Description

Oppenheimer & Co (“OPY”) appears to be an under-earning, middle-market investment bank. However, it is predominantly a capital light, highly cash generative, and growing private client and asset management firm.  These segments have been marred by recent poor performance in their capital markets group and short-term legal issues. OPY trades below its tangible book value; a massive discount to its peers; and presents a potential near-term catalyst to highlight this disconnect.  

Background

OPY derives over 67% percent of its $952 million of 2012 revenue from its private client (“PC”) and asset management (“AM”) business. It has over $81.8 billion of assets under administration (“AUA”) and $23.8 billion of assets under management (“AUM”). The PC group offers full-service brokerage, wealth planning, margin and securities lending through over 1,400 financial advisers to high net worth families and mid-size institutional clients. OPY makes money through a mix of commissions, securities lending, and advisory fees on client assets. Due to the current rate environment, interest income from margin balances and fees from cash sweep programs are practically non-existent. 

Their AM group provides a mix of proprietary and third-party advisory services to retail and institutional clients. It offers separate managed accounts, fee-based non-discretionary accounts, institutional fixed income strategies, and alternative vehicles. In their family of alternative vehicles they take 2 and 20.

AM is a high-margin and very stable business.  OPY allocates 22.5% of their AM fee revenue to their AM segment and the remainder to their PC group. This fee revenue before any estimate of performance fees is on a run rate of over $350 million, or about 1.67% of average AUM of $21 billion.

(Approximately $20 million per quarter allocated to AM group / .225 * 4 = $355)

OPY has a strong track record of growing AUM. From 2003 until 2007, they grew AUM from $9.5 billion to $17.1 billion, and from a low of $12.5 billion in 2008 back up to $23.8 billion. All of this growth has been organic. 

OPY just recently started breaking out segment income and margins, before legal and corporate overhead expense. The PC and AM group have industry consistent margins around 10% and 30%. These groups are now on a run rate of over $90 million pre-tax (pre-corporate overhead / legal expense) operating income.  

OPY trades at a discount to its $25.42 per share of tangible book value. TBV is primarily made up of corporate bonds, munis, agency securities, $86m of ARS, $38m of mortgage servicing rights, and a repo book. They have no loans or derivative assets. 

No other PC or AM firm trades anywhere near a discount to its TBV, and they usually trade at high multiples of earnings as TBV does not reflect the underlying earnings power of these steady, high-margin, fee-earning businesses that require minimal tangible capital. 

Its most similar competitor, Canaccord Financial, which also has an under-performing investment bank that is a larger component of its total revenues trades at 2.2x TBV.  CF has 2x the market capitalization, with 70% of revenues, with only $27 billion of AUA, and $17 billion in AUM. 

Raymond James Financial has 21x the market capitalization even though it only has 5x the AUA ($403 billion) and 2x the AUM ($56 billion). RJF trades 2x TBV with a P/E of 16.4. 

Stifel has 9x the market capitalization even though it only has 1.85x the AUA ($181 billion). It trades 2.3x TB with a P/E of 20x 

Looking at pure AM firms, the valuation dis-connect is as pronounced. 

Cohen and Steers has $48 billion AUM and $270 million in revenue. It has a market cap $1.7 billion, which is 5x OPY even though it generates half as much fee income over more assets. It trades 8.7x TBV and P/E of 24.5, and 3.5% of AUM.

Pzena Investment Management has $22.3 billion of AUM and $88 million in revenue. It has a market cap of $645 million, which is 2x OPY even it generates ¼ the fee income. It trades 13.4x TBV with a P/E of 25 and 2.89% of AUM. 

A brief look at OPY’s history further drives home this point.  Until 2003, the firm was known as Fahnestock & Viner, and was primarily a broker-dealer with a PC and small AM business.  That year, the firm purchased Oppenheimer, the PC & AM business of CIBC, for $250 million. This was an excellent transaction that increased AUA from $17.8 billion to $46 billion and AUM from $869 million to $9.6 billion. This transaction also highlights why tangible book is a poor proxy of value for these firms.  This transaction was funded with debt and reduced TBV from $19.20 to $8.65 per share, since then even with all the resulting legal issues they have grown TBV to $29.32 per share (adjusted for dividends) for a CAGR of 13%. It is interesting to note that the firm paid $250 million for $30 billion in AUA and $9 billion in AUM, while the entire market cap is now $310 million for $81.8 in AUA and $23.8 in AUM.

Transaction comps tell a similar story.

In January 2012, Raymond James purchased Morgan Keegan for $930 million at (1.33x TBV). They acquired 1,000 financial advisors, $70 billion in AUA, and their fixed income and equity capital markets group. This transaction is illustrative of the value of just the AUA, and is not comparable for the value of the AM part of OPY’s business.

Issues

On-going expenses from auction rate security (“ARS”) litigation, as well as poor performance and integration expenses from its 2008 acquisition of CIBC’s capital markets group have marred the underlying value of OPY. Both of these issues seem to be mostly resolved. 

They have settled a handful of individual lawsuits over the past 4 years related to client exposure to ARS, and I believe there are no major lawsuits remaining.  In 2008, clients held over $2.8 billion of ARS, and as of the last quarter this is now $195 million. The company is committed to purchasing another $34 million from their clients through 2016. Their 2008 acquisition of CIBC’s remaining capital markets business was incredibly poor timed.  Total expenses increased from $787 million in 2007 to $956 million in 2008 while revenues were basically flat at $920 million. The resulting retention payments, integration expenses, and massive decreases in revenues have pressured the company for the last few years. “Other” expenses increased from $70 million in 2007 to $112 million in 2011, before peaking in 2012 at $140 million due to a large ARS settlement. Other expenses are now on a $110 million annualized run-rate, and will improve as legal expenses continue to come down. The company moved offices in 2012 generating significant rent savings. While the capital markets business continues to be weak it is now slightly profitable before corporate and legal expenses.  

Potential Catalyst

Due to the current rate environment, OPY is highly leveraged to performance fees in its alternative vehicles. These performance fees are earned in the fourth quarter. OPY’s earnings in 4Q12 were impacted by two events: hurricane Sandy and an adverse legal ruling. Sandy shutdown their headquarters and forced employees to work from home or back-up locations for over one month.  Secondly, 4Q12 pre-tax earnings were further reduced from $23 million to $-7 million due to a $30 million ARS judgment.

2013 is set-up to be a monster year.  OPY’s AUM are up $1.6 billion in performance through September 30^th, and although it is not clear to what extent they take performance fees on all these funds, I think it is likely that there is material upside. In 2012, a year when the market was up about 10% performance fees were $11.1 million. In 2007, the company generated over $44 million in performance fees. Any remaining high-water marks have likely been met and I believe there is material upside as equity markets have marched higher since the end of Q3. 

For 4Q13, assuming a $7 million pre-tax operating income (after corporate & legal) across all divisions before any performance fees, which is similar to Q1-Q3, we would get to $27 million pre-tax operating income. I think $30 million in performance fees and total pre-tax operating income of $60 million is easily achievable. For the year OPY would reports EPS around $2.87 per share. This is ultimately a bit of a guessing game as OPY does not give too much detail on their alternative vehicles.

Valuation

Regardless to the extent of the near-term catalyst, OPY is cheap on a relative and absolute basis.

OPY is currently wiping over $7 million per quarter just in money market fees. This equates to over $2.05 per share of earnings. Overall, in 2007 with $68 billion in AUA the company had interest from margin, FDIC fees, and money fund products of $114 million, which was down to $35 million in 2012 on $80 billion in AUA. 

I think a very conservative estimate of normalized EPS would be $3.25:

$28 million in money market fees

+ $27 million operating income across all divisions before performance fees

+ $13 million average through the cycle performance fees

= $68 million pre-tax * .65 = $44.2 / 13.6

=$3.25

Performance fees:

2007: $44.8 million, 2008: $1.3 million, 2009: $10.5 million,  2010: $12.9 million 2011: $3.00 million, 2012:  $11.1 million   

Putting a below average multiple of 12x gets to $39.00 per share.

At 1.5x TBV $37.50

At a conservative 3.0% of AUM or 2x sales, OPY’s AM business would be worth $52.57

These valuations are designed to be very conservative. There is additional material upside from additional interest margin, higher performance fees as AUM have grown, and improvement from the investment bank.

Management

OPY is run and majority controlled by Alfred Lowenthal. He has a lot of owner-operator characteristics and a very solid long-term track record. He owns 23.5% of the company, and controls the firm through majority ownership of the class B shares, which have sole voting rights.

He has run the business since 1987 and has grown the firm from $13.75 in BVPS in 1998 to $41 (adjusted for dividends) today for a CAGR 7.56%. 

A few notes:

In 2011 the company expanded into providing a variety of services to developers of FHA approved commercial properties. This business is doing about $40 million in revenue and $10 million in operating income. 

I think a large reason why they have not bought back more stock is due to their ARS settlement in 2010. It would not look good to bargain down your purchase commitments and then aggressively buy-back stock. 

OPY has two significant outstanding lawsuits. One is against CIBC for $145 million and another against Deutsche Bank related to their 2012 ARS settlement. They believe DB is ultimately responsible for their 4Q12 ARS payment.

I have tried to contact the company and get answers to the amount they expect to fee on their performance, the composition of their client assets (% HNW, % institutional), normalized  “other expense” and other pertinent questions, but I have not been able to get in contact with anyone at the firm.

Catalyst