BGCP: Severe Undervaluation Plus A 7% Yield Equal 57% Upside by Nathanael A. Stewart, CFA – Opus Capital Management
Case Study: BGC Partners, Inc. (BGCP)
Before we get started on BGCP, we wanted to provide an update on our view of RMR Group Inc., a stock we wrote about in an article published at ValueWalk on January 6th, 2015. We purchased RMR Group Inc. for our Small Cap Value Plus Strategy (a dividend, growth, and quality focused strategy) in late December 2015, when it was trading at near a 4X EBITDA multiple and a 7% yield. Today, the Stock is trading at close to 10X our full-year 2016 EBITDA estimate, and the yield has fallen to less than 3%.
While we still believe that RMR Group has strong long-term potential, at this moment in time we see the stock as fully valued and vulnerable to a pullback. As such, we chose to lock in our 136% gain (computed using average trading prices) and move on. We are pleased that the RMR situation was able to make a solid contribution to our Small Cap Value Plus strategy’s year-to-date return, which stands at 15.35% vs. the Russell 2000’s 7.68% return (as of July 22, 2016).
Charlie Munger: Invert And Use “Disconfirming Evidence”
The question we seek to answer through our investment process is, “what is the best use of our client’s capital at this time?” In this vein, we believe that BGCP represents a compelling opportunity: It combines a juicy 7% yield, severe undervaluation, and an owner-operator CEO who has strong incentives to realize the business’s underlying value.
[Note: At the time of this writing, our SCVP strategy holds a position in BGCP]
BGC Partners, Inc. (BGCP) is made up of two segments, Commercial Real Estate and Financial Services
- Newmark Grubb Knight Frank (KGKF) is a full-service commercial real estate platform that offers tenants, owners, investors and developers a wide range of services, including leasing, corporate advisory, investment sales, real estate finance, consulting, project management, and property management and facilities management.
- The financial services segment specializes in the brokerage of fixed income, foreign exchange, equities, energy, commodities, and futures. The firm’s integrated platform is designed to provide flexibility to customers with regard to price discovery, and enables them to use voice, hybrid, or fully electronic brokerage services in connection with transactions executed over the counter (“OTC”) or through an exchange.
- FENICS is BGCP’s fully electronic brokerage platform. It is worth separating from the larger financial services segment due to its rapid growth and the premium multiple we believe it might command if sold to a strategic acquirer.
BGC was formed in 2004, when Cantor Fitzgerald separated its inter-dealer voice brokerage business into a new subsidiary. In 2008, BGC merged with Espeed, a fully electronic trading marketplace that had been launched by Cantor in 1996. This collection of newly merged businesses was renamed BGC Partners, Inc. Since that time, BGC Partners has grown both businesses through a series of acquisitions. In fact, the real estate business was formed as a result of the opportunistic purchase of Newmark & Company and Grubb & Ellis, which are still the core assets of the company.
The company’s recent acquisition of GFI Group and the subsequent sale of GFI’s Trayport electronic trading business to Intercontinental Exchange (ICE) is a particularly interesting – It resulted in one of the most immediately and substantially accretive transactions we have ever seen, and is a credit to CEO Howard Lutnick’s skill.
In early 2016, BGCP acquired GFI Group for total consideration of $750 million. On December 11, 2015, GFI completed the sale of their Trayport electronic trading unit to Intercontinental Exchange (ICE) for $650M. This left BGC Group with GFI’s voice/hybrid brokerage business, which it paid a net of $100M for ($750M – $650M).
However, it gets even better. BGCP has already realized $100M in cost savings identified as a result of the GFI-BGCP business combination, and now believes (as of Q2) that an additional $25M in cost savings exist. This means that all of the earnings lost via the sale of Trayport have been made back (and then some). As CEO Howard Lutnick recently stated,
“Now you’re making $70 million a year on a company I paid $100 million net for… And that, my friend, I consider the best risk-adjusted transaction I will probably ever do.”
We view CEO and controlling shareholder Howard Lutnick as a severely underrated CEO whose interests are well aligned with other shareholders. A recent article in Forbes Magazine suggests that BGCP might be suffering from a “Lutnick Discount” due to his reputation as a “sharp elbows” type of businessman. We view this as a positive – such perceptions only serve to increase the odds that BGCP’s stock is being unfairly penalized by the marketplace.
Regardless, Lutnick has delivered results, as documented by the GFI/Trayport deal and his opportunistic building of the real estate business. Based on recent statements and his large percentage ownership of the company, it is clear that he is motivated to unlock BGCP’s hidden value.
“We believe that BGC’s assets, including Trayport and NASDAQ as well as our NGKF and FENICS businesses are independently worth significantly more than what is reflected in our current stock price. Based on recent equity market and M&A multiples, we think that the market is undervaluing both NGKF and FENICS. We also believe that the market has yet to accurately value the more than $700 million in additional NASDAQ stock we anticipate receiving over time and the significant proceeds we expect to receive from the Trayport’s sale, neither of which are reflected currently on our balance sheet. Although no decisions have been made, we are considering a number of options designed to unlock substantial shareholder value.” – CEO Howard Lutnick, Q3 2015 earnings call
Voice/Hybrid financial services business:
- $140M pre-tax earnings (Not including Nasdaq earnout)
- 9X multiple
- Value: $1.3B, or $2.96 per share
FENICS electronic trading business:
- $110M pre-tax earnings – revenue and pretax profits were up 68% and 55% Q1/Q1
- 20X multiple
- Value: $2.2B, or $5.08 per share
Real Estate Business
- $137M pre-tax earnings
- 11X multiple
- Value: $1.5B, or $3.48 per share
Total Value: $5.01B, or $11.52 per share
Multiples are based on what we view as relevant comps. For example, we noted that the Espeed business was valued at over 20X pre-tax income and greater than 10X trailing sales when it was sold in 2013. We believe that BGCP’s FENICS business is a premium, high margin strategic asset that is vastly undervalued within BGCP’s complex structure.
The above calculations suggest immediate upside of 28%. Yet as they used to say on television, “but wait, there is more.” The above summary analysis does not factor in the company’s liquidity position or its Nasdaq shares receivable, which is a substantial hidden asset that does not show up on the balance sheet. As stated in the most recent 10-Q:
“In connection with the Company’s sale of its on-the-run, electronic benchmark U.S. Treasury platform (“eSpeed”) to Nasdaq, Inc. on June 28, 2013, the Company will receive a remaining earn-out of up to 11,906,964 shares of Nasdaq common stock ratably over the next approximately 12 years, provided that Nasdaq, as a whole, produces at least $25 million in gross revenues each year.”
These Nasdaq shares are presently worth around $850M, or $1.95 per share. We will add this value to the company’s cash, securities, and debt to position:
- Liquidity (Cash + Securities): $680M
- Nasdaq Shares: $850M
- Long term debt: 839M
Net: $691M, or $1.59 per share
Adding this $1.59 per share to the previous $11.52 value gives us a net value of $13.11 per share, or 50% upside from today’s $8.75 price. If we add the 7% yield to this figure (assuming a one year holding period), we get total return potential of 57%. It is important to note that our $13.11 price target would still allow for a generous yield of 5%. We see the current 7% yield as much too high in the current “yield hungry” environment, particularly given BGCP’s steep undervaluation.
FENICS strategic value example: Interactive Broker’s Group (IBKR)
While many investors focus on the stand-alone value of the BGCP’s KGKF real estate business, we believe that parts of BGCP’s brokerage business (particularly the electronic component) could create immense value for an acquirer. We believe that such a case can be made with Interactive Brokers Group (IBKR).
Interactive Brokers Group has two business units, electronic brokerage and market making. In recent years, the brokerage business has flourished, while the market making business has suffered. As CEO Thomas Peterffy explained in the recent Q2 2016 call, high frequency trading firms has sucked most of the profitability out of the market making business. Peterffy stated,
“Now I must say a few words about market making. While we have been focusing on our brokerage business, the world has changed and left us behind”
In a second part of the call he stated,
“So the uninformed trades have diminished in frequency, because the brokers, the retail brokers are now selling the order flow to Citadel and Susquehanna and Goldman. And so we end up trading with the informed traders, those who successfully trade for a living.”
While Interactive Brokers Group will explore setting up its own high frequency trading firm, Peterffy also suggested that the capital currently dedicated to the market maker ($1.7B) might instead be used to support the brokerage business. The above insight ties in with a second statement Peterffy made in the same Q2 2016 call. In response to an analyst’s question about opportunities in the Prime Brokerage/hedge fund space, Mr. Peterffy stated,
“Well you see, we have basically two large disadvantages. One is that we are a relatively new name in the space and we are certainly not too big to fail. And secondly, we do not do over-the-counter derivatives, which from a profitability point of view is an advantage, but from the product base point of view it isn’t, because as you know many of the big prime brokerage customers do those things.”
Here is the question: How valuable would parts of BGCP’s brokerage unit (The electronic assets, but potentially parts of the hybrid business as well), be to Interactive Broker Group at this time?
First, it would allow Interactive Brokers Group to profitably redeploy the capital assigned to the diminished market making unit into a highly profitable, growing business. Second, it would create the OTC platform that CEO Peterffy Identified one of the company’s key weakness in the Prime Brokerage/ hedge fund space.
From an investor’s point of view, this would further position Interactive Brokers Group as a “pure play” brokerage firm, while a venture into high frequency trading would (In our opinion) confuse investors – creating much the same problem that BGCP itself suffers from now.
While the above example is just a thought experiment, the point is that BGCP is a collection of businesses worth far more than the current market place. We see 57% total return potential over the next 12 months.
Note: BGCP’s Q2 earnings were out this morning. Performance was solid and in line with our expectations. We continue to believe that BGCP’s valuation is unsustainably low, and that the stock’s intrinsic value will grow over time.
Mr. Stewart is a Portfolio Manager for Opus Capital Management’s Small Cap Value Plus strategy. The Small Cap Value Plus strategy provides total return and income for investors by focusing on the attractive universe of small cap dividend payers. Historically, these companies have outperformed the broad small cap universe and provided superior downside protection. Make sure to bookmark our Institutional Insights blog to follow along with our latest thinking. Opus Capital Management reserves the right to make investment decisions regarding any security without further notification except where such notification is required by law.