Cowen Group (COWN)


Stock price: $13.82
Market Cap: $424.8 million
Enterprise Value: $380.1 million
Catalysts:
1.     Share buybacks: Board approved purchase of up to $178.6 million (Dec. 31 2018), and during 2019, the company repurchased $32.7 million worth of stock. Even though buybacks create value for shareholders, the may come at the risk of the company becoming thinly capitalized. The biggest impediment to buybacks is that Cowen has assets in liquid positions. However, as buybacks tend to decrease capitalization, the company does not want a scenario to arise in which they become a forced seller in order to generate liquidity.
2.     Paying down debt: Since 2017, convertible debt has decreased from $141 million to $134 million (year-end 2018) to $117 million (Q32019). This active decrease in leverage not only benefits Cowen’s financial position but also frees up future capital to be used for redeployment to build scale, buy back shares, and engage in other opportunities that are good for the company and for shareholders.
3.     Continued monetization of non-core assets: Though it provides less capital than proceeds from investment securities, divestiture of interests in management companies helps drive the company. In Q3 2019, the company completed the sale of stake in RCG Longview Management (legacy real estate), and other real estate assets. These transactions added up to $8.6 million in cash. Other legacy real-estate investments will be liquidated in the coming quarters. Total private real estate investments amount of $19.8 million, of which $9.2 million are portfolio funds (RCG family of funds) which serve as potential capital to be freed up.

Business Overview:
Cowen is a diversified financial services firm that provides investment management, investment banking, research, sales & trading, prime brokerage, global clearing and commission management services. It has two distinct business segments: investment management and investment banking.

As of Q2 2019, Cowen is divided into Operating Company (Op Co) and Asset Company (Asset Co). Op Co consists of investment banking, markets, research, and investment management. It is driven by brokerage revenue, investment banking transactions in capital markets, investment income (which decreases when investments are exited), and management fees (driven primarily by Cowen Healthcare Investments). Asset Co consists of private investments, private real estate investments, and legacy multi-strategy funds. It is driven by invested capital (mainly of large investments). Some large investments include that in Linkem ($70 mil, Italian wireless broadband provider), Formation8/Eclipse ($40.9 mil, PE funds), and Surfside ($9.9 mil, private real estate holding).

Segment Information:
Investment Management
The segment consists of advisors to investment funds, managed accounts, registered funds, proprietary capital and operates a myriad of strategies including multi-sector long-short equity, merger arbitrage, activism, health care royalties, private healthcare investing, private sustainable investing, and real estate. The segment’s AUM stands at $10.4 billion as of Jan. 1, 2019. On Jan 3, 2019, Cowen acquired Quarton International, a leading middle-market financial advisory firm to create significant scale for the investment management segment. In terms of management fees charged as a % of AUM, Cowen’s hedge funds take 2%, real estate funds take 0.25-1.5%, and private equity funds take 1-2%.

Investment Banking
The segments consists of research and sales & trading platforms for institutional investors. This includes the firm’s global clearing and commission management services and prime brokerage services. As of FY2019, Revenues from public and private capital raising transactions account for 36.9% of total Cowen revenues, brokerage accounts for 42.8% of total revenues, interest and dividends accounts for 11%, and everything else accounts for less than 5%. Generally, within the investment banking segment, 87% of segment revenues come from equity capital markets, and 38% from non-health care investment vehicles. To break down investment banking revenues, 60% comes from underwriting fees. Underwriting is not done by the Street anymore, which makes it Cowen’s specialty, esp. in the biotech sector. Cowen specializes in healthcare companies to help them raise money consistently. The other slices of IB segment revenues comes from strategic/financial advisory fees, which accounts for 23%. Then there is also placement and sales agent fees, which accounts for 13%, and finally expense reimbursements from clients, which is roughly 4%. To break down brokerage revenues, 91% comes from commissions, 5% from equity and credit research fees, and 4% from trade conversion revenue. The overall brokerage portion is the largest slice of total Cowen revenues. The big YOY jump (56%, and three-fold since 2012) was due in large part to the acquisition of Convergex Group – an options and electronic trading firm – which was responsible for $120 mil alone.

What Drives Cowen:
Cowen uses its balance sheet to drive its top line. It liquidates private businesses over time, and uses the proceeds to redeploy for scale. In other words, the monetized assets are used to acquire more accretive investments in the core business, or are used to carry out additional share repurchases. As of year-end 2018, its noncore investments are valued at $126.9 million. While these legacy assets are not the key driver for business, they do provide capital once monetized. So, they will probably go towards funding share repurchases. Additionally, Cowen has what it calls “trapped assets.” These are additional strategic and noncore investments that can be monetized over time. It has around $150 million of capital tied up in Asset Co, a stake in Starboard worth around $100 million (not recognized on the balance sheet), which makes up over half of its entire market cap.

Cowen is considered a market share taker. The reason being is that its competitors, such as Deutsche bank, are exiting certain US equity sales & trading strategies. This provides opportunities for Cowen. It allows Cowen to take up the mantle in nontraditional equity businesses, like their options business. Because they’re not competing with others, they can grab share for themselves.

For its core assets, such as those investments made to drive invested capital, Cowen does so in companies that are also market share takers. For example, its investment in Linkem allows it to own half of the fixed wireless market in Italy. The other players in the country compete at a disadvantage because they struggle to have access to the bandwidth and capability that Linkem offers. Linkem has a sustainable competitive advantage that has locked in its market leadership for at least a decade.


Valuation:
Given that Cowen is miscategorized as a boutique investment bank with ancillary investment holdings and an asset management business, I will be giving the largest weight to the base case. Considering that the underperforming investment bank obscures the value of the entire company, the base case assigns zero value to it. The value in Cowen lies predominantly in its portfolio of investment assets and its asset management business. Therefore, its invested capital per share serves as a margin of safety. For reference, invested capital is mainly driven by broker dealer capital and related trading (54% of stockholders’ equity) and private investments (15% of stockholders’ equity).

I will value Cowen using sum of the parts (per share): invested capital + IM + IB. DTA valuation allowance will serve as a consideration, as will leverage per share, but either one will not count towards the sum. Instead, they will be used to compare the intrinsic value the SOTP valuation produces.

















In conclusion, Cowen is an asymmetric bet. The downside is 12% higher than the current price, the base case is 145% higher than the current price, and the upside is 239% higher than the current price. Of course, I would put the greatest weight on the base case. To keep things even more conservative, perhaps it would help to subtract obligations due in the next four years for the base case, leading to a share price of $25.5 (83% upside).

Note: The valuation allowance per share does not take into account the $189.1 million from Luxembourg. If that number were added, the per share amount would be much higher.


Lastly, for the NAV sensitivity analysis, I have defined NAV as that similar to a closed-end fund: cash + net liquid investment assets. It is the most appropriate representation of what Cowen is: an investment management company that doesn’t keep offering new shares.




Financials:
In the past, earnings and FCF have not been stable sources of capital. The company has incurred multiple years’ worth of losses. In 2018, Cowen had positive earnings, OCF, and FCF. OCF was primarily the result of proceeds from sales of other investments in consolidated funds, proceeds from sales of securities owned at fair value, increase in payable to customers offers decrease in receivable from brokers, dealers, and clearing orgs, and purchases of securities owned at fair value. FCF did not match earnings, and was $296 million, while earnings lagged behind at $36 million. GAAP earnings were materially understated from misleading non-cash charges, including amortization of deferred acquisition costs, other expenses, payments to non-controlling interests, and payable to customers (on the CF statement). Adding back all of those charges, including the tax provision gets to roughly $291 million, which approximates FCF very well.

As stated above, the tax provision has been consistently higher than taxes paid in actuality, mainly due to not reflecting the company’s large deferred income tax position. The converse is true for the relationship between convertible debt interest expense and actual interest paid: $23 million vs. $90.8 million, respectively.

On the surface, debt doesn’t appear to be an issue. Cowen’s debt to equity ratio is 0.5 (up from 0.27 in 2014, cash to total debt is 1.11, and net debt to EBITDA is negative. All of the company’s debt is fixed rate, except for the Term Loan. There is also OBS pledge lines totaling $300 million, and the revolving credit facility totaling $370 million, with $70 million maturing in 2020. Luckily, Cowen has not dipped into either. The purpose of the revolving facility is to cover any increases in margin deposit requirements. In other words, to provide the company with immediate liquidity (as a last resort).


However, coverage of interest paid is quite poor. Interest coverage (EBIT/interest expense) is 2x, OCF/interest paid is 3.57x, and FCF/interest paid is 3.26x. Issues could arise should Cowen decide to take on more debt.

Total non-interest expenses also increased YOY, by $176.6 million, to $802 million. Fixed non-compensation expenses totaled $141.8 million, and variable non-comp expenses totaled $143.6 million. Meanwhile, working capital has been growing since 2008, and was $690 million in 2018. Cowen’s current ratio is 1.31, which is in line with the mean. LT debt/working capital has risen since 2012 to 0.58. AR/sales have risen since 2013 from 23% to 91%. AR/TA has risen since 2013 from 4% to 23%, and for AR/CA from 4% to 27%.

While margins were in the negatives in past years, in 2018, Cowen had 22% operating margins, and a 10% net profit margin.

On another positive note, Cowen has enormous NOL carryforwards as a result of years of incurring losses. $138 million was available as of year-end 2018 (this includes all foreign).


In addition to the chart below, the company has $189.1 million worth of deferred tax assets from its Luxembourg subsidiary (with a full valuation allowance of $189.1 million).


The company also has $37 million worth of leasehold improvements, which have been increasing each year. This offsets $24 million in real estate and facility rental lease liabilities.

Proxy:
In terms of “pay for performance,” 26.7% of the CFO’s compensation, and 28.8% of the COO’s compensation was paid in deferred cash and equity. The CEO’s compensation was split between 46.9% deferred cash, 24% cash bonus, and 29% deferred equity. The NEO average variable comp mix was split between 22.2% deferred cash, 66% cash bonus, and 11.8% deferred equity. The CEO’s pay for performance bonuses amounts to $7.6 million, which is roughly 8x his base salary. For other executive officers, it generally amounts to $2.1 million, which is roughly 3x their base salary. The CEO’s total compensation compared to the employee median pay amounted to a ratio of 28:1. Overall, there’s nothing egregious about these numbers.

Some of the executive officers do have golden parachute payments that would be made in the event of a change of control: Messrs. Soloman, Lasota, Holmes, and Littman. However, their severances are subject to a “modified golden parachute cutback” which outlines that “excess parachute payments” (excess meaning greater than $13.99 million for Soloman, $6.4 million for Lasota, $6.5 million for Holmes, and $6.398 for Littman) would be reduced to the extent that the reduction would result in greater after-tax benefits.

Risks:
Incurring losses
The investment bank segment incurred losses in 2016, 2013, 2012, and the investment management segment incurred losses in 2017, 2016, 2009, 2008. Any further losses may have a significant effect on the company’s liquidity as well as their ability to operate. Interest on convertible debt increased sharply YOY by roughly $67 million, and has far surpassed past OCF and FCF. While any principal amounts and some fractions of interest payments are covered by proceeds of securities, to cover future interest payments (if the same amount or greater is charged in the following years) the company may have to dip into its cash pile on the balance sheet.

Holding company with no business operations
Cowen is dependent on dividends, distributions, loans, and for subsidiaries to make payments of principal of interest on all of their indebtedness including senior notes due 2027 (effective interest rate of 7.35%), senior notes due 2033 (effective interest rate of 7.75%), cash convertible notes due 2019 with a conversion price of $21.32 (some increased to $28.72, effective interest rate of 8.89%) and convertible notes due 2022 (effective interest rate of 7.57%) with a conversion price of $17.375 per share (out of the money). Luckily, these bonds are so far out of the money that there is the possibility they might be called in order to replace existing bonds with a convertible issue that possesses a lower coupon rate.

MiFID II
The new regulation requires managers and advisors to unbundle research costs from commissions in subsidiaries within the EU. This means research costs cannot by funded by client commissions or soft dollars, and must be paid for directly by the investment firm through a research payment account funded by clients and budget agreed upon by the client. According to the IR rep, Cowen would be a net share gainer in a post-MiFID II world. The reason being is Cowen’s outsourced trading of its prime business. Its Westminister Research allows investment managers’ to consolidate all administrative, servicing and reporting functions with one counterparty, allowing managesr to create budgets at the firm, fund, and strategy levels, and allocating research payments against those budgets. This is done through CSA aggregation, a single, centralized account which eliminates the need for multiple, disparate CSA brokers. Directly because of MiFID II, Cowen has gained new clients as accounts look to consolidate their broker list. The Convergex acquisition positions Cowen to reach clients in Europe who are tackling the MiFID II implementation, and the company has seen enormous YOY jumps in brokerage revenues as a result.

Brexit
Cowen conducts its business in Europe through its UK subsidiaries, namely Quarton. The uncertainty around Brexit has slowed the conversion rate in Quarton’s backlog. For reference, Quarton advises middle-market companies throughout the EU on M&A and private capital raising. While the company has not addressed how Brexit itself may affect the company, only the uncertainty aspect of it seems to be having effects.







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