Description

I recommend to short Refco, even after the huge drop. Its businesses require that the customers trust them and feel confident in its financial situation. Right now nobody knows the real situation and the customers will withdraw and move their deposits to other companies and will stop operating with Refco. A big chunk of Refco´s revenues are spread earned on margin deposits and the related brokerage fees, and also will be affected its repo book.

BACKGROUND

Refco (headquartered in New York City) is a leading global provider of execution and clearing services in the derivatives, foreign exchange, and fixed income markets. Its two primary businesses are: Derivatives Brokerage and Prime Brokerage/Capital Markets.

The company went public on August 11, 2005 with an initial price of $22. The company sold 12.5 million shares and existing shareholders sold 14 million shares. Post-deal, the greenshoe option was exercised and an additional 3.975 million shares were sold.

Its Derivatives Brokerage division offers execution and clearing services for exchange-traded derivatives to its customers. Specifically, Refco’s customers (buy-side institutions, corporations and institutions, retail and professional traders) place buy and sell orders for exchange-traded derivatives through many ways (telephone, internet etc.).

In this business segment, Refco is the largest independent FCM and the fifth largest overall as measured by segregated customer balances. The company processed 654 million contracts in fiscal 2005 and houses $4.5 billion in customer deposits.

The second segment is prime brokerage services in the fixed income and foreign exchange markets; simply, the company facilitates customer access to interdealer broker markets that customers cannot directly access by themselves.

In fiscal 2005, Refco transacted $1.2 trillion in FX dollar volume and ranked as a top-four clearing firm within the U.S. Treasury repurchase market.

In fiscal 2005, Refco generated net revenues of $1.4 billion; derivatives brokerage represented 70% of total revenues while prime brokerage/capital markets contributed the remaining 30%.

The institutional investors plus professional traders generates almost 70% of the total revenues, so the risk of reducing future revenues are very high.

Since 1999 Refco has done 16 acquisitions, and most of them in derivatives brokerage business segment, therefore in its books there are lots of goodwill. The firm has few hard assets, so its cash flow from daily operations is key.

Refco currently has roughly $1 billion in debt outstanding (60% debt-to-cap ratio). The company’s outstanding debt is floating rate. As such, we expect corporate interest expense to be adversely affected by rising interest rates. Besides that, the company has violated its covenants and will be difficult to raise additional debt or refinance them.

The two biggest shareholders are the former CEO – Mr. Bennett , who owns 43.4 million shares (33.8% of the total) and funds controlled by Thomas H. Lee Company own 48.7 million shares, or 38.2% of total shares. The public float is 30.5 million shares. Moreover, of the eight board members, four are from Thomas H. Lee Company.

OTHER PROBLEMS

- SEC : The company received a Wells notice in May 2005 on an SEC investigation dating back to 2002 on the short sale of stock in Sedona Corporation. Although no formalized agreement has been entered into, Refco management expects to reach an agreement, in the near future, with the SEC. In anticipation of this, Refco reserved $5 million in 4Q05, which the company presumes will be enough to cover the amount of the settlement.

- Internal Controls: The Refco’s auditors, Grant Thornton, have notified management that they found deficiencies involving internal controls over financial reporting. The auditors had two basic problems with company’s accounting – 1) there was no formalized process for closing the books, and 2) a lack of resources in Refco’s accounting and financial reporting staff. The company is taking measures for eliminating these problems, however this compounds the problem of financial statements credibility.

THE CRISIS

On October 10th - 2005, the company released the following:

“Refco Inc. (NYSE: RFX) today announced that it had discovered through an internal review a receivable owed to the Company by an entity controlled by Phillip R. Bennett, Chief Executive Officer and Chairman of the Board of Directors, in the amount of approximately $430 million. Mr. Bennett today repaid the receivable in cash, including all accrued interest. Based on the results of the review to date, the Company believes that the receivable was the result of the assumption by an entity controlled by Mr. Bennett of certain historical obligations owed by unrelated third parties to the Company, which may have been uncollectible. The Company believes that all customer funds on deposit are unaffected by these activities. “

“This receivable from the entity controlled by Mr. Bennett was reflected on the Company’s prior period financials, as well as on the Company’s May 31, 2005 balance sheet. The receivable was not shown as a related party transaction in any such financials. For that reason, and after consultation by the Audit Committee with the Company’s independent accountants, the Company determined, on October 9, 2005, that its financial statements, as of, and for the periods ended, February 28, 2002, February 28, 2003, February 28, 2004, February 28, 2005, and May 31, 2005, taken as a whole, for each of Refco Inc., Refco Group Ltd., LLC and Refco Finance, Inc. should no longer be relied upon.”

The weird thing in this case is that only after the fact that Mr. Bennett paid its debt with Refco. Why not before the IPO?

The Bennett’s debt of $ 430 million represents approximately 88% of stockholder´s equity, and the financials (May 31, 2005) shows only a provision of $ 62 million for unpaid receivables.

VALUATION

This is dificult due to the fact that the financial statements are not reliable, therefore book value is misleading. The company has a book value of $ 515 million at end of May-2005 and yesterday the market cap was $ 1,383.38 million and the number of shares is 127,500 thousand.

The only way to get a guess estimate is using a Price to Sales multiple ( supposing that the historical sales figure is correct) and assuming that Refco will trade at a discount to the regional brokerage houses and this means around 1x sales. For the fiscal year of 2005, Refco had sales of $ 1,368 million, and assuming a drop of 40% , we will get sales of $ 821 million and a price per share of $ 6.44 . If we use the low end Price to Sales multiple of the comparable transaction we will get a price of $ 7.10.

COMPARABLE TRANSACTION: Refco acquired CIS – Cargill Investor Service (closed September 1st, 2005) and agreed to pay $208 million in cash upfront and $67- 192 million in additional earn-outs, dependant on EBITDA contributions. The total purchase price falls in a range of $275-400 million. Refco estimates that CIS would have generated roughly $250 in net revenues in fiscal 2005. Based on the low end figure, we will get a Price to Sales multiple of 1.1x.


RISK TO THE SHORT:

Someone with credibility makes an offer for Refco, but this is a low probability event due to uncertainties surrounding the company.

Catalyst

- Situation deteriorates further due the lack of trust and confidence;
- Dificult to refinance its debt because there is no reliable financial statements to evaluate its situation and the company has few hard assets;
- The review of past financial statements takes longer than expected;
- Potential new accounting irregularities which is very likely due to the fact that the company has done 16 acquisitions since 1999.