|Shares Out. (in M):||72||P/E||16.5x||14.5x|
|Market Cap (in $M):||2,600||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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We believe Stifel Financial Corp (SF) is an attractive short opportunity. Our thesis is fairly straightforward and has three basic highlights: 1) SF is investing heavily in capital markets businesses that are in secular decline 2) Earnings projections in 2013 and beyond are too high and are unlikely to be met due to our view that capital markets activity will not be as robust. 3) SF trades at a premium to its peers which we believe is unwarranted given nearly half of SF revenues are tied to capital markets cyclicality.
Background: Stifel, led by Ron Kruszewski, has transformed itself from a small regional brokerage firm with a sub $100mn market capitalization in 2002 to a $2.6B full-service retail and institutional brokerage and investment banking firm today. SF accomplished this massive growth through organic growth and by making over twenty acquisitions spending over $1.7B. In the last five years net revenues have grown from $870mn in 2008 to $1.6B and its balance sheet pro-forma including KBW is now $7.5B up from $0.4B ten years ago. While other competitors are shuttering and exiting a secularly declining commission driven business, SF continues to grow and acquire. Kruszewski’s goal is to become the dominant middle market brokerage firm. We believe he is rolling up capital markets businesses making “clubby” deals that will prove to be value destructive.
We believe Stifel has been overpaying for capital markets businesses in secular decline
We believe the most recent acquisition (and largest in Stifel history) of KBW was a reach and will prove to be value destructive for SF. Stifel paid $567mn in a cash and stock deal for KBW. The purchase price was roughly 1.5x tangible book and 13x consensus 2013 earnings. We note that KBW has not made money on an annual basis since 2010 losing more than $40mn in the last two years alone. Per our analysis, KBW has not earned more than $53mn in annual earnings (in 2006 the year they went public) in the last ten years. Roughly 80% of KBW revenues are driven off investment banking and commissions which have fallen for three consecutive years. For the year-ended 2012 KBW revenues came in at $246mn, down from $263mn in 2011 and $424mn in 2010. Investment banking revenues were $74mn in the first nine months of 2012, $99mn in 2011, and $209mn in 2010. Commission revenues were $75mn in the first nine months of 2012, $128mn in 2011 and $133mn in 2010. We note SF reported the total revenue for KBW in Q4 but not by line item, hence why we only show the first nine months.
See link: http://www.scribd.com/doc/131288356/Stifel-Financial-Write-up
Post the acquisition, SF will generate roughly 50% of its revenues from capital markets- investment banking and commissions. Anecdotally, we have engaged several SF current and former employees for color on the views of the firm and their recent acquisitions.
Feedback we received:
We also point to the sweetheart deal KBW management received which Tom Brown at Second Curve outlines well. See link:
In essence, the Board at KBW drove up the price of by an additional $20.8mn with the majority going to senior managers and employees in the form of a $17mn retention pool. Shareholders received a meager $3.8mn more. Further, key management personnel including KBW CEO Tom Michaud will continue to run KBW as a separate subsidiary.
For SF to realize value for the price they paid assumes that Stifel/KBW will have large revenue synergies and/or both the investment banking and institutional business environment picks up tremendously in financials. We are skeptical. Our view is that the days of big bank roll-ups are over. SF projects that they will be moving the best financials’ analysts to Stifel which will position them for the upturn in capital markets in the financial sector for years to come. Pre-Stifel, KBW investment banking franchise is not particularly stellar, in our view. For perspective, KBW does not even rank in the top 25 firms for all managed equity deals since 2010. Stifel ranks #8 in all managed equity deals since 2010.
Earnings in 2012 had a one-time benefit and projections in 2013 are too high and are unlikely to be met
Our view is that earnings expectations in 2013 and beyond are aggressive. In 2012 figures were benefited by a one-time gain from the Knight Capital Group preferred stock investment. As shown below Q3 and Q4 of 2012 SF had big jumps in its “other” revenue line driven off of a $39mn realized gain in Knight Capital Group which occurred in both Q3 and Q4. The success of Knight Capital Group’s preferred investment is unlikely to be repeated. SF breaks out their revenues into six buckets: commissions, principal transactions, asset management and service fees, interest, and other. Per the table below, the other income line jumped significantly in 2012 driven off the performance of Knight Capital Group preferred investments in the 2nd half of the year.
Table 2. see link: http://www.scribd.com/doc/131288356/Stifel-Financial-Write-up
Other Revs 2012 70,231
Knight Capital Gains 39,000
Other Revs ex Knight 31,231
2013E Other 78,000
Adjusted Ex-Knight 150%
Based on our analysis, the other revenue would have been $31mn excluding the Knight Capital gains. This compares to other income of around $20mn in both 2010 and 2011. Analysts currently forecast around 12% growth in the other revenue segment in 2013, which implies $78mn. However, from a pro-forma perspective of $31mn in other revenue last year excluding KBW gains, analyst projections imply a robust 150% growth – we view this level of growth as unlikely. If SF’s other revenue reverts to its historical levels of $20mn as in 2010 and 2011, it would imply 10c in earnings downside alone.
On page 144 of the SF 10K, pro forma SF/KBW figures are shown as follows:
(mns) 2010 2011 2012
Total Net Revenues $1,806.8 $1,680.1 $1,857.9
Net Income $25.5 $52.5 $112.5
EPS $0.43 $0.73 $1.56
Combined SF/KBW consensus estimates currently project net revenues of 1,954.9 in 2013 and $2,133.8 in 2014 and earnings per share of $2.50 in 2013 and $2.79 in 2014. Consensus earnings suggest that KBW will revert from its slide in revenues and losses and return to profitability. Additionally, $2.50 per share in EPS implies that pre-tax margins rise meaningfully to 15%, a level SF has never achieved. Pre-tax margins were break-even in 2010, 9.6% in 2011 and 13.7% (benefited by Knight gains) in 2012. To assume that SF will achieve peak margins in 2013 is a stretch in our view.
Street expectations for 2013
Net revenues 1,954
Pre-tax profits 293
Taxes at 39% 114
Net Income 179
Shs Outs 72
SF trades at a rich valuation which believe is unwarranted
SF trades at 1.9x TBV (1.3x stated book value). Given ROEs have been running under 10% for the past several years and due to the fact that 50% of their business is highly cyclical, we believe the multiple is too high. We think a more appropriate valuation would be closer to book value. In a scenario where SF maintains a historically high run-rate of 12-13% in pre-tax margins, EPS would range from $1.99 to $2.15. Based on these figures, SF stock, currenty at $36 per share, is trading at 17-18x 2013 earnings. We believe peer multiples of 13x more realistic 2013 earnings of $2.00-$2.15 would result in a $25-$28 share price.
Conclusion: SF is a compelling short. SF boasts about consolidating players to become the pre-eminent middle market firm in the brokerage industry; we believe they are making uneconomic deals to the benefit of sellers and the detriment of shareholders. Results are very correlated to capital markets activity and the KBW deal only increases earnings volatility. We are skeptical that the SF/KBW combination will deliver expected revenue synergies. We believe there is $10-$12 of downside to the stock from its current $36 level.
One final note: While not a core tenet of our SF short thesis, we are also very intrigued by the sensitivity of the business model to capital markets. If the market were to hit a rough patch, SF business will be hit very hard. With its current stretched valuation assuming a healthy trajectory in capital markets activity, we view the risk/reward very favorably in the event there is a dislocation in the credit or equity markets.
Risks to short:
* Historical financial data from SF financial filings, consensus numbers from Bloomberg
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