FXCM Q1 results explained – how exactly did they lose $629 million?

We’ve received a lot of feedback from our coverage of FXCM’s Q1 results announcement late Friday.

And most of it of the puzzled variety.

The key question folks seem to have is fairly straightforward: We know that FXCM Inc (NYSE:FXCM) already reported $276 million of negative client balances from January 15th’s Swiss Franc spike – that is, money owed to FXCM by its clients who lost big in CHF-short trades beyond the equity deposited in their accounts. And that FXCM was bailed out with a $300 million loan from Leucadia.

But how did that turn into a Q1 loss from continuing operations of more than $629 million?

Shouldn’t FXCM’s loss for the quarter have been the $276 million, less whatever was actually recovered from clients? (And less any other offsetting ‘real’ earnings FXCM had during the quarter).

Let us explain.

Other than some tax and goodwill related writeoffs FXCM took as it restructured its operations and began to sell assets after January 15, the bulk of the $600 million + loss can be divided into two parts:

1) The $276 million (or so) of negative client balances, and

2) The estimated value of what FXCM ‘gave away’ to Leucadia, close to $300 million.

Part 1) is fairly straightforward. FXCM actually took a $257 million Bad Debt Expense during the quarter, meaning that they were indeed able to recover some of the $276 million which clients owed them from January 15 Swiss Franc related trading losses.

Part 2) requires more explanation.

When a company borrows money, it typically is an earnings-neutral event, other than the periodic interest expense recorded. But the Leucadia loan was not a typical one. Beyond the $300 million borrowed (and to be paid back), Leucadia also received the right to force a sale of FXCM or its assets, and to receive most of the proceeds from that sale.

Accounting rules require FXCM to record the estimated value of that ‘option’ which Leucadia received as an upfront expense, and a liability on its balance sheet. Using a variety of assumptions and valuation methods, FXCM came up with a number of $292 million for that ‘liability’ to Leucadia. (Note that it is a non-cash charge).

The $292 million figure is indeed quite subjective, and might be adjusted in future quarters if assumptions or FXCM’s condition changes. By contrast, Leucadia recorded a much larger corresponding gain on its FXCM loan – $687 million.

The $257 million Bad Debt expense, plus the $292 million ‘Leucadia expense’, plus some other tax and goodwill related writeoffs result in the $629 million loss.

We hope that is helpful.

The other key issue to note in FXCM’s financial results is Interest Expense.

As we’ve discussed before, the Leucadia loan carries a very high rate of interest – initially 10%, rising by 1.5% each quarter, to a maximum of 17%. (The maximum would be hit in early 2016). FXCM also has more than $150 million of senior convertible notes to service, although they carry a much more serviceable 2.25% interest cost.

In Q1, FXCM reported more than $30 million of interest expense. That is big number, for a company which does $69 million of quarterly revenue. FXCM needs to bring that percentage down by either growing revenues somehow (despite selling some business units, such as FXCM Japan and Faros Trading), or lowering interest costs by quickly repaying the Leucadia loan. a company which pays out 43% of its revenues in interest cost is going to have a very tough time making money – or paying back hundreds of millions in debt.

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