May 23, 2011 - 11:13am EST by
2011 2012
Price: 6.04 EPS $1.00 $0.77
Shares Out. (in M): 35 P/E 6.0x 8.0x
Market Cap (in $M): 208 P/FCF 6.0x 8.0x
Net Debt (in $M): -50 EBIT 57 47
TEV ($): 158 TEV/EBIT 3.0x 3.0x

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Gain Capital (GCAP) is a leading online provider of retail Foreign Exchange trading.  It is a broken IPO in a nascent fast-growing industry with high margins (25%+ EBIT margins) and ~6% market share which should benefit from rising interest rates and continued industry consolidation.  60+% of their business is outside the US, providing geographic diversification.  There are some risks/unknowns with the business, but we believe at current prices these are priced in and the risk-reward is attractive.

GCAP has >$1 in net cash and has $.72/share in TTM adjusted earnings which equates to 7x ex-cash earnings at $6/share.  Consensus EPS estimates for 2011 and 2012 are $.77 and $1.00.   Earnings are volatile/unpredictable on a quarterly basis due to macro factors and their effect on Revenue Capture Rate and Trading Volume.  But the company has delivered .65-1.30 in adjusted eps the past 5 years and expect .70-.80 in eps for 2011, which should grow organically and as a result of a higher interest rate environment due to interest income and income from carry trade.  Additionally, Gain has high operating leverage and given the many smaller, unprofitable competitors they should be able to make accretive acquisitions as the industry consolidates (or be acquired themselves). 

For our target price, we apply a 10x multiple to $.80-1.00 of 2012 earnings and add back $1 in cash. Our target is $9-11, up over 50% from today.  There is some risk that future regulatory changes and increased competition could significantly impact the business, but believe this risk is more than priced in given their earnings history and likely M&A value.

The company recently announced a $10M repurchase program as part of their Q1 earnings release.  They had previously said they would retain all earnings for growing the business, but at current prices decided a repurchase makes sense, which should be a mild positive.

The company IPO'd in December 2010 and there are a number of reports on the company which we suggest you review along with our comments.  


Gain was founded in 1999 and is primarily an online provider of retail foreign exchange trading through 24-hour, five day a week access to the global OTC foreign exchange markets through their proprietary software.  They maintain one of the most frequented FX websites,, with 1.5-2M unique visitors per month, which is a main way they drive customers to sign up for a trading account.  They also co-sponsor (with, a larger publicly traded competitor) a new FX show on CNBC called "Money in Motion" which began in March. 

Gain either tries to act as a market maker and naturally hedge trades by matching customers BUYs/SELLs through their "managed flow" portfolio (and capturing the entire spread for themselves) or earns the difference between the retail price quoted to their customers and the wholesale price received from their wholesale forex trading partners.  The result is that the Revenue Capture Rate (Revenue per Million $ of Retail Trading Volume) can move around significantly ($100-160 the past 9 quarters) and makes earnings quite unpredictable on a quarterly basis as expenses are largely fixed.     

Customers can be "direct", in that they sign-up and download the trading software directly through the Gain/ website or "Indirect", through "white-label" partners or "referring brokers" (and split the economics ~50/50).  With white-label, a company such as a bank offers FX trading through their own portal, but uses the Gain software as the backend (the customer doesn't know they are using a Gain product); white-label contracts generally can be cancelled with short notice.  Referring brokers are used in many countries (such as China) which don't allow retail FX companies to advertise directly.

Overall, FX Trading Volume is estimated at $4T in average daily volume(~40% of which is Spot FX trading), up from 1.5T in 2001 and expected by Aite Group to grow to $10T by 2020. FX Retail Trading began in 1996 and Volume has grown from average daily volumes of $10 billion in 2001 to $125 billion in 2009, CAGR of 37%. Retail FX makes up 3.2% of total FX trading, up from 2.5% in 2007 and .8% in 2001.  There are only ~1.2M retail FX traders globally versus ~100M for equities.  The industry is fragmented: Saxo Bank has ~14% share, FXCM has ~9%, CMC has ~6%, IG Group has ~6%, Gain has ~6% and all others have ~60%. 

Recent/Normalized Earnings:

The main revenue drivers are retail trading volume and revenue capture rate.  In Q1 Gain delivered record volumes, but missed significantly on earnings, .04 of GAAP and .06 of adjusted EPS, which was well below Street expectations.  However, the primary reason for this was a very low Revenue Capture Rate.  This number is very volatile quarter to quarter as discussed, depending on a number of factors, primarily what % of trades they can immediately match directly between customers versus matching against a wholesale partner, but is fairly stable when looking at one-year periods.  Over the last nine quarters it had been between $103 and $162, and over the past 3 years between $123 and 144.  In Q1 it was $99.  Had this been a more normal $125-135 then Q1 earnings would have been ~.20-.25/share.  On the Q1 call the company said that volatility had picked up significantly and as of the midpoint of Q2 that the average YTD Revenue per Million of Retail Trading Volume was now comfortably within the range of $114-146.  Since Q1 averaged $99, to get to an average of $120-130 means 1st half of Q2 had to be $160-190.  Even if this tails off in the 2nd half of the quarter, an average of $130-150 would yield eps of ~.30-.40 for the quarter.  And an average of $120-135 for the year would yield normalized earnings of $.70-1.00.              

Other Revenue Drivers:

Carry Trade: Gain likely charges ~30-35bps (FXCM discloses, GAIN does not but appears to be similar) to customers for rollover.  The carry trade made up ~10-15% of historical revenue, while negligible currently due to lower global rates (low differential).  Assuming the return of carry trade adds 5-10% (lower % due to lowered leverage restrictions) to revenue, this would add 10-20M of EBT = .15-.30/share of earnings.

Interest Income: The company had $338M of cash and equivalents, including customer deposits, at 3/31/2011, but are earning a minimal amount due to low interest rates.  According to the company each 100bps increase in short-term interest rates would add 4.2M to annual pre-tax income, so a rise of 100-300bps would add .06-.18/share.  The company doesn't currently pay customers interest on un-invested deposits.  Some FX companies do, which would cut into this increase in interest income.  The company wouldn't be able to collect on both carry trade and interest income at once on customer deposits so the total effect is less than sum of the two, but the opportunity just from a changing macro environment is likely .20-.30, large on a $6 stock.   

Consolidation: The # of Retail FX Brokers in the US has shrunk from 43 in 2007 to 11 in 2010, primarily due to increased capital requirements and decreased leverage limits.  The industry has seen similar consolidation internationally and is expected to continue.  This should help the remaining players, including Gain, as there is high operating leverage in the business.  Gain recently bought the customers of DBFx, which stopped providing retail FX to customers (although Gain outbid FXCM, who had been their white-label partner and had more familiarity with the customers, so may have overbid.).        

Bear Case/Risks:

High Customer Attrition: Gain's customers are very active(~2 trades/customer/day), use high leverage(average 17:1), and a large % lose money (70-75%).  This has led to a high churn rate (40-70% the past 3 years) which could make it difficult for Gain to grow.  These numbers are skewed though by the very small ($500 min deposit) inexperienced account holders who use maximum leverage trying to make high returns.  The attrition numbers are better for the larger, more experienced customers who make up the majority of revenue.  And despite the high churn, the company has experienced growth in # of trading clients and volumes.

Competition: Some larger, more diversified, deeper-pocketed companies (Etrade/Schwab (OptionsExpress)/etc.) will enter the retail FX market and take share from Gain.  This is definitely a concern.  But Gain (and FXCM) have spent over a decade developing/refining their products/relationships/name brand.  New entrants seem better off partnering with or acquiring Gain (especially given current prices) than spending the time and money developing their own solution.  Schwab bought OptionsExpress recently, which is now developing a retail FX solution for June 2011.  Schwab is paying $1B for  OptionsExpress at 4x revenue, 12x ebit, 20x net income, while Gain is currently at $240M (fully diluted) market cap with approx. approx. $50M in net cash, trading at 1.25x revenue, 4x ebit, 8.5x net income.  M&A among existing retail FX companies appears beneficial as well, given the high operating leverage.  FXCM was able to remove ~50% of costs from ODL (a smaller unprofitable competitor) following their acquisition on 9/30/2010.  Assuming 25-50% of expenses were removed from Gain following an acquisition, they would generate $80-120M of EBITDA = 1.7-2.5x EV/EBITDA if purchased at current prices.        

Regulation: Most countries have increased capital requirements and decreased leverage for retail FX trading recently.  The US now requires capital of $20M + 5% of customer liabilities over $10M.  Leverage limits have been reduced in many countries as well (US: 100:1 to 50:1, Japan: 100:1 to 50:1 to 25:1 in August 2011).  This has caused significant consolidation in the industry, as many smaller companies have become unprofitable (see ODL and GCI acquisitions by FXCM).  This may help Gain in the near term, but other future legislation, such as outlawing the using of Credit Cards to fund accounts (37.6% of account deposits were funded in this way), continued decrease of leverage limits, etc. could have a significant impact on the business.    


IPO: The primary reason for the IPO in December 2010 was for the VC firms that had invested over the past 10 years to cash out a portion of their investment.  They initially intended to IPO at $14/share, but ended up IPO'ing at $9/share and currently trading at ~$6.10.  Gain is currently trading only ~10% above the weighted average investment price by the VC's, and well below the most recent investors at ~$11.50/share in January 2008.

DBFx Customer Acquisition: Acquired 1,650 DBFx customers with $55M in net assets from Deutsche Bank on 5/13/2011 for an undisclosed sum.  Previously DBFx was White Labeled through FXCM, who also bid on the customers so it's possible that Gain overbid. DBFx was 2.3% of FXCM's 2010 revenues. 

Tradestation: Tradestation decided to do retail Forex internally instead of referring relationship with Gain.  Tradestation represented $30.8M of client assets and 5.6% of 2010 revenues (~2.8% if net out referring broker fees).

Customers:  No customers account for more than 4%. 



Normalized Earnings: Delivering on expected stronger earnings, following weak recent earnings.   

Rising Interest Rates: Helps both Interest Income on cash (excess cash + customer deposits) as well as on Carry Trade.  Could add .15-.40/share in earnings in next couple years.

Industry Consolidation: Accretive acquisitions as industry consolidates (or sale of own company).  Recently acquired DBFX customers for an undisclosed price.   

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