GFI Group -- Loving The Volatility (GFI)

By Ryan Barnes | April 23, 2007 AAA

GFI Group (Nasdaq: GFIG) is probably a company you've never heard of, but it may be one to remember. This $2 billion cap "new-age" financial company could most easily be thought of as a broker, but the label doesn't do justice to what GFI Group actually does.

The company acts as an inter-dealer broker on complex derivatives transactions, covering everything from equities and fixed income products to new, exotic instruments such as weather derivatives and freight derivatives. GFI Group also acts a market-maker, performing price discovery services and matching up prospective buyers and sellers.

The $30 Trillion "Niche Market"
GFI group is also the largest dealer of an exploding corner of the derivatives market – Credit Default Swaps, or "CDS". Credit default swaps are essentially insurance policies on a "credit event" at a publicly-traded company, such as a bond default or a Chapter 11 filing.

Estimates on how big the CDS market is vary depending on the source, as trading is done over-the-counter, but the International Swaps and Derivatives Association (ISDA) says growth has averaged over 100% for the past few years. And to put the dollar value into perspective, the total notional value of all outstanding credit default swaps is three-times higher than that of all the outstanding equity derivatives.

All this for a product that was virtually non-existent just five years ago.

A typical CDS buyer would be a money manager who owns corporate bonds and wants to buy some insurance in case of default. The manager would purchase a CDS on the underlying company, and in the rare event that the bond went into default, the manager would be due the face amount of the bonds from the CDS seller. The main sellers of CDSs are the major wirehouse firms and multi-national banks who have the asset base to expose themselves to the credit risk.

But buyers are not restricted to owning the underlying bonds; the list (and wallet size) of speculators is growing as we speak, as hedge funds, S&P 500 companies, and even some ETFs all purchase CDSs as part of their overall hedging strategy.

Uncertainty + Volatility = Higher Profits
GFIG stock sold off a lot during the "market correction" at the end of February, but has since recovered that ground and more, trading at near all-time high levels. Investors soon remembered that GFI Group profits more off volatility than just about any other financial stock. As volatility rises, especially in derivatives, spreads also tend to rise, and the company earns the majority of its revenue from the spreads found in individual trades.

GFIG stock trades for about 24-times this year's earnings forecast, which calls for EPS of $2.93 on full-year revenue of $928 million, or growth of 24% for both metrics. Of note is that these estimates haven't changed since the end of 2006 -- before volatility rose sharply in the first quarter of this year. Volatility has been high not only in the equity indexes (along with record trading volumes), but also in the derivative markets, where GFI Group conducts most of its business. CDS spreads are much higher than in 2006, when the company still was able to grow earnings

Risks to Growth
As with any equity investment, there are both market risks and risks unique to the company. GFI Group's earnings growth will stall if markets become less volatile, especially in the commodity and credit markets. Also, margins have a limit to internal expand, as the company's main expense walks out the door every evening. Employee costs have been rising in-line with revenue, and in order to remain its competitive edge, the company has to retain its top-level talent. Also, as the size of the derivatives market continues to grow, competitors will increasingly try to gain a slice of the pie. So, GFI Group has to be very careful about raising prices for the next few years.

More Attention to Follow

There are currently only four analysts who cover the stock, but considering the recent growth in GFIG's market cap, expect to see this number rise over the next few quarters. Once companies get into the $2 to $5 billion-cap range, major sell-side analysts tend to arrive in swarms -- especially for a fast-grower in a rapidly-growing market. GFI Group reports first-quarter earnings on May 2, and with this release we should hear more from management on the "volatility climate" and CDS spreads for the remainder of the year.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

You May Also Like

Related Analysis
  1. Stock Analysis

    CME Group's Expense Control, Secure Capital to Drive Growth - Analyst Blog

  2. Chart Advisor

    Profit From Holiday Spending With This ETF

  3. Chart Advisor

    Cocoa Prices Setting Up For A Move Lower

  4. Chart Advisor

    How To Trade The Biggest U.S. Companies In 2015

  5. Chart Advisor

    'Tis The Season For Food And Beverage Stocks

Trading Center