Description

Following the announcement of its bid for Gain Capital (ticker GCAP) last week, I'm pitching the leading retail FX broker, FXCM, as a long.   For reference, GCAP was written up by abra399 in March of 2011; this is the first write-up of FXCM on VIC.

Highlights (for those of you working on an egg timer):

• CVIX (relevant index for FX volatility) at 5-year lows has translated into depressed earnings for retail FX broker FXCM (and GCAP);  signs of life (i.e., renewed volatility) in 1Q13
• Despite extremely low volatility, FXCM has been consistently profitable and has built record customer account equity of $1.2 billion
• FXCM achieved peak EBITDA in 2008 when customer equity was $253 million
• Increased regulatory scrutiny of retail FX has led to partial shake-out / consolidation/ decreased supply, particularly in US market
• FXCM does not screen well;  TTM financials clouded by significant one-time charges in 2Q12 & high amortization of intangibles that does not reflect economic reality
• Trailing 12 earnings do not reflect a) full year of Lucid Markets, a mid-2012 high margin acquisition catering to institutional clients;  b) full year of cost reductions implemented in 2012
• At current levels, FCXM trades at 9X my estimate of 2013 (EBITDA- Capex), WITHOUT assuming increased FX volatility, and without a GCAP deal
• Return of volatility as key opportunity – what can the company do with 4X the customer equity (vs. 2008) in a more volatile (or even “normal”) currency environment?
• Difficulty of navigating FX regulatory maze in multiple countries as barrier to entry
• Unlike some competitors, FXCM primarily operates on agency model, limiting principal risk and minimizing conflicts of interest with retail clients
• Management has thus far behaved as adults; see dividend and stock repurchases in 2011 – 2012 
• Acquisition of GCAP—if FXCM is able to nab it at this valuation or anywhere near it—would be icing on the cake; “cost synergies” are much more than a buzzword in this business; potential release of up to $100MM in restricted cash, post-merger
• FXCM earnings could thrive even in a low-growth / no-growth macroeconomic environment

 Introduction

Last week, the leading retail FX broker in the US and Asia, FXCM, offered to acquire the #3 player in the US, Gain Capital (GCAP).  

 To be clear from the outset, I harbor no illusions about the proposed GCAP acquisition.  GCAP’s senior executive team enjoys outsized (ridiculous?) salaries, and the majority of these positions would likely be eliminated if the deal were consummated.   GCAP’s cap table is dominated by insiders that have watched the stock slide from about $8.50 at IPO (December 2010) to a trading range of $4 to $4.50 most of this year, prior to FXCM’s offer this week of $5.35 per share (all stock or a combination of stock + $50 million cash).  From GCAP’s standpoint, they’d be selling at low tide with respect to industry fundamentals; indeed, they’ve presented themselves as buyers rather than sellers in recent communications.  Last week they wasted no time in adopting and publicizing a shareholder rights plan, which gives some indication of where management’s sentiments lie.  So although the deal would be a win for FXCM (more on that later), I’ll park the GCAP acquisition for the moment, and take a look at FXCM on a standalone basis.

Industry Snapshot

FXCM, although a relatively small company at an EV of less than $1 billion (as usual, many of the databases confuse the issue), is one of the largest retail foreign currency brokerages in the US, and for that matter, in the world (#2 globally).   FX is about a $4 trillion a day business, and after a sharp growth spurt, retail brokerages’ share of that dollar figure has leveled off somewhere south of 10%.  The Wall Street Journal’s rocket scientists estimated retail brokerage at 6% of the overall FX market; Aite Consulting estimated retail FX  at about 9% of the overall FX market as of November 2012, having roughly doubled from 2007 to 2010.    For those who may be new to the space, retail FX has gained considerable traction outside of the US:  about 45% of FXCM’s revenue came from Asian customers in 4Q2012; the US accounted for less than 10% of sales in the same time period.   I size the global retail FX market at about $8 billion in sales.

It should also be said that the customer base on the retail side is composed primarily of small fish—we’re talking account balances of $1,000 - $10,000 here.  Some may view this as a risk factor—this probably won’t come as a shock, but not all of these investors’ excursions into FX have been successful (it’s not hard to find periods in which the majority of accounts were unprofitable).  It’s certainly not unthinkable that regulatory authorities would act to “defend” small investors in response.  One such initiative is the proposal to prohibit the use of credit cards to fund retail FX accounts.  

While we’re on the subject, it’s worthy of note that FXCM, unlike some others in the space (including GCAP), relies heavily (although not entirely) on an agency model; i.e., FXCM usually does not sit on the other side of trades with its retail customers (with the acquisition of Lucid in 2012, it has increased its propensity to do on the institutional side).  One would think that FXCM’s positioning here relative to its peers (pre-GCAP deal) might help FXCM in the event of a political dust storm. 

In the U.S., the players and respective market shares are as follows:

FXCM  26%

Oanda  20%  (private Canadian company)

GCAP   12%

CitiFX Pro 11%

IBFX  9%

FXDD  4%

Interactive Brokers  4%

Other  13%

While not listed here, the largest retail FX player globally is Saxo Bank (Denmark), in which TPG invested $560 million to purchase a 30% stake in August of 2011.

Two factors have combined to slow growth of the retail FX industry in the US:  1) sharply reduced volatility, which has impacted the industry world-wide;  and 2) increased regulatory scrutiny.  The regulatory squeeze in the US has manifested itself in the form of increased capital requirements and other initiatives such as a contemplated ban on the use of credit cards to fund retail FX accounts.  The capital requirements have had a predictable impact—the number of retail FX brokers in the US decreased to 11 in 2012.

But the key industry driver—and the key to this investment thesis—is that volatility in FX has dropped precipitously over the past several years.   CVIX, the relevant index of FX volatility, dropped to 5 year lows in 4Q2012.   This point is critical in identifying the untapped value in FXCM; when you look at recent results—whether ttm, 4Q12, or what have you—it’s vital to understand that volatility is at the lowest ebb of its 5 year trajectory.  In 4Q12, CVIX reached the lowest level since the fourth quarter of 2007:

FXCM’s Behavior in a tough environment

Meanwhile, FXCM has prepared for the rebound, by a) growing the business organically and through acquisition to the point where the equity in customer accounts is at all-time highs; and b) by taking $15 - $20 million of cost out of the business and authorizing buybacks in 2012.  At the risk of employing a tired metaphor--- this is a coiled spring.  It’s instructive that FXCM’s record EBITDA was achieved in 2008, when customer equity was $253 million.  In 4Q2012, customer equity at FXCM was $1.2 billion.  To be fair, it’s not a simple, linear relationship —the business has changed since 2008—but it gives you an idea of what’s possible in a higher-volatility environment.

While it’s a limited sample size (and I’m certainly not banking on this), volatility has shown signs of life in early 2013, which bodes well for 1Q13 results.  For FXCM’s dominant business, the retail segment (FXCM also has an institutional platform), FXCM’s revenue is a function of (retail average daily $ volume) X (fee $ per million traded).  Here’s the trend over the past 4 quarters (note that FXCM releases operational metrics monthly, hence the advance look at 1Q13):

Income Statement

Here’s FXCM’s revenue and EBIT trend (the company uses “Adjusted Pro Forma EBITDA,” which I hate…)

In 2012, about 85% of the revenue came from retail trading (90% from customers residing outside of the US), and about 15% came from institutional trading.

A couple of observations.  First, note the jump in D&A expense from 2011 to 2012, which partially accounts for the decreased EBIT and net income.  This is primarily due to increased amortization of intangibles associated with the acquisition of Lucid Markets; in my opinion, the charge does not reflect economic reality. 

Also note the lack of financial leverage over the years prior to 2012, despite five acquisitions.

Two other points to bear in mind as you look at 2012 results.   First, the company took a bath in 2Q12; FXCM showed a total of -4MM EBIT in the quarter due to extraordinary charges associated with a one-time profit interest buy out / severance and a legal settlement (see p. 20 of 2Q12 presentation).  EBIT would have been $18MM (in other words, a 22MM positive adjustment) in 2Q12 if we ignore those charges.  (It’s contagious… now I’m adjusting EBIT…)

Balance Sheet

The business is a cash generator:  the company’s cash increased from $185 million at 12/31/11 to $272 million at 12/31/12.   Restricted (customer) cash was $1.19 billion, vs. 1.05 billion at 12/31/11.  Debt was $108 million at 12/31/12 vs. $0 at 12/31/11.

Cash Flow / Capital Allocation

2012 breaks down as follows ($ millions):

After-Tax CF from Ops:  $102

Capex:                               $27

Acquisitions:                    $37

Equity Investment:         $4

Dividends:                        $22    (yield is about 1.7%)

Stock Repurchases:        $7.5  (company authorized a $53 million plan in 3Q12)

FXCM bought a 50.1% interest in Lucid Markets, an HFT firm catering to institutional clients, in June of 2012 for $177 million (through a combination of cash and debt;  you’ll see a portion of the Seller’s note on FXCM’s balance sheet).   Lucid generated c. $45 million in EBITDA in the first 9 months of 2012 (3Q12 was $22 million of revenue, $15 million of EBITDA (not a typo)).  Lucid’s 4Q12 results were softer; I have not seen a breakout of EBITDA, but management said that revenues dipped to $16 million, due to the aforementioned decline in volatility.  On the same call, CFO Lande said that YTD 2013, Lucid’s revenues had bounced back, up 37% vs. 4Q12.

Shareholder Base

Michael F. Price owned 2.15 million shares – about 2.6% of the company—as of 12/31/12. 

As of the date of the 2012 proxy, insiders owned over 38% of the company (note that this included LLC holding units and common stock—see below).  This data is a bit stale—the new proxy is due shortly, but it should suffice to say that management’s incentives are aligned with those of shareholders.    

Thoughts on Valuation

FXCM does itself no favors with its cap structure.  To cut to the chase, following the IPO (at $15 per share, in December of 2010) the principals of FXCM are slowly converting LLC interests into common stock.  (I frankly wasted quite a bit of time assuring myself that this unusual structure was acceptable, but as always, do your own diligence…)

In its April 9, 2013 presentation, the company reports fully diluted common shares (i.e., upon full conversion of the LLC interests) at 81.6 million shares.  Note that a portion of these shares—about 7 million--- are related to an ongoing earnout with the principals of Lucid Markets.

IGNORING ANY UPTICK IN FX VOLATILITY, and ignoring the GCAP deal— simply incorporating the full year of Lucid, the cost reductions implemented in 2012, and the absence of the Big Bath quarter of 2Q12— in a baseline scenario I expect about $86 million of EBIT in 2013, $137 million of EBITDA, and about $110 million of (EBITDA – capex).  

Mkt Cap         $13.95 X 81.6MM fully diluted shares = $1.138 B

Net Cash        $164MM

EV                   $974MM

So the business trades at about 9X forward (EBITDA – Capex) in this baseline scenario that assumes zero impact from increased volatility (i.e., ignoring the “signs of life” in 1Q13) or a potential deal with GCAP.

There’s not a great set of comparables.    Looking at the larger competitors, Saxo Bank is private; Oanda is private; and GCAP is not particularly helpful.   TPG bought into Saxo Bank in 2011 at an implied value of $1.86B, roughly 12X 2011 pre-tax income (for reference, Saxo’s 2011 was a downtick from 2010).  IBKR trades at roughly 12X forward, 16X trailing.

In the absence of a substantial uptick in volatility, and ignoring the GCAP deal, I don’t think an EV of $1.4B is at all unreasonable once a full year of Lucid and cost reductions cycle through, and 2Q12 is a distant memory.  If CVIX returns to pre-2011 levels, the stock could easily be a double over the next couple of years.

Opportunities Going Forward (none of which are baked into the valuation above)

1)      Return of FX Volatility:   Far and away the biggest opportunity for FXCM.  I’ll leave it to others to speculate on the timing (a risk) and reasons for this, but management provides one example:  in 2008, carry trades generated 15 – 20% of FXCM’s revenue; in 2H12 they were about 2% of revenue.   In any event, a return of volatility would lead to an increase in the volume of transactions, and FXCM, as an agent that takes about 90 - 95 dollars in fees per million dollars traded on the retail side, is a direct beneficiary of this.   Obviously an online trading platform such as FXCM carries tremendous operating leverage as well.   In an environment of increased volatility, it’s not hard to see a path to $150MM in EBIT / $200MM in EBITDA as trading volumes increase and margins benefit from this leverage.  The timing is the wild card.

 2)      GCAP Acquisition:   As I said earlier, I’m a skeptic, particularly given the ownership dynamic at GCAP, but it’s great for FXCM if it happens.  The proposal is 0.3996 shares of FXCM per share of GCAP-- $5.35 per GCAP share (25% premium to 4/8/13 price) as of the date of announcement.   The relative valuation is 5.17 to 1 as of the date of the announcement;  assuming a 100% stock-for-stock deal, GCAP’s shareholders would wind up with 16.2% of the company (FXCM has offered to pay a portion of the proceeds-- $50 million--- in cash, at GCAP’s option).  On a pro forma 2012 basis, the combined company would jump to $569 million in revenue, client assets of $1.6 billion, and according to FXCM “….post-synergy run-rate adjusted EBITDA of between $163 and $183 million.”    From FXCM’s standpoint, this is a no-brainer:   one of its primary domestic competitors would be removed; client assets would increase by 37%; and revenues would increase by 36%, for a relatively modest amount of dilution.     Abra399 alluded to this in his 2011 GCAP write-up, but this business lends itself to serious post-merger cost reduction—he cited 25 to 50% cost reduction in a previous FXCM deal.  For its part, FXCM says “Potential significant operating synergies could potentially drive between $50 and $70 million in incremental run-rate EBITDA once integration is complete.”  Given the top-heavy cost structure at GCAP (seven figure salaries in an emerging company with $150 million of sales??) and significant geographic overlap (GCAP and FXCM compete for retail business in many of the same countries, e.g. the U.S., UK, Hong Kong, Japan and Australia), I like the opportunities here.   Finally, a merger could result in the release of $80 to $100 million in restricted cash, due to redundant regulatory capital held by the two companies, and collateral requirements with trading partners.

 3)      Return of higher interest rates:  with interest rates at historic lows, FXCM has generated only nominal amounts of interest income on customer balances… with $1.1+ billion of customer assets, the impact could be significant.   I note that in 2007, FXCM generated $16 million of interest income--- about 1/3 of total 2012 GAAP EBIT ( the company was significantly smaller at that time, generating revenues of $185 million).

4)      Expansion of Institutional Business:  There are a couple of distinct opportunities here.  First, FXCM has had success in the white-label portion of its business as major online brokers weigh the “build vs. buy” decision in FX (c. 45% of FXCM’s retail revenue now comes from partnerships).  E-Trade (Feb. 2012) and Barclays (Sept. 2012) recently signed on to utilize FXCM’s platform under their own brand, and there’s considerable potential to expand this business with other brokers that don’t offer FX tools, or currently offer an inferior FX product.   (Better yet:  why not buy FXCM outright…?).  Secondly, the company launched a new institutional product, FastMatch, through a JV with Credit Suisse in June of 2012:  http://online.wsj.com/article/SB10001424052702303379204577474863792524318.html

 A third point on the institutional front:  FXCM has aggressively moved institutional clients to its own proprietary technology platform.  The result is increased competitiveness for FXCM-- reduced pricing for institutional clients without impacting FCXM’s margins.

 Finally, my baseline valuation scenario holds run-rates steady for Lucid Markets, the high margin institutional platform that FXCM acquired in 2012.  Lucid could very well expand its top line by selling into FXCM’s pre-existing customers; according to management, the FXCM deal gives Lucid access to 400+ institutional clients.

 5)      Potential impacts on competitors? 

According to the 4Q12 presentation:  a) potential push toward agency model could be on the horizon:  “Will FX stand alone as only retail asset class where principal/dealer model is permitted or does harmonization with other Dodd Frank initiatives result in requirement for agency only?”  b) “Minimum Capital requirements in EU should force out thinly capitalized competitors.”

 6)      Loosening of currency controls in China – I view this purely as a free call option.

Risks

1)      Unknown/ unforeseen regulatory changes:  e.g., increased minimum capital requirements; political pressure to “defend” interests of individual investors

2)      Prolonged period of (continued) low volatility

3)      Arbitrary government levies when smaller firms implode (such as that imposed by the FSA in the UK)

4)      Opacity, principal risk, and high margins of Lucid Markets (FXCM has good rebuttals, specifically with respect to position sizes and timeframes)

5)      High cash compensation throughout industry

Catalyst