Cowen Group, Inc.

Ticker: COWN            Price: $19.35                Mkt Cap: $290MM     Date: 1/22/2007          

 

We believe Cowen Group, Inc. (COWN) represents a good short opportunity with 20-30% downside potential.  Our thesis is based on the following factors:

·      Very high earnings expectations from the Street for 2007 in a business with very little visibility beyond one quarter

·      2006 underwriting revenue bolstered by PIPE deals, an area that has slowed down due to SEC scrutiny

·      Peer group comparison support lower valuation

·      Effectively leveraged play on downturn in NASDAQ/Russell 2000 due to the company’s dependence on IPO’s and secondary offerings

 

COWN went public in July 2006 at $16 per share in a spin-out from the French bank Societe Generale.  SocGen had acquired Cowen & Co. in June 1998 for $615MM as SocGen, like other large commercial banks, sought to enter the investment banking arena via a purchase of a boutique investment banks.  The SocGen/Cowen deal was not the only one of these combinations that failed to work out and were unwound. (e.g., US Bancorp/Piper Jaffray).

COWN provides Investment Banking, Research and Sales & Trading services to companies and institutional investors in the healthcare, technology, media & telecom and consumer sectors.  Investment Banking is the main revenue driver of the business.  Sales & Trading is a flat to declining business given the trends in commission rates across the Street, although COWN also generates revenue using its own principal as a market-maker in OTC equities.  The last component of revenue is Interest and Dividend Income.

With its newly created independence COWN has naturally taken steps to grow its business.  Recent announcements include:

·      Formation of Cowen Healthcare Royalty Partners and the hiring of a team with private equity and healthcare investing experience

·      Hiring of a new head of Asset Management

·      Hiring of a new head of Investment Banking

·      Hiring of a new head of Leveraged Finance

·      Hiring of a new managing director in Health Care Investment Banking

Of course, COWN is not apt to announce any departures although Lazard has made a couple of announcements about hires from COWN.  We all know people in investment banking and know how frequently they move around.  Whether or not COWN’s new hires will be additive to their franchise remains to be seen at this point.

 

Let’s look at the first three quarters of 2006 year to judge COWN’s earnings power.  Each quarter requires some meaningful adjustments to the reported financials to get at the true earnings.

·      Q1 2006

o       Q1 was a strong quarter for COWN with underwriting revenue reaching $53.4MM.  By our count COWN advised on 11 PIPE deals in the first quarter, which helped boost revenue

o       Q1 reported net income was $36.5MM but this figure requires adjustment.  First, pro forma for distributions to SocGen under the spin-out, COWN would have had less cash so Interest & Dividend Income should be $3.1MM lower.  Employee Compensation & Benefits should be $4.4MM higher.  Most importantly, COWN experienced a $24.8MM gain on the sale of NYSE membership seats, which is obviously non-recurring.  Lastly, the company has indicated that an appropriate future tax rate to use is 45%.  Combining these items and using 15MM F-D shares, we get to EPS of $0.21 in Q1.

·      Q2 20006

o       Underwriting revenue declined sequentially by 33.5% (indicative of the short-term volatility of this business). Arguably the market’s swoon beginning in early May was a key contributor.  After adjustments for lower interest & dividend income and for a higher tax rate, our adjusted EPS figure is $0.13.

·      Q3 2006

o       Results were horrible and we saw it coming.  The sell-side began the quarter looking for EPS of $0.15 and ended it looking for $0.05.  The company delivered an adjusted pre-tax operating loss of $2.0MM, which when adjusted for taxes and F-D shares equates to EPS of ($0.07).

·      Q4 2006

o       Our read at this point is that it will be a strong underwriting quarter, better than even the first quarter.  We have used the ECDR function in Bloomberg to look at COWN’s participation in equity underwritings in the quarter.  The IPO market remained receptive to new deals well into December, and COWN appears to have generated 25% of its likely underwriting revenue in the two weeks from 12/07 to 12/22.  The sell-side is currently expecting a solid rebound in total revenue and EPS from Q3 but their numbers look to be low for Q4.  COWN should beat these numbers.

Our pro forma EPS figure for 2006 (assuming a strong 4^th quarter) is $0.64, assuming the full 45% tax rate that COWN anticipates going forward.  The Street’s targets for 2007 look very aggressive to us with a mean EPS estimate of $1.33.  To gauge the reasonableness of this target let’s back into the revenue increase required to generate this level of incremental EPS.

·      $0.69 of incremental EPS times 15MM shares = $10.35MM of net income

·      $10.35MM of net income grossed up for 45% tax rate = $18.82MM of pre-tax income

·      The major expense for the company is labor cost, which is more variable than fixed. If we assume 58% of every revenue dollar goes to compensation and benefits (company’s target ratio) then $44.81MM of incremental revenue is required to generate the $0.69 of incremental EPS that we started with

So one has to ask how difficult it will be to add nearly $45MM of revenue in 2007.  Again given the dynamics behind the company’s Sales & Trading revenue stream, this growth has to come from Investment Banking.  Total revenue from 2003 to 2005 hardly grew ($293MM to $294MM).  During that period Investment Banking revenue grew from $105MM to $126MM with declines in Sales & Trading and Principal Transactions revenue.  Total revenue for 2006 could come out around $340MM with $166MM of Investment Banking revenue, which would represent decent growth.

Can the company repeat its 2006 performance in Investment Banking in 2007?  The answer is that no one knows and it is very difficult to predict.  Looking at the company’s current IPO and secondary pipeline is not particularly encouraging.  (There is no way to know for sure what the PIPE and M&A pipeline looks like.) Our Bloomberg search yielded the following regarding the underwriting pipeline:

·      Three secondary deals priced so far in January.  COWN was the lead on none of them

·      Seven pending deals (6 IPOs and 1 secondary). Of the IPOs, three were filed in December.  For IPOs on which COWN worked that were priced in the last four months, the average number of days from initial filing to pricing was 153, meaning that half of the IPOs in the current pipeline and any new IPOs added to the pipeline at this point will probably not get priced during Q1 2007

·      Of these seven deals in the pipeline, COWN is the lead on only one

·      As a point of reference, during January and February 2006 COWN priced nine and ten deals, respectively (including PIPEs and converts), of which there were seven IPOs.  So our take is that the current pipeline looks materially weaker than it did a year ago

The Street is looking for a strong start to 2007 with a Q1 mean EPS estimate of $0.44 (fully-taxed), which is 110% higher than our adjusted EPS number for Q1 2006.  The bottom line for us is that the growth anticipated by the Street in 2007 will be hard to come by.  COWN obviously has plenty of competition and its ability to get financings done is highly dependent on the health of the market.  The performance of investment banks is hard to forecast.  Look for earnings guidance on the bulge bracket firms (e.g., Goldman, Morgan Stanley) and regionals/boutiques (e.g., Piper Jaffray, Jefferies, Greenhill) – it does not exist.  The aggressive forecasts surrounding COWN look highly suspect to us.

 

The company’s Website provides a list of closed transactions in terms of IPOs, secondary offerings, PIPEs and private placements and M&A advisory deals.  Various databases will also provide such transaction data.  COWN closed the following number of private placements by quarter in 2006 by our count:

·      Q1: 11

·      Q2:  7

·      Q3:  5

·      Q4:  5

PIPEs are very lucrative for the placement agent in that they are: 1) usually sole managed and 2) carry percentage fees that are higher than underwritten offerings, even above the 7% common in IPOs.  Average PIPE deal sizes were meaningfully lower than the typical IPO or secondary offering that COWN participated in during 2006.

The PIPEs arena has attracted increasing attention from the SEC over the past two years or so.  From the 12/27/06 Wall Street Journal come the following comments:

“Staffers at the Securities and Exchange Commission are increasingly reluctant to sign off on transactions involving "private investments in public equity," or PIPEs, a popular way for public companies to raise cash quickly.”

“In recent months, however, the SEC has blocked scores of companies from registering -shares sold in PIPE deals.”

We have no way of knowing what the consequences of this scrutiny will be, but investors should be discounting some risk to this part of the business.

 

Given the Street’s high expectations for 2007 COWN is currently trading at a forward P/E of 14.6x.  If one assumes that 2007 EPS will be more like $0.90 (still 41% EPS growth over pro forma 2006) than the Street’s $1.33, then the P/E multiple becomes 21.5x. 

The most relevant investment banking peer group for COWN consists of Piper Jaffray, Jefferies Group and Thomas Weisel Partners.  One could also look at boutiques such as Greenhill or regionals such as A.G. Edwards, but the business mixes of those other companies diverge meaningfully from COWN’s.  The peer group trades at the following multiples of 2007 estimated EPS:

·        Thomas Weisel Partners: 16.8x

·        Jefferies Group: 19.1x

·        Piper Jaffray: 23.0x

·        Average: 19.7x

Based on the sector (healthcare, technology, media & telecom and consumer), geographic (virtually all U.S.) and product (almost entirely equity; no fixed income) concentrations of COWN’s investment banking business, we believe the stock should trade at a discount to its peer group average and more like Thomas Weisel Partners than Jefferies or Piper Jaffray.  So if we are correct about 2007 earnings ($0.90) and apply EPS multiples of 15x – 17x, we come out with a valuation for COWN $13.50 - $15.30 representing downside potential of 21 – 30%.

One other valuation metric worth discussing is COWN’s book value multiple.  COWN is trading at 1.4x book value, a low multiple among its peer group and other financial services firms.  We contend, however, that this multiple is not relevant for COWN since its book value is such an engineered figure.  Remember, SocGen paid $615MM for COWN.  As part of the spin-out, COWN made distributions to SocGen of approximately $350MM that lowered its book value to a level that was conveniently similar to its market cap at the IPO price.  We argue that even at this much reduced book value COWN is still overcapitalized and its appropriate book value should be lower.  Consider the company’s return on equity.  Even if the company achieves the Street’s $1.33 in EPS in 2007 it will have generated an ROE of only 9%, a fairly low return by investment banking standards. 

 

As we have described above, we expect Q4 2006 to be a strong one for COWN, better than Street expectations.  How will the market react to this?  Will the market look forward or back?  With the third quarter earnings disappointment the stock tanked pre-market but rebounded to close down just $0.05.  Was it because the market was looking ahead to a stronger Q4?  Perhaps.  If the market does look ahead to Q1 2007 the stock should go down despite a strong Q4.

Another risk is that the market for equity offerings in COWN’s targeted sectors remains ebullient during the rest of 2007 and the company fills its pipeline above its current low level.

 

·        Deal pipeline weakness persists and materializes in the form of much worse than expected Q1 earnings, ratcheting down 2007 expectations

·        Overall stock market or small-cap equity weakness has leveraged effect on COWN