Description

eSpeed, Inc. (ESPD); $7.75 - A patent-rich, cash-heavy, fixed-income electronic platform provider operating in a growing and duopolistic market trades at a compelling valuation.

eSpeed, Inc. (NASD:ESPD) is a leading provider of fixed income trading platforms and operates primarily in the US Treasury market. The trading of US Treasury bonds is primarily (90%) electronic and there are only two key players that control the market – eSpeed and BrokerTec (BT). The benchmark Treasury market is mostly (at least 90%) electronic whereas the off-the run market and futures trading is still accomplished through voice brokers. eSpeed used to be a part of Cantor Fitzgerald, the leader in fixed income trading for more than a decade prior to the 9-11 tragedy. Known as an innovator and a technology leader, ESPD has operated in a duopoly with BrokerTec. The market has high barriers to entry and these two players have a lock on the market.

ESPD suffered a steep decline in it stock price last year when BrokerTec took away a decent chunk of its market share due to some, I believe, temporary dislocations in the market (discussed in detail later). ESPD has come back hard and should now start to gain back its market share. There are some strong secular trends that are very supportive of ESPD’s volume growth in the next several years. Trading volumes in the business should grow substantially because:
a) The fixed income market is only 30-35% electronic and certain third-party research firms believe that this penetration of electronic platforms should rise to at least 70% by 2007-2008.
b) As electronic automation rises in the Treasury and the fixed income market, computer-to-computer trading should take off just as program trading took off in the equities market.
c) Ongoing treasury-deficit financing alone should keep Treasury volumes growing at least 8-10% per year. Even if you believe that the U.S. is moving from a deficit to a surplus, the overall Treasury debt outstanding has an average duration of 5 years implying that at least 20% of the existing debt would have to be refinanced every year.

eSpeed owns significant patents and trademarks in the entire fixed-income arena, the value of which alone could equal a substantial portion of the current enterprise value of the company. eSpeed has only monetized a fraction of these patents so far and should look to obtain license fees from additional patents this year.

Growth from new products could be substantial. One advantage of being a technology leader and an innovator, ESPD can create new trading platforms with relative ease. They have a new trading platform for spot forex trading which targets a market that is four times the Treasury market and is a natural extension for ESPD leadership in the Treasury market. The forex market is similar to the Treasury market in many ways - it is a very liquid market, it is a hedging market and over the last several years, forex and Tsy traders have started to consolidate onto common trading desks. Since ESPD already has a substantial footprint at major Wall Street firms, it was natural for them to target the forex market. The forex market has two major entrenched players that have name-give up systems, in other words, trading systems that are single-buyer, single-seller systems that allow trading to occur only when the trader’s identity is revealed. ESPD’s system is very different from the current systems that trade spot forex in the capital markets. ESPD’s new system has the tightest markets on them, allows anonymous trading matching multiple buyers and multiple sellers simultaneously. This system is gaining ground and has Citibank as the credit counterparty. This system could, in a few years, rise to the top position in the forex market and represents an eventual $400M revenue opportunity.

Trading at around $7.75 per share, ESPD has $3.75 per share in cash, no debt and should do at least $0.30 in core-business FCFs and at least $0.20-$0.25 in overall FCF this year. So a technology and market leader, that owns substantial patents and trademarks; is the superior player in a duopoly with high barriers to entry; operating in a market that could double in volumes over the next two to three years, trades at 12x core FCF. With significant upside potential to overly conservative and flushed-down estimates on the Street, one could be buying this business at 8-9x its annual FCF. In the last six months, ESPD has also had a $100M share buyback in place and has bought $40M of its stock under the share buyback plan.

Another misunderstanding has contributed to the negative sentiment in the name. ESPD’s operating expenses have gone up significantly in the last year reflecting their decision to capitalize further on the enormous forex opportunity by spending on additional salespeople, technology and R&D. So while the core business continues to be significantly profitable, overall earnings have suffered due to ESPD’s emphasis on long-term performance and opportunities.

Financial Snapshot (All Figures are in $M)

Share Price 7.75 Net Inc. ('05) 10.1
52Wk Hi-Lo 19.5/7.75 Net Inc. ('06) 21.9
Market Cap 401 FCF ('05) 13.8
Net Cash 200 FCF ('06) 23
EV 201 EV/FCF ('05) 14.6 x
Book Value 270 EV/FCF ('06) 8.7 x
Rev ('05) 155
Rev ('06) 175



Why has the stock gone down from $28 a year ago to its current $7.75 level? Miscellaneous Concerns?

Rising Rates to Affect Treasury Volumes?

It all started earlier in 2004, when prospects of rising interest rates spooked investors. Investors fear that with rising rates U.S. Tsy trading volumes would go down. Investors fear that rising rates would prompt investors to take their carry trades off and wouldn’t have “anything else” to put on. I have found that Treasury trading volumes depend more on the level of interest rate volatility than on the direction of interest rates itself. Yes, we all would agree that interest rates are going up in the near future but there is a wide difference of opinion on whether rates would go up 25bp, 25bp and 25bp or 25bp, none and 25bp or perhaps even none, none and 50bp in the next three Fed meetings. This difference in opinion creates the volatility in the market and hence my case for a lack of volatility rather than rising rates that could bring Tsy volumes down – as long as there is interest rate volatility, markets would continue to trade Treasuries.

Loss of Market Share in 2004

The second and more severe leg down in the stock price came when ESPD preannounced their Q2-04 earnings and warned of market-share losses, slowing summer volumes and a delay in the traction of new product launches. ESPD’s market share of the overall Treasury market used to be 28-29% in late 2003 and over the summer of 2004 it had fallen closer to 24-25% while the market share of BrokerTec (ESPD’s only other electronic trading competitor) had risen from 22% to about 26% during the same period (remember ESPD and BrokerTec have a duopoly on the electronic piece while the other 46-48% of the overall Treasury market is the voice market). Most (90%) of the benchmark Treasury trading is electronic but other off-the-run sections, when-issueds and interest-rate futures are still voice-driven. Also, dealers often like to get their complicated trades done with the help of a voice broker who may then direct the trade through the eSpeed system and pay eSpeed a fee for the transaction.

BrokerTec’s Earnout Issue

I believe BrokerTec started to gain market share due to an earnout-related issue coupled with a concurrent price cut and a new product from eSpeed that was not being received well by traders. BrokerTec used to be owned by a group of 14 investment banks that sold BrokerTec to a U.K. based broker, ICAP. The banks got a volume-related earnout as part of the purchase price and the earnout was to be decided at the first anniversary of the sale of BrokerTec in May 2004. My checks on the Street indicate that as the earnout anniversary rolled around in May 2004, the owner banks started pushing more volume down the BrokerTec platform and also, in the process, hit their maximum caps that they had in their sale agreements (banks had to do a minimum amount of volume each year and an upper cap over which they would literally trade for free). The earnout volume pushed trading over the maximum cap after which traders sent more volume to BT since it incrementally cost them nothing to do so. Right around that time, BT had given their clients a price cut. So eSpeed lost some market share but woke up and started to make their pricing more competitive. They had a fixed plus variable pricing structure before and they started to change to a bigger portion of fixed and a lower portion of variable. They gave up some of their upside but also firmed up the downside and made their pricing more competitive. ESPD also went back and started to hire more voice brokers because they had lost all their US voice brokers in the WTC 9-11 tragedy and had not hired any new ones in the U.S. betting that the switch from voice to electronic would happen relatively quickly. One reason, I believe, BrokerTec gained market share was that its sale to ICAP gave it additional business from ICAP’s many U.S.-based voice brokers. ESPD then also learnt that traders overwhelmingly disliked its Price Improvement (or P-I) product. Traders saw its benefits but perceived its costs to be significantly more than its benefits. So, despite believing that reality was quite different, ESPD came back and nixed P-I all together.

Cantor Adds More Voice Brokers

ESPD also made a firm commitment to grow the voice-side of the business like they had never done before. Cantor (its parent) spun off BGC Partners and announced plans to hire 100 new voice brokers. They subsequently upped that objective by announcing that they would look to hire as many as 500 voice brokers around the world. BGC recently announced the acquisition of Maxcor Financial Group (MAXF) for around $100M in cash. In return, BGC gets close to 400 brokers and assistance squads and gets to grow their both their voice business and ESPD’s electronic business. I believe this piece of Cantor’s business could provide huge upside to eSpeed’s business. When dealers/clients trade with voice brokers because they want a warm voice to help them with their trade, more often than not, the voice brokers get the trade executed over espeed’s electronic platform. So business that eSpeed used to lose to other voice brokers, it now gets a part of from Cantor’s new business.

Cantor used to apparently have a $1B plus voice business before 9-11 that they almost entirely lost out on. Cantor now plans to bring its level of business back to pre 9-11 levels. eSpeed gets 4% of any voice-assisted electronic transactions but also a significantly higher portion (close to 40%) of any new voice business that Cantor executes on its electronic platform. All this at just the cost of installing its systems for the new voice brokers.

Patent-Infringement Case against BrokerTec

The stock had just begun to climb back when ESPD announced the nixing of Price Improvement (that would cost it 5-10% in annual revenues) and also lost the 580 patent court case against BrokerTec at the District Court level. ESPD had sued BT alleging that they had copied ESPD’s entire electronic platform, the keyboard and that the court should slap an injunction against BT. BT countersued that ESPD’s patent was not valid since it was being commercially used by Cantor prior to it being granted patent status. The jury found that Garban GTN and BrokerTec USA did infringe ESPD’s 580 Patent but that there was a deficiency in the application which led to the 580 Patent, finding that ESPD “failed to provide adequate written description of each and every element recited” in certain claims of the 580 Patent. ESPD lost the case at the district level based on the way its patent had been constructed. The market viewed this as incrementally negative for ESPD. I do not think this was that material an outcome. I believe that this case could only have upside for ESPD. ESPD is most likely going to appeal the jury verdict. Approximately 80% of the cases at the district level are appealed and decisions on 50% of these cases are reversed. If ESPD ultimately wins the infringement case, they could extract a huge settlement out of BT. It is unlikely though, that the courts would allow an injunction against BT since this would disrupt the market in a significant way and hand over to ESPD considerable power in the current duopolistic environment. If ESPD ultimately is not able to prove its case and gets its patent ruled invalid, the industry would still continue to exhibit high barriers to entry. There would likely still be only two players in a growing market.

Conservative FY05 Earnings Guidance

ESPD guided FY05 conservatively at its recent earnings call. They guided to a minimum of $155M in revenues with operating expenses in the $34.5-35M range per quarter. This approximately equates to an FY05 EPS of $0.18-0.20, down significantly from $0.54 in FY04. Though ESPD has suffered price declines of up to 30-35% from FY04 levels in their recent negotiation of service contracts with key dealers, the level of annual revenues, I believe, should still be at least $155M this year. Bear in mind, this does not include any market share gains by ESPD this year nor does it include any overall U.S. Tsy market volume gains. And nor does it include any gain from the substantial increase in the voice business that ESPD would definitely benefit from. On the expenses front, while the overall level of expenses has gone up significantly the increase has not been unintended. The company indicates that they can still continue to generate a core level of $155M in revenues with a quarterly expense rate of $26-27M per quarter. The balance of $7M in operating expenses is all being spent on technology, R&D and on new salespeople to drive the forex platform. It is one thing to “have to” spend more to keep a core level of revenues at a certain level but it is quite another to increase expenses intentionally, on top of a profitable core business, to drive significant growth in new and promising areas. I believe that ESPD’s core business of US Treasuries in its existing form (even after the 20% or so price cuts) generates $0.30 in EPS and $0.30-0.35 in free cash flows.

The market reacted negatively to ESPD’s “lowered guidance” but perhaps didn’t notice that any increase in the top-line would fall almost directly down to the bottom-line. The incremental operating margins in this business would probably allow an additional $10M in revenues to provide $0.09 in incremental EPS. The $0.20 EPS number for FY05 could then end up being higher but more importantly, FY06 EPS could easily be north of $0.40. The current 15x EV/E multiple that seems rich right now could end up being much lower. The abovementioned acquisition of Maxcor could be one of the ways the revenues could increase. Cantors’ acquisition of Maxcor would give it at least 400 new voice brokers that with BGC’s current sub-100 number could provide a sizable boast to voice-assisted transactions that BGC provides to ESPD. When clients call BGC’s voice brokers, some of the resulting voice-assisted trades then are directed to ESPD’s electronic platform. Over 400 new voice brokers could add significantly to ESPD’s top-line, a possibility that is currently not reflected in any of the Street’s conservative numbers.

The Foreign Exchange Opportunity

Foreign exchange is a large opportunity for eSpeed. The forex interbank market has many players in it but has only two that are entrenched. Reuters and EBS are the two most important players in the market that is 3-4 times the size of the overall Treasury market. This is a natural extension for ESPD since both the Tsy and the forex market are hedging markets, are very liquid and are increasingly being traded by common traders. eSpeed is the only large-scale, liquid and anonymous trading platform while both Reuters and EBS have systems that trade on a name-giveup basis. eSpeed’s forex trading platform is gaining ground among traders and revenues from this system grew sequentially for each quarter except the last where it declined 12%. While this growth is lumpy on a small base, the potential of the forex platform, I believe, is enormous. Systems that allow anonymity in a liquid fashion could allow for a structural change in the industry dynamics. Earlier, hedge funds that wanted to trade forex had to go to bigwigs like Citigroup to get trades done on a name giveup basis (having to give up their identity). Hedge funds were also most likely to get their trades done only on the “outside of the market” either at bid or at ask but not any better. With systems allowing increased liquidity and anonymity, hedge funds and CTAs can now trade differently, more efficiently and more profitably. While ESPD expects increases in its forex revenues, it also expects to plough the revenues all back into hiring more sales people and refining the system. Forex contribution to EPS will likely be minimal in FY05 but FY06 could see it generate $0.05 -$0.10 in EPS from forex alone.

Patent-Rich Portfolio

ESPD’s has a strong portfolio of patents that it could continue to monetize. It has a history being successful in defending its patents in the past. Howard Lutnick has pursued a keen strategy of ploughing technology dollars back into eSpeed’s R&D, technology and infrastructure to make them world-class. It reportedly has spent over $450M on its technology and infrastructure in the past 5 or more years. As a result, its technology and systems are fastest in execution and boast 99% redundancies with 15% capacity utilization rates. Management has consistently built or acquired a patent portfolio in diverse areas of the fixed income arena. The value of the patent portfolio, I believe is not at all reflected in its market cap. ESPD has successfully monetized the Wagner patent in deriving multi-million dollar license payments from CME, CBOT and MYMEX. It could also soon monetize the Lawrence Patent that it owns that it would license to providers of technology systems in the municipal securities.

Howard’s Reputation/Lack of transparency/Contentious Nature of the Bond business

Howard Rudnick, speed’s Founder, Chairman & CEO, is consistently regarded as a brilliant businessman. One of the key reasons for his, Cantor’s and eSpeed’s tremendous success in the last decade could be attributed to his business acumen, his tenacity and his ability to see the “right” evolutionary path of the business very clearly. Howard is frequently mentioned as a “brilliant businessman” who was able to revive Cantor and eSpeed out of near extinction post the 9-11 attacks on their world HQ in the World Trade Center. He is also consistently regarded as “arrogant” and “litigious”. This pervasive negative take on Howard continues to rear its ugly head every time a seemingly negative headline hits the tape. Investors complain about a general lack of corporate-executive access at the company which compounds the fact that a clear understanding of the “real” opportunity and story at eSpeed is rare on Wall Street.

Having spent some one-on-one time with Howard and other senior executives at eSpeed, I have come to the conclusion that while the level of transparency may not be very good at eSpeed and its executives may not be fully and readily accessible, the management team is very capable of executing on its plan. From my several due diligence checks with market leaders and investors, I have concluded that negative aspects of Howard’s reputation are perhaps somewhat overstated and unfair. I have found his and Cantor’s gestures of help and support for the 9-11 victims’ families to be extraordinarily generous.

Possible Acquisition of MTS, Europe’s leading bond-trading platform

eSpeed is currently in negotiations to buy 51% of MTS, the leading European bond-trading platform, similar in size to ESPD. ESPD has an offer out for $150M for 51% of the business. If this goes through, it would make ESPD a very strong platform that offers access to global bonds in both cash and futures and also offers forex trading making it the only comprehensive bond-trading platform in the world. The implications of this could be enormously positive for ESPD. I believe management of ESPD is quite price-conscious to not overpay for MTS. There is a competing bid out there so ESPD may not end up getting MTS. We will wait to see how this develops but don’t foresee much downside and huge upside from this transaction.

Conclusion

In conclusion, eSpeed is the stronger one of two players in the US Treasury market – a market that is poised to grow healthily. Its patent-rich portfolio, highly profitable and cash-flow generating business model; and its foray into the forex, derivatives and equities market should be viewed as cheap call options. The core Treasury business is likely to grow substantially as the fixed-income markets get more electronic and execution becomes very fast. That is likely to boast program or computer-to-computer trading in the same way as faster execution brought-on the advent of program trading in the equities market. A leading player such as eSpeed is then likely to benefit significantly from this increase in overall volumes. While commission rates are likely to decline over time, the expectations of their decline are overdone in the market. Increasing volumes and high incremental operating margins should more than offset the contained decline in commission costs. With extremely conservative estimates on the street, negative analyst opinion; a likely bottom in eSpeed’s market share; and net cash of $3.7 per share (on stock price of $7.75 per share) the stock provides a compelling risk-reward ratio in the near and the long term.

Catalyst

Catalysts

eSpeed’s stock has been quite beaten down on headlines related to the patent-infringement case, conservative guidance for FY05 and overall skepticism surrounding market share gains and the general robustness of the company’s business model. I believe several events, news or release of earnings could drive the stock up in the next six months and beyond. First, U.S. Treasury volumes have been rising at rates faster than the Street or even the company had expected to happen. Second, conversations with eSpeed’s leading customers and statements by ICAP (eSpeed’s competitor) would indicate that eSpeed’s market share has bottomed here. Third, recent news of aggressive voice-broker acquisitions by Cantor (eSpeed’s parent) could significant new business to eSpeed at high incremental operating margins. Fourth, as the forex platform gains acceptance, announcements regarding new players providing liquidity on the system would be taken positively. Mentions and release of earnings results indicating any or all of the above over the next few quarters are highly likely to make investors aware of eSpeed’s high operating leverage and of its discount valuation. As the Street realizes this is a high-growth company with rich patents, market leadership, strong balance sheet and very good profitability they are likely to bid the shares up. eSpeed could realize a $0.60-0.80 in EPS in a year or two – recognition of that possibility could drive the price up to the high teens over the next twelve months. Continued and significant share buyback by the company would add to the momentum.