The Opportunity

RCS Capital Corp (“RCAP”) is a newly formed high-growth independent retail advice brokerage with a $1.9b market cap that trades at only 6x and 8x our estimates of 2015 EBITDA and Cash EPS/free cash flow, respectively.  This represents a substantial 43% discount to its closest publicly traded peer LPL Financial (“LPLA”).  We believe that a combination of transitory factors (discussed below) has created a massive dislocation in the stock price (the stock is down 50% off of its March highs) and a great entry point to own a) the #2 US independent retail advice brokerage (which has grown its Assets under Administration (“AUA”) organically at a 15% CAGR over the past several years, while generating similar growth in revenue and EBITDA) and b) a rapidly growing wholesaler and investment bank in the nascent retail alternative investment products industry for free.  With recent overhangs cleared, this relatively unknown stock now represents an asymmetric risk/reward.  We believe that over the next year RCAP will trade at 9-10x 2015 EBITDA and 14-15x 2015 Cash EPS, resulting in a stock price of ~$38 or nearly 75% upside from here. 

Further, there are two other significant opportunities which are NOT in the above targets.  The first is accretive M&A where management believes the Company’s $4.50/share in excess cash can be deployed to acquire retail brokerage platforms at 6x in the private market resulting in meaningful earnings accretion (15-20%).  A second source of upside is an eventual rise in short term interest rates where a 100bps rise would generate another 20% earnings accretion.  In the case where interest rates rise modestly, and RCAP deploys its cash into accretive acquisitions, we believe EBITDA and Cash EPS would approach $510 and $3.58 which at a 14-15x P/Ex implies $55 or 150% upside from current levels.  Moreover, these impacts combined with healthy underlying growth will create a positive mix shift towards the Company’s highest multiple Retail segment, driving that segment to 75% of total EBITDA from 60% currently.  We believe this dynamic will be the main driver behind the multiple convergence with LPLA over the medium-term. 

We also believe that the stock has been substantially derisked recently, as the company issued new pro forma financials, announced a solid Q2, and issued 2014 guidance.  There are several upcoming catalysts, including the release of 2015 guidance, as well as a management non-deal road show in the upcoming weeks.  Finally, the stock is heavily insider owned (management owns 35% of the stock or nearly $650m in value), and several directors have made open market purchases within the last few months very near current prices.  While the Street and analyst community has bid up other retail focused platforms (LPLA, SCHW, AMTD, etc) due to a) the attractive secular dynamics of the independent retail brokerage model and b) step function EPS power from rates, we believe RCAP is quite similar yet hiding in plain sight at a massively discounted valuation.

 

Background

RCAP IPO’ed in June 2013 at $20.00 with JMP Securities as the lead underwriter.  At that time the company was a ~$530m market cap with only $50m of tradable float, the remaining 90% was owned by management and insiders with no outside capital having been raised along the way.  The company didn’t attract much interest given the lack of comps for its Wholesale business, the lack of float and meager analyst coverage (the stock was only covered by JMP).  In the fall of 2013, RCAP announced the acquisitions of retail advice platforms ICH, Summit and First Allied, and the investor manager Hatteras for total consideration in cash and stock of ~$350m. No pro forma financial information was given, and no financing was announced.  Around this time the Company brought in well-regarded industry veteran Larry Roth, the former head of AIG’s and ING’s retail brokerage units, to run its new Retail operations.

The stock languished around its IPO price until the January 2014 announcement of the Cetera deal, which is the flagship operation for RCAP’s Retail franchise.  The Company did not provide pro forma financial guidance at the time, but conducted a roadshow for credit investors to finance the Cetera transaction.  Some investors were vaguely familiar with Cetera due their involvement LPLA and had heard of Cetera’s former head Don Marron who had previously run Painewebber’s retail brokerage unit successfully and had earned a good reputation in the industry.  As part of the Cetera financing, Luxor (a well-respected distressed shop) invested in a significant RCAP convertible debt and convertible preferred, giving them a large equity stake as converted.  The combination of Luxor’s involvement, the transformational nature of the transaction (Cetera is a very large player in the retail advice business), and credit crossover investors buying the equity, got people excited about the stock.  Pro forma financials were released which described 250m+ of EBITDA and significant earnings power.  As a result, the stock has a tremendous run from $20 to $40 towards the end of Q1. 

Around this time, a few events simultaneously happened, none of which were directly related to RCAP’s fundamentals, but which ultimately drove a severe dislocation in the stock, taking it down 50%.  First, the IWM broke down and many small cap stocks traded off.  Secondly, ARCP (whose affiliates are related to RCAP via some overlap of the management team and Board) aggravated shareholders by raising capital, driving ARCP’s stock down 15% and drawing the attention/ire of several activist firms.  Third and most importantly, RCAP needed to close on its announced Retail transactions and issue stock to finance the funding gap between debt raised and cash on the balance sheet.  The company had “telegraphed” the need for this equity raise on announcement of the deals, and the number of shares issued did not change since the announcement of the transactions.  However, as the equity roadshow for the follow-on issuance began, the combination of a) a stalling market, b) ARCP distaste, c) one lone analyst covering from JMP, d) a large dollar raise on a limited float in an illiquid stock (the Company had to issue 20m shares on 3m float which represented nearly 250x the stock’s average daily volume), and e) a substantial business model change with 2/3 of RCAP’s Pro Forma EBITDA from the Retail advice businesses (in what amounted to a “backdoor IPO” of these assets and was unfamiliar to investors in a short time frame), all proved to be too much for the stock to handle and created a “perfect storm” for the stock to move lower.  The stock began a precipitous decline from $40 to $25 and with a limited float and limited flexibility, RCAP priced its deal at $20.25, ending down 50% in two months.  Now that the dust has settled from the recent events, this brings us to the opportunity today.

 

Executive Summary

There is a lot of detail in the following pages, but these are the main takeaways –

• The story here is the retail advice market, one of the more powerful secular trends in financial services.  RCAP is a low capital intensive, high margin, scale player in a high growth industry that’s taking market share. 
• The stock is worth between $38 and $55.  It’s egregiously undervalued on low numbers, even more so on its ultimate earnings power which grows through organic top-line growth, margin expansion, synergy realization, interest rates, M&A and a positive mix shift as Retail expands as a percentage of the overall pie. 
• The opportunity exists because the stock is unknown, the financials are messy, the sellside hasn’t “done the work” and there are three concerns, which we think are misplaced -
• The management team (where there is some overlap with ARCP affiliates, but where here the team owns 35% of the stock or $650m in value, representing a majority of their net worth, and has brought in well regarded outside management to run its “crown jewel” Retail segment).
• An external management structure (which we agree is not ideal but is in lieu of G&A, represents a reasonable MSD% of overall expenses, is based off of performance, and could be internalized ultimately). 
• The Company’s non-traded REIT business (which is growing well, but even in the face of an abrupt 50% decline in volumes (which we illustrate but only due to the Street’s myopic focus on this segment) would lead to only a 10-15% loss in EPS).   
• The conversation around concerns is out-of-place at prices anywhere near this level anyway, as RCAP is trading at an EV/EBITDA range of 4.3x – 6.2x its base case outcomes and 4.7x - 7.2x its bearish outcomes,…

Retail Secular dynamics

Recent secular trends are driving increasing demand for unbiased advice from independent advisors and financial products sold through independent channels. As baby boomers reach the age of 60, the number of people expected to retire in the next 10 years will increase sharply, expanding the target market looking for investment advice. Wells Fargo estimates from 2012 to 2022 the number of retirees will grow from ~3.6m to 4.2m per year, or 44m total in the period, which demonstrates substantial growth off of the existing base. The industry as a whole has grown AUA well during the past 3 years, driven by the first cohort of baby boomer retirees in 2011.  Secondly, the market meltdown in 2008, continued stock market volatility, low interest rates, and reduction in defined benefit pensions have contributed to the need for increasing levels of financial advice in recent years.

The target market – mass affluent investors – is both large and expanding, and given substantial aggregate U.S. household wealth and significant investment product and advice needs, demand for retail investing advice and services is likely to remain robust. Additionally, the independent retail channel is likely to grow at a higher rate than the wirehouses, as disgruntled brokers are leaving to achieve better pay terms.  Brokers who “hang their own shingle” like those at RCAP, typically achieve ~85-90% payouts versus only ~30-50% at the wirehouses (although wirehouses cover overhead while independent brokers incur these costs as an owner/entrepreneur).  Demonstrating this phenomenon, organic assets at the ebrokers have grown roughly $800b in the last five years versus only ~$250b at wirehouses.  Other drivers of growth in the independent channel has been brand damage at the parent banks of wirehouses exiting the crisis, investors seeking advice that is perceived to be unbiased and conflict free, and certain tax benefits to advisers that monetize their business vs retention payouts at a wirehouse. RCAP’s retail business has capitalized on these trends, demonstrating significant organic and total growth over the last several years, CAGR’ing at 15% (see table) –

 

Synergies

RCAP is initially targeting $61m in synergies due to its acquisitions which will enhance Retail EBITDA margins by 200 bps.  Synergies are expected to be fully achieved by the end of 2014.  The synergies are mostly driven by increased pricing to financial product providers (such as mutual funds), i.e. they are not customer facing and therefore should have limited disruption to the day to day operations of the advisor.     

The largest synergy bucket is what the company calls “strategic partner revenues”,  where the company expects to be able to renegotiate the fees paid to independent brokers used to support communications, marketing and distribution efforts for product providers’ investment products.  In other words, with greater size and scale RCAP will be able to attract better pricing from providers of financial products such as mutual fund companies and insurance firms.  This is approximately $30m of synergies.  The second largest synergy category is “registered representative fees” which are charged to financial advisors to access RCAP’s platform and services.  RCAP is currently undercharging advisors relative to peers, and has the ability to raise fees and standardize them across the platforms.  The company feels that its ability to provide advisors with a more comprehensive advisor solution package (technology, education, training, new products), will help retain advisors in the face of increasing fees.  Retention will also be aided by high switching costs and hassle of changing firms, and thus far management has not seen any elevated attrition rates. These synergies are expected to be $12-15m.  The remainder of the synergies are back office expense related and are outlined below –

 

Management has commented synergies are well on track to be achieved as planned.  In addition, we believe there may be further strategic partner revenues and clearing synergies in 2015 above what has been announced, as management moves into a deeper examination of these opportunities.  We believe the initial synergies outlined above brings the other smaller acquired platforms to parity with Cetera’s pricing, but with total company AUA of $234b vs Cetera’s AUA of $152b, RCAP can extract more leverage on its service providers in the future.  It’s important to note that Larry Roth, the CEO of Retail, and the rest of the Retail management team, have completed 20 similar acquisitions and 50 smaller “liftouts” of brokerage teams in their careers and are bullish on the opportunity to bring RCAP’s strategic partner revenues and other synergies in line with industry peers.  Larry actually ran the same assets before, as CEO of ING’s retail advice unit, the assets from which Cetera was formed after he had left.

As it relates to acquisitions and clearing, a big impediment in retail advice acquisitions is switching costs and distractions to the financial advisor of changing a clearing platform.  Because RCAP works with most major clearing firms, they will be able to seamlessly convert advisors to their platforms without requiring a change in clearing providers to the financial advisor. This helps retention, the ability to achieve synergies, and facilitates the purchase of other retail advisor networks in the future.

 

RCAP wholesale/Investment Banking (17%and 18% of EBITDA) Business Overview

RCAP’s wholesale broker dealer (17% of total company EBITDA, with current EBITDA margins at 4%) is the market leader in distributing direct investment programs (“DIPs”) (which are mostly non-traded REITS (“NTRs”) but also mutual funds and business development companies) to the retail financial advisor community.  RCAP earns a 2-3% commission based fee off of the volume of product sold. NTR’s are public, non-listed securities that deploy investor capital to purchase properties and/or mortgages on properties.  NTR’s are designed to produce a steady stream of dividend distributions to its investors/shareholders, until a planned liquidity event (public listing or sale). 

Closely tied to the Wholesale segment is RCAP’s investment banking segment (18% of EBITDA, 65% EBITDA margins).  This segment provides strategic and M&A advisory services, capital markets execution (debt and equity raises), fund formation advisory, and transfer agent services (record keeping).  The Company serves both non-traded and publicly traded companies.  For its DIPs clients, RCAP’s investment banking unit can manage the entire life cycle; fund formation, capital raising, and liquidity through an IPO or sale.     

According to Robert A. Stanger research, total direct investment industry capital raised will approach $30b in 2014 and has grown at a 38% CAGR in the past six years.  Over this same period, RCAP has grown market share in its wholesale business from 5% to 45%.  Through July 2014, RCAP has raised $5.2b in direct investment equity, and is targeting $14b in 2014 (pro forma for its recent acquisition of Strategic Capital (“StratCap”)).  RCAP’s YTD results (ex StratCap) are even more impressive considering RCAP exited its net lease direct investment program business in 2013 which was 38% of 2013’s equity capital raised.  In other words, we believe volume growth at RCAP in 1H14 was ~+50% on an apples to apples basis.  RCAP boast’s the industry broadest platform, currently distributing 31 DIP offerings through 325 brokerage firms, 1,150 active selling agreements, and 80,000 financial advisors.  Since inception, RCAP has distributed 24 offerings, for which it has raised $17.3B of equity capital.

Of the 31 programs currently being offered, 13 are operated by company’s affiliated with ARCP, representing 49% of total registered equity, and the remaining 18 are unaffiliated programs.   No more than 4.8% of the $2.6 billion in equity raised during the second quarter was concentrated at any one broker-dealer on the RCAP distribution platform. Roughly 8% of Wholesale’s revenue comes from RCAP’s Retail segment and total revenue in RCAP’s Retail segment from all DIPS runs in the mid-single digits, in line with other firms such as LPLA.

RCAP executes its offerings on a “best efforts” or “reasonable best efforts” basis, in that the firm has no obligation to purchase any unsold shares in the syndication process. RCAP does not engage in any proprietary trading.

Revenue model

RCAP’s Wholesale business generates revenue through selling commissions and dealer manager fees for its marketing and execution efforts in the wholesale distribution process.  This is driven by the amount of gross equity capital raised for the direct investment programs.  The company recognizes revenue on a gross basis and typically receives a commission of ~9% on gross proceeds, then redistributes 6-7% to selling group members based on the volume of shares sold and the level of marketing provided, which is recorded as third-party commission and reallowance expenses.  Net/Net RCAP generates net revenue approximating 2-3% of equity raised.

Secular/Business backdrop

Broadly speaking, RCAP’s products are part of a growing trend toward increasing demand for alternative investment solutions and the increasing availability of those products to the retail investor.  Demand is being driven by the outperformance of alternatives versus the broader equity and fixed income markets over the past 20 years.  Additionally, the combination of high levels of correlation between equities and fixed income and recent periods of extreme market volatility, have caused advisors to seek greater portfolio diversification for their clients.  These financial advisors are increasingly addressing portfolio diversification through alternative asset classes, similar to the way institutions have done over time.  Despite the recent growth, the market is still only at the beginning of this trend, as alternatives make up only 2-3% of retail investors portfolios, versus 20% institutionally.  RCAP’s wholesale business is a “pure play” way to capitalize on the growth in this market segment.

The company’s product suite of liquid and illiquid DIPs include NTRs (the majority), mutual funds, and BDCs.  In general, these programs are designed to deliver capital preservation and cash distributions. Net yields are typically 6-8%, post fees.  Programs are sector specific, and typically target $500M to $2B of equity raised. They typically offer limited liquidity but are freely tradable 3-7 years after closing.  Within NTRs, RCAP’s product breadth gives it a competitive advantage, as RCAP is able to focus on sector-specific products based on its assessment of the demand for a particular sector and the timing of relevant market cycles. For example, some of RCAP’s non-traded REIT products currently include healthcare, grocery anchored retail, real estate debt, oil and gas, anchored core retail, small mid-market lending, global sale lease-back, New York office and retail, closed-end and open-ended real estate funds, and non-traded business development company funds.  RCAP exited its most rate sensitive triple net lease product, where Cole is the major provider.  We expect RCAP will continue to adapt to the current environment by focusing its distribution on products more oriented to the current point in the economic cycle (i.e. products that generate NOI growth if inflation/rates rise due to economic expansion) and floating rate products.  RCAP’s recent StratCap acquisition will complement RCAP’s legacy wholesale distribution with additional “unaffiliated” products (those not sponsored by ARCP or its affiliates). 

Industry sales growth has been driven by the growth in alternatives as a class, a desire for yield and lower volatility, development of new products, increased distribution, and via liquidity events/recycling of capital from funds that have matured.  As it relates to new products, RCAP’s new product pipeline is robust; the Company is marketing 31 products in 2014 versus only 14 last year.  RCAP’s 31 products in distribution/registration represent $40b in equity, or close to 3x the Company’s estimated 2014 equity raise forecast.  RCAP has also rapidly expanded its distribution footprint over the past several years; since 2009 total broker dealer firms distributing RCAP’s products has increased from 197 to 325 and active selling agreements have increased from 334 to 1,150.

One of the nice features and/or growth drivers of this business, is the embedded client base.  With a core of satisfied customers, RCAP is able to retain customers as old vehicles are liquidated and new ones are created, providing good visibility into new product sales (perhaps 80% of new fund investments are from existing customers in funds that have liquidated after reaching their 3-7 year target life).   These liquidity events have been a strong driver of sales in recent years (although they can make sales in any given quarter somewhat lumpy).  However, In addition to repeat clients purchasing new offerings, RCAP has visibility into product sales based on the schedule of anticipated closings.  As new products close (over a typical 2 year marketing period), the rate of capital raised generally increases over the life of the program with as much as perhaps 40% in the final months of closing.  This phenomenon we believe helps RCAP forecast its pipeline ($14b in equity sales in 2014, including $2b from StratCap).  Stanger research also estimates that over the next 12-18 months $40b of non-listed direct investment products will likely complete liquidity events.  This capital is likely to be recycled into new products, providing further pipeline visibility.  Moreover, Stanger estimates that over the next several years organic growth will propel the industry to $75b+ of equity raised.

Addressing Overall Issues/Risks

There are three reasons the market is offering us the opportunity to buy this stock here – concerns regarding a) the wholesale business, b) management, and c) the company’s external management structure.

• Concern #1 - Wholesale -
  • Before we dig into the market’s concerns, it’s worth noting that we think there is likely limited earnings risk from Wholesale/IB and the segment is not relevant to our overall valuation. Here’s why -
    • We are already modelling $13b in DIP equity raised in 2014 (vs mgmt’s $14b guide).
    • We are modelling flat volume growth in 2015 and 2016, versus management’s expected 38% growth in 2014, $40b of industry liquidity events over the next 12-18 months, and Stanger’s forecast of a $75b DIP equity market in a few years.  We believe our flat assumption may likely prove conservative.
    • We are already modelling a 26% EBITDA decline in Investment Banking EBITDA in 2015, as we think the Company had an exceptional 1H14 that is unlikely to repeat.
    • The reader is free to make their own assumptions about this segment, but for every 20% decline in Wholesale/IB EBITDA we lose 6% of total Company EBITDA. This would impact our valuation by $2 due to the fact that Wholesale/IB is a significantly lower multiple business than Retail.  If Wholesale/IB was cut in half our base case value would be cut from $38/share to $34/share.  We believe these draconian scenarios are unlikely and academic, but we point it out to show that our thesis does not hinge on this segment.  We believe in general, the Street/Buyside is overly focused on this segment.

• Wholesale Issue #1 - FINRA 14-06.  With all that said, the market’s biggest concern around the Wholesale segment relates to the existing fee structure to financial advisors who sell non-traded REITs, and pending reform which will lead to a restructuring  and perhaps an ultimate reduction in those fees.  Currently, financial advisors receive an upfront fee or “load” in these products of around 7%.  In an effort to promote better transparency, FINRA has created a new rule called “FINRA 14-06”, which will likely be implemented in the first half of 2016.  FINRA 14-06 will require that NAVs be stated on customer’s brokerage statements earlier than the prior industry convention of ~18 months post offering.  With the large upfront load plus underwriting/other fees, the initial upfront NAV would be shown as 88-90c which is an unappealing mark for an investor, understandably.  In response to this, the industry is changing the structure of its fees.  For the financial advisor fee, product providers are moving to spread the fee out over the life of the product, so instead of 7% upfront, it will be 1% a year for seven years as an example (similar to the way mutual funds have created Class B shares).  This will cushion the NAV hit to the investor.  In addition, the greater transparency of NAV’s may make it more likely that the financial advisor fee will come down over time, in addition to being spread out over the longer duration.  FINRA is mandating only the NAV disclosure, not any fee changes, but the industry is implementing these changes as a result.

  RCAP is publicly very supportive of these rule changes.  The Company is already systems compliant, and ready for FINRA 14-06 implementation.  With the NAV issue “resolved” the most tangible negative impact could be that financial advisors will be less likely to sell NTRs, because they are making less commission upfront.  We think the exact impact is unknown but would make the following observations.  First, at least initially advisors are still making the same dollars, they are just spread out over time.  Secondly, the absolute levels of the fee is still very attractive to an advisor, as compared to stocks, bonds and other regular trades.  Even if fees ultimately come down, this still holds true.   Third, this is a relatively low touch product for a retail broker; it’s not tradable, and the client/investor isn’t staring at daily volatility and calling in saying “what happened to AAPL today”, nearly to the degree they are at the other parts of their portfolio.  Fourth, the fee stream is long-lived (versus most parts of the portfolio that are subject to market and liquidity risk).  Finally, the NTR product is still a very small piece of an overall portfolio, not enough for the broker to care so much as to avoid selling them.  All in, it seems likely that brokers will still have incentive to sell the product.

  In addition, there are likely to be positive benefits brought on by the change in NAV disclosure and fee structures, which is why RCAP has been vocal in its support.  The first benefit, is that the industry becomes more transparent and accountable.  As the largest provider in the industry, RCAP believes this will benefit them disproportionately versus others.  Second, the changes are likely to grow the market.  In the past, NTR sales have been hindered by the reluctance of wirehouse brokers to sell the products partly due to lack of transparency and the high upfront load which hurt the initial NAV.  WIth only 20% of the retail brokerage industry currently selling NTR’s, its likely these changes will expand the market as new distributors come onboard.  In fact, management analogizes similarity increased transparency, reduced fees, and increased distribution as responsible for the booming growth of the annuities market in the past two decades and even partly aiding the growth of the mutual fund business as fees there have come down over time.  Other benefits of the fee changes include an earlier and larger deployment of capital at the fund level, which will increase the IRR to the investor.  If retail broker fees drift down over time, this will benefit investor returns as well.  Finally, we think it’s also important to contextualize these fees to other similar products.  Fees for all illiquid financial products are always higher.  The absolute level of fees here are not so dissimilar to an annuity product (4-7%) or a hedge fund product (2/20, fund of funds fee, broker fee).  Underwriting fees in an IPO are 7% and follow on fees are 5%, the investor doesn’t “see” these fees because companies don’t publish NAVs, but the fees are still there.

  It’s also interesting to note that SCHW and other RIA firms sell a significant amount of NTRs (approximately 20% of the market is sourced through the RIA channel), this is significant because an RIA makes a 1% wrap fee regardless of whether he’s selling a stock, mutual fund, or a NTR.  So the fact RIAs are selling a substantial amount of NTRs indicates a level of “pull” demand rather than “push” selling in an effort to sell product with the goal of generating as much fees as possible.

  Most industry participants think as a result of FINRA 14-06 there will be a several month “blip” in sales as brokers adjust to the new fee structure and selling of Class B shares, after which education/training will lead to a resumption in current growth and ultimately likely market expansion due to broader distribution.

  It’s important to note, the increased NAV disclosure will likely restructure and perhaps reduce FA fees, but it will not directly impact RCAP’s fees.  RCAP’s fees are more akin to the underwriter of an IPO/follow on which have demonstrated good pricing consistency over the years.  In addition, RCAP’s wholesale business is almost entirely variable cost, so if there were to be any pressure on fees/volumes in the future, it would likely result in commensurately lower payouts to its salesforce without meaningful negative operating leverage on EBITDA.

• Wholesale Issue #2 – the future sales outlook for non-traded REITS.  A second debate relates to the sustainability of the growth of these products going forward.  Recent volumes have been aided by the appeal of NTR yields versus abnormally low interest rates, excess returns driven by increased real estate values, and a large recycling of capital via liquidity events.  As rates rise, this could impact all of the above.

  First off, the goal of these programs is to generate a 12% total net return in an average market, with 75% of the return generated via dividends, and the remainder or upside driven via capital appreciation.  The appeal and marketing of these products centers around capital preservation, current income, and tax deferral benefits.  For an investor focused on current income, the difference between achieving a 6-8% annual net yield in a NTR product versus the 4-5% yield available in the public REIT market is a big deal.  For the ability to buy in at a lower NAV and a higher yield than they otherwise could in the public markets, the investor is exchanging liquidity that they likely do not ascribe much value to (for better or worse).  While recent IRRs have undoubtedly been bettered by strong capital appreciation on exit, that has likely been viewed as “upside”.

  So with the ten year at 240 bps currently, and even up to significantly higher levels, there is likely real appeal for a certain piece of the portfolio to generate a 6-8% net yield, with limited volatility and tax deferral advantages.  Remember, this is being sold to Main Street not Wall Street.  I imagine most readers here wouldn’t be interested in buying a NTR and they also wouldn’t be interested in buying annuities either, but that hasn’t stopped the annuity business from being a multi hundred billion dollar market (which is now mature).  In fact the fees and low absolute yields make the annuity product unappealing in this environment, yet it is still a huge market and people buy the product because they need income.

  As a testament to the appeal of these products, from 2003 to 2006 the industry generated ~$6b in capital raised annually.  In 2007, as the equity market was peaking, the industry generated close to $12b in equity raised and then as the world collapsed in 2008 (when people were literally putting money under their mattress), the industry still generated a near record $10b in equity raised.  In 2009, with strong equity market appreciation, the industry brought in another $6b of equity (investors did not pull away much from the prior several years pace in spite of significant gains in stocks) and the industry has continued to grow since then.

  As rates rise, RCAP’s products will still maintain their healthy spread above other yield oriented products (and if RE values decline newly issued products will have a higher go forward yield).  In addition, RCAP’s products could still achieve some capital appreciation on new products issued (as new NTRs would be buying in at lower values vs the older embedded books at public REITS) and RCAP will likely be distributing products more positively levered to a growing economy such as office, retail, and floating rate products.  It’s also interesting to note that in the last rate hike cycle which began in 2004 and ended in 2007, the industry raised nearly twice as much capital in 2007 (with fed funds at 5%) as it did in 2004 (with fed funds at 1%).  Lastly, liquidity events certainly could slow, but with $40b of capital industry-wide waiting to be recycled in the next 1-2 years, it’s unlikely that they will stop.

• Wholesale - Conclusion on Concerns.  To summarize, industry fee changes will impact the 7% financial advisor load and not RCAP directly.  There is some risk of a temporary impact to industry volume as the changes are enacted, but longer term the changes should actually help industry volumes.  When/If a blip does occur, it will be a long ways off, as FINRA 14-06 is set to be implemented 18 months from now in the first half of 2016.  Moreover, demand is likely pretty durable even if rates rise as there seems to a real appeal for these products as demonstrated by the industry’s resiliency in the face of several different market environments.  Most importantly, we feel we are already being conservative on the outlook for this segment and given its immaterial impact on valuation, it may prove to be upside.

• Concern #2 - Management.  This is some of the same team that was the external manager of ARCP.  Nicholas Schorsch is on the Board of both companies.  Mike Weill and Bill Kahane are no longer affiliated with ARCP, but are partners of AR Capital which sponsors many of the NTR’s that RCAP’s Wholesale business distributes.  This team is generally viewed as empire builders, continuously buying assets to generate incremental fees.  In this situation however, management owns ~35% of RCAP’s stock or ~$650m in value, so the vast majority of their net worth is in RCAP stock.  Under the external management agreement described below, we are estimating management will earn roughly $48m in fees in 2016 which equates to a mere 7% move in the stock price based on the value of their holdings; it’s clear the easiest path to maximize value for themselves is through stock appreciation not through management fees. While management did sell some stock in the June follow-on (they sold 5m shares which took their ownership down to 30m shares or 35%), this was done solely to pay for tax liabilities related to the First Allied Deal and from the collapsing of their Class B shares into Class A shares which created a gain.  We would be very surprised if going forward, management sold any meaningful amount of stock at anywhere near these levels.  They are well incentivized to execute, and seem intently focused on generating a value off of their investment in RCAP stock from here.  In addition, for the asset that matters the most here which is Retail, they have hired excellent outside executives headed by Larry Roth the former CEO of AIG’s and ING’s retail advice businesses, as well as former executives from First Allied and LPLA.

• Concern #3 – External management structure.   The Company has a somewhat convoluted external management fee and performance fee structure, which we find distracting and unnecessary although not unfair in dollar terms.  Specifically, in lieu of G&A, RCAP management is paid a) a management fee based on pretax income and b) a performance fee based off of 20% of the net income on which they earn more than an 8% ROE.  Specifically the management fee formula is 10% of GAAP pretax income, which is advantageous because GAAP is weighed down by purchase amort, stock comp, and acquisition charges.  The performance fee is based off (net income + D&A + other non-cash) to derive a “core earnings” metric.  If the core earnings metric is greater than 8% of $1.3b (which is the weighted average price of stock issued x basic shares), then they receive 20% of the excess of core earnings over the 8% hurdle rate.  The company paid de minimis management fees in 1H14, because they were barely positive in GAAP pretax income as a result of charges, and they have not hit their hurdle rate yet on the performance fee.  We are modelling $23m of management fees and $25m performance fees in 2016.  That equates to $48m of G&A in 2016 on a business doing $425m in pre-management fee EBITDA or roughly 10% of EBITDA and 100bps of EBITDA margin, which seems reasonable.  In addition, the fees are tied to P&L performance so interests should be aligned (less they are taken with undue risk).  While there may be some argument that this model isn’t quite as scalable as regular internally managed companies (where G&A is arguably more fixed, although G&A would grow at least with inflation, new hires, etc), again we are dealing with reasonable numbers here.  We come back to the fact that management owns $650m of stock, they are set to earn $48m in management fees in 2016 which equates to a 7% move in the stock price; management is just much more economically incented to make the stock work rather than just generate fees.  Net/net we are comfortable with this external management structure, the biggest issue we find is the unneeded complexity this introduces into the model.  If this turns into a gating item for the stock, we believe RCAP will internalize this management structure, simplifying the story and removing a potential overhang.

Financial model/Valuation

We’ve modeled Retail growth in line with management estimates for low double digit organic revenue growth, driving mid-teens EBITDA growth.  Pro forma for synergies, Retail is running at an 8.4% EBITDA margin, overtime management believes that margin can approach 10.5%.  That target is outside the forecasting period, but we have them getting to 10% in 2016.  By comparison, LPLA grows revenue and EBITDA in the high single digits.  Analysts include incremental EBITDA from a rise in rates for LPLA in 2016, but most do not include it for RCAP.  Our projections do not include a contribution from a rise in rates or future M&A.  We address those separately below, as well as the company’s tax shield.  In the Wholesale and Investment banking business, we have conservatively modelled flat growth going forward.  We believe the bias could be to the up here.  Company Guidance for 2014 is $304-$327 in total EBITDA, we are modelling ~$301m of EBITDA in 2014 (due to lower wholesale) and $352m of EBITDA in 2015 with $2.63 of Cash EPS. See below -

Based on our numbers, RCAP is trading at only 6.2x ’15 EBITDA and 8.4x Cash EPS.  Despite its inferior growth, LPLA trades at 10.9x ’15 EBITDA and 17x ’15 EPS, roughly a 80% to 100% premium to RCAP.

Moreover, even a comp set of broker dealers and AMP (an insurer, wealth manager, and asset manager) trade at 13.2x 2015 EPS, a 60% premium to RCAP, despite bank holding company capital requirements and lower organic growth.

Based on a weighted average of RCAP’s EBITDA mix, rolling forward 2014 multiples for LPLA and assigning conservative multiples for wholesale and investment banking, RCAP should trade at ~10x EBITDA ’15 EBITDA and 15x Cash EPS in a year.  Beyond 2015, Retail will continue to grow as a larger % of the total, as the benefit from a) rates, b) M&A and c) margin improvement will all accrue to this segment while if Wholesale were to slow it will be a “lower multiple” impact on the stock’s valuation.  Net/Net some combination of this positive mix shift towards Retail would add ~1x to the multiple.

9-10x 2015 EBITDA implies roughly 75% upside to the stock, including $3 for the company’s tax shield -

14.5x 2015 Cash EPS implies similar 75% upside to the stock -

The Earnings Power from of A Rise in Short Term Interest Rates –

There is substantial incremental upside should short term rates rise.  Currently RCAP earns only roughly 10 bps on cash in client accounts.  In addition, client cash as a % of assets is at a low point in the cycle given the low yields.  When fed funds rise, RCAP will earn more on this cash and pass through some of the increased yield to the investor.  In addition, investors will likely park more money in these money market funds (MMFs) or cash sweep accounts as they achieve a greater yield, more likely to a level approaching historical averages close to 8%.  For the first 100 bps rise, RCAP will retain about 70% of the rise, for higher rate levels we believe RCAP will follow LPLA’s lead and syndicate out some of its cash to wholesale banks in exchange for a spread which will allow it to achieve yields at a 50% contribution.  The following table demonstrates the incremental EBITDA contribution on estimated average 2015 AUA (assuming VSR and Girard close at the end of 2014) at 4-8% of cash as a % of AUA under various rate scenarios.  Note for a 100 bps rise with client cash at 6% of AUA, RCAP generates an incremental $72m of EBITDA (20% of 2015 EBITDA) or 50c in EPS.  EBITDA at 200 bps fed funds could be ~135m (38% of 2015 EBITDA) or 93c in EPS.

If you believe rates rise in 2016, by then RCAP’s Average AUA should be around $284b.  At this AUA level, with a 100 bps rise with cash at 6% of AUA RCAP would generate an incremental $78m of EBITDA or 54c in EPS.  EBITDA at 200 bps fed funds could be ~146m or $1.01 in EPS.

The Earnings Power from M&A Execution –

Management’s execution of the company’s M&A strategy should result in further accretion.  We assume RCAP currently has around $400m in free cash available for M&A.  This is current cash of $475m less ~$60m paid to close the StratCap transaction post the June quarter.  Note also that RCAP generates ~$200m in FCF per year.  As a scale buyer, RCAP can buy retail assets between 0.4x-0.5x gross revenues and drive synergies which results in a low effective EBITDA purchase price.  See below –

Combining Rates, M&A, and Wholesale Sensitivities, and Summary

In combination, rates and M&A create a big “step function” up in earnings power.  Moreover, they increase Retail’s contribution mix as a % of EBITDA which will drive incremental multiple expansion.  As shown below, its likely Retail approaches 75% of EBITDA over the next couple years.   In addition, if we are wrong in our already conservative forecasting of flattish Wholesale/IB in the coming years, even draconian scenarios lead to di minimis earnings risk.  Any reduction would be dwarfed by any one of the positive levers in Retail, leaving us net/net meaningfully ahead of our own base forecasts and consensus estimates.  The stock is trading at dramatically cheap multiples, under a variety of bullish and bearish scenarios.

The Street is overly focused on the Wholesale/IB segment as it is not a large driver of value -

 

In summary, the story here is the retail advice business.  This stock is extremely cheap.  Management has a ton of skin in the game.  Wholesale risks are manageable, and may even prove to be a source of upside.  Even applying your own modest “complexity”, management or integration discounts, the stock has tremendous upside.           

Catalysts

The first catalyst is we think the sell side will become more bullish on this name as the company executes.  The three initiation reports were completely uninspiring, don’t really hit on any of what we’ve written, and sentiment there seems like it can literally only go up.  Secondly, we expect RCAP’s 2015 guidance released with Q3 earnings to be positive as they will hopefully articulate more retail synergies and continued execution on wholesale.  In the near term, management will do a non-deal roadshow to better explain the story to new investors.  Longer term, we think the company will refinance its high cost debt, and benefit as rates rise and more M&A is announced.

Appendix - $3 Tax shield

RCAP has a tax shield from generating purchase amortization form its deals.  The Company reports ~$100m in tax deductible purchase amortization a year.  At a 10% discount rate and an 11 year life, this generates roughly $3/share in present value tax savings.  As they do more deals, this shield will grow.  We haven’t really adjusted our EBITDA multiples for this as it represents less than 1x but I alluded to it in the valuation grid, in that it should be added back to the stock price incremental to an EBITDA based target multiple.  It represents about $0.45c in EPS which we’ve included in Cash EPS (similar to company reporting) as it’s large, arguably perpetual, and more closely maps to FCF.  Valuing at 14.5x EPS gives about $3 of extra credit over the $3 in tax savings, so you can back that difference off a P/Ex-based target (which will be a rich man’s problem if the stock is at $38 or $55), and again on EBITDA it’s a net benefit. See below –

Appendix - Capital structure

RCAP is only moderately levered at 2.4x Gross debt/2015 EBITDA and 1.1x Net debt/2015 EBITDA; the Company’s debt is relatively high cost and we expect it to be refinanced over time.

 

• 2015 guidance
• 2015 synergies announced
• Upcoming non-deal roadshow
• More bullish sell side sentiment
• Execution/Integration
• Achievement of synergies
• RCAP engages in more M&A
• Eventual rise in short term interest rates
• Refinancing of high cost debt