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FCStone Group: Catch It If You Dare


If you are looking for commodity trading ideas that have not yet made the front page of the Wall Street Journal, this one might do the trick.

"We are experiencing unprecedented volatility. The increase in demand generated by renewable energy industry has resulted in one of the largest increases in corn production acres...This is driving the extreme volatility the entire [grain complex] is experiencing and that [we] tend to benefit from. The energy complex continues to trade in the upper 30% of its trading range compared to the previous five years with an unprecedented premium for political risks, driven by the increased demand for commodities and the need for risk management estimates the various commodity exchanges are realizing record volumes and profits in all the strategic markets and segments that [we have] targeted where we are experiencing increased volumes driven by increased volatility."

Thus did FCStone Group (FCSX) explain quarterly results which drove its stock price up more than $8 on Friday. Plucking it right from the release:
"FCStone Group, Inc... is an integrated commodity risk management company providing risk management consulting and transaction execution services to commercial commodity intermediaries, end-users and producers. The firm assists primarily middle market customers in optimizing their profit margins and mitigating exposure to commodity price risk. In addition to risk management consulting services, FCStone, LLC, operates one of the leading independent clearing and execution platforms for exchange-traded futures and options contracts."

It does not take a genius to realize that this is where the real trading action currently resides.

After Friday's 22% move the obvious question is whether it is too late to get on board. The short answer is 'I doubt it,' and here is why:
  • If for the next two quarters FCSX shows no revenue growth, it will likely earn $1.85 – 1.95ish for its Aug '07 fiscal year (my guestimate). That's an increase of more than 100% over FY '06 against a current P/E of 23x on the mid-point of my guestimate. That leaves plenty of room for a later slowdown in growth rates. By comparison the Nymex (NMX) and the CBOT (BOT) trade at 49x and 42x forward estimates.

  • According to this article from SeekingAlpha, "the OTC commodity derivative market is five times larger than the exchange traded market. The OTC market reflects the demand for non-standard products and also reflects the need for an expertise company such as FCSX."

  • Aside from sustained volatility in the energy and agricultural markets, FCSX stands to benefit from yet untapped markets in China and Brazil and the consolidation of smaller entities. Given the capital requirements for the kind of market operations FCSX is involved in, size matters and the big are likely to get bigger.

  • In the same vein, the competition in the market is intense, but the market potential is huge (if you believe that developing economies in China and India will put pressure on food and energy demands) and there aren't that many players. The barriers to entry from both a regulatory and human-capital standpoint are high.

  • Subscribing to the view that interest rates are in the final stages of the secular bear market that began in 1980, and that inflation is at the beginning of a secular move up, FCSX has tremendous leverage to both rising nominal money supply and higher interest rates. Of course if you think that deflation is in our future then, this is a distinct negative.

Not all is roses of course, and the drivers noted above are inherently volatile and unpredictable. Therefore:

  • Should things turn south in China/India, that would be a big problem.

  • As a risk manager, one bets that FCSX can manage its own risks. They do play with very "sharp" objects (leverage, volatility), which increase the chances for accidents.

  • The company's business model does not lend itself to predictable, linear growth, so one should be prepared for the possibility of down $8 days, even though the basic story may well be intact.

  • While its business model is rather "simple" to understand, especially for those who live and breathe the markets, the guts of its operations are inherently obscure and arcane.

  • The last three items put more importance than usual on the quality of management. Most of the key people at FCSX have been with the company for many years if not decades, and management owns 16% of the company. Watch for any "meaningful" insider sales when the lock-up expiration date arrives on September 12. I highlight "meaningful" because of course these guys will cash in some of their holdings when the window opens. If they didn't, you'd have to wonder about their risk management skills, if not their sanity.

The last time I ran across a company that played: (i) in an enormous potential market; (ii) with tough competitive barriers; (iii) relatively few players; (iv) had fast growth; and (v) traded at relatively reasonable valuations, I was building what would utlimately become a significant position in Akamai (AKAM). FCSX is not quite as appealing as AKAM was. Back then AKAM had a monopoly (still does) in a market which would/will grow exponentially out as far as the eye can see, notwithstanding what happens to the economy and the markets. FCSX does not have the luxury of being a monopoly, and its fortunes will follow certain financial markets and economies. But if you are looking for commodity trading ideas that have not yet made the front page of the Wall Street Journal, or if you are looking for long beta to balance bearish gamma, this one might fit the description.

Position in FCSX, AKAM
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