GFI Group a Play on Volatility and Derivatives

GFI Group is not your average financial company, and represents a rare stock play on growth in hedge fund assets and derivatives trading.  They act primarily as a principle or agent on inter-broker dealings with institutional clients, dealing derivatives in equity, credit, commodity, and currency markets.  The company has a wealth of experience in many of the newer and more exotic instruments like weather and freight derivatives.

GFI’s customers includes the big wirehouse fims, smaller regional banks, insurance companies, investment funds, and most importantly, hedge funds and their seemingly endless supply of new capital.

Since releasing 4^th Qtr earnings on Feb. 23^rd, GFIG stock has dropped nearly 20%.  Although the company beat consensus numbers, there seems to be a lingering concern over GFI’s inability to extract more operating leverage out of its business model.  But considering the products they trade and markets they make, it’s simply a model based more on human capital rather than technology.  And human capital is notoriously hard to scale.  GFIG stock is also very closely held – nearly 50% owned by insiders – so a base of selling pressure will be there for a while. 

As we’ve seen with the 25% plus volume growth at the derivative-based exchanges such as NMX, CME, and ICE, derivatives are increasingly becoming democratized, being used not only by hedge funds but also most of the S&P 500 companies.  Derivatives are especially useful as hedges in a world of increasing volatility – like the one seen in global markets for the past week.  If the volume trend continues, A company like GFI stands to benefit greatly, as they make increased profits on trades with higher spreads (when acting as principle), especially in the credit markets, where last week spreads grew massively after being razor thin so far this year, and for much of 2006.  Per the company’s 10-k report released last week:

“Our business generally benefits from robust trading volumes and volatility in the markets we serve….During 2006, the global business environment was generally positive for our business, with satisfactory volume levels and generally modest volatility in global credit and equity markets, and instances of more pronounced volatility in certain global financial and energy markets.

It is very likely that revenue assumptions for this year were made based on what we saw in 2006, and GFI has to be salivating over a market environment filled with high volumes and uncertain investors.

GFIG currently trades just over 19x FY07 earnings estimates, and is forecasting top-line growth of about 23% for the year.  With a current PEG of 1, any upside to earnings projections could quickly be reflected on the stock, which has a 52-week range of $43.50 to $68.47.

Ryan Barnes