(Mis)understanding FXCM’s $500 million 1H loss and valuation

Poor FXCM.

They had the indignity of not only losing upwards of $275 million (in the form of negative client balances) due to the ‘Black Thursday’ Swiss Franc spike, requiring a very onerous bailout rescue loan from Leucadia National Corp (NYSE:LUK), but they did so on January 15.

Why does the date matter?

Had Black Thursday occurred, say, back in mid December, then FXCM would likely have written off (most of) the financial hurt from the entire episode in Q4, and would have begun 2015 anew with a somewhat clean accounting slate. They of course would still have owed Leucadia all that money plus a major chunk of any future sale proceeds of the company (more on that below) as they do now, but at least from an accounting point of view the deed would have been done.

But that’s not what happened.

Since the loss happened early in Q1 of this year, the large loss gets to be repeated and reminded to investors in each quarter’s financial report for the remainder of the year – Q2, Q3, Q4 – as year-to-date financial statements are presented alongside the quarter.

And with the total (accounting) loss at FXCM topping the half billion dollar mark as of June 30, that provided some good FXCM-bashing fodder at certain blogs choosing to sensationalize FXCM’s ‘huge’ loss. As we explained above, that will probably continue later in the year as Q3 and Q4 are reported.

However we believe that most in the financial community do not really understand the $392 million ‘Loss on derivative liability — Letter Agreement‘ which FXCM took in the first half of this year, nor the $522 million net loss it suffered. Nor, for that matter, the reason that FXCM – despite reporting some fairly healthy trading volumes the past few months – is now seeing its shares head down into Penny Stock range and trade at below $1.00.

Let us explain. First, the large writeoff/loss.

A good part of FXCM’s 1H loss is real, in the form of negative client balances. FXCM was (we believe) fairly balanced and hedged on paper on January 15. However the clients (and liquidity providers) which won big when the Swiss Franc spiked 20% that day had to be paid, while the ‘balancing’ gains FXCM made from clients which were on the wrong side of the CHF could not be collected. Real money lost. Real cash out the door.

However most of the overall writeoff/loss is non cash and non operational, and has nothing to do with FXCM’s operations and corporate health, but rather with accounting charges FXCM needs to take due to US GAAP accounting rules thanks to the future benefit that FXCM gave up to Leucadia.

Leucadia’s ability to force a sale of FXCM in about two and a half years, plus the fact that Leucadia will get a large/majority portion of the proceeds from a sale of FXCM or its assets (see Table A below), must be accounted for today by FXCM as a ‘derivative liability’. Using fairly complex calculations, FXCM and its accountants have to figure out something of the sort: What is the current value of the ‘option’ Leucadia has to get some/most of the sale proceeds of our business?

At the end of Q1, FXCM estimated that value to be about $292 million – and all of that had to be recorded as an expense of the company. No cash out the door, just a large ‘accounting’ hit.

During Q2, FXCM had to increase that what-our-shareholders-will-have-to-give-up-in-the-future-to-Leucadia charge by an additional $100 million, charged as an expense in Q2. Ironically, FXCM had to take that additional $100 million charge because it was doing better – since FXCM was now in better shape operationally, the value given up to Leucadia is greater. In FXCM’s words, ‘due to an increase in the estimated value of the Letter Agreement.’

The better FXCM continues to do, the more it likely will have to expense in the future. Ironic. But again, it doesn’t and shouldn’t affect FXCM’s operations or perceived financial health.

So now for Question #2: Why are FXCM shares trading so low?

To explain, we first need to look at the FXCM-Leucadia agreement. This (taken from FXCM filings) is how the division of future sale proceeds of FXCM will go:

FXCM sale proceeds allocated

Assuming that FXCM pays its loan to Leucadia back in full (meaning that we can ignore the first line of the table), if FXCM is sold at some point down the road (as seems likely from the agreement) then Leucadia and FXCM shareholders split the sale proceeds 50-50, up to $350 million. If FXCM is sold for more (up to a total sale price of $850 million), then Leucadia gets 90% (!!) of those additional proceeds. FXCM shareholders get just 10%.

So unless FXCM is sold for more than $850 million (which we view as unlikely), FXCM shareholders are basically capped out at between $2.50-$3.00 per share, as the following Table B shows.

FXCM sale proceeds divided

To briefly explain Table B above, if FXCM is eventually sold for, say, $300 million, Leucadia gets half of that ($150 million) and FXCM shareholders the other half. With about 71.74 million FXCM shares outstanding (after accounting for the conversion of FXCM’s Class B shares into ‘regular’ Class A shares), that means that FXCM shareholders can expect about $2.09 per share.

Were FXCM to be sold for double that price, or $600 million, FXCM shareholders’ take would increase to just $200 million, or $2.79 per share.

FXCM’s current share price in ‘Penny Stock’ range of $0.96 is well below that, but remember that everything has to go well for that $2.09 or $2.79 to be actually realized. A lot could also go wrong.

And, as one analyst mentioned to us, why buy a stock with effectively capped upside? All stocks have risk, but you may as well take that risk when you at least have greater upside if the company you are investing in does well.

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