GAIN CAPITAL HOLDINGS INC GCAP
February 13, 2015 - 12:30pm EST by
piggybanker
2015 2016
Price: 8.50 EPS 0 0
Shares Out. (in M): 49 P/E 0 0
Market Cap (in $M): 415 P/FCF 0 0
Net Debt (in $M): 85 EBIT 0 0
TEV ($): 500 TEV/EBIT 0 0

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  • Investment Brokerage
  • Electronic Trading Platforms

Description

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·         Summary

o    We believe that GCAP stock has the potential to triple over the next 12-18 months

o    GCAPs PF EPS could be ~$3.00 per share exiting 2016, v consensus of  ~$1.00 per share

o    Applying a 9x PE multiple (v historical average of 12x) gets us to a $27 stock, versus the current share price of ~$8.50 today

o    We believe that there are several upcoming catalysts that should provide a path to realizing this value.

·         Business Model

o    GCAP operates electronic trading platforms, allowing customers to trade global financial products. GCAPs main financial product is currencies, aka foreign exchange (FX)

o    GCAP operates two businesses, Retail and Institutional (~70% and ~30% of TTM revenues for GCAP, respectively). While GCAP does not break out profitability of the two businesses, we believe that retail could contribute the vast majority of GCAP’s profitability.

o    Retail Business

§  GCAPs retail business provides individual investors access to global financial markets, mainly FX. GCAP conducts its business primarily through its FOREX.com brand. Competitors to GCAPs retail business include Forex Capital Markets (FXCM), Saxo, Alpari, IG Markets (IGG LN), Oanda, LMAX, FXOpen and Interactive Brokers (IBKR)

§  By and large, retail revenues are earned from customer trades. For its OTC products (FX), GCAP captures the bid/offer spread offered to customers. GCAP discloses that ~96% of customer volume is either matched with another customer, or offset with a wholesale liquidity provider (ie, a bank). For exchange-traded products, GCAP acts as agent and earns commission revenues on each trade. Additionally, GCAP earns fees for financing positions, and for giving customers access to real-time exchange data.

o    Institutional Business

§  GCAPs institutional business consists of two main businesses, GTX and Sales Trading

§  GCAP owns and operates the GTX  electronic communications network (ECN)… GTX allows institutions to trade FX electronically, directly with each other. GCAP acts as an agent for the trades executed on its GTX platform, generating revenue by charging a commission on trades executed on the platform

§  Competitors in this segment include EBS (owned by ICAP), Reuters, FX Connect and Currenex (both owned by STT), and Hotspot FX, which was recently sold by Knight Capital Group (KCG) to BATS Global.

§  GCAP also employs a team of sales traders, who interact with institutional clients across several asset classes. GCAP generates revenues through commissions earned by executing client trades on an agency-basis.

·         Investment Thesis

o    FX volatility has returned after a long period of dormancy

§  Currency volatility (as measured by the CVIX Index) reached a low of ~5 in June of 2014.

§  Since bottoming, FX volatility has rebounded substantially, and currently sits at ~11.5, just above its 10 year average of ~10.2

§  We believe that the move from the lows in the CVIX has been driven largely by divergent monetary policies in the major economies around the globe (ie US expected “lift-off” on monetary policy tightening vs Eurozone continued/accelerated accomodation). We believe that given current global monetary policy dynamics, a return to trough levels in CVIX is unlikely.

o    GCAP stands to benefit significantly from the recent increase in FX volatility

§  We believe that FX volatility is the key determinant of trading volumes (and in turn revenues) for GCAPs retail business.

§  GCAP used the period of low volatility to embark on a roll up of the retail FX business. By our estimates, GCAP has increased its client assets by nearly 5x since 2010.

§  In an acquisition, GCAP generally moves acquired clients onto its own platform, eliminating the legacy platform. We believe it is common for over 50% of the acquired company cost base to be eliminated in an acquisition.

§  Additionally, as GCAP’s operating costs are largely fixed,  incremental margins are extremely high in its retail business (we calc 86% flow through to operating income in Q3’14 v Q2’14, for example)

§  Accretive acquisitions have allowed GCAP to remain profitable despite low industry volatility.

§  Going forward, we believe that higher trading volumes, coupled with a larger account base and high incremental margins will dramatically increase profitability at GCAP.

o    Benefits from the recent increase in FX volatility have already shown up in GCAP’s profitability.

§  GCAP reports their volume metrics monthly.

§  We believe that the best metric to track is Average Daily Volume divided by Total Active Accounts (ADV/Account) for GCAP’s retail business. This measures the notional value of FX trades for each of GCAPs retail accounts on a daily basis. Basically, it is a metric of how much each account trades per day.

§  ADV/Account averaged ~$84,000 in 2H 13 and 1H 14 (the period when the CVIX was at its lowest)

§  However, since volatility began in increasing in 2H 14, GCAP has experienced a robust acceleration in ADV/Account. It increased from ~$86,000 in July, to ~$94,000 in August, and ~$116,000 in September.

§  GCAP reported very strong profitability in their September quarter, but we would argue that the improved profitability came with just one-month of volumes (September) at non-trough levels

§  Importantly, monthly numbers post-September have shown continued strength. ADV/Account averaged $119,000 in the to-be-reported December quarter. This is above the September month level, and nearly 20% above Q3 levels.  We believe this bodes very well for forthcoming Q4 results.

§  Additionally, just this week, GCAP reported monthly results for January. ADV/Account was $138,000. This is the highest level in at least the past three years.

 

HISTORICAL GCAP ADV/ACCOUNT (MONTHLY)

 

2H 13, 1H 14

Jul ’14

Aug ‘14

Sep ‘14

Oct ‘14

Nov ‘14

Dec ‘14

Jan ‘15

ADV / Acct ($000s)


84


86


94


116


126


117

 

113

 

138

% Ch from
2H13, 1H 14


0%


+2%


+12%


+38%


+50%


+39%

 

+35%

 

+64%

 

HISTORICAL GCAP ADV/ACCOUNT (QUARTERLY)

 

2H 13, 1H 14

Q3-14

Q4-14

Q1-15 (QTD)

ADV / Acct ($000s)


84


99


119


138

% Ch from
2H13, 1H 14


0%


+18%


+42%


+64%

 

o    The Street has been slow/reluctant to increase their forward earnings estimates.

§  There are five analysts that cover GCAP. The consensus estimates for 2015 EPS is ~$1.00 per share

§  The quarterly estimates for 2015 are 31c, 26c, 23c and 20c in Q1-Q4, respectively.

§  We would make two observations about these estimates.

·         First, these estimates show a sequential decline in EPS in each quarter throughout 2015. We believe this represents analyst skepticism of a sustained return to historical average FX volatility.

·         Second, the Q1 estimate is 31c. This compares to actual EPS of 36c in Q3 (Sep ‘14)… ADV/Account averaged ~$99,000 in Q3’14. This compares to ~$138,000 reported in January. Basically, analysts expect GCAP to earn LESS money in Q1’15 than in Q3’14, despite ADV /Account being over 35% HIGHER quarter to date.

§  Additionally, we believe that the upcoming Q4 14 numbers (est end of Feb) should be poised to significantly outperform consensus.

·         Importantly, we already know the volume numbers from GCAPs reported monthly metrics, so we believe we have very good visibility into profitability for the quarter

·         In Q4, ADV/Account averaged ~$119,000 (up ~20% compared to ~$99,000 in Q3)… GCAP earned 36c in Q3. It would not surprise us to see GCAP earn north of 60c per share in the quarter, versus consensus expectations of ~40c.

o    We believe near-term catalysts exist to unlock potential value

§  Over the course of the next month, there will be two significant events that we believe could unlock the value in GCAP shares

§  First, GCAP will report earnings for Q4 2014, likely at the end of this month.  As we discussed above, we believe that these numbers could surprise positively.

§  Additionally, we believe GCAP’s acquisition of City Index (CI), announced in November ’14, is likely to close in March.

·         GCAP stated that they expect $45-55mm of cost savings from the acquisition. On the PF share base of ~49mm, this represents ~65c to ~80c in annual EPS to GCAP.

·         We believe that once the acquisition of CI closes, analysts will incorporate these cost savings (or at least a portion of them) into their forward projections for GCAP. It is important to note that GCAP has significant experience in successfully integrating platforms (most recently through their acquisition of GFT, where they are well on track to meeting their $35-45mm cost savings goal)

·         Also, it is important to note that we believe that two out of the five analysts (KBW and Jeffries) that cover GCAP are currently restricted, as they advised on the CI deal. Once the deal closes, these banks should be unrestricted and able update their numbers, PF for the deal.

o    We believe that as a result of the factors above, the PF earnings power of GCAP could be ~$3.00 per share exiting 2016. Below we discuss our assumptions in further detail.

·         PF Earnings Power Analysis--- How we get to ~$3.00 in EPS

o    In GCAPs presentation in conjunction w/ the announcement of the CI deal, management presented a slide deck showing their financials pro forma for the deal. This is the basis for our analysis. Additionally, we use Cash EPS, which adds back deal-related D&A on an after tax basis to GAAP numbers.

o    Standalone City Index---Est $0.90 Contribution

§  GCAP disclosed that CI earned $125mm in revenues TTM (9/30/14), and  $11mm of Adjusted EBITDA… We believe this translates into ~$8mm of Cash Net Income, or ~0.16 in EPS per PF share. While we believe that the CI business could benefit from the same market dynamics as GCAP, we do not adjust their historical numbers upward. The only adjustment we make here is to reduce net income by the after-tax interest expense on the debt used to fund the deal, which brings CI’s PF contribution (ex synergies) to ~$0.10

§  We then assume that GCAP management is successful in extracting the high end of cost savings from CI, as discussed above, thid equates to ~$0.80

o    GCAP Standalone—Est ~$2.10 Contribution

§  We estimate that GCAP standalone can earn ~$100mm in Cash EPS in 2015, which equates to ~$2.30 on GCAPs current share count of 44mm, and ~$2.10 on the PF share count of 49mm.

§  Our numbers assume trading volumes that drop down below January levels, to levels consistent with 2014 Q4 reported volumes.

 

GCAP
TTM 9/30/14

Adj

GCAP
2015E

CI
TTM 9/30/14

Adj

CI
2015E

Cost
Savings (est)

GCAP
PF EPS (est)

Net Revs

337

141

479

125

0

125

0

603

Cash Net Income

32

71

103

8

(2)

6

40

149

Cash EPS

$0.66

$1.46

$2.12

$0.16

($0.04)

$0.12

$0.81

$3.04

 

·         Valuation: Investment Case:

o     GCAPs historical PE multiple has averaged ~12x. If we apply a ~9x multiple to our PF ~$3.00 EPS number (roughly where GCAP is trading now on consensus estimates), we arrive at a $27 share price v $8.50 per share currently.

·         Valuation: Downside Case

o    FX volatility reverts back to trough (2H13, 1H14) levels. GCAP earned ~$0.45 in Cash EPS (on the PF share count) during that 12 month span; adding in CI profitability of $0.10 and the low-end of the deal synergies of $0.65, we arrive at downside PF Cash EPS of $1.20 per share.

§  A few points. First, our downside number is still ~20% above the current consensus estimates (driven by synergies).

§  Second, with GCAP stock trading at $8.50, it is trading at ~7x our downside case PF number.

o    As we discussed, we believe that the consensus numbers are only factoring in a modest increase in profitability from trough levels for GCAP (well below what has been observed over the past 5 months), and are not factoring in any cost savings from the CI deal, which we believe are highly probable. As such, we believe there is significant wiggle room for volatility to decline from current levels, and for GCAP to still outperform.

·         Risks

o    Business Model

§  Given the prior write up and comments on FXCM (excellent work, btw!), we fully expect a long idea in this space to get a low rating, and significant push back from the VIC community. We agree that this is not an easy business model to get behind. The majority of GCAPs clients lose money every month, and GCAP needs to continually add accounts to offset high levels of customer attrition. Also, the more money that GCAP makes per dollar traded usually corresponds with a higher loss rate for customers (ie this is a zero sum game). However, the business generates significant cash flow, and GCAP has and we believe will continue to consolidate this business, and has the scale to be successful. Also, industry headwinds turning into tailwinds should be a meaningful benefit. Additionally, we believe we are conservative in using a multiple significantly below historical levels in our analysis. We believe there is a price for everything. At <3x our PF earnings number, this stock appears just way too cheap.

o    Regulation

§  US Retail FX is regulated by the NFA, which is overseen by the CFTC. In the wake of the SNB currency peg decision that crippled FXCM, the NFA took action to temporarily increase margin requirements on the CHF, NOK and SEK. Additionally, per the WSJ article below, CFTC Commissioner Bowen has called for stricter regulation of the FX markets, and CFTC officials “are monitoring the fallout from the Swiss move”. It is important to note, however, that in 2013; 79% of GCAPs retail volume was from non-US customers, and pro forma for the CI deal, only 11% of GCAP Trading Volume will be from the US. Outside of the US, GCAP operates in many International markets, all of which are regulated by local authorities (or unregulated). A detailed description of international regulation can be found in GCAPs 10-K (link below). We are not aware of any pending international regulatory actions in the wake of SNB, but welcome anything we may have missed in the comments.

·         http://www.wsj.com/articles/cftcs-bowen-calls-for-review-of-retail-fx-rules-1421866479

·         http://www.sec.gov/Archives/edgar/data/1444363/000144436314000048/gcap2013123110-k.htm

o    FX Market Dislocation /Customer Losses

§  Unlike FXCM, GCAP did not suffer significant trading losses from the SNB currency decision. GCAP actually raised margin requirements in September ’14 on EUR/CHF after an assessment of risk exposure in the currency, which saved them from material losses. (See below for GCAP’s press release). However, another similar shock to the FX market could either a) cause GCAP to experience a sizeable loss, b) accelerate customer attrition/impair ability to attract new customers or c) provoke increased interest in further market regulation. However, we believe that after the fallout from the SNB decision and the awareness of the marketplace to future dislocations, the severity of any future event should be diminished. Additionally, we are encouraged by management’s foresight in identifying at risk-currency pairs and acting in advance to reduce risk of potential loss.

·         http://ir.gaincapital.com/phoenix.zhtml?c=241648&p=irol-newsArticle&ID=2008285

·         Catalysts

o    January Monthly Metrics (already reported)

§  We list this even though it has already happened, as it is unclear how well the record numbers are understood by the market, given the lack of analyst response to the record numbers

o    Q4 Earnings (est end of Feb)

§  Monthly volume metrics for Q4 have already been disclosed, and based on the data, we believe that GCAP is poised to outperform consensus expectations.

o    February Monthly Metrics (est first/second wk in Mar)

§  Another good month in February should solidify a strong Q1’15, which should mark 3 consecutive strong quarters for GCAP

o    Closing of the CI Deal (est middle/end of Mar)

§  Shareholder vote is scheduled for Mar 12, and deal should close soon thereafter

§  Upon deal closing, KBW and JEF both become unrestricted on the name, and analysts can focus on PF profitability for GCAP

·         Disclaimer

o    The author of this posting and related persons or entities ("Author") currently holds a long position in the securities mentioned above. The Author makes no representation that it will continue to hold positions in these securities. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

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