,423 voice brokers on 150 desks and should generate approx. $1,130mm in revenues in 2009.  Average broker productivity is around $730,000 per year.

 

Shares outstanding & Market Cap:

Class A: 55.006mm

Class B: 26.448mm

RSUs: 4.154mm

Partnership Interests: 131.371mm

Total: 216.980mm

Market Cap @ $4.48 = $972mm

 

Cash: $475mm

Debt: $169mm

Regulatory Capital (est. 10% of rev): $115mm

EV: $781mm

 Summary:

BGC Partners (BGCP) is a deeply undervalued business not well covered by Wall Street which has led to a low valuation both on an absolute and relative basis. BGCP is trading for 7.3x our trailing EV/PBT (profits before taxes) estimates, and for 3.5x our PBT estimates 2 years out (FY11).

No single Wall Street analyst covers all the inter-dealer brokers (IDBs) as a group. And no analyst in the US covers any of the UK IDBs.  Without a worldview of IDBs, we do not believe the investment community fully appreciates the dynamics of the global IDB business and the comparative advantages of one IDB over the others.  Though the entire industry has seen some modest revenue declines post the credit crisis, they remain highly profitable and cash generative businesses.  We think this lack of global coverage has led to an undervaluation of the entire group, and we think BGCP is the most undervalued.

Furthermore, we think Wall Street is mis-valuing BGCPs current earnings stream and future growth prospects.  Wall Street is estimating that BGCP will earn $0.37-$0.40 in FY2010.  We think the earnings power is more like $0.55 in FY2010.   

BGCP is the #3 IDB in the world and trades at a discount to its peers, yet has the most significant growth prospects and operating leverage in the group.  As these misperceptions are resolved, we expect BGCP to more than double within the next two years, using a conservative 12x EV/PBT. 

 Thesis:

 The thesis for BGCP is very simple.  It is trading at a discount to its peers, while possessing higher revenue growth potential and operating margin leverage.  BGCP is one of only two IDBs who have developed proprietary trading technology that has been widely distributed and accepted in the marketplace.

 As of Sept 30^th, 2009 BGCP had $475mm cash & $169mm debt on the balance sheet.  We have estimated that IDBs need to have regulatory capital on their balance sheet at around 10% of revenues.  This would be about $115mm of capital for BGCP.  With a market value of $972mm as of Nov 16^th 2009, the enterprise value is $781mm.

 We expect that BGCP will generate $106mm in PBT in 2009 and $160mm in 2010, and $128mm in Net Income in 2010.  Thus it trades for 4.7x 2010 EV/PBT and 7.8x 2010 MC/NI. 

 

Earnings Power 2010

According to Bloomberg consensus estimates are for $0.40 EPS, however, we think the earnings power is closer to $0.55 in FY10.  We don't think Wall Street has properly factored in the revenue growth that will come from the 180 brokers BGCP has hired over the last 12 months.  Also, on their last earnings call BGCP announced guidance for the month of January of $300mm+ in revenues, which would imply $1200 in revenues given normal seasonality.  If you assume a modest industry growth rate of 3%, and then add in the incremental revenues from the gains in productivity for BGCPs recent hires, you can easily get to $1,265mm of revenues.  This assumes that the recent 184 brokers hired have corporate average productivity of $750,000.  It assumes BGCP doesn't hire any more brokers nor make any further acquisitions.

 Given the simplicity of the earnings model, 30% incremental margins on revenue can get you to 13% PBT margins and $0.55 in EPS.

 

Faster Growth & Margin Expansion

We think that as the company executes on its growth strategy over the next several years of hiring new brokers and acquiring smaller IDBs in both new asset classes and new geographies, it should be able to outgrow the industry by 5-6% points per year.  Historically, the industry has grown around 8-9% per year.  Also, as some of the asset classes they trade migrate to fully electronic trading (from more labor intensive, traditional voice brokered trading) operating margins will expand even faster.  We think the market will be unable to deny that this business deserves a higher multiple on a growing earnings stream. 

 BGCP has added 184 brokers (14.7% growth) in the last 12 months.  We believe that Wall Street has not fully appreciated the significant of these hires.  We estimate these brokers are at $250,000 annual revenue productivity today and will ramp up to corporate average over the next 12 months.  Once they are at $800,000 production per year, these brokers will produce close to $150,000,000 in annual revenue and drop $37mm to the bottom line. 

 Additionally, BGCP has hired away approximately 130 brokers from Tullett, however only 51 have started working.  The remainder are in limbo until the lawsuits that Tullett has brought to BGCP are settled.  These brokers had produced $120mm of revenues for Tullett, and roughly $40mm PBT.  This is a very significant win for BGCP, however I have not factored the additional brokers into my estimates.    

 With a little help from a rebound in the market (or stabilization from the forced deleveraging), we think BGCP could grow the top line by 12% in 2010, expand PBT margins to 13% and throw off $0.55 in earnings.  Thus it is only trading at 8.1x our 2010 EPS estimate.

 A miscellaneous point is that BGCP reports in USD, however, only 26% of its revenues are based in the US.  So as the dollar weakens, BGCP will report higher revenues.  There is only a slight impact on the P/L from a weakening USD since most expenses are based in the functional currency.  BGCP's reported revenues were negatively impacted in Q4 2008 - Q2 2009 when the USD had strengthened considerably.  The importance of noting FX rates is that TLPR.LN and IAP.LN report revenues in GBP, so you can have a misleading view on relative growth rates if you don't convert to constant currency growth rates. 

 Peer Multiples

Its peers (IAP LN, GFIG, TLPR LN, CFT SW) trade for an average of 6.4x EV/PBT on next FY, and 10.5x Market Cap/Net Income (based on Bloomberg Estimates).  We think the true multiple is probably a bit higher since the estimates for TLPR LN  are too high given their announcement on Friday Nov 13^th, 2009.

 We actually think all the IDBs are undervalued relative to the exchange space.  We think that the best IDBs should have a mid-high teens multiple given the historic stability of their revenue and profit margins, the long term growth prospects, migration from voice to electronic trading, high cash flow and ROIC, and the eventual M&A potential for exchanges wanting to enter the OTC trading space. 

 

Valuation

Thus, to simply trade in line with its peer group (10.5x PE, 6.4x EV/PBT), BGCP would rise to $6.00, approx 33% over its current stock price. However, we believe that BGCP should trade more on par with ICAP (largest IDB), and at a premium to its lesser competitors: GFIG, TLPR and CFT.  ICAP trades at 8.5x EV/PBT and 11.7x PE.  At those valuations BGCP would trade $8.00 (80% higher than current price).

 We think it deserves to trade on par with ICAP because, in addition to faster revenue growth and greater margin expansion opportunities, BGCP is the only other IDB (besides ICAP) which has a proven electronic platform.  As the government pushes greater transparency over the coming years, IDBs will be required to adapt to the greater use of electronic platforms for trading (both fully electronic and hybrid), and those IDBs with technology deserve a higher multiple since they will gain market share, grow more quickly and deliver strong operating leverage.  As noted below, BGCP already generates $100mm of fully electronic revenue. 

 At a more appropriate 15-16x PE multiple which we think both ICAP and BGCP should fetch, you would have an $8.80 stock (95% upside).  And when you look to 2011 earnings power of $0.75, you could easily see $13.00 (188% upside) per share.

 An alternative valuation methodology, using a 10 year DCF model with the following assumptions:  7.5% CAGR revenue growth; 27% tax rate; 60% comp rate; long term broker productivity of $1mm per year; long term 20% PBT margins; net capx 1% of revenues; working capital -1% of revenues; regulatory capital -10% revenues; 25% net acquisition spend (40% of incremental revenues acquired paid 50% in cash); 3% share dilution per year; an 11% discount rate; and a terminal multiple of 8x PBT.  This produces a DCF of $11.00 (144% upside).    

  In the meantime, the company has committed to paying out 75%+ of its quarterly earnings as a dividend.  We estimate they can earn nearly $0.36 in 2009, thus distribute $0.29 per share which equates to a 6.3% dividend yield at today's $4.50 stock price.  In 2010, they would pay out $0.42 in dividends based on my estimates which represents a 9.3% yield.  If I am accurate about my growth assumptions, you will receive more than 50% of your investment in the form of dividends over the next 4 years.

 

 

BGCP Growth Opportunities

 We think BGCP will grow faster than their peers for a few reasons.  BGCP is only in 19 cities worldwide (vs. 40 for ICAP).  BGCP doesn't yet trade every asset class.  And BGCP has a strong hybrid and fully electronic platform.

 We think BGCP will be aggressive in hiring additional brokers and expanding into new cities and asset classes.  They have successfully hired 180+ brokers over the last 12 months.  In many ways this growth opportunity is not open to someone like ICAP because they are already in all the cities and already trade most asset classes.  It doesn't make sense for ICAP to buy another commodity trading desk since some brokers will need to be let go.  Customers like to make sure they spread the business around and don't want to be too concentrated using only one IDB.  We have heard it anecdotally said that no one wants to give an IDB more than 40% market share in any given product. 

 However, BGCP doesn't trade commodities, so they can easily acquire a commodity desk and expand the business to other cities across its network.

 BGCP has built a platform which can handle 2x the number of brokers they have today.  They provide technology which can increase broker productivity as well as provide a platform for the fully electronic trading of the asset class.

 The incremental PBT margins for voice/hybrid revenue growth is approximately 25-30%.  At scale, the voice business should generate 20% PBT margins.  The way the model works is that 60% of revenue is paid out to brokers as a commission, 20% goes to back office and corporate overheads, leaving 20% for profit.

 That said, we think overtime, BGCPs margins will move higher than 20% since fully electronic revenues can carry significantly higher margins at scale.

 Expansion of Fully Electronic Trading:  Today BGCP and ICAP share a duopoly in cash US Treasury trading.  The electronic platform that BGCP built over the last 10 years is fully scalable to other asset classes.  BGCP is seeing traction in the fully electronic trading of Spot Foreign Exchange, FX Options, and Credit Default Swaps.  These trades are done directly by the customers input, with zero broker involvement.  The payout to the broker declines from 60% to 15% over time on fully electronic revenue. 

 

Misc Opportunity: ELX (Electronic Liquidity Exchange)

BGCP owns 25% of a new futures exchange, ELX.  BGCP contributed its technology platform to the JV, while the 13 founding partners (Bank of America, Barclays Capital, BGC Partners, Breakwater, Citi, Credit Suisse, Deutsche Bank Securities, GETCO, Goldman Sachs, JPMorgan, Morgan Stanley, PEAK6 and The Royal Bank of Scotland) contributed the money and a commitment to trade on the exchange.

 ELX has already managed to gain 3% market share in the interest rate futures market, which has been a monopoly of the CME.  In the 2-year future, ELX has recently achieved 10% market share.  We think overtime this market share will grow.

 This remains a zero cost option to BGCP.  If ELX is wildly successful, the 25% economic interest could be worth $100-200mm.  However, I have not included this in any valuation estimate.

 Currently, BGCP earns a nominal amount ($4mm per quarter) of revenue from providing services to ELX. 

 

Another way to look at it - Sum of Parts:

 These numbers are all estimates since the company does not disclose the profitability of their pure electronic business.

 The pure electronic business is doing $100mm in revenues.  Let's assume it throws off 30% PBT margins, which is not unreasonable when compared to ICAP's electronic business (which produces 40% PBT margins).

 This is $30mm of PBT.  We think that the fully electronic piece could get an 14x multiple = $420mm.

 

 Market Cap: $972mm

Cash: $475mm

Debt: $169mm

Regulatory Capital (est.): $115mm

Fully Electronic: $420mm

Voice Business (implied value) = $361mm

 

If I am correct about the PBT from the electronic business, then the voice business will throw off $81mm in 2009.  Thus the voice business is trading at 4.4x 2009 EV/PBT.  And 2.6x 2010 EV/PBT.

 You can do the math assuming a different multiple for the fully electronic piece.  Any way you slice it, it is obvious the voice business is undervalued.

 

 Competition

The main competitors in the IDB space are ICAP (IAP LN), GFI Group (GFIG US), Tullett (TLPR LN) and Tradition (CFT SW).  To keep things short, I will only briefly discuss each company.

 ICAP is the largest, most diversified, and profitable IDB today.  They are a leader in most asset classes and own two key electronic platforms (BrokerTec in rates and EBS in FX).  They have the largest number of brokers and the highest % of fully electronic revenue among the IDBs.  We think they will remain #1 for sometime.  They reported solid six month 2009 results on Nov 17^th, 2009. They've also started to expand to post-trade processing with their acquisition of Triana. 

 Tullett has a very large voice brokerage business and is the current #2 IDB.  But TLPR has no technology and so is limited in what they can do as markets migrate to electronic trading.  Further, they are having trouble recruiting brokers since the brokers know they need technology in the coming years since they recognize IDBs with technology will gain market share.  BGCP recently hired away approximately 130+ brokers from Tullett.  Tullett has said that these brokers represented 7.5% of group revenues (approx $120mm) and produced a 33% pre-tax margin.  This is a big win for BGCP.

 GFIG has a decent credit business and commodities business, but they are non existent in rates.  They've struggled the most during the recent credit crisis.  CDS trading was the majority of their revenue, and it has fallen considerably.  BGCP, thankfully did not have a large naked CDS trading operation.  GFIG has also been a net loser of brokers, having lost a number of high producing brokers to Tradition in the last 18 months.  They have some technology (Trayport) in the commodity space, but its design is not scalable to other asset classes. 

 CFT Tradition is purely voice broker with zero electronic capabilities.  They carry the lowest margins because they have offered the highest payouts (75%+) to their brokers.   

 Over the last few years and even in the last few quarters, BGCP has outgrown their peers.

Please see the attached model for a quick comparison of each firm.

 

			Pretax	Pretax	Net	EPS	Stock	Market	Cash	Debt	Regulatory	Enterprise	EV /	Market Cap /	PE
FX: GBP	IAP	SALES	Profit	Margin	Income Adj	Adj	Price	Cap	Last Rept	Last Rept	Capital	Value	PBT	Net Income	Ratio
	Mar-10	1,615.17	322.08	19.94%	200.00	0.32	418.30	2,852.63	438.00	559.00	161.52	3,135.14	9.73	14.26	12.99
BBRG Est	Mar-11	1,693.08	359.55	21.24%	221.00	0.36	418.30	2,852.63	438.00	559.00	169.31	3,142.93	8.74	12.91	11.62
	y/y	4.82%	11.63%		10.50%	11.80%
			Pretax	Pretax	Net	EPS	Stock	Market	Cash	Debt	Regulatory	Enterprise	EV /	Market Cap /	PE
FX: USD	GFIG	SALES	Profit	Margin	Income Adj	Adj	Price	Cap	Last Rept	Last Rept	Capital	Value	PBT	Net Income	Ratio
	Dec-09	825.00	63.28	7.67%	39.96	0.32	4.76	585.06	334.84	209.46	82.50	542.19	8.57	14.64	14.88
BBRG Est	Dec-10	906.00	93.00	10.26%	58.86	0.47	4.76	585.06	334.84	209.46	90.60	550.29	5.92	9.94	10.21
	y/y	9.82%	46.97%		47.30%	45.63%
			Pretax	Pretax	Net	EPS	Stock	Market	Cash	Debt	Regulatory	Enterprise	EV /	Market Cap /	PE
FX: GBP	TLPR LN	SALES	Profit	Margin	Income Adj	Adj	Price	Cap	Last Rept	Last Rept	Capital	Value	PBT	Net Income	Ratio
	Dec-09	950.20	153.70	16.18%	99.99	0.47	349.50	698.69	405.20	422.60	95.02	811.11	5.28	6.99	7.52
Noble Est	Dec-10	890.60	134.10	15.06%	87.20	0.41	349.50	698.69	405.20	422.60	89.06	805.15	6.00	8.01	8.61
	y/y	-6.27%	-12.75%		-12.79%	-12.69%
			Pretax	Pretax	Net	EPS	Stock	Market	Cash	Debt	Regulatory	Enterprise	EV /	Market Cap /	PE
FX: CHF	CFT SW	SALES	Profit	Margin	Income Adj	Adj	Price	Cap	Last Rept	Last Rept	Capital	Value	PBT	Net Income	Ratio
	Dec-09	1,408.50	127.00	9.02%	62.05	10.00	126.20	778.24	447.00	190.00	140.85	662.09	5.21	12.54	12.63
BBRG Est	Dec-10	1,369.00	134.50	9.82%	70.00	11.77	126.20	778.24	447.00	190.00	136.90	658.14	4.89	11.12	10.73
	y/y	-2.80%	5.91%		12.81%	17.71%
			Pretax	Pretax	Net	EPS	Stock	Market	Cash	Debt	Regulatory	Enterprise	EV /	Market Cap /	PE
FX: USD	BGCP	SALES	Profit	Margin	Income Adj	Adj	Price	Cap	Last Rept	Last Rept	Capital	Value	PBT	Net Income	Ratio
	Dec-09	1,132.81	106.11	9.37%	76.78	0.37	4.50	976.50	475.80	169.00	113.28	782.98	7.38	12.72	12.25
My Est:	Dec-10	1,265.20	170.41	13.47%	124.69	0.55	4.50	976.50	475.80	169.00	126.52	796.22	4.67	7.83	8.18
	y/y	11.69%	60.59%		62.39%	49.72%
												Avg 2010	6.39	10.49	10.29
												BGCP Value	1,395.52	1,308.54	5.66
												% return	42.91%	34.00%	25.79%
												BGCP @ IAP.LN Multiples	1,796.39	1,609.45	6.39
												% return	83.96%	64.82%	42.02%

IAP	Brokers	Rev / Broker
Mar-10	2304	0.70
Mar-11	2350	0.72
y/y	2.00%	2.77%
	Brokers	Rev /
GFIG		Broker
Dec-09	1069	0.77
Dec-10	1100	0.82
y/y	2.90%	6.72%
	Brokers	Rev /
TLPR LN		Broker
Dec-09	1647	0.58
Dec-10	1650	0.54
y/y	0.18%	-6.44%
	Brokers	Rev /
CFT SW		Broker
Dec-09	1548	0.91
Dec-10	1600	0.86
y/y	3.36%	-5.96%
	Brokers	Rev /
BGCP		Broker
Dec-09	1451	0.78
Dec-10	1571	0.81
y/y	8.27%	3.16%

BGCP's Unique Structure

This has been a source of great confusion for anyone first looking at BGCP.  The ownership chart looks like an sea creature.  That said, if you spend some time studying it, you can get comfortable with what it means and what it is out to achieve.

 The company is structured as a limited partnership and its most productive brokers own forfeitable partnership units, representing a combined 32% economic interest in the business.  These partnership units provide a quarterly cash distribution based on the pre-tax distributable earnings of the company to the brokers.  The individual brokers are responsible to pay the tax on the distribution.

 By having such a large stake in the company, the brokers are incented to think like owners, which is also a rarity in the IDB world.  This ownership provides an additional incentive for brokers to convert voice revenue to higher margin electronic revenue.  But the true advantage of this structure is that these partnership units act like golden handcuffs, because if a broker quits and competes, he forfeits his substantial equity ownership.  This provides an incredibly powerful retentive force, keeping the best brokers loyally committed to growing BGC while also serving to control overall broker compensation costs.  This equity participation provides a fundamental structural advantage that BGC's competitors simply cannot replicate.

 Furthermore, one issue that has plagued IDBs over the years is the "retention bonuses" they had to pay to the top producing brokers at the end of their contract.  For BGCP, as the value of their stock increases (and the annual cash profits distributions grow), the negotiating leverage tilts to BGCP's favor and thus they will not need to pay the same kind of retention bonuses that their competitors will over time.  Brokers accept these partnership units in lieu of upfront cash because it provides them a more stable earnings stream and an equity multiple on the company's earnings provided they stay through to retirement.

 The 4 main competitors (GFIG, ICAP, TLPR and CFT) have pre-existing corporate structures and shareholder bases.  It would be nearly impossible for them to develop a similar partnership structure - as conversion from a corporation to a partnership would trigger significant income tax liabilities.  BGCP was only able to do this because the operating Company was always structured as a Partnership and the brokers were partners at Cantor and BGC prior to the reorganization/merger of its business with eSpeed (the public Company survivor).

  

BGCP Management Team

The Chairman/CEO is Howard Lutnick.  Howard became the CEO of Cantor Fitzgerald when he was 29 years old, and successfully managed that business to be the world's #1 IDB until the terrorist attacks of Sept 11^th 2001 in which 658 of Cantors employees perished (approx. 2/3rds of its worldwide employees).  After that day, he went out with his top managers (Shawn Lynn, Lee Amatis, Dan Levecchia) and rebuilt the firm.  They created a separate division within Cantor named BGC Partners.  They invested $350mm and grew from zero brokers to 1,000 brokers in 4 years.  It is a testament to their capability that BGCP is now the #3 largest IDB in the world.

 This management team has done this all before and they are well down the path toward doing it again.  They know what it is like to be on top of the world and they are hungry to regain that status.

 Regarding the CEO, Howard Lutnick, I suggest the following book to get a good sense into the nature of the man: On Top of the World : Cantor Fitzgerald, Howard Lutnick, and 9/11.  I think it speaks volumes about his character and his true reputation on Wall Street that he has been able to bring both Cantor and BGCP back from 9/11 to where they are today.

 

Cash Flow, ROIC and Balance Sheet

BGCP (and most IDBs) are highly cash generative businesses.  Their revenues are the commissions paid by customers and convert to cash very quickly.  Furthermore, IDBs tend to pay out 60% of the revenues to the producing brokers, which is predominately a variable expense.  Margins are shielded during declining revenue periods, to some extent, by the variable pay received by brokers. 

 The company doesn't hold any Level 3 assets on its balance sheet since it acts primarily on an agency basis.  Any securities that are held on the balance sheet at quarter end are generally settled a day after the quarter closes. (Receivables from brokers, dealers, etc... that you see on the balance sheet are generally offset with a liability which settles within 3 days after the quarter closes.)   They are not an investment bank; they do not underwrite business nor take large principal risks

 There is little maintenance capital expenditures (as the Company has built a premier electronic trading platform and ongoing maintenance expenditures are included in recurring operating expenses) and minimal working capital requirements. 

 The company has committed to paying 75% of its quarterly cash earnings as a dividend.  The secondary primary use of cash would be to acquire regional IDBs to expand the company's geographic and asset class footprint.

 The company has $2.49 in book value per share.

 

 Relationship to Cantor Fitzgerald

At this point, the only material relationship between BGCP and Cantor is that of ownership.  Cantor has a 40% economic interest and controls over 80% of the voting share.

 While there might have been reason to be concerned about related-party transactions between Cantor and BGCP/ESPD; at this point it is a non-issue.

 You can read the commentary in the 10K about Cantor's rights to use BGCP market data for no cost, and ability to trade with BGCP at very low costs, but there is nothing materially significant in there.

 

Long Term View on the IDB Model

The IDBs as a group have one of the most flexible models on Wall Street.  Currently they sit in the middle of a tremendous amount of order flow in many asset classes.  They tend to be where new asset classes are traded (e.g...Credit Default Swaps).  As the world evolves, the good IDBs will evolve with it.

 Those with technology and electronic platforms that can siphon off their pre-existing voice order flow will succeed. 

 IDBs are very good at pure agency brokerage.  No matter what market structure or trading environment, this unbiased trading support will always be valuable and the good IDBs will position themselves to take advantage of any new opportunities.

  

Do IDBs deserve a lower multiple?

The argument has often been made that since IDBs are people intensive and trading oriented they deserve a lower multiple than exchanges.  Historically there has been a lot of poaching of brokers between firms, often leading to higher payouts to the top brokers who switch, and thus higher expenses for the IDBs.  Anytime a company's key asset goes up and down the elevator, it can be a cause for concern. 

 However, the long history of the IDB model shows that well run IDBs can still produce great profits and returns on capital.  We think that IDBs as a group are undervalued and the best IDBs should trade on par with exchanges as the business moves more electronic.

 If you look at how the IDBs as a group fared through this credit and economic crisis, you will see that they have a much more stable business than even some exchanges.  The IDB model has withstood the crisis and has come out of it stronger than before. 

 

Risks to the business:

Regulation.  The government could regulate certain asset classes out of existence.  The government could mandate that OTC products are cleared and TRADED on the same exchange.

 We don't think so -- It seems fairly certain we will see greater regulation on the OTC market.  Despite all the talk, it seems the government is going to simply mandate that OTC products be cleared without designating how these products are traded.  As BGCP has shown, even the most plain-vanilla of commodity products (US Treasuries) can still trade on an IDB platform (BGCP and ICAP).

 Regulation: OTC Clearing, could that harm the IDBs?

 We think the answer is a definite NO.  In fact we view the addition of clearing to many OTC products a big positive for the IDBs as they will get paid at the time of settlement rather than have a receivable, and they will be able to provide their services to some buy-side clients who are members of the clearinghouse and had previously been off limits to the IDBs.

 Exchanges entering OTC market: If markets move electronic, won't the CME or NYX enter the business and take market share?

 We think the risk of this is very low.  The exchanges who have talked about the OTC market have only talked about entering the clearing business.  None of them have talked about doing OTC trading.  For now and the foreseeable future, the majority of OTC notional volume will trade via voice/hybrid.  Furthermore, the traditional exchange technology is designed for homogenous products that trade actively.  A scalable OTC electronic platform needs to be capable of trading many different kinds of asset classes in order for it to be economically efficient.

 Deleverage at banks & higher capital requirements: If banks pull back on proprietary trading or refuse to extend credit to hedge fund customers to facilitate trading and if the government imposes higher capital requirements on OTC products, there could be a pull back in trading at the IDBs.

 While prop trading at the large investment banks drives a substantial portion of IDBs trading, it is by no means 100%.  Most of the notional traded by IDBs relates to banks needing to offset positions they entered into with their customers who are likely hedging a real business risk.

 In fact, data from recent press releases suggest that after record performance of trading divisions banks have increased hiring in their derivative trading desks. 

 That said, we acknowledge that these are legitimate issues that could be a ceiling to the growth of the OTC market for a few years.  Over time, however, this issue will resolve itself.

 Lack of Scale: The BGCP platform does not achieve scale in a given asset class, and thus is locked out of the market.

 Always a risk, but at this point BGCP has shown they can innovate and win market share.  It is our belief that the firms who have the pre-existing volume/liquidity have the best shot at keeping that volume on their platform so long as it is as good as the other alternatives.

 

 Broker Poaching: Other IDBs could try and take away BGCPs best brokers with high pay packages.

 We don't think so -- Actually BGCP has been a net gainer over the last 5 years.  Additionally, their company structure outlined above insulates them to some extent against this.

 Customer Concentration: Customer Concentration must be high given the small number of large banks in the world.

 You would think that IDBs have extreme customer concentration; however for BGCP (as the other IDBs) no single customer represents more than 6% of revenues, and the Top 10 represent just 40% of revenues.

 Their customers range from Goldman Sachs to Morgan Stanley to Jefferies to tier 2 banks in international markets, to some large buy-side firms.

 Furthermore, as the world moves toward more centralized clearing, the customer set for the IDBs grows.  Once a buy-side firm becomes a clearing partner with a clearinghouse, they become part of the "club" and the IDBs would be able to service them directly.

 Tullett Lawsuit: Tullett is suing BGCP in New York and in London for poaching their brokers.

 As is quite common for IDBs, there are often legal actions brought by a firm that has recently lost a large number of their employees to a competing firm.  Currently Tullett is suing BGCP in London and New York over 160 brokers that have left Tullett to join BGCP.  While we have no idea how the case will play out, we do know that several of these brokers have already started working at BGCP and the remainder need to wait out the results of this trial.  The trial is ongoing today and you can do some Google searches to read about it online.  While we expect this to be settled at modest cost to BGCP - as has been the case in the many similar litigation matters that have preceded it -- there can be no assurances that this will be the outcome. 

Risks to the investment:

I could be optimistic in my growth estimates for the business and the extent to which these asset classes move electronic.  The financial model is fairly straight forward, so if they get the growth they will get the operating leverage. 

 I could be optimistic in what multiple the market will pay for this business, despite all the logic that says it should be in the mid teens.  Many investors would tell you they look at the CME or ICE's multiple as the top, and everything else should be lower than that... 

 Everyone needs to come to their own conclusion.

  

Other Misc Industry Items:

It is long been thought that TLPR LN and GFIG would merge.  The reason for the merger is compelling.  Tullett has no technology and GFIG has some decent technology.  As the IDB model evolves to more electronic trading the need for technology becomes more important.  As of the moment, the two companies have not been able to agree to a price but the logic for the deal is compelling.

I think BGCP would be a natural beneficiary.  GFIG and Tullett would have several overlapping desks which would not be sustainable.  BGCP would be the natural spot for one of those desks to end up.  ICAP would not be since they are already in every market.

 

  

In an effort to keep this thesis of readable length (I think it is already too long), I have moved additional comments and details to the appendix attachment.   Since VIC does not allow for attachments, I have pasted it below the disclaimer. 

 - My apologizes that this doesnt print right on a PDF, I can't seem to figure out how to format it correctly.

Disclaimer: This is not a recommendation to buy or sell (short) any security. This recommendation is my own personal view and does not necessarily represent the view of my firm. Please do your own work and come up with your own conclusion. My firm and I may or may not have a capital position in BGCP. At the same time we may or may not trade in and out of the stock and take no responsibility to update anyone regarding our investment position and/or view.

 

 

 

BGCP - Appendix

 Background on IDBs & OTC Market

Inter-dealer brokers provide a valuable service to the marketplace. Inter-dealer brokers are really a brokers' broker.  IDBs act like an "exchange" for all products that are not traded on an exchange.  IDBs work with broker/dealers and other large financial institutions in the primary over-the-counter markets to execute customers' orders, facilitate their proprietary/dealer trading and manage their exposure to risk.  It is difficult to rapidly identify potential counterparties and develop transaction and price information in these products.  Inter-dealer brokers serve as intermediaries that facilitate access to OTC and exchange traded pools of liquidity across a full range of asset classes and their associated derivatives.  

 Importantly, the IDB model is an agency only commission model where they serve to match buyer and sellers without taking on any derivative inventory/price risk.

 Inter-dealer brokers also provide the OTC market transparency through publication of unbiased and independent market data and pricing data before, during and after trades are executed. The information collected, maintained and generated by inter-dealer brokers provides a helpful tool to market regulators in monitoring for fraud and manipulation in the markets.

 Under the new laws being debates in Congress, the investment community fears that the large IDBs will be dis-intermediated amid widespread regulatory proposals to require "exchange" trading of derivatives.  However, given the disparate nature of the OTC products that trade in the over the counter markets - IDBs serve (and will continue to serve) as the price discovery mechanism for all inter-dealer trading of these products.  Proposed regulations about "exchange" trading of OTC derivative products have been drafted very broadly to permit the major IDB platforms (referred to as Alternative Swap Execution Facilities) to readily qualify as 'exchanges" for these purposes

 Fully Electronic

BGCP developed a fully electronic trading platform and matching engine over the last 10 years. You can think of this like the underlying guts of any exchange (NYX, NDAQ, CME, etc...).  However, there is a subtle, yet important difference.  The CME/NYX/NDAQ model is to trade homogeneous instruments in vast and deep liquidity.  For example, a equity security is just like any other in terms of its structure.  An interest rate future is just like any other interest rate future, and they trade in very deep markets.

 In the case of BGCP, their platform is far more horizontal.  In the OTC markets there are hundreds of thousands to millions of different types of securities that trade, and often infrequently.  BGCP's platform was designed to trade any asset class imaginable.  The important distinction here is that it would be nearly impossible for a CME/NDAQ/NYX to effectively break into the OTC market given their vertically focused platforms.  However, it would be much easier (from a technological perspective) for BGCP to break into other markets.  As noted below, this is what BGCP has done with ELX to attempt to break into the interest rate futures market.

 Furthermore, BGCP has been developing technology for so long now that their incremental yearly spend matches their depreciation.

 The economics of the fully-electronic business are all about scale.  The variable costs are minimal and the incremental transaction cost is reduced to the customers.  These lower commissions are more than made up for by increased volumes.  Most importantly the operating margins for fully electronic trading are significantly higher than traditional voice brokerage as the human broker costs are eliminated.  And importantly, the voice broker now has new found time to devote to rebuilding his voice brokered business with the next generation of new and more innovative financial products - and hence driving more organic revenue growth.  It is this labor intensive voice brokering that is so essential to new product innovation/distribution and it serves to prevent the "people lite" exchange model from competing in the IDB space.

 

The US Cash Treasury Business

BGCP's Espeed platform is one of only two platforms that trade US Treasury securities.  They have 45-50% market share based on volume.  The business model for the US Treasury business is more like a software-subscription model.

 

BGCP will charge a flat fee of, say, $3mm to an investment bank or trading firm and for that they can transact an unlimited number of trades.  There are some smaller accounts that are still charged a per-transaction fee, however the majority of the business is on the all-you-can eat model.

 This revenue model provides a lot of stability to BGCP's Treasury business.  As the Fed expands the number of primary dealers & the number of electronic trading firms grows, the customer base for BGCPs Treasury business will grow as well.  Any new primary dealer will need to subscribe to BGCPs Treasury platform.  And that will produce some modest growth for the Fully Electronic Treasury Business.

 BrokerTec (owned by ICAP) operates the only other electronic Treasury platform on an identical model to BGCP.

 Other Fully Electronic Business

As was mentioned, BGCP's platform is capable of trading a wide variety of asset classes.  The barrier to additional products being traded electronically is not technology; rather it is the willingness of the big banks and investment banks to transact electronically.  Interestingly enough, they have preferred to deal directly with IDBs rather than input trades directly.  This is starting to change in a few asset classes like Credit Default Swaps (CDS), FX Options, and Spot Foreign Exchange.

BGCP is seeing some early traction in these asset classes, and we think that over time more and more asset classes will migrate to fully electronic trading.

 Voice Only Business

 

At full scale, the financial model for inter-dealer brokerage is straight forward.  In a voice brokered product, generally 60% of the revenues are paid to the brokers as commissions.  Another 20% of revenues go toward the back office and other general corporate expenses, leaving 20% for the operating profit. 

 BGCP employs 1,431 brokers today. 

 

Broker Headcount:

Oct 2004: 483

2005: 800

2006: 1,187

2007: 1,188

2008: 1,289

2009e: 1,451

2010e: 1,571

2011e: 1,776

 

We believe BGCP will achieve full scale in their voice business by 2011.

Between now and then, the incremental margin on voice revenue is roughly 30%.

 Average Revenue Per Broker was $744,410 for the trailing 12 months ended Sept 30^th 2009.  We expect that over time BGCP's brokers will increase productivity by leveraging BGCPs technology and gaining market share; eventually producing north of $1.0mm per year.

 

 History of beating guidance (source Goldman Sachs).

Revenues	4Q08	1Q09	2Q09	3Q09	4Q09e
Outlook Range	$260-280	$275-300	$260-280	$265-285	$255-275
Midpoint	$270	$288	$270	$275	$265
Actual	$288	$286	$294	$291
Actual vs. Est	6.5%	-0.05%	8.9%	5.9%

 

Pretax Earn	4Q08	1Q09	2Q09	3Q09	4Q09e
Outlook Range	$22-29	$16-26	$20-24	$21-29	$12-20
Midpoint	$26	$21	$22	$25	$16
Actual	$11	$30	$32	$30
Actual vs. Est	-55.6%	43.1%	45.9%	20.2%

 

Acquisitions

 May 2005: Maxcor/Eurobrokers - 325 brokers - New York, London, Tokyo - fixed income

Sept 2005: ETC Pollack - 70 brokers - Paris - OTC & Exchange Traded Products

Nov 2006: Aurel Leven - 70 brokers - Paris - Equity Derivatives

Dec 2006: AS Menkul - Istanbul - Turkish equities and electronic bonds

Aug 2007: Marex Financial - London, Johannesburg - Equity Deriv in emerging markets

Mar 2008: Radix Energy - Singapore - Energy broker

Jun 2009: Liquidez - 70 brokers - Sao Paulo - FX derivatives, commodities, etc...

 

Generally when an acquisition is made, the brokers are less productive than the BGCP average broker.  With the opportunity to leverage BGCP's technology and access to other the other asset classes BGCP trades, over the course of the following 12-24 months these brokers increase productivity to the company average.

 BGCP generally pays 50% in cash and 50% in stock for an acquisition.  Most of the back office expenses (especially technology spend) of the acquired company are generally eliminated and the business can be accretive in year 1. 

 

 New hires

The economics of a new hire are as follows.  Let's assume that the broker can produce $2mm per year in commissions.  Before he agrees to work for BGCP, they will negotiate over an upfront payout and back end commission share.  Let's say they settle on an upfront $2mm bonus and a 45% back end payout.  The broker must commit to a 5 year contract which automatically extends if he fails to meet his revenue estimates.  BGCP also will pay the 50% of the upfront bonus in cash and 50% in restricted convertible partnership units.  The cash is considered an upfront payment against the dividends to be received from the partnership units.  So the net cost to BGCP is $1.5mm.  BGCP is required to begin amortizing this $1.5mm upon payment over the life of the contract, even if the broker hasn't yet started!  At $300,000 of amortization per year +45% payout, if the broker produces $2mm revenues, BGCP's comp ratio would be 60%.

 

Furthermore, if the broker should quit and compete with BGCP he will forfeit his equity stake.

 

To analyze the ROIC of hiring a new broker, we will not include any amortization of the upfront payout since that is considered the "investment" by BGCP.  Over 5 years, if the broker produces $2mm of revenue per year = $10mm revenue.  The variable payout is 45%, so that means BGCP will get 65% or $6.5mm over the life of that broker's contract.  BGCP had to give up $2mm of value, so they earned a 225% return on their investment.  (Truthfully the math is a bit trickier since $1mm of that was in stock and depending on where the stock is trading at the starting and ending point, the ROI could be higher or lower by some amount).

  

Misc Opportunities

ELX - Electronic Liquidity Exchange.  BGCP contributed its electronic trading platform technology to this joint venture with 13 other trading firms and dealers (Bank of America, Barclays Capital, BGC Partners, Breakwater, Citi, Credit Suisse, Deutsche Bank Securities, GETCO, Goldman Sachs, JPMorgan, Morgan Stanley, PEAK6 and The Royal Bank of Scotland).  BGCP has a 25% economic interest in ELX. 

 

ELX is attempting to crack the CME's monopoly on interest rate futures.  It opened its doors in July and has garnered about a 3% market share of average contracts traded.  It announced in early November 2009 that ELX has garnered 5-6% market share of the 2-year and 5-year contracts during the month of October.  In early Nov, there were days where ELX had over 10% market share in the 2-year contract.  We think that over time this market share will grow. 

 

The mother of all victories for ELX is the Exchange For Futures (EFF) rule that the CFTC has passed.  We think that in the coming months this rule will be challenged by the CBOT/CME and ultimately the CFTC will rule in favor of the rule thereby opening the world of interest rate futures to real competition.  This would mean that a customer can create an open interest on the CME and close it out on ELX.  This would mean that ELX's contract is fungible with CME's contract and potentially lead to savings on initial and variable margin.  This would be a huge victory for ELX.

 

While this has very little impact on BGCP earnings in the near future, we view it as a free call option since BGCP does not contribute cash to the business rather it provides the technology that it had already developed and paid for.  If ELX is successful, it could be worth $100-200mm alone.

  

BGCP's distributable earnings vs. GAAP

 

Due to BGCP's unique structure GAAP is not a relevant measure when determining the earnings of the business.  The company reports on GAAP and their own measure, Distributable Earnings and provides reconciliation between the two measures.

 

Simply put, Distributable Earnings are the economic cash earnings of the company divided by the total number of shares including partnership interests.  The reason for doing this is that the partners will receive a pre-tax cash distributions at the end of each quarter.

 

Their income statement can seem overly complicated when you first look at it.  However, they do provide the reconciliation from GAAP to Distributable Earnings in their earnings releases.  We feel confident that the numbers are clean and that distributable earnings are the proper economic metric to look at. 

 

They pay quarterly cash dividends based on pre-tax distributable earnings.

 

 Shareholder base

They have no major institutional sponsorship.  The two largest holders (outside of Cantor) are Par Capital with 4,760,000 shares and Downtown Associates with 3,900,000 shares.  Both appear to be very patient and long term oriented.

  

BGCP Comp Rate

During periods of rapid hiring, it is likely that BGCP's comp rate will be above the long term model.  This is due to the fact that new brokers are often less productive for the first 12-24 months than the company average.  And in many cases the company is required to start amortizing the up-front bonus payments even before the broker starts working!  Having added 184 brokers over the last 12 months (14% growth), they are in a current period where the comp ratio is higher than normal.  We think this will remain at/near the 60% level for the course of 2010 as these brokers become more productive and the company adds additional brokers at a similar rate.  Over time we would expect that the normalized comp ratio run rate would fall to the 58% level due to faster growth from electronic trading.

 

 History/Background on BGCP

BGCP was formed through the merger of BGC Partners (a division of Cantor Fitzgerald) and the public company Espeed (ESPD), which was also controlled by Cantor Fitzgerald.  E-Speed built and operated a fully electronic platform for trading inter-dealer products.  Due to common ownership E-Speed served as the exclusive platform for Cantor's electronic IDB business, receiving a contractual share of the commissions generated. Cantor was the largest IBD in the world, but in the terrorist attacks on 9/11 Cantor lost 658 employees and their voice brokerage business was decimated. 

 After 9/11 E-Speed's existing fully electronic market continued to flourish, however without the voice brokers at Cantor to fuel the migration to E-Speed's electronic trading, growth disappeared and its stock price fell from $20 to $8. In 2004 Cantor committed $350M of its own capital to rebuild its voice brokerage business.  By mid 2005 Cantor's success was already evident. 

 In mid-2007, E-Speed merged with the voice-brokerage division of Cantor and the company was renamed BGC Partners.  We supported the merger because it allowed ESpeed shareholders to participate in the voice-brokerage profits while we waited for these products to migrate to fully electronic trading. 

 

 Useful Links

http://www.bgcpartners.com/

http://www.elxfutures.com/

 

http://www.icap.com/

http://www.gfigroup.com/

http://www.traditiongroup.com/uk/home3.asp

 

http://www.wmba.org.uk/index.php

 

 

http://www.amazon.com/Top-World-Fitzgerald-Lutnick-Renewal/dp/product-description/0060510307

http://leadershiptheory3450.blogspot.com/2009/09/leadership-in-time-of-crisis.html

 

 

http://www.bauer.uh.edu/spirrong/

http://www.creditresearch.com/cdrweb/index.jsp

http://www.markit.com/en/home.page

http://www.johnlothiannewsletter.com/

 

 

Disclaimer: This is not a recommendation to buy or sell (short) any security. This recommendation is my own personal view and does not necessarily represent the view of my firm. Please do your own work and come up with your own conclusion. My firm and I may or may not have a capital position in BGCP. At the same time we may or may not trade in and out of the stock and take no responsibility to update anyone regarding our investment position and/or view.

 

 

Catalyst

* Sell side at $0.40 EPS in 2010; we are at $0.55 EPS
* Sum of parts (Voice / Electronic) significantly higher than current market cap
* Sell side does not properly cover the sector leading to lower than necessary multiples for the entire group.
* BGCP trades at discount to peer group, despite having higher growth and operating leverage.