Description

Investment Thesis

 

When eSpeed completes its merger with BGC Group, the combined company, to be called BGC will be a direct comparable to GFI Group (GFIG) and ICAP (IAP in London). On our estimates, the new BGC is trading at 8x 2008E EPS, vs GFI at 18x and IAP at 15x. The main difference in our estimates vs the 3 analysts that cover eSpeed (all “Sell” or “Hold”) is that we are assuming eSpeed/BGC simply grows revenue inline with comparable companies, despite posting better growth in recent quarters. Sell-side analysts have simply used the company’s guidance for 2008 which assumes flat revenue and we believe this projection represents over-conservativeness to enable the company to exceed estimates and establish credibility with the street.

 

Catalysts

 

In order of timing: 1) filing of proxy to merge eSpeed and BGC, 2) 3Q results and we know activity in the quarter has been very strong, 3) likely reporting EPS above analysts expectations when combined, and 4) reporting as a combined company

 

Description

 

eSpeed is a leading inter-dealer electronic platform for fixed income securities, primarily US Treasuries (the other is BrokerTec owned by ICAP). BGC is a full-service inter-dealer broker trading OTC products and derivatives. The combined company has over $1B US of revenues, making them one of the largest inter-dealers in the world.

 

US Comps	Price	08E EPS	Mkt Cap $	EV	E P/E	08E EBITDA	EV /EBITDA	08E Revs	EV/ E Revs
GFIG	$70.18	$3.86	2.1 B	2.0	18x	$229	8.5x	$1.2 B	1.7x
Europe
IAP LN	481 pc	3.1	6.2	6.1	15x	$723	8.4x	$2.5	2.4x
TLPR LN	384 pc	3.1	2.1	1.9	12	297	6.3	$1.5	1.2
CFT SW	184 ch	9.89	0.8	0.7	19	130	5.5	$1.1	0.6
ESPD/BGC
Guidance	$7.48	$0.58	1.4	1.3	13x	$190	6.8x	$1.1	1.2x
Our Est.*	$7.48	$0.95	1.4	1.3	8	283	4.6	$1.3	1.0

*Our estimates assume 08 Revs grow 19.75% over 1H07, inline with street estimates for GFIG and ICAP

Note: all amounts, except per share, converted to US$

 

 

Combining the two companies puts together a leading electronic inter-dealer with a leading voice inter-dealer. This is the same business model used by GFI and ICAP (GFI merged back with GFI Net prior to their IPO and ICAP purchased BrokerTec in 2002). The two companies are basically merged today in reality and eSpeed was realistically nothing more than a tracking stock. This means integration risk is minimal. eSpeed was IPO’d in 1999 because of the high multiple the market awarded pure electronic trading platforms at that time. However, in the last 8 years, the market has come to realize that the best business model for inter-dealers combines a strong electronic platform with an active voice brokerage business that helps push liquidity onto the electronic platform.

 

Background

 

Prior to Sept 11, 2001, Cantor Fitzgerald was widely recognized as one of the leading full-service wholesale inter-dealers. However, the company lost the majority of their US workforce on 9/11. In August, 2004, Cantor announced they would re-build this business under the name “BGC”, in honor of the original founder. In three years, BGC has gone from start up to an industry leader, an amazing accomplishment. Critics will say that this growth was expensive, and it was. BGC lost over $150m in 2005 and 2006 combined. However, looking forward, the expensive part of the build out is complete and the company has been profitable in 1Q07 and 2Q07. We believe that because the company has just recently made the turn to profitability, significant margin expansion will be realized going forward.

 

 

US Comps	2008E EBITDA Margins
GFIG	20%
Europe
IAP LN	29%
TLPR LN	19%
CFT SW	12%
ESPD/BGC
Guidance	17%
Our Est.*	22%

*Our estimates assume 08 Revs grow 19.75% over 1H07, inline with street estimates for GFIG and ICAP

Note: we estimated ESPD/BGC D&A from ESPD 1Q 10Q + BGC S-1 D&A, annualized + 10% growth

 

We Believe Estimates Are Too Conservative

 

A key point to our investment thesis is that management is guiding to 2008 estimates that are far too conservative. The company is guiding to 2008 revenues of $1.1 billion, yet if we simply annualize the combined company’s 1H07 revenue (excluding inter-company eliminations), this 2008 guidance represents flat revenue from the 1H07 run-rate. Contrast this with street estimates for ICAP and GFIG. The street assumes ICAP can grow their 2008 revenues by 16.5% over their 1H07 run-rate and that GFIG can growth theirs 23%. Either the street is too aggressive on ICAP and GFI 2008 estimates, BGC management is being too conservative, or there is fundamentally something different about these three companies that would explain how three industry leaders, serving similar clients bases, and competing for the same pool of labor, would some how have such contrasting growth. BGC / eSpeed’s recent revenue growth has exceed all peers.

 

 

US Comps	1H07 Rev Growth	1H Rev Run-Rate	2008E Revs	08E Rev / 1H07 Run-Rate
GFIG	26%	$937	$1,152	23%
Europe
IAP LN	18.5%	2,153	$2,509	16.5%
TLPR LN	N/A	N/A
CFT SW	13.4%	$1,128	$1,124	0%
ESPD/BGC
Guidance	31%	$1,094	$1,100	1%
Our Est.*	31%	$1,094	$1,310	19.8%

*Our estimates assume 08 Revs grow 19.75% over 1H07, inline with street estimates for GFIG and ICAP

Notes:    We have eliminated $60m of intercompany revenue

                IAP uses F2009 ending 3/31 for 2008 estimates

                TLPR has not reported 1H results yet, but in 2006, rev growth was low single digits

 

It is important to note that BGC has shown industry leading revenue growth the last 3 years as they have aggressively re-built the business. While we expect some pull back in the aggressive build out as the company focuses on expanding profitability, we see no reason why BGC wouldn’t at least grow inline with the industry.

 

Operational Leverage – What if Growth is ‘Just Average’

 

The simplest way to think about operating leverage in this business is that compensation is a set percentage of revenues and the operating leverage comes from fixed non-comp expenses. If we assume BGC can simply grow their 2008 revenues inline with the street estimates for GFIG and ICAP (19.75%), and we hold their compensation expense at 56% of revenue as management has guided and hold non-comp inline with guidance of $340m, we estimate the company’s 2008 EPS will be $0.95 and EBITDA will be $283 million, giving the company valuation multiples of 7.9x EPS and 4.6x EV / EBITDA

 

Answers to Skeptics

 

Skeptics of BGC generally point to 2 items: historical compensation costs and corporate governance. These are addressed below:

 

1)      In 2005 and 2006, BGC’s compensation ratio was 77% and 69%, respectively. So some skeptics argue that the 56% comp ratio management guides to for 2008 is unachievable. Seems logical. However, the past was over stated from the build out and one-time expenses to recruit new brokers. The build out hurt margins because there is a lag between the time a broker is hired and on the payroll and when he generates revenue. The more aggressive a company builds out its brokerage force, the bigger impact this lag effect will have on depressing margins. Second, one-time incentives to new brokers to join BGC have depressed margins.  The company has paid transition expenses, guarantees, signing bonuses, etc. and this has hurt historical margins. The impact of this growth is highlighted by looking at 2004 comp percentage of 59% when the company was just operating in Europe and before beginning the aggressive expansion. Going forward, on a normalized basis, is there any reason why BGC would need to pay a sizable premium to market comp simply to retain their brokers? More important than our opinion is that the comp percentage the company reported for 2Q07 which is likely most representative of the percentages we will see going forward. In 2Q07, the comp percentage was 58% (see transcript of 2Q07 call). We believe the skeptics are looking backward and not looking at the most recent data let alone the potential for further improvement.

Historical Comp Ratio

 

US Comps	2004A	2005A	2006A	2Q07	2007E	2008E
GFIG	63%	61%	62%	63%	64%	65%
Europe
IAP LN	n/a	n/a	n/a	n/a	n/a	n/a
TLPR LN	n/a	n/a	n/a	n/a	n/a	n/a
CFT SW	69%	69%	67%	n/a	n/a	n/a
ESPD/BGC	59%	77%	69%	58%	57%	56%

Note: IAP and TLPR do not breakout compensation expenses

Fundamentally, we believe BGC/eSpeed can have a compensation percentage below peers for two reasons: 1) higher component of electronic trading with the ESPD merger which has a lower payout percentage and 2) greater reliance of restricted stock amortized over a 10 year vesting schedule. While we can argue the true economic cost of restricted stock compensation, the reality is the market seldom penalizes companies for its use, especially in the early years when share dilution is minimal.

2)      Governance issues have long plagued eSpeed. The public shares have lower voting rights and there was a clear incentive to shift profits from eSpeed to the parent company which remained privately held (not arguing if this did or did not happen, only confirming that the incentive was there). For those skeptics that believe this conspiracy, I suggest they embrace it now that the tables have turned. Once the merger is completed with eSpeed and BGC, there will be no inter-company dealings, and Howard Lutnick will have a huge incentive to expand profits at the newly public BGC and drive the stock higher. First, Mr. Lutnick owns 65% of the pro forma company, second insiders will own 19% of the pro forma company, and possibly most important, the company has stated that Mr. Lutnick will divest 25% of his holding in a public offering in the next two to three years. Even the most skeptical of skeptics have to realize that Mr. Lutnick is incentivized to beat his own guidance, drive the stock higher and maximize his proceeds in this coming sale. Does he want to sale 25% of his holding, representing 31 million shares, with the stock languishing at $7.50 or does he want to hit the type of EPS numbers we estimate ($0.95), be awarded an industry multiple of 17x and sell his shares at $16 (17 x $0.95)? This would result in an additional $260 m of proceeds on his sell coming within just the next two to three years. Even for Mr. Lutnick, that’s a big incentive!

 

Catalyst

In order of timing: 1) filing of proxy to merge eSpeed and BGC, 2) 3Q results and we know activity in the quarter has been very strong, 3) likely reporting EPS above analysts expectations when combined, and 4) reporting as a combined company