Currenex and the re-rating of FX platforms

Although there were a few audible gasps in the FX market when it was revealed that State Street was buying Currenex for $564 million, the deal doesn’t look too rich with a little bit of hindsight. State Street has paid about 22 times forecast 2007 earnings, which hardly seems excessive but which no doubt will please Currenex’s biggest shareholder, TH Lee Putnam Ventures.  It will also bring cheer to investors in other trading venues, who might have been briefly worried about their stakes following the sale of HotspotFX and EBS last year.

The deal will force a re-rating of FX platforms and has highlighted just how cheaply both Hotspot and EBS were sold. Knight Financial bought Hotspot, which had made pre-tax profits in 2005 of about $9 million, for just $77.5 million. Why its owners decided to ditch it in such haste and on such a low multiple is not clear. We can all deal backwards, but it looks as if legendary speculator Joe Lewis, Hotspot’s main investor, got that one wrong.

The reasons why EBS went for a bargain price of about $825 million to Icap is more clear cut; I have already contacted several of its former board members and told them I’m going to report them for failing in their fiduciary duties for flogging the company so cheaply. But as a (very small) Icap shareholder, I suppose I should be glad that Michael Spencer managed to stage such a coup.

I doubt Currenex’s average daily volumes are even a third of what EBS turns over. Of course, the two companies are growing at different rates – EBS’s growth is far slower, which is not surprising given its self-imposed limits on its audience. But even though Currenex is able to charge more – apparently users pay about $10 a million dollars, whereas the big users of EBS are probably only paying about $2 or $3 – the difference in tariffs doesn’t justify Currenex’s sale at such a higher rating than Hotspot or EBS.

Brokerage hardly ever goes up, so there has to be a chance that Currenex’s revenue growth will slow as a result of downward pressure on its fees. Still, State Street’s uncharacteristically large acquisition looks sound. It has effectively bought a self-funding technology platform, said by many to be the most advanced in the market. At a stroke it will be able to upgrade its FX Connect trading system probably more cheaply than if it embarked on an IT spend. Therefore, whether or not Currenex can maintain its rate of revenue increase might well prove irrelevant to its new owner.

Back to EBS, though. Just what multiple was it sold for? EBS’s revenue in 2005 was $206 million. Its operating profit before exceptional items and goodwill amortization was $37 million. When the deal went through last April, EBS was predicting that its 2006 turnover would rise to $227 million and its operating profit to $57 million. There is no reason to believe it didn’t beat these objectives.

These figures are pre-tax. Now, I may be many things, but one thing I’m not is an analyst. In fact, because of what some say is a tendency to talk out of my nether regions, I’m more likely to be called an analist, but that’s a different story. Fortunately I was able to get some help from Joanna Nader at Lehman Brothers, who told me that P/E ratios by convention refer to post tax earnings. In a research note on Icap published at the time, Joanna argued that Icap bought EBS on 15 times projected earnings, once synergies had been taken into account.

If it had been sold on a multiple of 22, including synergies, its true value at the time was closer to $1.2 billion. Funnily enough, the day before Icap announced its purchase, I was out for lunch with one of the board members who told me categorically that was EBS’s true worth. Therefore, it is hardly surprising that my view is that Icap’s Michael Spencer got his hands on a bargain.

To a large degree, EBS has been freed from the shackles imposed by its previous owners. What guarantees Icap gave EBS’s mainly bank former owners is something for conjecture, but if the competition does heat up, which it is predicted to do so, it will be interesting to see its response. I don’t believe its management will stand back and watch it wither and die and its volume growth since its sale has been steady verging on impressive. EBS still has the potential to be the FX market space, even if there is another platform poised to launch with that very name.

So far, the potential of EBS and its actual true worth isn’t reflected in Icap’s share price. It could be argued that only Icap could have extracted such value from EBS, because of synergies. Others might have been able to make the same case, but EBS’s previous owners wouldn’t countenance talking to them. I believe that none of the various incarnations of Cantor Fitzgerald was invited to bid; Collins Stewart apparently took a look but only to drive the price up to make Icap pay more; EBS also declined to talk to any exchanges in the belief that such a move would lead to the spot FX market becoming regulated. As for private equity, the feeling was that a venture capital firm would simply buy it and flip it a year later. That’s why I’ve been joking about a dereliction of fiduciary duty.

At the time of the deal in April 2006, Icap’s shares were trading at around the same level as they are today. Sure, the shares were suspiciously ramped up ahead of the purchase. But does the price today reflect EBS’s real worth? I think not.

Back of a fag packet calculations imply that EBS’s 2007 revenue is going to be about $250 million to $260 million. Some of this will come from ancillary services but the bulk will come from matching FX trades. The margins on pure electronic trading are high; 50% is a reasonable figure.

As a stand-alone business, I reckon EBS is worth $1.5 billion, possibly more. Because of its unique position at the heart of what is a truly global market, it should be a trophy asset, much liked the over-hyped London Stock Exchange. If stock exchanges can be priced on an average multiple of 31, why shouldn’t EBS?

The next obvious question to ask is whether Icap itself should now be rerated. The company’s market cap of about £3.25 billion implies a prospective P/E ratio of 20. Why this is so much lower than the regulated exchanges is beyond my belief.  Icap’s current valuation might prove attractive to any decent-sized VC fund that decides to take a pop. The only impediment they face is Michael Spencer’s 20% holding in the company.

I like making the odd prediction and I reckon that it’s just a matter of time before others with bigger brains and deeper pockets than me decide Icap’s parts are worth more than their current sum. Spencer will no doubt be rubbing his hands with glee that Currenex’s sale has brought about a re-rating of FX platforms, as will all the VCs who have invested in the likes of Saxo, Oanda, FXall and others.