BGC Partners Tops CME Group in Bid for GFI Group

 BGC Partners (BGCP) announced on Sept. 9 that it intends to commence a $5.25 per share tender offer for  GFI Group  shares. This offer is 15% above the  CME Group (CME) equity offer of $4.55 per share announced in late July. Besides the price, another major difference between the two offers is that CME Group's offer is structured as a tax-free exchange for CME shares, whereas the cash offer from BGC Partners will create an immediately taxable event for most shareholders. The BGC Partners offer is also contingent on enough shares being tendered for it to own a majority of GFI Group when added to its existing 13.5% ownership interest. With the change in GFI Group's management, large influx of cash at BGC Partners after selling eSpeed, and tough interdealer broker industry environment, we had always thought that BGC Partners was likely to be a consolidator and that GFI Group would be a likely target. We don't anticipate making a material change to our fair value estimates for BGC Partners or CME Group, but we may raise our fair value estimate for GFI Group to reflect the probability of this tender offer going through. We are maintaining our wide moat rating for CME Group and no-moat ratings for GFI Group and BGC Partners.

Though BGC Partners’ $5.25 proposed tender offer for GFI Group shares is about 40% above our stand-alone fair value estimate for GFI Group and 15% above CME Group’s offer, the premium could be justified by merger synergies and a resulting change in the competitive dynamics of the interdealer broker industry. Even if we assumed absolutely no synergies, the loss from overpaying would be about $0.50 per BGC Partners share. Given that BGC Partners hasn’t given much detail about synergy benefits, and given the possibility that the tender offer won’t materialize, we don’t anticipate making a material change to our fair value estimate for no-moat BGC Partners.

In terms of justifying the premium, we would point to several value-enhancing financial and operational options that wouldn’t have been available to GFI Group as a stand-alone company. An unusual financial item would be a potential lowering of GFI’s debt financing costs, as GFI’s interest expense increased with the deterioration in its financial position. GFI is still operating cash flow positive by itself, but its free cash flow and accounting net income have been depressed by the low volume trading environment. BGC Partners would also be able to use GFI’s deferred tax assets earlier, which has a time value of money benefit.

A combination of the two interdealer brokers would also come with operational synergies. Driving GFI’s business volumes through a rationalized employee base will benefit compensation expense. BGC Partners’ competitive position could also improve, as it gains liquidity and information advantages in asset classes where it scales up.

We Think a BGC Deal Offers Greater Industry Benefit
In our opinion, a transaction between BGC Partners and GFI Group would likely be more of a boon to the entire interdealer broker industry than a transaction between GFI Group and CME Group would be. This means that ICAP, though not directly involved in these acquisition deals, could be a beneficiary. The resulting operational consolidation and rationalization between BGC Partners and GFI Group would take capacity out of the interdealer broker space and could firm up the prices for trading, while also decreasing the competitiveness for brokers and the compensation that they can demand. That said, it’s not yet a sure thing that the BGC Partners transaction will occur, so we don’t anticipate making a material change to our fair value estimate or moat rating for ICAP.

There are at least two distinct reasons that the tender offer wouldn’t be consummated. First, CME Group could raise its offering price for GFI Group. Given CME Group’s $25 billion-plus market capitalization and annual net income of around $1 billion, increasing its offer by $100 million or more would be easy. As GFI Group’s shares are currently trading above BGC Partner’s offer price, the market appears to believe that another bid is coming. It’s difficult to place a price on what CME Group might bid, as GFI’s assets have more of a strategic rationale via expanding its ties in Asian and European energy markets. Any price CME pays likely has more value attributed to this positive, competitive positioning optionality than the current profitability of GFI’s business assets.

Second, GFI Group’s management team, which owns around 40% of the company’s shares, may not opt for the BGC Partners deal. Given that a stipulation of the BGC tender offer is that it has to attain majority control, GFI management could prove a hurdle.

Long-Term Outlook Contingent on Outcome of Three Issues
Three issues may change our long-term outlook for GFI Group as an independent company. The first is if a pullback in trading of bank customers (due to higher regulatory capital requirements or some asset classes like credit default swaps or physical commodities being out of favor) permanently resets interdealer broker industry revenue lower. The second is if GFI Group or another company is a winner or loser in the swap execution facility competition. Trading volume and market share may concentrate at just a handful of SEFs, which would provide a network effect competitive advantage for the leaders and lost business for everyone else. The third is the possibility of some rationalization in the hiring and retention packages for brokers, which would improve operating margins.

Fair Value Estimate of $5 Factors In Buyout Offers
Our fair value estimate for GFI Group of $5 per share is lower than BGC Partners' proposed tender offer of $5.25 per share because of the probability that BGC Partners' offer isn’t accepted and the time value of money until the transaction closes. There is a distinct probability that CME Group will raise its offer for GFI Group from $4.55 to $5.25 or greater, but we are taking this into account through our uncertainty rating. On a stand-alone basis, we still believe the company is worth $3.80 per share, up from $3.70 due to the time value of money since our last valuation update. Our stand-alone fair value estimate correlates to 38 times forward adjusted earnings and an enterprise value/EBITDA multiple of 9 times.

We forecast a five-year compound annual total revenue growth rate of 3.7%. Though the company had a fairly strong start to 2014, we forecast brokerage revenue to be down about 3% for the year, as we believe credit and commodities were unusually high in the first quarter and multiple brokerages have stated that the coming quarter will probably be down double digits from the preceding year. We project a 5.5%-plus increase in brokerage revenue in 2015 and 2016, predicated on higher corporate bond trading turnover and changes in government monetary policy positively affecting interest rate and foreign exchange trading. After 2016, we model normalized brokerage revenue growth of 4.5%. We forecast compound annual revenue growth of more than 5% in software and data and about 2.5% in clearing. Our overall net revenue forecast for the company during the next five years comes out to a 4% compound annual growth rate. We believe the company will be able to maintain a normalized compensation/net revenue ratio of 67%, compared with an average of slightly more than 70% over the past several years, as business activity recovers. After including noncompensation expenses, we forecast midcycle operating margins of nearly 8%. Part of the reason we project lower than historical operating margins is that the company's new clearing business has low gross margins.

Limits of Interdealer Broker Industry Mean No Moat for GFI Group 
We don't rate GFI Group as having an economic moat. Interdealer broker clients are relatively large and sophisticated and can choose from several similar-size firms. This, along with a move toward more electronic trading, limits the ability for interdealer brokers to manage pricing, as evidenced by the trend of lower revenue per transaction or volume traded. Revenue-generating broker employees also have a decent amount of bargaining power with the inter-dealer broker firms, as compensation ratios have remained high despite the lowered profitability of the firms as a whole and industry players agreeing that there's overcapacity.

We believe it would take a significant change in the interdealer broker industry, such as consolidation among the top players, for returns on capital to significantly improve. Even with industry consolidation, GFI Group would probably have to dominate trading and price discovery in certain asset classes to garner a narrow moat.

Management's Performance Has Room to Improve
Colin Heffron has been the CEO of GFI Group since early 2013. During his more than 25 years at the company, Heffron has had multiple positions, including president and head of operations in Europe. Founder and former CEO Michael Gooch is now executive chairman of the board. We believe management's stewardship of the company is standard. Leading up to the financial crisis, GFI Group and other interdealer brokers produced handsome returns on capital thanks to favorable industry trends, such as the rapid growth of credit default swaps and rising interest in commodities trading. However, regulatory changes in the financial industry and the generally agreed-upon overcapacity in the interdealer broker industry may greatly reduce returns on capital. Though management has taken steps to adjust to the financial landscape postregulation, such as reducing its reliance on large financial institution customers and head-count reductions, we don't think the measures guarantee superior returns to peers.