Description

Summary

• “If you can't beat 'em, join 'em.”
• INTL and GAIN Capital (GCAP) have entered into a definitive agreement for INTL to acquire GAIN for $6.00 per share in an all-cash transaction.  As part of the transaction, INTL intends to make an offer at closing to repurchase GAIN’s $92 million convertible notes due 2022.  Jefferies has provided $350 million of committed debt financing for the acquisition.  
• I have been making the case on VIC how undervalued GAIN Capital is (https://www.valueinvestorsclub.com/idea/GAIN_CAPITAL_HOLDINGS_INC/7199851252), and what a great deal INTL will be getting if the GAIN acquisition closes.  If the deal does close, the flip side of the transaction is that it will be extremely accretive for INTL, and should lead to a meaningful valuation increase for INTL as well.  
• INTL’s stock closed at $45.23 on Feb 26 (the day before the deal announcement), and $45.96 on Feb 27 (after the deal announcement).  It closed at $42.21 on 5/22, so INTL’s valuation does not reflect any increase due to the impending GAIN merger and the improved economics of the combined company.
• On the merger conference call, INTL’s CEO described the merger as “a fairly compelling financial transaction for our shareholders.”  That is an understatement.  He also said “We are very conservative in terms of making sure that when we enter into transactions, we do them at a price that provides us a margin of safety. And we also want to make sure we have very short payback periods. We don't ever pay a lot of goodwill, and we want to make sure these transactions are accretive quickly to our shareholders.”
• In describing the rationale for the transaction, INTL highlighted “Significant positive optionality for INTL’s financial performance in normal or better macro conditions for GCAP’s business given very substantial operating leverage and cash flow conversion.”  That option is already deep in the money.
• He also said “I would like to add that I'm not saying it would ever happen. But one of the things we are getting in this deal is we are getting a lot of potential volatility on the upside. If we end up having a year like 2018, you would add another 5 percentage points onto the combined ROE. I'm not saying that will happen, but just to illustrate the leverage we have to better market conditions. So we are acquiring this business in the worst of market conditions. We believe we can get this business acceptably profitable on that base case just through synergies and costs. And if we have a return to more normal market conditions, this business can be significantly accretive to us. And of course, that ignores some of the benefits and industrial logic we have discussed upfront.”  In the first four months of 2020 EBITDA, GAIN’s EBITDA has already surpassed its 2018 EBITDA by 53%.
• Following GAIN’s recent strong financial performance, INTL will be acquiring GAIN for less than the value of its cash and cash equivalents, prior to any merger synergies (see below).
• The merger allows INTL to take advantage of GAIN’s performance in recent multi-decade lows in volatility, and positions INTL for significant upside as volatility in FX market conditions normalize.  In addition, the increase in diversity of their portfolio of product and customer segments will reduce the company’s overall revenue volatility.
• There is a risk that the merger gets voted down by GAIN’s shareholders, so investors may want to wait until the merger is approved.  But once it is approved, I would expect INTL’s stock to increase to reflect the improved economics of the combined company.
• INTL’s merger presentation projected “Year 1” GAIN standalone EBITDA of $29 million, and “Year 2” GAIN standalone EBITDA of $49 million.  In 2020 through April 30, GAIN has already done $133 million in EBITDA:

Q2 ’20 Post Signing Period = April 1 - April 30, 2020

• Including the projected synergies, GAIN would add 106% to INTL EBITDA-Cap Ex based on LTM results, or 100% based on CY 2018 results (prior to 2019’s multi-decade low volatility in FX).  Even excluding any of the projected synergies, GAIN’s EBITDA and EBITDA-Cap Ex as a % of INTL’s would significantly increase INTL’s performance: 83% based on LTM, or 70% based on 2018 EBITDA-Cap Ex:

Merger Benefits

• The combination would broaden the product offering for both sets of customers, and it would add an important new distribution channel for INTL’s products: GCAP’s ~130K+ retail and institutional clients in 180+ countries.  
• GAIN brings a digital platform with global reach into the retail and professional trader market that will increase INTL’s transaction volumes.  GAIN would enable INTL to grow its client footprint, increase its client float, and add a significant new retail client segment.  
• GAIN would also bring technical and marketing expertise to accelerate the digitization and integration of its client platforms from electronic trading to analytical tools to market intelligence.  GAIN would make INTL client acquisition more targeted and efficient, and it would enable them to cross-sell services across all of their platforms.  
• GAIN’s Futures business is highly complementary to, and overlaps with INTL’s business, and would be a straightforward and easy addition that would be easy to integrate.
• The merger would naturally address some key challenges for GCAP’s performance as a standalone public company—significant quarterly volatility and insufficient scale.  Many of INTL’s single products exhibit similar revenue volatilities as GAIN’s FX business.  But combining them would have the effect of diversifying the revenue portfolio. The combined revenue volatility would be 56% lower than GCAP standalone and 26% lower than INTL standalone, as the two businesses are uncorrelated.  
• The economics of the equities and futures businesses are now largely driven by clearing, which INTL can bring to GAIN’s customers, and which represents additional margin they can extract from the existing GAIN business because INTL would be able to internalize clearing costs.  
• When they combine the flows of their respective businesses, there are potential synergies from being able to cross more spreads, as well as using INTL’s infrastructure to enhance the margins of GAIN’s current business.  They can also combine prime brokerage arrangements, which would lower costs.  
• GAIN trades meaningful equities volume in its City Index business, and INTL is one of the leading market makers of foreign equities. Of GAIN’s top 100 equities INTL is a market maker for 45 of them, so GAIN would immediately deal with INTL as a market maker, and INTL would get to take a market maker spread on GAIN's flows, which GAIN does not take as a standalone firm.
• GAIN has a very efficient digital on-ramp for smaller customers, and INTL thinks they can deploy that on-ramp through its businesses and make that on-ramp even more frictionless and more attractive to customers, thereby enabling them to attract more volume and more customers.
• INTL’s CEO described the regulatory capital synergies as follows: “We are sitting with significant excess capital in some of our operating subsidiaries, particularly in London. And we will merge the GAIN entity in there and make better use of that capital. And there's also just some obvious synergies when you merge two businesses, you don't need two buffers and things just kind of work better that way. Also, obviously, on the FCM side, we will just be merging that FCM into our FCM, and we have sufficient capital to carry that business. So in both instances, we can release a lot of capital – a lot of the GAIN Capital out of their transaction and just better utilize the capital we have.  We think this will amount to around $100 million, and we think this will be executed on very quickly because we just need to merge the FCM in. And in fact, in London, that will just operate as a subsidiary of our London business, and we'll get that capital relief immediately. I suspect there's more capital we can extract out of the business longer term. We've chosen not to build that in.”

Merger Consideration

Following strong recent performance, INTL’s total merger consideration is less than the sum of Gain’s April 30 Cash and cash equivalents + Receivables from brokers, so the Enterprise Value is actually now negative:

INTL’s offer gives no credit for GAIN’s cash or “Receivables from brokers,” which represent Gain’s cash, simply on deposit with brokers to cover their hedge positions.  As Gain's CFO said on an earnings conference call, “So it's still our cash; it's obviously just not in our bank account.  It's covering our hedge positions.”  For that quote from Nigel Rose (CFO), see: https://seekingalpha.com/article/4256958-gain-capital-holdings-inc-gcap-ceo-glenn-stevens-on-q1-2019-results-earnings-call-transcript?part=single

Even if you exclude Gain’s net “Receivables from brokers” and treat them as worth $0 (which INTL might try to argue, even though they are worth $47.2 million), INTL’s offer represents an Enterprise Value of $34.7 million:

Gain’s LTM EBITDA as of Q1’20 was $133 million, and EBITDA – Cap Ex was $116 million.  Those results reflect significant improvement in GAIN’s financial performance in 2020 primarily due to significant increases in trading volumes (ADV) and volatility (which leads to higher revenue per million traded (RPM)), and the two key drivers of GAIN’s revenue are ADV and RPM.  So 2020 results should not be expected to represent a new steady state.  But even in a low volatility market in 2018, Gain’s 2018 EBITDA was $86.5 million, and EBITDA – Cap Ex was $71.6 million.

INTL’s merger consideration represents a valuation of far less than 1.0x GAIN’s 2018 EBITDA – Cap Ex, prior to any synergies, which in the combination will be significant and very easy to realize.  The merger deck estimated $32 million in “anticipated fully phased-in cost synergies,” which I believe are meaningfully understated given the significant overlap of offices, including offices that can likely be consolidated in New York, Chicago, London, Sydney, Shanghai, Hong Kong, Dubai, Singapore, and Ohio.  There are also easy-to-achieve revenue synergies.  INTL’s CEO summary of the synergies was the following: “By leveraging INTL FCStone’s products and services, we can enhance GAIN’s product offering to drive market share growth by capturing additional business from existing clients, as well as enable the acquisition of new clients. As a clearer, we can enhance margins on their transaction flow, and by combining the transactional flows, we believe we can increase revenue capture by internally crossing more spreads and getting better execution from markets. In addition, as a result of the elimination of GAIN’s public company costs and the consolidation of our two infrastructures, we expect to enhance our earning power.”  

If you are wondering, “why would GAIN’s board agree to sell for $6.00 per share?”: Discussions with potential acquirers began in Jan 2019.  There were previous offers above $6.00 per share that they turned down, but negotiations dragged on throughout all of 2019, which included multi-decade lows in volatility, and GAIN’s financial results reflected the low volatility environment.  Against the backdrop of the ongoing negotiations, Q2 volume was down 32% y/y, but RPM remained strong.  Then Q3 volume was down 9% y/y, and RPM was also lower than Q1.  Then Q4 volume was down even further, and RPM was also down, resulting in an EBITDA loss.

In January 2020 after that steadily worsening financial performance, GCA had approached 108 potential bidders, and INTL’s $6.00 offer was the only active offer at the time. Trading conditions (volatility and volumes) had been getting steadily worse for years, and there was a concern that conditions might either stay as they were or maybe even continue to get worse.  Glenn Stevens summarized the thinking on the merger conference call in response to a question from Raj Sharma:

Raj Sharma, B. Riley FBR

Hi, guys. Good morning. So my question is, this is certainly seems like a great deal for INTL. So congratulations to INTL. You have amazing cost synergies that can be stacked on top of Gain's operating leverage. And I understand that these synergies are probably – were probably not possible as a stand-alone, but I want to come back to the price of $6 a share. It seems like a great deal for INTL, but is Gain leaving money on the table?

So my question is to Gain, and Glenn, just less than a year ago, you would have thought $6 to be too low a price. Has anything fundamentally changed in your view of the value of Gain other than the fact that we've had a tough fiscal 2019?

Glenn Stevens

No, I think a couple of things. First of all, the market, whether or not was right or wrong, clearly didn't recognize the value. We spent a fair amount of time trading below $4. And so it's one thing to believe it, consider it and what have you, it's another thing to be recognized for it. And so in considering strategic alternatives and trying to do the right thing for our shareholders, all the – the whole opportunity set has to be built in. And I also think that if you go back a year ago or more, you have to do this comparison to say, do a risk-adjusted potential for the future.

So to answer your question, no, fundamentally, nothing's changed in the business at all. But a lot of macro factors come into play, and then you try to do what's right – what right they can. And so in terms of our business being healthy, absolutely fine. In terms of trying to arrive at a fair outcome, in terms of a strategic alternative, you know what, there was a lot of clamorings to do a strategic review of what our options could be, and that's what we did. And this one ticked a lot of boxes in a lot of positive ways.

GAIN released an investor presentation regarding the merger: https://www.sec.gov/Archives/edgar/data/1444363/000095010320009665/dp128281_ex9901.htm

I think the reason 5 of the board members still recommend the merger boils down to the bullet point on slide 9 of the presentation “Challenges facing GAIN were likely to remain present following the anticipated resolution of the COVID-19 global pandemic,” in combination with the 108 parties contacted with only one final bidder, no alternative proposals since Feb 1, and fatigue from the large shareholders.

INTL’s CEO’s view on the logic for GAIN to agree to the merger was the following: “as far as we are aware, there was a very competitive process run here. And I think when we were thinking about this and perhaps how maybe some shareholders will think about this, I think it would be very challenging. If you're suggesting that GAIN should have just stayed as an independent company and sort of waited for volatility to come back.  My response to that might be that, I think it's going to be very challenging for GAIN as a stand-alone entity to unlock some of what we think is critical for the long-term success of GAIN, which is all these products and capabilities to compete with some of the bigger players and grow their market share and all of that stuff. Now we can do it because we have those products, and we are clearer and it's easy for us to do. But as Glenn said, it's really hard, and they've tried to do that on a stand-alone basis and short of a massive investment. I think it would be really hard for them to do that.

"And as a result, I guess, one of the issues I'm sure they were thinking about is it's become a small monoline business with a fair degree of volatility. And we have a lot of those, right? So I'm not being critical in any way. But investors don't pay a lot for volatile monoline businesses that aren't able to kind of compete in what is becoming a more challenging market.  So I'm not so sure that – so the sort of let's just stay the way we are and wait for volatility to come back would necessarily be the best outcome for GAIN shareholders. And I think with this merger, we can address all of those things, not because we're smarter or anything, but we have those capabilities and products ready to go. The volatility, actually, in a way, doesn't affect our shareholders, probably enhances our shareholders. And we can really position Gain in what's a consolidating world where size matters, we can really help this business to compete at a higher level in a bigger game.”

Merger Status

• GAIN will hold a virtual special meeting of stockholders on June 5, 2020 to vote on the merger.  Stockholders of record at the close on April 23, 2020 are entitled to vote at the special meeting.  There were 58 holders of record that day. 17 of them are named in the proxy.  
• INTL entered into voting and support agreements with GAIN stockholders representing 43.8% of GAIN stock (VantagePoint Capital Partners, Michael Spencer’s private investment group IPGL, and Glenn Stevens, CEO), who agreed to vote their shares in favor of the merger.  These voting agreements cannot be terminated unless the merger agreement is also terminated.
• Abstentions, “Broker Non-Votes” and “Failure to Vote” all count “against” the merger.  Proxies that are returned with no instruction will count “for” the merger.  
• Shareholders who bought stock after 4/23 are not entitled to vote.  I expect that most, if not almost all or all of the shareholders of record on 4/23 who have since sold their shares will not bother to vote, and any non-votes from these shareholders will count against the merger.  So I expect that close to the full volume of trading since 4/23 (net of volume from anyone who both bought and sold after 4/23) will effectively end up as votes against the merger.  In addition, 2.1 million shares traded on 4/23 above $6.00, which are entitled to vote and represent likely “against” votes.  
• From 4/24 through 5/22, 12.9 million shares have traded, over 34% of the common that can vote (although some of that volume is almost certainly double counted as shares that were both bought after the record date and then sold).  Including the 2.1 million shares that traded above $6.00 on 4/23, that represents 40% of the stock that can vote, with 9 more trading days before the special meeting.  If the average volume over the next 9 trading days is the same as the average volume since 4/23 (616k shares), the shares traded since 4/23 plus the 2.1m shares traded on 4/23 will represent a total of 55% of the shares that can vote, with the caveat that some of that volume is almost certainly double counted, as discussed above.  But even net of the double counting, that represents a large percentage of the relevant votes, and as mentioned above, any non-votes count “against” the merger.
• In order to approve the transaction, INTL needs 50% plus 1 share.  So it is possible that the merger will be voted down.  But on May 14, the GAIN board reaffirmed its recommendation that the stockholders adopt the merger agreement by a vote of 5 to 3.  The three members of GAIN’s board who voted against recommending that the stockholders adopt the merger agreement believe that $6.00 per share no longer reflects the long term value of GAIN. 
• On INTL’s quarterly conference call, the CEO said “we are well down the path of obtaining the necessary regulatory approvals, and hope closing can occur by mid-summer.”  INTL has started the integration with the GAIN team and “are now even more convinced of the commercial logic of combining these two franchises in order to become one of the leading global financial platforms.” Re. Jefferies $350 million of debt financing, he said, “So we're working with Jefferies. Perversely and surprisingly, the markets actually look fairly stable at the moment, and the high-yield issuance has been pretty active. So we're sort of in-process with getting ourselves organized to get the capital in place in good time for the closing of that transaction. So all under way and kind of all on track.”

INTL Background

INTL offers a financial platform that provides execution, risk management and advisory services, market intelligence, and clearing services across asset classes and markets around the world.  INTL a clearing and execution member of 46 derivative exchanges globally, and connects over 30,000 clients and over 80,000 retail clients with the exchanges and hundreds of liquidity sources.  They trade every foreign exchange market, they are a broker dealer, and a swap dealer.  They serve commercial clients—businesses looking to hedge risks and make their business less volatile. They also have institutional investor clients—buy-side institutions ranging from small hedge funds to the largest in the world, and professional active traders who want access to the markets INTL can access. 

They have a lot of small broker-dealers and introducing brokers who effectively are aggregating retail for them, and the GAIN acquisition would give them a digital platform that can facilitate that flow better.  In addition to execution, INTL also handles clearing and custody.

INTL monetizes its client activity across its platform by earning commissions and spreads on trade execution, and they earn interest on >$3 billion of balances which clients custody with them.  They have a scalable platform, and are looking for ways to increase the flow across their network, so the GAIN transaction would help with that.  In addition, because they handle clearing, they end up with client balances in the system, either through the clearing or the custody of assets.  GAIN would bring an additional $785 million of client assets (as of 3/31/20), which would increase INTL’s client float by ~25%.  INTL also monetize assets via securities lending, margin accounts, etc.

INTL has 44 offices around the world in 11 countries.  The company provides products and services across five market segments: commercial hedging, global payments, securities, physical commodities, and clearing and execution services.  Customers include the producers, processors and end users of virtually every major traded commodity, as well as asset managers, introducing broker-dealers, insurance companies, brokers, institutional and retail investors, commercial and investment banks, and governmental, non-governmental and charitable organizations. 

The breakdown of 2019 revenue was the following:

Risks

As discussed above, there is a risk that the merger gets voted down by GAIN’s shareholders, so investors may want to wait until the merger is approved before investing. 

Catalyst

• Merger approval:  if the merger is approved by GAIN’s shareholders, I would expect INTL’s stock to increase to reflect the improved economics of the combined company.

• Announcement of combined results: as discussed in the writeup, I believe the projected synergies are conservative and will be able to be recognized quickly, with a short payback “in months, not in years,” according to management.  More than doubling INTL’s free cash flow for essentially no net consideration should be reflected in an increased company valuation.