|Shares Out. (in M):||78||P/E||20.0x||48.0x|
|Market Cap (in $M):||1,209||P/FCF||20.0x||48.0x|
|Net Debt (in $M):||-219||EBIT||92||52|
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1) Low Value/High Risk Business Model
- High attrition rates
Public disclosures show that 75% of clients lose money every quarter (the National Futures Association started requiring these disclosures several years ago). This is not an investment business, its gambling disguised as ‘investing’ except the odds of winning are much worse than most standard casino games.
This high failure rate of 75% per quarter, statistically implyies that only 0.4% of accounts will make money on an annual basis and means that account attrition is very high. FXCM won’t disclose their actual account attrition, but I recently met with Plus500, a similar company listed in the UK and they said their average account life is 18 months. Gain Capital reported numbers when they first went public showing investors lost their full investment in less than 12-months. Ignoring the ethical challenges of selling a product with a 99.6% failure rate, from a business model perspective, this means that the company must spend heavily on marketing and account acquisition just to replace the accounts that burnout and close each year. This makes for a low value business model. Contrast this business model to that of asset managers and financial advisors where their revenue and earnings increase with market appreciation. Theoretically, an asset manager could grow earnings without spending a dollar on marketing because equity markets appreciate over time.
This also explains why, despite the company announcing three ‘significantly accretive’ acquisitions (according to sellside and management) since their IPO, earnings power has still declined. These costly acquisitions are not to grow earnings power, they are simply to fill the hole left by all the burned clients.
-High reliance on introducing brokers
Almost half of FXCM’s volume comes from ‘indirect sources’, meaning introducing brokers or selling agents that then split the revenue generated with FXCM. First, these marketing agents have legal risks since FXCM cannot control how they market, but also, these agents own the client, not FXCM. So if another retail FX firm offers better economics (or less legal scrutiny – see FATCA discussion below), volume could quickly move. I suggest doing a search on Linkedin is get a better flavor for the quality of agents that resell FXCM’s services.
-History of Regulatory Problems and Management Lapses
In 2011, FXCM accrued $16m for fines and restitution in a settlement with the National Futures Association (I believe this is the largest settlement ever for the NFA). Apparently, FXCM didn’t feel they were emptying out their clients’ accounts fast enough and in order to more quickly move cash from the client accounts to their own corporate accounts, they implemented a trading strategy against their clients called ‘negative slippage’. The negative slippage strategy was pretty simple. When client limit orders were submitted, if the market moved away from the client, they were asked to re-submitte the order. If the market moved in the clients favor, the order was executed at the old price. Additionally, the NFA cited a laundry list of other violations and failures.
This leaves open a glaring question that the company has never answered. FXCM claims to be an ‘agency model’ in which client trades execute against market makers and FXCM simply receives a transaction fee, similar to how E*Trade or Schwab just receive a commission on a stock trade without ever ‘trading against’ their client. However, if this were the case – how was FXCM profiting from higher/illegal mark ups on the actual trade execution?
In February of this year, the FCA in the UK fined FXCM $10m for the same practice and tacked on a laundry list of other violations including not disclosing to the UK regulator that the US had been investigation them for the same practice.
These two fines came in the two most highly regulated jurisdictions (they were also fined by Japanese regulators in recent years for other violations). Nearly half of FXCM’s client volume comes from unregulated markets. One has to wonder what types of practices are occurring in the unregulated markets.
-Recent Entry and Expansion into High Frequency Trading, now under Scrutiny
FXCM has purchased two high frequency trading firms in the last two years. The first was Lucid in 2012. Luciid only does high frequency trading in the FX markets and per publicly filed financials realized an 800% ROE before they were acquired. Not many true ‘market making’ firms realize that type of profitability, but HFT firms can. Also, according to FXCM’s presentations, Lucid was founded by “computer scientists, mathematicians and physicists’ and its positions are “small enough to flatten at a reasonable cost in seconds”.
In 2014, FXCM purchased Chicago HFT firm Infinium which has been unprofitable in recent years due to the increase competition by HFT firms. We don’t see how FXCM will make this acquisition profitable and with increased scrutiny, the challenge will be event more difficult.
In 2012, according to press reports, Reuters caught Lucid cheating on its FX market and kicked them off the trading platform. Its possible or even likely that regulators could be looking into the alleged cheating.
2) Hasn’t Made a Single Estimate Since IPO
FXCM went public in late 2010. Initial consensus estimates for 2011 was just over $1.00. They ultimately reported $0.80 (pro forma adding back 1-time items and non-cash stock comp). For 2012, initial estimates were for $1.40 and the company ultimate reported just over $0.60 – yes, making less than half the initial estimate. 2013, initial estimates were for the company to earn over $2.00, but ultimately reported just over $0.80 – another more than 50% miss to initial estimates. 2014 estimates have already declined from $1.15 initially to $0.74 currently and as detailed below – the current $0.74 estimate is laughable.
Despite missing initial estimates by well over 50% from the time of the IPO, the shares are somehow more than $1 above the IPO price.
3) Highly Unlikely to Make Current Estimates
Analysts are expecting flat earnings this year of $0.74 (pro forma), despite forecasting that 1Q14 will be only 12c or 46% below last year’s 1Q. Seasonally, 1Q is usually one of the strongest quarters of the year, yet this year the street is assuming EPS will increase 58% from 1Q to 2Q and grow another 21% into the seasonally slow summer quarter of 3Q.
But wait, there is more: monthly volumes as reported by the company have been trending down all year. March volumes were 10% below the Jan/Feb average on a per day basis. So if 2Q volumes just stay at the March level, I estimate the company will report $0.08 (pro forma) or less than half the current consensus. However, this $0.08 estimate is wildly optimistic because if we look at April month to date FX volumes as reported by the Chicago Mercantile Exchange (CME), they are running 40% below March! I doubt FXCM will report April volumes down 40%, but I do expect that to be down. If April is down 10% and volumes stay at that level for 2Q, the company may not be profitable.
4) Massively Bullish Sentiment, LOVED by the sell side
Every analyst that covers the company rates the shares a Buy. The company is covered by 10 analysts and in the 3+ years that the company has been public, only one analyst has ever downgraded (but then upgraded not long after). My desk is stacked with research notes on FXCM reducing estimates, but reiterating their Buy rating pointing to hockey stick earnings growth to come in the future (some day).
Best example of the love fest with FXCM, look no further than the April 15th estimate reduction by UBS. UBS, cut their 1Q estimate by 28%, full year by 10% and 2015 by 7% - yet the analyst never published a research note, just changed estimates on First Call. I’m not even sure if that is legal, but it highlights that the sell side refuses to publish any negative news on FXCM.
5) Regulatory Headwind #1: Reuters FX Marketplace Clamping down on High Frequency Trading
Last month, Thompson Reuters announced they would change their trading rules on their FX market specifically to take away advantages from HFT traders. Reuters is one of the two largest FX trading platforms. Given that these rule changes are specifically designed to take away advantages from firms such as Lucid, it is reasonable to assume that Lucid’s earnings will be impacted when the rules are enacted this summer. Note that not a single sell side analyst has published on the coming rule changes and of course none have updated estimates for likely reduced Lucid profitability. Lucid accounted for 20% of revenue last year and 30% of EBITDA.
6) Regulatory Headwind #2: FATCA
As of June 30 of this year, the Foreign Account Tax Compliance Act will require 30% withholdings on any payments made by non-US entities to possible US citizens. This will put increased and unwanted scrutiny on FXCM’s foreign subsidiaries and the introducing brokers that account for half of FXCM’s volume. Will their introducing brokers in Eastern Europe and other light or no regulation jurisdictions want to undergo an IRS audit of their account base or will these referral brokers simply move their client accounts and volume to a non-US FX retail firm? FXCM’s latest 10k says “Compliance with FATCA could have a material adverse effect on our business, financial condition and cash flow”
Once again, no sell side analyst has published on this risk, no sell side analyst has changed estimates to reflect this risk which starts just 63 days from now and all sell side analyst have earnings increasing after FATCA is implemented.
7) Regulatory Headwind #3: NFA Proposal to Ban Credit Cards
The National Futures Association has proposed that retail FX accounts can no longer be funded by credit card because the funded accounts result in infinite leverage.
In 2011, the LA Times wrote a good article highlighting how quickly unsuspecting retail FX traders were funding accounts with credit cards, losing everything and rather than making additional income as they were told in the marketing literature, ended up further in debt.
8) Regulatory Headwind #4: SEC Will Re-Review Retail FX Trading in 2016
In Summer 2013, the SEC issued Release No. 34-69964; File S7-30-11 which reviewed the retail FX industry. From this report, it is clear that the SEC has concerns about the industry and ultimately adopted the current rule until July 21, 2016 “the expiration of the rule is designed to provide the Commission with reasonable period of time to consider further whether additional requirement for broker-dealers engaging in a retail forex business may be appropriate”
“Many customers may view forex as a possible investment opportunity or portfolio risk management strategy. However, the Commission, its staff, and other regulatory authorities have cautioned investors that the forex market poses risks for retail customers”
9) Expensive on ‘Run-Rate’ and ‘Normalized’ Earnings and Book Multiples
As detailed already in this write-up, sell side analyst forecasts have proven to be grossly optimistic and thus are of no use in valuing FXCM shares. If anything, we should probably take the current 2015 sell side estimate, reduce it by 60% similar to past misses and shares trade at nearly 40x this estimate. On 1Q14 annualized earnings, FXCM trades at 32x pro forma EPS (the company reports monthly volumes so the sell side has been forced to embrace reality and reduce their 1Q estimates to reflect actual volumes while their forward forecasts are based upon their own erroneous estimates of future volumes). Since the company has been public, they have reported pro forma cash EPS of $0.92 in 2010, $0.90 in 2011, $0.58 in 2012, and $0.76 in 2013. The trend is declining, but let’s optimistically say that run-rate earnings represent an average of these 4 years. On this basis, shares are trading at 20x pro forma EPS for a company with a declining earnings trend and all the risk highlighted earlier. On book and tangible book, shares trade at 2x GAAP book and 5x tangible book.
10) Insider Selling
According to Bloomberg, there have been 22 sells by insiders YTD and only 1 buy (the 1 buy was conversion of a derivative security, which was then immediately followed by an open market sale).
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