GFIG

[nicknite20]

Hi all,

This is a niche provider / broker of OTC derivatives which is a sector showing phenomenal growth especially in times of increased volatility.

I think the long term prospects of this co. are very attractive. Furthermore, I feel this stock is undervalued given the 30-40% growth YoY. Trading at around 20 times FY 08 earnings.

While this stock may not double overnight, but 20-30% appreciation over a 12mth timeframe is very realistic.

Comments welcome..thanks & good luck.
Nick

[David Randolph]

Hi all,

This is a niche provider / broker of OTC derivatives which is a sector showing phenomenal growth especially in times of increased volatility.

I think the long term prospects of this co. are very attractive. Furthermore, I feel this stock is undervalued given the 30-40% growth YoY. Trading at around 20 times FY 08 earnings.

While this stock may not double overnight, but 20-30% appreciation over a 12mth timeframe is very realistic.

Comments welcome..thanks & good luck.
Nick

Hi Nick, I just came across GFIG, I hope you're not holding it anymore, since it fell 23.8% on Friday:



I wonder what happened in points 1 and 2, let me see:

1 - GFI Group shares slump 37%
at MarketWatch (Mon, Mar 17)

2 -  GFI Group Inc. Confirms Resignation of Head of North American Credit Brokerage and Estimates First Quarter 2008 Revenue Growth and Earnings Per Share
PR Newswire (Fri, Apr 18)

Goldman Sachs downgraded GFIG to Neutral, on a 12 pages report:



What happened
We have removed GFIG from the Americas Buy List, lowered our rating to Neutral and adjusted our 12-month, P/E-derived price target to $15 ($20.5). These changes follow the company's disclosure that its head of North America Credit, Donald Fewer, resigned from the firm, and roughly 25 brokers may be in the process of following him to one of GFIG's competitors. Since we added GFIG to the America's Buy List on January 17, GFIG shares have declined 35% compared to a 4% rise in the S&P 500. Over the past 12 months, GFIG has declined 32% vs. a 6% decline in the S&P 500.

Current view
The longer-term impact of this announcement will take a few quarters to become evident. Specifically, revenues, pre-tax margin, and industry competition may all materially change from this process. GFIG indicated the departing brokers account for approximately $50 mn of 2007 revenues – 16% of credit revenues and 5% of total revenues.

This announcement further highlights a number of issues in the interdealer brokerage industry that may become more apparent in valuation. First and foremost, the level of competition between inter-dealer brokers is both a threat and an opportunity that is unlikely to dissipate. We lower our 2008 and 2009 credit revenue estimates by 12% and 19%, respectively.

Further, the level of competition may keep the compensation rate higher than our previous estimate. In addition, as investment banks grapple with lower top-line revenue growth, we would not be surprised if industry pricing comes under pressure. We increase our comp ratio estimates and lower our pre-tax margin assumptions.

While valuation appears compelling at these levels, the lack of a near-term catalyst and concern GFIG may be unable to replicate its solid growth of the past few years drives our move to a Neutral rating. Risk to our view is GFIG's ability to retain or attract more brokers than we anticipate.

Lacking a near-term catalyst, we downgrade to Neutral

We have lowered our rating for GFIG to Neutral. Though the inter-dealer brokerage (IDB) sector may benefit over the next few quarters from elevated volatility relative to prior periods, our positive thesis based on robust revenue growth has come under pressure amid the loss of a significant number of credit brokers in the U.S.. Further, volumes on many of the regulated exchanges have decelerated over the past few weeks as volatility has declined across many asset classes following the Fed's initiatives to inject liquidity into the financial system. Lacking a near-term catalyst to move the shares higher, we felt it prudent to lower our rating until the impact from the potential broker defections can more accurately be quantified and GFIG has an opportunity to proactively address the situation.

The longer-term impact of this announcement will take a few quarters to become evident. Specifically, revenues, pre-tax margin, and competition may all materially change. GFIG
indicated the departing brokers account for approximately $50 mn of 2007 revenues – 16% of credit revenues and 5% of total revenues. There are a few likely outcomes:

(1) GFIG is able to retain some of the 25 or so departing brokers. These brokers would likely be paid material retention bonuses and lower margin. Revenue loss may be less than we are now currently estimating.
(2) All 25 brokers or more depart. An 18%-19% decline in 2009-10 credit revenues from our prior estimates negatively impacts EPS by 10%-12%. Pre-tax margins decline 140 bp as we estimate credit is one of the higher margin products.
(3) GFIG and other IDB's more aggressively compete for brokers to offset losses as well as a potentially lower industry growth rate. This will lead to pre-tax margin compression and higher compensation both in the U.S. and internationally.

All three of the above scenarios would cause us to lower estimates to some extent, though
we note we do not model any unforeseen acquisitions or new broker headcount.

GFIG also announced that its 1Q2008 results would be healthy. 1Q2008 brokerage revenues were estimated to be up 25%-30% by CEO Mickey Gooch on the fourth quarter conference call, and that figure was reiterated along with a minimum 1Q2008 EPS of $0.28. We currently estimate $0.29 in earnings compared with the consensus of $0.28.

More important than earnings, on May 1st (May 2nd conference call) will be management commentary regarding the actual level of broker defections and early 2Q2008 growth trends. We would not be surprised if management bypasses its traditional revenue guidance until the situation with its brokerage force is finalized, though the market may interpret any lack of guidance as a negative data point.

Departure of Credit Head sparks likely loss of valuable credit teams

GFIG's former head of North America Credit Product Brokerage, Donald Fewer, resigned last Monday and has moved to a competitor, which we believe to be Compagnie Financiere Tradition ("Tradition"). On its own merit, this move would have been viewed as an incremental negative as Mr. Fewer was well regarded within GFIG and helped build the firm's credit business into the industry-leading credit default swap ('CDS') trading franchise. However, the more substantial issue surrounding Friday's announcement was the affiliated departure of roughly two dozen brokers from GFIG's North America Credit team, which together accounted for roughly $50 mn in revenues.

In 2007, GFIG reported credit revenues of $318 mn, roughly 33% of total revenues. The $50 mn potential loss of revenues from these broker departures represents 16% of credit revenues and 5% of broader GFIG revenues. While GFIG does not break out the percentage of its 1,037 brokers that are based in North America, 43% of 2007 revenues were based in North America.

If we assume that a similar ratio of revenue exists across most product lines, then $136 mn of credit revenues in 2007 were generated in North America. However, we believe revenues may be closer to $150 mn (47% of global credit revenues) given the equity franchise appears to have a stronger European base as it has grown from the acquisition of a Paris-based equity derivatives team from Refco. Using this estimate, the 'at risk' revenues of $50 mn represent roughly 33% of North America credit revenues.

We also estimate that credit brokers have been more productive than brokers in other areas, and estimate the number of brokers that generate the 33% of firm revenues to be less than 33% of brokers, probably 25%-28% of total brokerage headcount of 1,037, or roughly 260-290 global brokers. We estimate 120-135 brokers are U.S.-based (utilizing our estimate of 47% of revenue is U.S. based), and this would imply that 18%-20% of credit brokers may be considering a move to the competitor firm.

We estimate credit revenues accounted for roughly 35% of 2007 EPS given a higher yield per broker. We are lowering our 2009 credit revenue estimate by 19% to $310 mn, generally in line with 2007 and down from our prior $380 mn estimate.

We have lowered our 2008-10E EPS to $0.96/1.10/1.30, from $1.05/1.25/1.46, to account for
today's news as well as modestly lowering our assumptions regarding the growth and
profitability of industry-wide credit derivatives activity.

The most significant changes to our model are in credit brokerage, compensation, and travel and promotion. We believe credit revenues will be down 18%-20% on a combination of lost brokers, increased industry competition, and potentially decelerating industry trends. Nominal compensation costs decline with lower revenues, though we expect it may increase as a percentage of revenues as GFIG may compensate some of its remaining brokers with retention bonuses or a higher revenue pay-out. We now estimate overall pretax margins to remain in the 17%-18% range near term.

Volumes may decelerate and industry dynamics could be changing

Over the past three weeks, CME Group volumes have decelerated from extremely robust early year levels, specifically in interest rate and equity products. We have traditionally viewed interest rate volumes as a good proxy for OTC credit trends and equity volumes as a good proxy for OTC equity growth. Similarly, we view commodity and foreign exchange contracts as good proxies for OTC commodity and financial growth, respectively. With lower early quarter volumes, near-term growth could be somewhat constrained. While less than one month of data is not enough for us to make any material thesis change or adjustments to our 2Q2008 and full-year estimates, we note the decline in market volatility may create a negative headwind for 2Q2008 revenue growth. Management is likely to address early quarter trends on its conference call next week.

In addition, there continues to be discussion regarding a cleared solution for CDS products,
potentially as early as this summer. One of the key issues for CDS has been the lack of pricing transparency and significant counter-party credit risk that exists (though we note GFIG does not hold customer accounts or have material counter-party credit risk as part of its business strategy). Should the investment banks organize a cleared solution for CDS, we believe overall industry volume growth should remain healthy; though any change to the trading environment, which today is dominated by the inter-dealer brokers, could pose a challenge to IDB credit revenue growth.

Is a wave of potential consolidation on the horizon?

There are six major inter-dealer brokers and dozens of smaller niche players. One of GFIG's growth drivers over the past few years, outside of the secular growth of OTC derivatives, has been its ability to either acquire competing firms or teams of experienced brokers from other firms. Certainly, other firms have employed this same strategy and this level of competition has kept pre-tax margins relatively low and the compensation rate high. Creditex is the only significant private player among the major inter-dealer brokers, and is focused exclusively on the credit sector and trades almost all electronically.

While today's news is among the most significant examples of brokers defecting from one firm to another, we believe the number of inter-dealer brokers may encourage this type of
"poaching" and irrational behavior (i.e., raising overall industry compensation levels and lowering margins). It could make sense if one or two of the inter-dealer brokers merge or acquire one another. Speculation has been high in the past that a few IDB's have been close to a merger in the past, or potentially even been acquisition targets of public exchanges. However, acquisition by an exchange seems unlikely given the lower margins and people-intensive business. As competition continues to pressure compensation and pre-tax margins at IDBs however, expense synergies and a higher revenue base to offset non-compensation expenses could be a solution. Further, as investment banks face pressure to lower costs as revenues decline, they may pressure the inter-dealer brokers to lower fees (usually on a fee per million basis), which could further reduce margin.



GFIG has grown through broker headcount increases, acquisitions

Brokers moving between firms is not without precedent, and GFIG has benefited over the past few years at least as much as it has lost. Recall, GFIG acquired a 30 person equity derivatives team in Paris following Refco's bankruptcy, and has been involved in a number of other broker acquisitions and losses. A major part of GFIG's growth strategy has been to attract best in class brokers to its platform and pay near the top of the market. Although lowering the compensation rate has been a strategic goal of the firm over the past few years, it has been unable to meet this goal given industry pressure on compensation.

While shifting more volumes to an electronic platform could increase profit per transaction
as well as lower its reliance on any one brokerage team, those benefits have yet to materially play out in the U.S., though they are more advanced in Europe. GFIG has been
active on the acquisition front, acquiring Amerex Energy, Starsupply Petroleum, and Trayport over the past three years, and we expect it will continue to be acquisitive to build out other product lines. Any meaningful acquisition could help GFIG grow out of this loss of headcount. Over the past few years, most of GFIG's acquisitions have been in the commodity sector, though we would not be surprised to see GFIG pursue selective acquisitions in equity brokerage and data as well. As of the end of 2007, GFIG had $240 mn in cash on its balance sheet.

Valuation seems compelling, but larger questions linger

GFIG has traded at an average forward multiple of 20x and currently trades at 12x our new
2008 estimate. Over the past few weeks, investors concern over the trajectory of CDS volumes and potential impact of a cleared solution on GFIG's business have lowered the firm's multiple, and GFIG has settled in at about 14x forward earnings. Our new $15 price target assumes the stock trades at 14x our new 2009 estimate of $1.10 in twelve months.

Risks to our rating include a higher than expected retention of brokers, the ability to attract
a material number of brokers to replace departing staff, or significant M&A activity.
Downside risks include lower pre-tax margins, industry pricing pressure, lower industry volumes, or anything that changes the state of industry trading activity to GFIG's detriment.