StoneX: strong upside potential after a great acquisition

Disclosure: Integer Investments is not an investor in StoneX. The author owns shares in StoneX in its personal portfolio.

I believe StoneX (SNEX) is worth 38-48% more than its current market price of $64.12, thanks to the acquisition of Gain Capital (GCAP) at a bargain price. I expect the share to re-rate within the next 12 months, as the company execute on the announced synergies. An early catalyst might come in a few days, as StoneX will release its fiscal year-end results on December 9: these will be the first post-acquisition financials, hopefully allowing more investor to notice how cheap the company is, and what a bargain the GCAP deal has been.

Company overview

What StoneX does

StoneX Group Inc. is a financial services company operating worldwide. Formerly known as INTL FCStone, it changed name in July 2020, mainly for marketing reasons - like having a pronounceable name. The company operates five segments that serve three main categories of customers:

1) With the “physical commodities” and “commercial hedging” segments, it serves commercial companies looking to manage risks, mostly in commodity prices, but also FX rates and interest rates. StoneX provides its clients with access to the markets and advisory services on risk management.

2) In the “securities” and “clearing & execution” segments, StoneX customers are financial institutions and professional traders/investors. StoneX is a market maker of OTC equities, provides access to derivatives exchanges and several other markets (FX, swaps and bilateral deals), and engages directly in post-trade services such as settlement, clearing and custody.

3) Lastly, under “global payments” StoneX offers funds transferring, with a focus on developing countries. Its clients are institutions needing to transfer funds across international borders, such as banks, commercial businesses, charities, governments and non-governmental organizations.

Source: 2019 annual report

Given the variety of services, StoneX monetizes its businesses in several ways: it earns commissions and bid/ask spread differentials on trading activities, charges fees for its advisory business, and earns interests on client’s custody balances. Therefore, the key drivers for the business are volumes of trades, market volatility and interest rates levels.

Growth

StoneX does not pay a dividend: it reinvests all its earnings into the business, and has an internal target of compounding capital at 15% per year. To feed its growth, StoneX engaged in several acquisitions in the past (six between 2015 and 2019), and has a clear set of principles for M&A transactions: they need to be of clear strategic value, accrue financially quickly, have a short payback period and must require limited leverage and goodwill.

Source: merger presentation

The strategy had paid off so far, and revenue have grown steadily in the last five years. Net income has been flat initially, but took off in 2019 and early 2020. However, there has been one major bump, in 2017, when a bad debt provision on physical coal (47 million) has whipped out earnings almost entirely.

Source: Q3 company presentation

Overall, the business is well diversified: each segment generates a meaningful portion of revenue, and percentage contributions do change with time, but not dramatically.

As far as geography goes, StoneX makes roughly 70% of its revenues in the US, 20% in Europe and 10% in South America and Asia, so it is quite concentrated in its main market.

Risks

Since volumes, volatility and interest rates are the main driver of StoneX business model, the two main risks I see at a macro level are the persistence of low interest rates and the return of low market volatility. In the latest quarters, high volatility has covered the decline interest rate earnings, which has been substantial, as per company disclosure.

Source: Fiscal Q3 earning presentation

At a micro level, StoneX main risks derive from its trading and market-making activities, since it acts as a principal, committing its own capital to buy and sell financial instruments and physical commodities. Therefore, it is exposed to market risk, credit risk, counterparty risk and the likes. In particular, it routinely records bad debt expenses. As previously mentioned, these have been very meaningful in 2017: the default of a supplier in the physical coal business cost 47 million to the company (and the entire ROE-based bonus to the executive team). The issue shed light on a material weakness in the company’s internal controls, although management claimed this pertained only to its Singapore subsidiary. Afterwards, StoneX closed the physical coal business, and recently recovered part of the loss (12 million).

Notwithstanding this fiasco, StoneX seems to be doing a decent job in taking care of “standard” bad debt expenses: the company explicitly aims at keeping bad debt provisions below 1% of operating income, and has consistently improved its performance in that regard in recent years.

Source: FY 2019 annual report

Introducing GCAP

On July 31 2020, StoneX completed the acquisition of GAIN Capital (GCAP), a global provider of trading and execution services to investors. GCAP main business is its trading platform for retail customers: with the FOREX.com and Cityindex.com websites/brands, it offers FX and contract for difference (CFD) on a variety of products, such as bonds, equity/indices, commodities, cryptocurrencies and interest rates. The company is also in the exchange-traded futures and options business, a smaller segment that normally generates 10-15% of its revenues.

Similarly to StoneX, GCAP makes money from bid/ask spreads and trading commissions, so the main drivers of the business are the same. However, GCAP lacks in diversification, so its results are much more volatile. In particular, it performed very poorly in 2019: facing multi-decade low volatility in the FX market - as measured by the CVIX index - it generated 5-year record lows in both revenue and EBITDA:

Source: merger presentation, red emphasis mine

The acquisition - story of a bargain

Deal data

StoneX and GCAP announced the acquisition agreement on February 26, 2020, and the price reflected the disappointing 2019 performance of GCAP: $6.00 per share, or 236 million, in cash. This was approximately 1x GCAP book value at the time (235 million) and 1.1x its tangible book value (210 million). StoneX would have also redeemed 92 million of outstanding GCAP debt, and estimated 24.4 million of transaction fees and expenses, for a total cost of 352.6 million. To fund the operation, StoneX announced it was going to raise 350 million of debt.

Source: merger presentation

Merger benefits

From StoneX point of view, the deal had many advantages: first, they identified capital synergies for around 100 million, to be realized in a few months. This is free capital resulting from the elimination of duplicate capital requirement, cash buffers and working capital. Management indicated that they would use the extra cash to pay down debt. They also said that they believe there is more capital that can be extracted out of the business, in the long term, but they decided not to build that in to value the acquisition.

Source: merger presentation

Second, they identified cost synergies for 30 million yearly, stemming from the elimination of GCAP public company costs and some other rationalization/consolidation activities. These should be reasonably easy to achieve, as there is significant overlap in terms of business and in terms of physical offices around the world. Factoring in these synergies, management expects the GCAP business to be acceptably profitable even in unfavourable macro environments such as 2019.

Source: merger presentation

Third, the revenues side: StoneX will have an even more diverse offering, with a new “retail” segment which is relatively uncorrelated with the other services. Management quantified this as a 26% reduction in quarterly volatility of net operating revenue:

Source: merger presentation

Perhaps more importantly, StoneX can increase the combined revenues by offering several services directly to GCAP customers, such as clearing and market making: for example, StoneX is a market maker for 45 of the top 100 OTC equities traded by GCAP’s clients. No revenue synergies have been officially quantified for the acquisition offer.

To sum it up, StoneX purchased GCAP with the plan to make it profitable again already in year one, thanks to a combination of cost cuts (already implemented by GCAP at the end of 2019) and the above mentioned cost synergies. As the time of the agreement, StoneX estimated a GCAP business EBITDA of 50 million for Year 1 - with synergies partially in place - and 80 million for Year 2 (full synergies).

Source: merger presentation, red emphasis mine

GCAP performance post-agreement

When the companies announced the agreement, the market had just started its COVID-19 induced rollercoaster. Both companies benefitted from the increase in volatility, posting record numbers in the quarter ending in March and solid performance in June. In particular, GCAP completely crushed the estimates for Year 1 on the merger presentation, in just two quarters:

Additionally, GCAP liquidity increased dramatically: at the end of 2019, it had 190 million of cash and cash equivalents, and 152 million of debt. As of March 2020, it had repaid 60 million of debt (as announced in the merger agreement), leaving outstanding only the 92 million to be paid by StoneX, and nevertheless its cash balance increased to 293 million, for a net cash increase of 143 million - in just three months! Moreover, it generated $2.06 of EPS in the quarter and increased its book value to 297 million, or $7.9 per share.

At this point, the market started to believe that the merger agreement had to be renegotiated. 236 million for the equity (0.79x updated book value) seemed to low: with 100 million in synergies, 143 in additional cash, and better-than-expected profitability likely to persist for several quarters, the deal almost paid for itself. In mid-April, JB Capital Partners bought 7.7% of the company just under $6 per share, arguing that GCAP had to negotiate a price of at least $8 per share to reflect the improved performance. The stock frequently traded above $6 in April and May. However, the GCAP board ultimately reaffirmed its support to the agreement with a 5-3 vote (versus 7-1 of February) and on June 5, shareholders approved the deal. StoneX will reap all the benefits of the muted market conditions, at no additional cost.

Bargain figures

The deal closed officially on July 31, but we do not have the combined financials yet. For the quarter ending in September (which is also fiscal year-end for StoneX), results will be released on December 9. However, the company published an 8-K with pro forma combined financials, which gives us an idea of how the merged company might look like. Two major highlights from the preliminary purchase price allocation (which assumes the acquisition date was March 31):

1) StoneX calculated a bargain purchase gain (meaning, negative goodwill) of 30.7 million. It arrived at this number despite assigning no value to GCAP intangible assets, which were carried at a book value of 21 million. These are preliminary figures, subject to revision, and I think the bargain purchase gain will ultimately be higher, also considering that GCAP book value of equity increased by another 14 million between March and June.

2) The combined company would have almost 500 million in extra cash, net of debt. Summing up the two companies cash and debts as of March 31, and adjusting for new debt issued and cash remaining after paying GCAP shareholders, the resulting cash balance is almost 1.1 billion, against a little more than 600 million of debt.

Source: StoneX 8-K

It is hard to say precisely how much of that extra cash is really free, meaning not needed for regulatory or operational reasons. Additional caution is warranted because 176.9 million were “generated” by a mere reclassification of GCAP balances: StoneX eliminated 785.2 million of “Cash and securities held for customers” and moved them mainly to “restricted cash” and “receivables” accounts, but also to “cash and cash equivalents”.

Source: StoneX 8-K, red emphasis mine

However, I believe the combined company will be substantially overcapitalized. I estimate that at least 200 million could be safely taken out, and I think StoneX would most likely use them to reduce its debt quickly, anticipating what it already intended to do with the capital synergies.

Market reaction

Lastly, let’s have a look at StoneX stock price during the events. The market reaction to the deal was tepid, to say the least: in late February, after the original agreement, the stock barely moved around $45 per share. In early June, After GCAP shareholders approved the deal, it did spike for a couple of days, trading in the $56-57 area, but then dropped in the $49-53 area for the rest of the month.

Ultimately, the stock did appreciate significantly from its February levels, but I believe this is well justified by its own improved financial performance, as 2020 is being a record year for StoneX too, and I do not think the current stock price reflects the proper value of the GCAP acquisition.

Valuation

I will use StoneX normalized earnings to put a value on the stock. With so many moving pieces around the company, normalize its profitability requires some assumptions. Historical figures cannot be taken at face value, because 2019 was too bad (for GCAP), early 2020 was way too good (for both companies), and synergies must be taken into consideration. As a starting point, I take the net income estimate from the merger presentation: 113 million.

Source: merger presentation

This number seems too low for several reasons:

1) It assumes only 49 million of GCAP standalone EBITDA (plus 30 of cost synergies), which is a very prudent estimate: in normal market conditions, such as between 2015 and 2018, GCAP posted 62 million of EBITDA on average. True, they did zero in 2019, but they also did 140 million in 2020 (six months…). Eliminating these two outliers, I think 60-65 million of EBITDA is a more reasonable estimate for the long term.

2) It includes 22 million of interest expense, which is the 8.625% coupon to be paid on 250 million of debt (350 issued for the acquisition, minus 100 of capital synergies). I see this as too high, since StoneX will get the extra cash generated by GCAP from March onwards, and has increased its own cash balance by over 100 million in the meantime. I think they could, and should, redeem most of the debt early, by simply using cash on hand. Should they decide not to do it, consider that the notes were initially priced at 98.5%, but are now trading at 108%, according to FINRA. Therefore, StoneX could easily refinance the debt at lower rates. I will use 0-5 million as my interest expense estimate.

3) When the dust settles, COVID-19 is gone, market volatility is back to normal, and the two companies are fully integrated, I doubt that 83 million will be the right number to put on “INTL” net income. Considering both revenue synergies and StoneX’s history of growth, I will put an extra 10-15 million of EBITDA in my calculation.

Putting it all together, I arrive to a net income range of 141-152 million, or normalized EPS of $7.36-$7.94. StoneX is currently priced at a PE of 10.5, and traded between 9x and 12x since 2019. I believe the post-merger company deserves to trade at the higher end of this range, because it has more diversification and stability in its revenues and it is overcapitalized. With a PE of 12, the resulting share price range is $88-$95, for an upside potential of 38-48%. Should the stock remain at a PE of 10, it would still be worth somewhere around $73-$79.

On top of that, there is the extra income StoneX will earn as long as above-average market volatility persists. I will not factor this in, but in the last quarter the two companies generated a combined 51 million of net income (without synergies), which would be 204 million annualized. The extra 50 million “one off” would be worth roughly $2.50 per share.

Management

The management team is stable and experienced: both CEO and CFO have been in their positions for more than a decade, and all remaining executives have been with the company for at least five years.

Source: 2019 proxy statement

Management have skin in the game as well: the CEO alone owns 6.6% of the company, and directors and executives as a group own 17.5%. Executives receive performance bonuses linked to return on equity, which further align their interest with those of shareholders.

The CEO performance plan. Source: 2019 proxy statement

Catalysts

StoneX is an underfollowed company, to say the least, which might partially explain why it is still so cheap. It had no analyst coverage until November this year, when Jefferies initiated with a buy rating and a target price of $70. They had zero question asked in one of the earnings conference call this year (fiscal Q1), and they routinely have just one or two questions, normally from investors. In the latest earnings call, both questions were addressed to Glenn Stevens, GCAP CEO, who participated as he will keep running its business as a StoneX subsidiary. I believe additional coverage on the stock can act as a catalyst, especially after the publication of FY 2020 results, which can be a catalyst in and of itself, as it should bring more clarity about the GCAP acquisition value.

Conclusion

StoneX is a relatively unknown company, run by competent management who has grown the business by opportunistic acquisitions. They bought GCAP for a low price in the worst market conditions, and immediately benefitted from the extreme spike in volatility in March. I think the market has not priced in the full value of GCAP, and I see a 38-48% upside potential based on current overcapitalization and mid-term, normalized profitability.

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