Description

Disclaimer: We are currently owners of this stock and may sell our position at any time.  Please be advised that parties reading this document will need to do their own research and determination of its investment merit.  

Note 1: See the following link for the complete write-up with full tables, charts and graphs: https://docs.google.com/open?id=0B4xbUnte_0Q2Qm5UUUJRaTk0V1k.  This will only be up for two weeks.  We decided to create a link to our original write-up becuase there were too many graphics that we felt would be helpful in understanding the investment story.

Note 2: We attempted to insert our graphics (via pictures), but were uncertain if it worked.  Therefore, if they are not visible, please follow the URLs for links to the graphics.

Summary

FBR & Co. (“FBR”, “FBRC” or “the Company”) provides investment banking, merger and acquisition advisory, institutional brokerage, and research services through its subsidiary FBR Capital Markets & Co. FBR focuses on the following industry sectors: consumer; diversified industrials; energy & natural resources; financial institutions; insurance; real estate; and technology, media & telecom.  During 2Q 2012, FBR announced the sale of its asset management business to Hennessy Advisors for ~$30 million, subject to change and closing conditions.  Its asset management business was FBR Fund Advisers, Inc., a subsidiary of FBR & Co., which provides clients with a range of investment choices through The FBR Funds, a family of mutual funds.  FBR is headquartered in Washington, D.C.

Shares are trading at approximately 73% of tangible book value (TBV), which is unlevered and comprised primarily of liquid cash and securities.  The Company also has significant deferred tax assets (“DTAs”), currently with a 100% valuation allowance, which the Company estimates at ~$1.67 per share.  We believe the Company could return to profitability and largely recover these DTAs with consistent profitable results.  Including the DTAs, shares are trading at about 50% of TBV, although unlikely until the Company returns to consistent profitability.  

FBRC may remain at depressed levels until the market appreciates its return to consistent profitability, continuing capital and shareholder friendly actions and continued sharp cost reductions.  Nevertheless, we believe the firm can operate at profitability in a slower functioning capital markets environment, and that potential option value exists which is greater than what is reflected in face value on the balance sheet.  We currently value FBR’s stock conservatively at $4.00 per share. Therefore, we are buyers of the stock at or below $3.10 per share.  In the immediate term, we believe that there is an inherent floor of $3.70 per share, which reflects the liquid cash component of net assets. Our valuation omits any credit for improving earnings power of the business or DTAs.

We also see a few near term catalyst which include: i) recognition of NMI Holdings (mortgage insurance deal) fees; ii) further reduction in personnel and fixed expense; iii) the return of “dead capital” (~$3.70/share) improving ROE; and iv) proceeds received from sale of its marginally profitable asset management business and the removal of its associated corporate cost.  Unlike some value traps, FBR is delivering on returning capital and cost cutting initiatives. The Company returned to profitability in Q1/Q2 2012 after sharp expense reductions. 

Table 1: FBRC Trading and Corporate Information

https://docs.google.com/file/d/0B4xbUnte_0Q2cG41RlUtX202ZGc/edit?pli=1

Source: SNL.

Exhibit 1: FBRC Trading and Corporate Information Cont’d.

https://docs.google.com/open?id=0B4xbUnte_0Q2NHEyZWp0V3ZDQUk

Source: SNL.

Company Overview

As a leader in 144A private placements, the Company has experienced meaningful growth driven by greater adoption by new industries and financial sponsors.  FBR has built a dominant market share in Rule 144A offerings in the United States.  The firm’s specialty in this niche capital markets product has created fairly modest barriers to entry, enabling it to earn sole-managed 6%–7% fees on its deals while securing its reputation in the market.  Unfortunately, the Rule 144A product is fairly small when comparing against other equity capital markets products.  In addition, individual 144A deals tend to be very large, lumpy and timing unpredictable.

As a result, the Company has expanded its expertise into other middle-market investment banking and capital raising advisory.  FBCR focuses on six core industry sectors — 1) financial institutions and real estate (mortgage-related), 2) insurance, 3) energy & natural resources, 4) technology, media & telecommunications (TMT), 5) consumer, and 6) diversified industrials.  In investment banking, FBCR primarily provides capital raising services, including underwriting and private/public debt placement, and financial advisory services, including M&A, restructuring, recapitalization, and strategic alternative analysis.  In the institutional brokerage business, the firm provides institutional sales & trading and research services in both equities and debt (see Exhibit 3).  Its research services are well regarded in the financials insurance and banking sectors. 

On June 6 FBRC signed an agreement to sell FBR Fund Advisers Inc., its asset management business.

Exhibit 3: FBRC Investment Banking Platform Overview

https://docs.google.com/file/d/0B4xbUnte_0Q2aF9rZW1DU2lnR2s/edit?pli=1

Source: Company reports and endur.  Asset Management segment announced sale to Hennessy Advisors for ~$30 million in 2Q 2012.

Brief Historical Overview

1. In 1989, the Company, originally known as Friedman, Billings, Ramsey Group, Inc. (FBR Group), is founded by Eric Billings, the Company’s recently retired Chief Executive Officer and Chairman, Emanuel J. Friedman, and W. Russell Ramsey.  
2. In 1992, positioned as a research-driven securities trading company, FBR Group expands beyond the institutional brokerage business by starting an investment banking arm, initially focused on financials (banks and insurance), real estate, and technology firms. 
3. In 1997, FBR Asset Investment Company, the then parent REIT to FBR Group, is listed on the American Stock Exchange.  
4. In 2002, the listing is transferred to the New York Stock Exchange.
5. In 2003, FBR Group merges with FBR Asset Investment Company.  Later that same year, FBR Group floats a $450 million secondary offering. 
6. In July 2006, FBR Group forms FBR Capital Markets (precursor to today’s FBRC) as a new subsidiary to hold its investment banking and associated businesses. 
7. Later in 2006, FBR Capital Markets completes a private placement of 18 million shares at $15 per share ($270 million offering) to private equity firm Crestview Partners and a variety of other 144A buyers. 
8. In 1Q 2007, FBR Capital Markets acquires Legacy Partners, an M&A advisory firm with 26 investment banking professionals, offering services to growth-oriented, middle-market companies. 
9. In June 2007, FBR Capital Markets becomes a publicly-traded company, while FBR Group and certain other shareholders sell approximately 13 million shares of common stock in an IPO at $17, or $221 million.  As a result of the IPO, FBR Group reduces its ownership in FBR Capital Markets to just over 50%.  This was done so that FBR Group could focus on building its subprime mortgage business.
10. In 2008, FBR Group’s business model comes crashing hard, shrinking it to only a fraction of its former self.  Its subsidiary, FBR Capital Markets, emerges as the primary business in the franchise. 
11. In 2009, FBR Group decides to change its name to Arlington Asset Investment Corp.(NYSE: AI) and also decides to divest its ownership in FBR Capital Markets. 
12. In October 2009, Arlington sells its remaining 23% ownership in FBR Capital Markets through a public secondary offering.  Arlington prices the public offering of 14.8 million shares (with over allotment) of FBR Capital Markets at $6.00 per share. 
13. Subsequently in 2009, Arlington revoked its REIT status and begins acquiring residential mortgage-backed securities (MBS), either agency, agency-backed MBS and MBS issued by private organizations (private-label MBS). 
14. In 2011, FBR Capital Markets Corp. restructures itself by forming an investment banking holding company, FBR & Co., which houses its broker-dealer FBR Capital Markets Corp.  The Company changes its ticker from “FBCM” to “FBRC.” 
15. In May 2012, the Company announced plans to potentially enact a reverse stock split of 1-for-4, 1-for-8, or some ratio between those two ratios, as a means to increase larger investor awareness. 

Positives

Leader in Niche Capital Markets Segment

The Company is a niche leader in 144A capital raising and financial services investment banking.  The 144A market came into existence in the early 1990s as a way, primarily, for foreign issuers to tap the U.S. debt and equity markets.  The idea was that issuers could tap U.S. capital markets via sophisticated institutional investors through an SEC rule filing that did not require such issuers to file registration documents with the SEC.  However, certain restrictions were put in place: i) securities can only be sold to qualified institutional buyers with AUM >$100 million; ii) a 144A issue could only have up to 500 of these qualified investors – any amount over that threshold would require securities to be registered.  Interestingly, the majority of 144A issuance is foreign-related, and the great majority is for debt-related securities.

FBR’s unique positioning within 144A is its deep relationship with its list of buyers, which are fairly narrow.  These securities lack liquidity and because of their non-standard nature, are mostly bought by mutual funds with “exceptions baskets.”  The remaining buyers are a variety of hedge funds.  According to the Company, FBR is the #1 book-runner across all industries and all levels of market capitalizations within 144As.  FBR is also a top middle market initial equity underwriter in the Financial Services sector for deals under $1.5 billion. 

While 144As are lucrative, this niche is fairly small in the context of the whole equity capital markets industry.  For example, within Financials (which includes certain Mortgage REITs and Financial Tech) there were a total of $12 billion of 144As executed from 2007 through today.  In comparison, all common offerings for deals smaller than $1.5 billion (excluding 144As) in Financials from 2010 through today totaled $27 billion, or 131% greater.

Table 3: 144A Offerings – Financials		Table 4: Common Stock Offerings – Financials
https://docs.google.com/file/d/0B4xbUnte_0Q2X3dhV01vakpJZWM/edit?pli=1		https://docs.google.com/file/d/0B4xbUnte_0Q2blNxM3BZcWVqOWM/edit?pli=1
Source: SNL – Private Placements from 1/2007 – 9/2012.		Source: SNL - .Primary &Secondary from 1/2012 – 9/2012 (<$1.5B transaction size).

Crestview Ownership

Crestview Partners has substantial ownership and control over the board and the direction of the Company as part of its original 2006 investment.  Crestview Partners is a private equity firm focused on leveraged buyout, growth capital and distressed-for-control investments in companies across a range of industries: financial services, media/cable, healthcare and energy. Founded in 2004, Crestview’s executive management team had previously worked together at Goldman Sachs.  The firm has raised approximately $4 billion since inception across two funds.  Crestview completed fundraising for its first fund in 2005 with ~$1.5 billion in commitments.  That fund was invested in 11 companies from 2004 through 2007.  The firm began raising its second fund in November 2007 and raised ~$2.4 billion in commitments. 

Although Crestview has officially two assigned board members, it is entitled to opine on four other “independent” seats.  Therefore, they indirectly control 75% of the board.  If Crestview sells >2/3 of its 2006 original purchased shares, then they lose their board designations.  While FBRC might turn out to be a mediocre investment for Crestview, at best, we believe that the firm will continue to influence the board to maximize value for its holdings. 

Cost Reduction Initiative

The Company has been pro-active in adjusting its business model to perform in a hard post-crisis environment (see Exhibit 4).  However, the Company has continued to have poor performance in investment banking and institutional brokerage activities.  During the second half of the 2011 FBRC’s total revenues decreased 52% as compared to the first half of 2011.  In response to these conditions, in the fourth quarter of 2011, FBRC implemented a restructuring plan intended to reduce its fixed expenses by 35%, principally through headcount reduction.  In addition, it also restructured its variable compensation programs.  Due to the Company's market capitalization having been below its carrying value for an extended amount of time, it has also taken goodwill impairment charges.  The Company believes that all of these efforts and changes to its cost structure should better position the Company to perform in the different types of markets experienced since the financial crisis began.  Its goal is nimbleness, creativity, speed-to -market and a focus on core competencies.  Its other goal is to continue to maintain a strong liquid and transparent balance sheet with high levels of capital.  We believe that the Company should be able to return to at least break-even in the near term.  Excluding investment and interest income, the Company has been able to reduce “break-even” revenue by 68%, to $144 million, since 2008.

Exhibit 4: FBRC Reaction to Challenging Environment

Source: Company Reports.

Exhibit 5: Compensation Analysis		Exhibit 6: Employee Efficiency
https://docs.google.com/file/d/0B4xbUnte_0Q2YmN2Q1d6LU9Ga1U/edit?pli=1		https://docs.google.com/open?id=0B4xbUnte_0Q2SFdYZ2ItdHpCVmc
Source: Company Filings.		Source: Company Filings

Recent Investor Friendly Actions

FBRC, through the direction of the board, has repurchased more than 20% of FBRC’s outstanding shares over the past year.  During the second quarter of 2012, the company repurchased 6.6 million shares of its common stock at an average purchase price of $2.75 per share, and at a total cost of approximately $18.3 million.  There were approximately 50 million shares outstanding at the end of June.  As of the end of July there were 48.9 million shares outstanding.  The Company's Board increased its stock repurchase authorization by 5 million shares during the 3Q 2012.  As a result, the company has the authority to repurchase up to 6.1 million shares of its common stock.  Management has shared its thinking about deploying capital back into the business versus share repurchases.   CEO Rick Hendrix stated that share repurchase activity is attractive as long as shares trade significantly below tangible book value. 

Management has been mindful of redeploying capital back into its business.  A natural place to deploy capital during strong markets is to its trading desk, since it allows the Company the ability to execute client trades more efficiently.  In an environment with less liquidity and lower trading volumes, the Company is motivated to “take risk off” of its trading desks: less active trading environments often lower a company’s Value-at-Risk (VAR) calculations.  Effectively, less capital is required for trading and can/should be redeployed elsewhere.  We believe that management and the board are actively managing the Company’s true “excess capital” position and will plan on returning capital to shareholders, as needed.  We believe that the Company manages the right “cushion” of reserved cash to opportunistically redeploy if the trading environment changes. 

Over-Capitalized Balance Sheet

Currently, the Company has ~$60 million of excess FINRA regulatory capital for trading.  Moreover, with the expected sale of its asset management business, an additional $30 million of excess liquidity should hit the balance sheet in 2H 2012.  We believe that there is at least $3.70 per share of excess liquidity ($4.30 per share if the asset management proceeds are included).  Approximately $44 million of its $244 million of cash and securities are Level 3 assets or non-public less-liquid equity securities.  Separately, we believe that if FBRC can continue its recent profitability momentum then its excess liquid cash should continue to grow.  We arrive at our $3.70 per share of liquid cash as follows:

1) Cash = $145.534

2) Plus: Financial instruments owned, at fair value = $70.763

3) Plus: Other investments, at cost = $27.674

4) Less: Other investments, at cost: $27.674

5) Less: Level 3 assets = $15.891

6) Less: 1/2 of Level 2 Assets = $37.987/2 = $18.9935

7) Equals: Liquid assets = $181.4125

8) Equals: $181.4125/48.936241 (shares out) = ~$3.70 per share

Exhibit 8: FBRC Investment Portfolio Fair Value Analysis

https://docs.google.com/open?id=0B4xbUnte_0Q2MW1NQWkzTmxrRVE

Source: Company Reports, SNL.

Return to Profitability

Not since pre-Crisis (circa 2007), has FBRC’s business operations been able to have two quarters of positive earnings.  We believe this is significant since it gives management’s cost savings initiatives, implemented in the 4Q 2012, more credibility.  More importantly, the completion of FBRC’s NMI Holdings $550 million private placement should hit the income statement in 2H 2012.  As mentioned above, 144As typically command 6%-7% in fees.  That could mean a fee of at least $30 million for FBRC.  We believe that this fee can prove to be significant to the bottom line, since these deals should not increase marginal costs. 

In addition, beside the NMI deal, FBRC completed a $234 million transaction for American Residential Properties which will also be recognized in the 2H12.  The vehicle for single-family rental properties captures opportunities created as distressed sales continue.  

Deferred Tax Assets

As of December 31, 2011, the Company reported that there was approximately $94.4 million in deferred taxes related to NOLs.  The Company updates this figure on a yearly basis.  However, we believe that some of those DTAs will be used for the gain on sale of its asset management business, confirming that most of the proceeds from this transaction should be tax-free.  We believe that if the company can prove the sustainability of its recent profitability then there is significant value that has not been fully reflected in the balance sheet or share price. 

Strong Cash Position – Valuation Floor

We believe that the Company’s excess cash position of nearly $3.70 per share should hopefully provide a comfortable floor on valuation, assuming that cost can be reasonably contained with no further restructuring charges.  If the business can plug its historical cash burn and management can adequately deploy excess cash then the returns on the business should eventually exceed its cost of capital, which should push valuations closer to book value. 

Negatives

Niche Focused and Small Revenue Diversification

The Company depends on a small number of capital raising transactions and trading volumes to provide a significant portion of its revenues per year.  In particular, it depends heavily on the 144A capital raising market for most of its capital raising assignments.  Although FBRC has been the market leader in private placement, it depends on a few large deals per year, making its revenue stream “lumpy”.  For example, in financials, FBRC has completed only 10 deals since 2007, which are about two deals per year.  Interestingly, FBRC’s Capital Raising segment (i.e. 144As, equity and debt) has shrunk by almost a 40% CAGR since pre-Crisis peaks.  Since 2008, FBRC’s Capital Raising business has shrunk by at least 18% annually.  Large deals have become increasingly rare, as seen in FBRC’s recent completion of NMI Holdings’ $550 million raise.  NMI Holdings, Inc. is a new pure-play mortgage insurer. 

Like most agency brokers, FBRC agency commission revenue is highly sensitive to market volume and share fluctuations, pricing, competition, and customer concentration.  On the trading side, a majority of its agency commissions are primarily equities but also include a small percentage of fixed income products.  Agency commissions are, mostly, trading volume driven.  Trading volumes typically depend on increased market volatility.  Big macro event situations and general uncertainty in the markets help market volatility blossom.  Low event or quiet periods in the market lower volumes and hence trading commissions.  2012 has continued to see market trading volumes deteriorate (see Exhibits 9-10).  Not surprisingly, agency commissions, which average nearly 80% of brokerage revenue, have deteriorated as well.  FBRC’s Principal Transactions segment, 20% of brokerage revenue, is primarily fixed income related trading.

Capital raising volatility and deteriorating trading volumes have reinforced FBRC’s motivation for expense management.  We believe that these market trends may continue to pressure FBRC’s ability to remain consistently profitable.

Exhibit 9: NYSE U.S. Monthly Equity Volumes (B of Shares)		Exhibit 10: Fixed Income Trading Volumes
https://docs.google.com/open?id=0B4xbUnte_0Q2ZzZZNWJWUUY0b1k		https://docs.google.com/open?id=0B4xbUnte_0Q2R1RJR1lreEZVazA
Source: NYSE-Euronext, endur.		Source: Federal Reserve, Sandler O'Neill.

Crestview Overhang

As discussed above, Crestview Partners has substantial ownership and control of the Company.  Crestview owns 18% of the Company, based on latest filing information.  Although we believe that Crestview will continue to influence FBRC’s board to maximize value for its holdings, FBRC is a legacy investment for Crestview.  We believe that Crestview will look for ways to monetize its investment over the next two years to conclude what might be a mediocre investment for the private equity firm.  Crestview initially invested around $77 million, but has subsequently bought shares in the open market at various times over the last six years.  As a result, we believe that Crestview may have invested well in excess of $100 million at prices significantly higher than today’s levels.  Therefore, we believe that there could be meaningful downward pressure on the stock, due to Crestview opportune exits, particularly in the face of positive price moving catalysts. 

Lowest Cost per Employee (i.e., Talent Retention Issues)

As we mentioned above, in response to harsh market conditions, in the fourth quarter of 2011, FBRC management implemented a restructuring plan intended to reduce its fixed expenses by 35%, principally through headcount reduction.  The goal was to create operating nimbleness, creativity, and speed-to-market, all while focusing on core competencies.  Excluding investment and interest income, the Company has been able to reduce “break-even” revenue by 68%, to $144 million, since 2008. 

Exhibit 11: FBRC Compensation Analysis		Exhibit 12: FBRC Employee Efficiency
https://docs.google.com/open?id=0B4xbUnte_0Q2ZmFOQy04aEZNQ3M		https://docs.google.com/open?id=0B4xbUnte_0Q2QVZ1UUdnaHlySFE
Source: Company Filings.		Source: Company Filings

When we compare FBRC to peer boutique and middle market investment banks, we see that FBRC has been able to capture the lowest overall compensation expense as a percentage of revenue.  This gives credibility to management execution of its cost savings initiative.  However, when we compare peer employee efficiencies, boutique M&A advisory firms still lead.

Exhibit 13: Comparable Compensation Analysis		Exhibit 14: Comparable Employee Efficiency Analysis
https://docs.google.com/open?id=0B4xbUnte_0Q2ZHo3MGNaWWdldm8		https://docs.google.com/open?id=0B4xbUnte_0Q2NEJsaW1IM2tJQUE
Source: Company Filings, SNL.		Source: Company Filings. SNL.

Exhibit 15: Comparable ROAE Analysis		Exhibit 16: Comparable Equity Analysis
https://docs.google.com/open?id=0B4xbUnte_0Q2cVRVbGtxS0ZQcDQ		https://docs.google.com/open?id=0B4xbUnte_0Q2b0Y1TzJ4dE0xVWM
Source: Company Filings, SNL.		Source: Company Filings. SNL.

Pure franchise M&A advisory businesses (i.e. minimal agency brokerage trading operations) like Lazard, Evercore and Greenhill require little regulatory capital to operate but use higher talent compensation packages to retain former bulge-bracket “marquee” bankers.  As a result, ROAEs generally tend to be higher.  In fact, Jefferies, which has been known for its large debt and equity trading operation, has been acquiring talent from 2^nd Tier bulge bracket banks in an attempt to diversify, dominate middle market investment banking and increase its ROEs.  Nevertheless, its strong employee efficiency continues to come from its powerful sales/trading franchise. 

We believe that if FBRC is not careful in the short-term, sharp compensation cost reductions may strain talent retention in the long-term.  We believe that there is a natural trade-off between aiming to be the lowest paying firm and properly developing and incentivizing human capital.  However, unlike M&A advisory (which often depends on individual “rain-maker” talent) Capital Raising Advisory can be developed into an institutional “franchise” (not as dependent on any one or two rain-makers) more readily.  FBRC’s long-standing reputation as the leader in private placement should allow the company to execute on its compensation cost initiatives while theoretically retaining the right personnel, if done carefully.

Insider Ownership and Shareholder Alignment

Other than Crestview Partners, only Adam Fishman, FBRC’s 32 year-old head of sales sensation, owns over 5% of the common stock of the Company.  FBRC’s original founders and current executive management all own less that 5% each, and collectively (including Fishman) own less than 20% of the company.  We are unsure how the Company’s executive team would manage FBRC outside of the influence of Crestview Partners, who we clearly believe directionally controls the Company.  We believe that without Crestview’s influence management may have had a harder time in aligning its interest with shareholders. 

FBRC’s executive management compensation format is less than ideal in the long-term, but understandable in the short-term.  The Company funds its bonus pool for its executives based on achieving a revenue threshold, which has been $140 million over the last few years.  Funding of the pool is 5% of the threshold for the year.  Once funded, the Company uses opaque returns/earnings criteria to determine final distributions.  Given the dismal results over the last few years, the compensation committee has had to change its metrics (e.g. using headcount reductions, regulatory capital compliance, etc.) to justify compensation.  In 2011, management did not receive bonuses, despite surpassing its revenue threshold. 

For 2012, however, the new threshold was lowered by 28% to $100 million.  We believe this downward adjustment reveals just how strong the headwinds are for FBRC.  We were surprised that specific earnings or returns metrics were not mentioned in determining compensation in 2012, given the board’s announced cost cutting initiatives.  Interestingly, when bonuses have been paid in the past, a majority of them have been paid in cash.  This is understandable since share price performance has reflected business performance and as a result equity compensation may not be as enticing a retention mechanism.  In contrast, firms like Lazard, use three year return-based metrics in determining bonuses for its senior executives, and a majority of payment is in the form of stock incentives.  We believe that senior management may be harder to retain and motivate.

Low Liquidity in the Stock for Institutional Investors

There is low trading in the stock, despite the size of the float.  A few thousand shares traded a day moves the needle significantly.  Building a reasonable position may take days or patient good-to-cancel (GTC) staggered bid trading. 

Earnings Outlook

Mediocre to Poor Historical Performance

A favorable market environment is the most important driver of improving results for FBCR and its investment bank peers, which means an equity market rally, improving investor risk appetites, and increasing industry-wide capital raising activity.  However, the last four years has proven to be unpredictable for advisory and deteriorating for capital market activities (see Exhibits below).  2Q 2012 brokerage revenues declined 23% sequentially.  FBRC attributed the deterioration largely to lower levels of activity industry wide.  Additionally, management noted that the softer revenues were roughly evenly split between both fixed income and equities.  This has been an ongoing trend for investment banking and brokerage operations over the last four years.  The former has declined by roughly 16% annually and the latter by 17%. 

We do not see this trend abating anytime soon.  Therefore, we must trust in management’s ability to lower its fixed and manage its variable costs.  Not surprisingly, fixed costs (mostly compensation expense) will need to be at least below 70% of revenue if the company wants to demonstrate consistent profitability.

Exhibit 18: Brokerage Revenue Sequential Growth		Exhibit 19: Advisory Revenue Sequential Growth
https://docs.google.com/open?id=0B4xbUnte_0Q2SEJOU0RtUzVXQ0U		https://docs.google.com/open?id=0B4xbUnte_0Q2MV9SQnA0V2dZZlU
Source: Company Filings.		Source: Company Filings.  Excludes Asset Management Fees

Long-term Cost Structure – Expected Margin

As discussed, the current environment has affected the Company’s ability to be profitable and to find the right cost structure to not burn cash.  The Company has just barely returned to profitability in the last two quarters of 2012.  Although this appears promising, it also comes on the back of very sharp cost reductions in personnel, compensation and non-core operations (e.g. sale of FBR Fund Advisers).  The Company has stated that its new break-even revenue is $144 million.  However, we believe this figure is quite arbitrary. Examining Exhibit 20 shows that Capital Markets (i.e. FBRC’s Capital Raising and Advisory businesses) is the largest cost component segment.  Examining Exhibit 21 shows the business has been profitable when Capital Markets fixed and variable costs remain below 50% of total segment revenue.  Two other trends of interest are i) Capital Markets fixed costs as a percentage of total revenues have been steadily increasing since 2005 (going up to nearly 100% in 2011) and ii) Capital Markets variable costs have been shrinking over the same time period (going as low as 26% of segment revenue in 2012).

We believe that an ideal long-term goal management should be targeting, in this economic environment, is a least a 10% earnings margin.  When we compare pure advisory businesses, most of these franchises have achieved consistent above 20% operating margins, despite high compensation structures.  More recently, however, margins in these businesses have fallen to almost 10%.  We believe that over the long-run, FBRC may be able to achieve margins at least as high as the trough of its pure advisory competitors. 

Ideal “Excess Capital” for Agency Business

As shown in Exhibit 7, the Company carries excess capital of at least $60 million.  We believe that management and the board have thought through the right amount of capital to have on the books in order to be able to capitalize on the potential opportunity for trading volumes to increase as markets react to the broader economic environment (i.e. European banking crisis, ongoing U.S. recession, interest rates rising, etc.).  As a result, we believe that $60 million is most likely the appropriate level of capital to have in the agency equities and debt trading business.  Currently, this means that there is at least $3.70 per share of excess capital in the business. 

Valuation

Normalized Earnings

We believe a long-term 10% operating margin could be achievable as FBRC focuses on defining its core business and execution of its cost cutting initiatives.  However, we also believe that this targeted performance should be viewed as an option value only for investors.  In other words, we believe that an investor should not pay for the “possibility” of FBRC returning to 10% margins.  The risks inherent for this niche investment bank to achieve such consistent returns are too high and unpredictable.  As Exhibit 21 shows, the Company has struggled to return to profitability.  Over the last three years, Wall Street has waited for FBRC to “turn to corner” on profitability.  We believe that the Board’s cost reduction initiative is gaining credibility with the market. 

Our normalized earnings calculation consists of four key assumptions: i) adding $33 million in revenue coming from the NMI Holdings transaction to get normalized annualized earnings to $76 million; ii) fixed and variable costs of 70% and 20% of total revenue; iii) lowering marginal taxes to 10% through the utilization of outstanding DTAs; and iv) once profitable the Company targeting a share repurchase that lowers net assets (i.e. equity) to achieve a 12% ROE, while still having enough capital for the trading operations.

We believe that an investor should be indifferent if the Company uses a share repurchase program at discounts to book value versus a dividend program above book value when targeting an equity level that creates a 12% ROE.  Either way, for simplicity we assumed that shares are repurchased at an average price of $4.00 per share. 

Although, we are not suggesting that FBRC will return to $14 million in after-tax earnings, we do point out that if it did, then the Company could be worth at least as much as its existing book value plus the present value of its deferred tax assets ($1.67 per share, undiscounted).  We calculate in Exhibit 22, a value of $5.35 per share or a ~40% margin of safety to current prices. 

DTAs

The Company has stated that it has at least $1.67 per share, based on December 31, 2011 financials.  Although it represents a large piece of potential value, we believe that the market will need to believe that real earnings power has returned to the business first before assessing the value of FBRC’s DTAs.  In other words, stemming cash burn (which is what FBRC was able to accomplish in the 1H 2012) is not enough to ascribe value to the Company’s DTAs.  In fact, we believe that the only way for the stock to bridge its discount to book value is for FBRC to continue its share repurchase program and simultaneously give a real indication that ROEs may return to healthier peer levels.  We believe that Crestview and management have this exact focus in mind. 

Cash Floor

Assuming the FBRC can adequately convince the market that it has put a plug in its operation’s cash burn, we believe that FBRC’s discount to book value should close, providing floor valuation of at least $3.70 per share.  FBRC is currently trading at 73% of tangible book value, and with $3.70 of that value being liquid excess cash, we believe that it is actually trading at 87% discount to cash. 

Catalysts

We believe that the near term catalyst include: i) recognition of NMI Holdings (mortgage insurance deal) fees; ii) further reduction in personnel and fixed expense; iii) the return of “dead capital” (~$3.70/share) improving ROE; and iv) proceeds received from sale of its marginally profitable asset management business and the removal of its associated corporate cost.

Recommendations

Shares are trading at approximately 73% of tangible book value (TBV), which is unlevered and comprised primarily of liquid cash and securities.  The Company also has significant deferred tax assets (“DTAs”), currently with a 100% valuation allowance, which the Company estimates at ~$1.67 per share.  We believe the Company can return to profitability and could largely recover these DTAs with consistent profitable results.  If the DTAs are factored, then the shares are trading at about 50% of TBV.  FBRC could remain at depressed levels until the market appreciates its return to consistent profitability, continuing capital and shareholder friendly actions and continued sharp cost reductions.  Nevertheless, we believe the firm can operate at profitability in a slower functioning capital markets environment, and we believe additional option value exists than what is reflected in face value of the balance sheet.  We currently value FBR’s stock conservatively at $4.00 per share. Therefore, we are buyers of the stock at or below $3.10.  We believe that there should be an inherent floor of $3.70 per share.  Moreover, this valuation currently gives no value to improving earnings power or DTAs of ~$1.70 per share.

We believe that setting up GTC staggered bids make the most sense in patiently putting on a position in FBRC.

Risks

We believe that one of the largest risks the Company faces is failing in the execution of its cost reduction initiatives.  If it proves that costs still have not been contained, then the market will continue to push the stock down to historical discounts to book value.  Share repurchases will then not have the desired effect.  In fact, if this risk scenario plays out, it might be better for the Company to go private and wait for a better opportunity to re-enter the market.  However, we suspect that Crestview will seek to avoid this option as FBRC is a mediocre legacy investment that Crestview would likely desire to exit.  Crestview’s overhang on the stock could put pressure on prices which could create buying opportunities for investors. 

Low trading volume in the stock means that, outside block trades, institutional investors would most likely need to build their positions in FBRC over time.  Investors may also end up competing with the Company when attempting to buy stock in the open market. 

Finally, the NMI deal has to pass Arizona and regulatory approval which may delay fees until next year or could not be approved which would mean no fees are realized.  Arizona officials, acting as receivers for PMI Mortgage Insurance, which they seized last year, sued NMI and at least six of its employees on Aug. 8, 2012, saying some PMI workers stole information and did tasks for NMI over at least seven months before joining the upstart. Along with damages, the state wants NMI to be forced to withdraw any applications with insurance agencies and mortgage financiers Fannie Mae and Freddie Mac that relied even partly on material taken from PMI. Upstarts such as NMI need the blessing of states and the GSEs as they seek to take market share. NMI’s shareholders can take their money back if its National Mortgage Insurance Corp. unit doesn’t receive necessary approvals by mid-January, though it could ask for an extension. FBR’s fees on NMI’s private stock offering are contingent on the deal not being unwound.[1]

Follow-up Questions for Management

1)       What is your target excess capital to be able to capitalize on trading volumes returning to historical levels?

2)       What are you long-term margins for each segment (i.e. Capital Markets and Principal Investing)?

3)       What is your outlook for the Principal Investing segment?  What goal posts are you eyeing in helping you determine what to do with this business?

4)       How does the pipeline look and how should an investor think about normalized earnings in the Capital Raising segment?

Catalyst