Description
MF Global is the largest independent broker of exchange-listed options and futures in the world. The company also deals in OTC options and provides clearing services. MF dates its origins back some 200 years, and was spun off from Man Group in an IPO at $30 per share just about a year ago. The shares presently trade around $5 and we own them. The following is not a complete description of the situation and is based on the facts as known as of September 29, 2008. More complete information can be obtained by reviewing the relevant public filings.
The company principally derives its revenues from four separate activities. These comprise agency trades where MF simply acts as an intermediary between customers; matched principal trades where the company will fill a customer’s order for its own account with a view towards quickly finding another customer to take the other side of the trade; clearing, which entails posting collateral on a customer’s behalf at various exchanges, collecting collateral from customers and handling the related administration; and interest income which is principally generated from spreads on customer cash balances and from a substantial repo business. In addition, the company conducts a London-based stock loan operation. The repo operation is substantially back-to-back, which is to say that the company borrows against assets on which it has lent, and for similar terms. It is able to earn a spread doing this. As is described in greater detail below, the generation of interest income on customer cash balances entails a small amount of credit and basis risk.
MF’s historical income statement is of limited predictive value, owing to (i) the company’s former ownership by Man Group; (ii) its growth in recent years through acquisition; (iii) complications related to its IPO; and (iv) a number of other one-time items.
The company prepares an “adjusted net income” calculation which attempts to adjust for these factors by adding back non-recurring or non-economic items. It shows a progression from $89.1 million in FYE 3/06, to $147.7 million in FY 07 to $199.8 million in the recently completed fiscal year.
MF has had a short and star-crossed existence as a public company. Taken public as a quasi-exchange at a time when exchanges were beloved by investors, MF’s shares traded at around its IPO price until March of this year. Subsequently, four separate events combined to drive the shares to a low of less than $4 per share in July. In turn, these were: (i) a $150 million loss attributable to a former broker’s disastrous night’s trading in wheat futures; (ii) general hysteria about financial firms; (iii) a self-reinforcing fear that the company would be unable to refinance the $1.4 billion bridge loan with which it was burdened on its IPO; and (iv) an unexpected shortfall in net interest owing to permutations of the yield curve and Company actions to enhance liquidity in response to concerns about its viability.
Investment Premise
The concerns which pummeled the company’s share price have largely abated leaving it with an unimpaired franchise at a very attractive price.
The Rogue Broker: MF’s ultimate customers deal with the company either directly or through brokers. The former class of customer is subjected to rigorous automated monitoring to assure that he or she has sufficient equity to support his or her positions. Brokers’ customers have been more loosely supervised on the premise that their brokers would monitor their accounts. This arrangement broke down when a former MF broker accessed the company’s broker system to trade wheat futures for his own account. While resulting pre-tax loss of $150 million was staggering, after foregone incentive compensation and taxes, it represented less than $0.50 per MF share. The company has, needless to say, altered its systems to prevent a reoccurrence of this event.
Wall Street Turmoil: The notion that MF could be the next domino to fall on Wall Street seems to derive from a misapprehension of the company’s business. Unlike, say, a commercial or investment bank which (until recently at least) earned its money by making leveraged bets on the value of financial assets, MF earns its money principally by providing a service. While it has a very substantial balance sheet, its assets are of very high quality
[1] and are almost perfectly matched by its liabilities. The principal risks MF faces are from breakdowns of its systems or calamitous market failures. In principle, given six months, the company ought to be able to essentially liquidate without substantial impairment in book value
[2]. Understanding that such an exercise is very unlikely, the fact that it’s possible means the company is much less likely than others to face a ruinous crisis of confidence.
Refinancing risk: While it wasn’t pretty, MF ultimately succeeded in refinancing its bridge loan. The replacement package included the sale of convertible debt and equity securities to a number of investors, including J.C. Flowers. Even after giving effect to various anti-dilution provisions, all securities are convertible at prices well above the current market. For purposes of my valuation, I simply assume that the 40 million shares into which the new securities are convertible are outstanding, without assuming any benefit from reduced financing costs.
Interest rate squeeze: MF pays its customers interest on certain cash balances at a rate which is generally a discount to 60-90 day government yields. In June, as concerns about the company and markets generally rose, it moved its own cash to very short-term liquid investments. This caused a precipitous narrowing of spreads and caused interest income to decline by $18 million pretax year-over-year. While this was an understandable and immaterial development, it represented the final straw for many investors. At present, spreads (which can be approximated by comparing a 30 day agency yield with a 90 day Treasury yield) are near historic highs which augers well for current quarter earnings.
Valuation
- MF has 167 million fully diluted shares outstanding. In FY08 the company earned adjusted net income of $200 million, or $1.20 per share. In its fiscal first quarter, the company earned $0.29 notwithstanding the shortfall in interest income. The consensus of analysts, who hate the company, is for current year earnings of $1. Tangible book is $8. A price of $12 would represent reasonable multiples to all of these values.
- MF went public with 127 million shares valued at $30 for an indicated market capitalization of $3.8 billion. With 167 million shares today, and assuming no reduction in its debt attributable to the new shares, its value at $12 would be $2 billion, or 47% less than it went public at.
- The principal exchanges on which MF Global operates are the CME, EUREX, LIFFE, NYMEX and ICE. Of these, the two publicly traded” pure play” futures and options exchanges, CME and ICE, trade at 22X and 14X ‘08E earnings respectively.[3]. EUREX and LIFFE are both owned by equity exchanges, Deutsche Börse and the NYSE, which each trade at 11X[4]. If we conservatively assume that MF earns $1, a $12 price would, as before, represent a 12X P/E ratio. The Company is gaining market share on its principal exchanges, and it’s difficult to understand why it should trade at a lower multiple than those exchanges.
[1] The company owns $15
million of level three assets.
[2] More than 60% of repo assets have terms of less than 30 days. 94% are less than 90 days.
[3] CME earnings of $16.44, share price $355. ICE earnings $4.79, share price $65.
[4] DB earnings of €5.38, share price of €61.80; NYSE $3.12 and $34.00.
Catalyst
- a couple of quarters of normal operations.
- potential stock buybacks
- takeover