StoneX Group Inc (SNEX) 2014 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the INTL FCStone's fiscal year 2014 third quarter earnings conference call.

At this time, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session, and instructions will follow at that time.

(Operator Instructions)

I would now like to introduce your host for today's conference, Bill Dunaway.

Please go ahead, sir.

Good morning.

My name is Bill Dunaway, CFO of INTL FCStone.

Welcome to our earnings conference call for the fiscal third quarter ending June 30, 2014.

After the market closed yesterday, we issued a press release reporting our earnings for the fiscal third quarter.

This release is available on our website at www.intlfcstone.com, as well as a slide presentation, which we will refer to on this call in our discussions of our quarterly results.

You will need to sign on to the live webcast in order to view the presentation.

Both the presentation and an archive of the webcast will also be available on our website after the call's conclusion.

Before getting underway, I'd like to cover a couple of housekeeping items.

As discussed on previous conference calls and in our filings, accounting principles generally accepted in the US, which I will refer to as GAAP, require us to carry derivatives at fair market value but Physical Commodities inventory at the lower or cost of market value.

Enough gains and losses on Commodities inventory and derivatives, which the Company intends to be offsetting, are often recognized in different periods.

However, following the discontinuance of our physical Base Metals business, we believe these differences will no longer be material to our consolidated earnings.

And we will no longer be reporting our results on a non-GAAP basis.

Secondly, we are required to advise you -- and all participants should note -- that the following discussion should be taken in conjunction with the most recent financial statements and notes thereto, as well as the Form 10-Q filed with the SEC.

This discussion may contain forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, and Section 21E of the Securities Exchange Act of 1934.

These forward-looking statements involve known and unknown risks and uncertainties which are detailed in our filings with the SEC.

Although the Company believes that its forward-looking statements are based upon reasonable assumptions regarding its business and future market conditions, there can be no assurances that the Company's actual results will not differ materially from any results expressed or implied by the Company's forward-looking statements.

The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Readers are cautioned that any forward-looking statements are not guarantees of future performance.

With that, I'll now turn the call over to Sean O'Conner, the Company's Chief Executive Officer.

Thanks, Bill, and good morning, everyone, and welcome to our third quarter earnings call.

As we mentioned during the last call, we had started to see some improving market conditions.

And for the prior quarter, that being our second fiscal quarter, we had benefited from really positive market conditions in certain of our verticals.

However, during the third quarter, we had a slightly more challenging environment, especially in May, where customer activity across the board dropped noticeably.

While this did negatively impact our quarter's results, we continue to believe that the market environment is generally improving.

Although more market volatility would be helpful.

As I'm sure you've all noticed, market volatility is now pretty close to all-time lows, driven largely by coordinated central bank activity, which has dominated all of the markets.

Overall for the third quarter, we recorded aggregate revenues down 4%; net operating revenues down 7%, offset by a reduction in aggregate costs of 3%.

Unfortunately, we had operational leverage working in reverse and net income, on a continuing operations basis, was down 44%.

Although overall net earnings were up 6%.

On a year-to-date basis, the results are not directly comparable due to non-recurring gains made in the prior period on the sale of our LME shares and exchange [sheets].

Adjusting for these items, our post-tax income from continuing operations increased 24% year-on-year, reflecting better overall market conditions.

Bill will later go into the results in more detail.

But just to give you some highlights.

Our Global Payments business was again our star performer, with transaction volumes up 26% quarter-on-quarter and 29% for the 9 months to date versus the prior period.

This resulted in quarterly revenues increasing 21% and segment net income increasing 30%.

On a year-to-date basis for the 9 months, revenues were up 31%.

And segment income was up 35%.

We continued to see steady adoption of our services by large and midsize banks.

And despite processing a larger volume of transaction payments, some of which are much smaller, we have managed to keep the average revenue per trade almost constant over the year.

Our Securities business had a strong quarter with revenues up 25%, and segment income up 53%.

On a year-to-date basis, revenues were up 20% and segment income up 24%.

Our largest segment, Commercial Hedging, showed steady results driven by strong gains in LME and energy, offset by slightly weaker results on grain OTC.

We have seen some significant price declines in our core Ags verticals, that being the price for corn and beans.

And we are now seeing some Contango carry in the market, which is a very positive market environment for this business over the long term.

The gains in these three quarters were largely offset by much weaker results in the Physical Commodities and Clearing and Execution segments.

And in the Clearing and Execution segment, the declines were largely on the foreign exchange side, which showed big declines in revenues, resulting in segment income from both Physical Commodities and Clearing and Execution being pretty marginal for the quarter.

So overall, not as good as the immediately preceding quarter, but stronger results than the first fiscal quarter.

Despite these softer results, we're still hopeful that the overall trend line is up.

We continue to put focus and effort into controlling costs and are making good and steady progress, as evidenced by our overall decline in costs for the quarter and zero growth in costs for the year-to-date, despite continued cost pressures due to regulation.

During the quarter, we revised our approach to enhancing our interest earnings from our segregated funds.

This revision was due to changes both in market conditions and regulatory changes in the interest rate swap market, which required us now to post margin, where previously, our banks would fund our margin requirements.

These changes require us to earn a higher incremental spread to justify the higher capital usage resulting to this interest rate strategy.

Consequently, we expanded the scope of our program from 2 to 5 years in terms of maximum maturity.

We have set an average duration for the entire program of less than 2.5 years.

Now, we will also consider the outright purchase of treasuries, as well as just interest rate swaps.

Our approach will be to continue to ladder our exposure to interest rates.

So we'll benefit from rate increases as the interest rate cycle turns.

We did implement this revised strategy during the quarter.

And in aggregate, we have now invested about $400 million across the yield curve, which should add incremental pretax earnings of around $3 million per annum.

We will look to make (inaudible) investments in interest rate instruments in line with this policy, subject to us achieving the minimum returns on capital utilized.

We have now also completed the consolidation of our European operations into a single regulated entity.

This has resulted in better utilization of capital, ability over time to rationalize systems and infrastructure costs.

More importantly is the benefit to clients.

You can now deal with only legal entity and execute trades in a variety of markets without the need for additional paperwork, thus simplifying cross-selling and reducing paperwork.

With this process now complete, we are assessing whether we should combine the various parts of our US regulated businesses, starting with the broker-dealer and the FCN.

This is, of course, a much bigger undertaking and hopefully, the synergies and benefits will be much greater as well.

The evaluation will be completed soon.

And if we decide to move forward, is likely to take 6 to 12 months to complete, which will put us in even a stronger position to compete for business.

We are of the view that we have assembled a unique platform and are now starting to see costs flatten and possibly decline slightly.

We believe we now have an infrastructure that can be scaled without commensurate increase in infrastructure costs.

Our business, on average, realizes pretax margins of about 50% on incremental revenues, which results in big operational leverage to the bottom line.

Assuming a stable business mix, a 10% increase in our gross revenues results in a near doubling of our pretax income.

As we saw this quarter, this can work in reverse as well.

We continue to see a more positive market environment and a slowly consolidating industry, as smaller players are squeezed out of the market and larger players refocus and deal with regulatory constraints.

Both of these factors should help increase revenues which, when combined with strong operational leverage, should drive our bottom line.

We have had some good positive feedback about our recent changes in reporting format.

This quarter, we made another change, as Bill mentioned, by dropping our mark-to-market presentation of our earnings.

This was due to the closure of the Base Metals business, which accounted for the bulk of the difference between mark-to-market and GAAP results.

While we still have small differences between mark-to-market and GAAP results for the Precious Metals and the physical soft Commodities business, these are now not considered material.

This should provide a more simple and conventional presentation of our results going forward.

I will now hand you over to Bill Dunaway for some more detail on our financial results for the quarter.

Bill?

Thank you, Sean.

I'd like to start my discussion with a review of the quarterly results.

And we'll refer to the fifth page of the slide presentation titled Quarterly Financial Dashboard.

Operating revenues declined 4% in the third quarter of 2014 to $118.2 million, as compared to the prior year, as a result of the declining Clearing and Execution Services and Physical Commodities revenues.

These declines in operating revenues were partially offset by strong operating revenues in Global Payments, which matched its record operating revenues in the first quarter of the current fiscal year, which is historically the strongest period for that business.

In addition, the Securities segment operating revenues recovered with a 25% increase in operating revenues versus the prior year.

Interest income on customer deposits remained constrained by historically low short-term interest rates.

However, as Sean mentioned, we have begun to take steps to take advantage of the steepening of the yield curve with limited purchases of treasury Securities with longer durations.

And we plan to make further purchases in the future, along with re-implementing our revised interest rate swap strategy.

Average customer equity, which generates the interest income for us, continued to grow, increasing 8% to $1.8 billion as compared to the prior year.

Looking at our operating segments, Commercial Hedging segment operating revenues increased 2% to $54.9 million in the third quarter compared to the prior year.

In this segment, we serve our commercial clients through our team of risk management consultants, providing a high value-added service that we believe differentiates us from our competitors and maximizes the opportunity to retain our clients.

These services span virtually all traded commodity markets, with the largest concentrations in grains, energy and renewable fuels, coffee, sugar, cotton and food service, as well as base metals listed on the LME.

The increase in our core Commercial Hedging operating revenues was primarily the result of a 13% increase in exchange-traded revenues, driven by strong growth in LME metals with an expansion in the Far East, as well as improved domestic agricultural market conditions, resulting in a 12% increase in overall exchange-traded volumes.

However, these gains were partially offset by a decline in structured OTC Commodity revenues and declines in foreign exchange activity in South America.

While OTC customer volumes increased 3%, the decline in structured products drove an 11% decline in the average rate per OTC contract.

Overall, Commercial Hedging segment income increased 3% to $16.6 million for the third quarter, driven by the increase in operating revenues, as well as a slight reduction in the variable expenses as a percentage of operating revenue.

Moving on to our Global Payments segment, which provides global payment solutions to banks and commercial businesses, as well as charities and government organizations.

Operating revenues experienced strong growth compared to the prior year, with operating revenues at $13.6 million, matching the record levels of our first quarter of 2014, and exceeding the prior year quarter by 21%.

This sustained growth is the result of continued acquisition of commercial bank clients and the successful implementation of a new back-office platform, which enables us to process increased volumes, including smaller notional payments, without requiring the hiring of additional support personnel.

The number of payments made in the third quarter of 2014 increased 26% as compared to the prior year.

Overall, Global Payment segment income increased 30% to $7 million for the third quarter, driven by the increase in operating revenues partially offset by higher introducing broker expenses.

Operating revenues in the Securities segment increased 25% compared to the prior year to $20 million in the third quarter of fiscal 2014.

In this segment, we provide value-added solutions that facilitate cross-border trading in the equity markets, provide a full range of corporate finance advisory services, originate structure and place a wide array of debt instruments.

And operate an asset management business in Argentina.

Operating revenues increased in each one of these businesses, as compared to the prior year.

Improved equity market conditions drove a 15% increase in equity market-making revenues, while debt-trading revenues increased 129%, driven by stronger performance in Argentina and the addition of a municipals trading team.

Investment banking operating revenues experienced modest growth versus the prior year, while asset management revenues increased by 23% as a result of a 12% increase in the average assets under management to $484.2 million in the third quarter of fiscal 2014.

Segment income increased 53% to $4.9 million in the third quarter compared to $3.2 million in the prior year, primarily as a result of the increase in operating revenues.

Physical Commodities segment operating revenues decreased 57% compared to the prior year to $3.6 million in the third quarter.

This segment consists of our physical precious metals trading and physical agriculture and energy commodity businesses.

In precious metals, we provide a full range of trading and hedging capabilities, including OTC products to select producers, consumers and investors.

Our physical agriculture and energy commodity business provides financing to commercial commodity-related companies against physical inventories including grain, lumber, meat, energy products and renewable fuels.

Additionally, we engage as a principal in the physical purchase and sales transactions related to inputs to the renewable fuels and feed ingredient businesses.

This decline was primarily driven by a $3.5 million decrease in our physical precious metals operating revenues, primarily driven by a 30% decline in the number of ounces traded and a lower average revenue per ounce traded.

Physical agriculture and energy Commodity businesses declined $1.3 million as compared to the prior year to $2.5 million due to lower customer activity.

Segment income was $100,000 versus $3.5 million in the prior year due to the decline in operating revenue as fixed costs were flat with the prior year.

CES operating revenue declined 21% versus the prior year to $27.1 million in the third quarter.

In this segment, we seek to provide competitive and efficient clearing and execution of exchange-traded futures and options for the institutional and professional trader market segments, as well as providing prime brokerage foreign exchange services to financial institutions and professional traders.

Commission and Clearing fee revenues decreased 13% to $23.4 million in the third quarter as a result of a 23% decline in exchange-traded volumes, driven by low market volatility and the effective rising exchange fees on customer volumes.

Interest income remained constrained in the third quarter.

And customer segregated equity was relatively unchanged at $815 million.

Operating revenues in our customer prime brokerage product line decreased 54% to $2.9 million in the third quarter, as a result of a 16% decline in customer volumes and lower performance on our arbitrage desk.

Segment income declined to $900,000 in the third quarter versus $3.3 million in the prior year, primarily as a result of the decline in customer volumes.

Now, moving on to non-interest expenses, they were $111.7 million for the third quarter, which was a 2% decrease over the prior year, and 55% of these expenses were variable in nature.

Transaction-based Clearing expenses decreased 3% in the third quarter as a result of the lower exchange-traded volumes in our CES segment.

While introducing broker commissions increased 5% in the third quarter and were 10% of operating revenues in the third quarter compared to 9% in the prior year.

The increase is primarily due to increased activity in our Global Payments and the LME Metals businesses.

Compensation and benefit expenses decreased 5% to $49.2 million, with the variable portion of compensation of benefits decreasing 11% to $22 million in the third quarter as a result of the decrease in operating revenues.

The fixed portion of compensation and benefits increased 1% to $27.2 million in the third quarter.

Other non-compensation expenses increased 1% to $22.8 million in the third quarter, as a result of increases in communication and data services expenses and professional fees, which was partially offset by lower contingent consideration expense related to prior acquisitions.

Interest expenses increased to $2.5 million in the third quarter of 2014 as compared to $1.8 million in the prior year.

The increase is primarily related to the coupon interest and amortization of related debt financing costs, which aggregate to $1.1 million per quarter related to our offering of 8.5% senior notes due July of 2020, completed during the fourth quarter of fiscal 2013.

Net income from continuing operations for the third quarter was $3.7 million versus $5.1 million in the prior year period.

Over the long term, the Company looks to achieve a minimum return on equity of 15% or greater on its stockholders equity.

And for the current period, the Company was below that target at 4.4%, which was below the 6.2% achieved in the prior year.

We target to recognize $500,000 in annualized revenues across the entire employee base.

For the current period, this metric was $423,000 per employee as compared to $446,000 for the prior year period.

On December 11, 2013, the Company's Board of Directors replaced its previously authorized share repurchase plan.

Under the new plan, the Company may repurchase up to 1.5 million shares of its outstanding common stock.

During the third quarter of 2014, the Company repurchased 127,186 shares of its outstanding common stock in open market transactions at an average price of $18.79.

Finally, in closing out the review of the quarterly results, the trailing 12-month results have led to an increase of 5% in the book value per share, closing out the quarter at $18 even.

Moving on to our year-to-date results for the 9 months ended June 30, 2014, operating revenues increased 1% to $360.3 million.

However, the prior year period included the $9.2 million gain on the sale of the LME and Kansas City Board of Trade shares.

Net income from continuing operations declined $3.1 million versus the prior year to $13.8 million in the current year-to-date period.

However, the prior year included the $5.8 million after-tax gain on that sale.

Excluding that non-recurring gain, net income from operations increase d 24% versus the prior year period.

With that, I would like to turn it back to Sean to wrap up.

Thanks, Bill.

As we have mentioned in the last couple of calls, we believe we are entering a more positive cycle for our business, with slowly improving market environments; market volatility, which really can only increase; interest rate cycles starting to turn and a consolidating industry.

We believe we have put together a fairly unique global platform, allowing us to serve customer needs.

And we are well placed to take advantage of these improving trends.

None of this is likely to be explosive in the short term, but in combination, should provide a steady long-term push to our revenues, which combined with our operational leverage should drive our net income to more acceptable levels.

With that, I would like to turn it back to the operator to open for a question-and-answer session.

Operator?

Thank you.

(Operator Instructions) John Dunn, Sidoti & Company.

So just given the low volume environment, can you talk about the business lines where you think you have the most capacity?

I think we've worked pretty hard across the board to scale operations, put in some better systems and make sure we can handle additional volume.

Because it's clear, we need additional volume to hit our targets here.

I think we can handle a decent amount of increased volume and activity in all of our business segments.

I would say we could handle 30% to 50% increase in almost everything we do without running into any constraints, whether it be operational, liquidity or capital.

Some of our businesses, such as Global Payments, for example, we have a lot more capacity than that that we can drive through that business.

Because it's just much less capital-intensive, not as liquidity-intensive.

It doesn't consume a lot of regulatory capital.

So all in all, I think we have some pretty good ability to grow probably easily in the 30% to 50% range from where we are now.

And in some businesses, much higher than that.

I don't know if that answers your question (inaudible).

That makes sense.

Then just from a more macro standpoint, can you list for us some of the factors you're looking for that could help improve the environment, and volatility as well.

Obviously, the big one is interest rates, but anything beyond that?

Yes, I think I've tried to hit all the high points in my wrap-up comments.

Yes.

But certainly, market volatility across all of the instruments we trade has a direct correlation to short-term volume, clearly -- whether that be in the equity markets, whether it be in certain commodity verticals, foreign exchange.

And for the most part, every single thing we trade is trading at close to all-time low volatility levels.

There's certain commodity verticals, particularly last quarter, for example, coffee and some of the energy things we traded.

There was some good volatility here and that's why we did well.

So volatility is clearly a big factor for us.

Interest rates is a big factor for us.

I think the other issues for us are industry issues.

We've come through this massive period of regulatory change, which has required more capital.

It's required more infrastructure costs.

We feel we're through that now; 2 years ago, we were in the thick of that.

It was very distracting.

I think we're through that.

But that's provided a real burden on smaller players.

And we're just constantly seeing a slow reduction in the number of small players, people getting out of the business, scaling back.

And at the high end -- and I'm sure everyone on the call has noticed this -- the big banks are also facing their challenges

They're having to deal with a different way to look at capital.

There's massive fundamental deleveraging happening in the banks, which I think has still got a long way to go.

And almost every bank we know of has pulled out of our businesses.

They've pulled out of the Commodities business.

They're getting out of equity market-making.

They've scaled back fixed income.

They've scaled back.

Everything you think about, they've scaled back on.

So I think that's all good for us in the long term.

A lot of that business was proprietary trading.

It wasn't customer-related flows, which is what we're interested in.

So not all of it is business we see or have an opportunity to compete for.

But along the way, there's a lot of business that's going to go to other firms.

And we've worked hard to make sure that we're that firm that can pick up that business.

And we don't see too many midsize financial services franchises that have our capabilities that are well placed in the long term to pick up the business these big banks are exiting or these small players are giving up.

And so that's a big driving force for us.

And one of the things we, as management, can focus on, we can't focus on interest rates.

We can try and enhance our interest rate earnings.

We can't generate volatility.

But what we can do is we can make sure every day we're out there trying to get new customers in the door, trying to find those customers that are being displaced.

We are really in the last, probably 12 months and increasingly now, really pushing all of our people to look at customer engagement metrics, not just how much revenue are you making.

We want to make sure every single one of our people is out there speaking to the existing customers and serving them as best they can and trying to get the biggest market share they can, but also looking for new business.

And that's really -- now that we're through all the regulatory stuff and through the building phase, we're really pushing very hard on growing our market share and growing our customer base.

And that's the one thing we can focus on.

All the other macro factors I think are going to give us a slow and steady push.

And if we do all of that right, I think we're setting up for an interesting time in our business.

So I hope that answered your question.

It was long-winded, but --

No, no, it's great.

And specifically on customer acquisition and Commercial Hedging, I think in the past, first to give us just a flavor of how that's going.

And then in the past, I think you might have mentioned a goal, about whether it be monthly or quarterly, what you consider good in terms of adding new customers.

So we definitely have seen, in the past, for example when MF Global went down, and we've had -- some of our more direct competitors have issues.

We've seen big inflows of customers.

In our Clearing segment, we do handle smaller, lower value customers.

And a lot of the customers out there are of that nature.

We tend to be a relatively high-cost provider in that business.

We are trying not to race to the bottom.

We're not looking to expand a very low-margin, low-touch business.

We're really looking for the higher value side.

And that is a much smaller universe of customers.

And we are, at the moment, seeing in our core Commercial Hedging business, between energy, LME and the grain side, we're probably picking up a couple of hundred customers a quarter.

And these are all high-value customers.

I think we can do better than that.

So that's what we've got to look for.

The other thing we've got to look for is we do know that over the last 3 or 4 years, customers have tended to, I think, just as a result of the fear in the financial markets, the fear of what happened [after] MF Global, they've tended to split their business around the market a little more.

So even our existing customers, I think there's a lot more business we can gain back if we push harder on that.

So the two things are a greater share of wallet from our existing customers as they become more comfortable with the situation and with us.

And us going a little harder after those other customers.

And if we could get to the 200, 300 high-touch customers a quarter, I think that would be an excellent goal for us to achieve.

And that would be very meaningful over a period of time for us.

Great, thank you very much.

John Leonard, Singular Research.

I have two questions and first really just an observation on the Global Payments segment.

I think breaking this segment out on a standalone basis due to reorganization last quarter is really going to help investors better understand and appreciate the strong growth prospects there.

And related to that segment, my question is as its contribution, as a percentage of net operating revenue, continues to increase, do you see this segment offsetting some of the volatility of other segments, such as Physical Commodities or Clearing and Execution?

Definitely.

Global Payments, just to repeat the (inaudible) history, really grew out of our FX business.

And it's now become a payments business.

And we don't see that that is really linked to any market cycle we can see.

This is fulfilling an operational need that big banks have.

There seems to be a general move by the big banks to get out of the corresponding banking business and to outsource this.

And it seems to us that that is unrelated to any short-term market environments.

Where we may be impacted by market environments in this business is we do make more or less on the payments depending on what the FX spreads are in any one market.

And we've gone through a period here of very low volatility in interest rates.

Despite some of the things going on in the world today, we don't seem to see that translating into the markets in any great sense.

But we have historically seen situations where there has been a bit of financial distress that some of the FX rates in these local markets blow out.

When that happens, we can make a lot more money.

But the steady increase in customer volume seems to be unrelated to any economic environment or financial market.

But our profitability may be enhanced by some dislocation in the market.

So I don't know if I've answered the question correctly.

But I think this business can grow in underlying volume terms regardless of market conditions.

But I think we could make more money when conditions get a little stressed.

Great, yes, that was a perfect answer.

Just my second and last question is somewhat related.

I know you talked about how the large banks are really pulling out.

They really don't have the desire or the ability to compete for every customer new.

On the smaller side, they really just can't compete with the middle and top tier.

My question is as you continue to gain this new business again, do you see this really offsetting any quarterly decreases in volume or volatility or spread compression?

We are always finding spread compression.

And we try and insulate ourselves from that by going off to higher touch customers, people who value our service, more commercial-type customers.

But the reality of our world is great compression.

So one is always fighting that.

I think we're well placed to offset that with -- through a consolidating industry, as we've discussed.

I do think we are fairly unique franchise now in the mid-market space.

Most of the competitors at our level tend to be [mono]-line businesses; they do one thing.

They're just an FCM or they just trade stocks.

We're a broker dealer; we're a swap dealer; we're in FCM; we're global.

That's a pretty unique platform for the more sophisticated customer that may not be large enough for JP Morgan.

And I don't think there are too many people like us out there.

Just anecdotally, what we're seeing is, I don't know, every week, every 2 weeks, we get a call from a team of people, a business, someone being dislocated from a banks.

Can we come and join you?

Our business is closing down.

We don't have enough regulatory capital because I'm at a small shop -- whatever it is, a variety of reasons, in all of our businesses -- Commodities, Securities, all over the place.

The problem is a lot of these businesses just don't fit us very well.

They're either very marginal, low-cost offerings, which we think ultimately, will be disintermediated out by technology.

So we don't want to stand in the way of that.

They're proprietary trading businesses.

We don't want to do that.

So we're really looking for those kind of opportunities that come to us that really fit with our model of serving real customers' real needs for the long term.

That's what we want to do.

And we've found a couple of those opportunities and I think we'll find some more.

And aside from discrete take-ons of teams or buying of businesses, it's one customer at a time deal.

And we've got a lot of people out there and hopefully, we're going to be pushing them harder to go find new customers.

So does that answer your question?

Sorry, again, I keep going on longer than you want me to, but --

That was perfect.

Thanks for the color.

That's all I have.

Will [Suttle], Woodmont.

A few things going on this morning, so I apologize if I missed everything.

But could you repeat some of the changes in the cash management approach?

And maybe -- I know that was something contemplated for a while, but was some of that already implemented in the second quarter -- or excuse me -- your June quarter?

Okay.

So let me talk about that in a little bit more detail.

Those of you who've read the detail of our Qs and maybe listened to our calls know that I would say 3 years ago, we took the view that we were sitting on a big opportunity with our customer funds, which really earn us enough interest.

We can't use that capital.

It has to be segregated out for customers.

It has to be placed in segregated accounts.

But commercially, we get to keep a large portion of the interest return on those assets.

And that's the economic model in the futures clearing business.

The problem is keeping those funds in T-bills or exchange-approved money market funds, we're making 6, 7 basis points.

It's effectively zero.

So

about 3 years ago, we took the view that we would synthetically enhance that interest rate asset or interest rate earning by swapping, using swaps.

And we would swap ourselves to the 2-year part of the curve.

What we would do is we would ladder ourselves out by doing 1/8 of our aggregate interest earning assets every quarter.

And we'd end up with a strip of 2-year swaps.

And ultimately, we would get the 2-year moving average of the 2-year swap rate.

So that was what we did.

We implemented that.

It worked very well.

We were given credit by the banks to do that.

So we didn't really have to put any capital up against those trades.

They were done on bilateral credit lines.

So the cost of capital to do that for us was zero.

So it was just incremental earnings at that point.

So we did that.

And Bill, on an annualized basis, at its peak, what did that add to the bottom line?

It was probably $4 million a year or something?

Yes.

Yes.

So we did that.

What happened is the curves started to flatten out about 2 years ago.

The incremental return that those swaps were giving us, we're at the point where we didn't think it was worthwhile entering into those transactions.

So a lot of those 2-year deals have rolled [off] over the last 2 years.

In fact, I think two quarters ago, they had all rolled [off].

Yes.

So we've constantly rethinked this.

And the other thing that happened over the last 6 months is the regulatory changes to the interest rate market.

The result of that is we cannot do interest rate swaps the way we used to do them because we now have to put hard cash collateral up to our banks.

Our banks can no longer extend bilateral lines to us for our interest rate swaps.

So now, we have a real capital cost if we want it on our interest rate earnings.

What we always try to do is do a cost-benefit analysis every time we put capital to work.

So anyway, we sat down and relooked it.

And basically, we've decided we're going to extend our tenure on that interest rate program.

So we're not going to look just to the 2-year swap rate.

But we're going to look out to 5 years and we're going to continue to ladder things.

We don't want to take big -- we don't want to put big amounts of money on the sweet parts of the curve because we believe, in an interest rate environment, that is increasing for us.

So we want to make sure that we appropriately ladder, so that we have stuff maturing every quarter that we can replace hopefully at higher rates.

And we also decided that we'll just do straight outright of purchases of treasuries, which tend to be slightly more capital efficient for us than doing swaps.

So what's changed in our program is we do both outright purchases of treasuries and we will do swaps.

But we've extended it that way.

We've extended our tenure.

We'll now look out to 5 years.

We want an average duration of around 2, 2.5 years.

And every time we look at the curve and every quarter when we invest money, we set a hurdle rate on that capital we deploy to make sure that we are actually deploying that capital at high rates of return.

So there may be situations, depending on how the yield curve works, where we're just not going to deploy capital that quarter.

Because we're just not getting incrementally enough increased margin to justify the tying up of that capital.

So again, a long-winded answer, but it's a slightly more complex process than it was before.

And we don't have any desire to take any credit risk.

So we're only looking at interest rate swaps, listed interest rate swaps, or buying [Dublin] securities.

We're not interested in doing anything other than that.

And this is simply just trying to enhance our interest rate earnings as best we can, and doing it in a way that we still are able to benefit should interest rates start to increase.

So that's what we've done.

We've implemented -- about $400 million of our $1.8 billion of customer assets are now invested.

The incremental earnings today currently at current rates on that portion of the funds is a run rate of about $3 million a year.

We will look at it next quarter and we may do another tranche next quarter.

And we'll just keep doing it quarterly until we feel we're fully invested.

So my question, the $400 million, is that prorata all these different -- the swaps and the treasuries?

Correct.

That is a whole -- that is the aggregate of all the laddering we've done over the last two quarters.

So if you were fully invested in today's rate environment, you'll be looking at 4 times or a little -- 4.5 times the $3 million in terms of --

Correct.

If we had to just take a view that we'd max out everything today, it would be depending on how that -- where on the curve we invested.

And it would probably be between $9 million and $14 million, give it a range, depending on exactly where we invested on the curve.

Yes, that's a significant earnings contribution.

Yes, but [it would] --

(Inaudible).

-- tie up everything at the far end of the curve and then find that interest rates start increasing very rapidly.

Yes.

So we're very keen to do it on a very laddered portfolio approach.

Right.

And [ultimately], 2.5 years is all you're willing to [step out] anyway.

On a weighted average basis, yes.

Right.

So the next question, July and August, you mentioned Contango and the grain market, I believe --

Yes.

-- was important?

Yes.

So could you give us an update then?

You're seeing better --

Yes, so for the first time in really a long time -- and I don't know when exactly; I don't have the details available to me -- we -- a carry market in some of our big Ags sector, so in corn and beans, which basically means the forward price is higher than the current price.

In that scenario, our core customers being the grain elevators and their core customers being the producers, tend to hang onto the grain longer.

And remember, we had this discussion about what drives our futures revenues, how many bushels are sitting in the elevators.

If those bushels sit around for longer, we make more money because they roll their hedges more often.

So we're now in a situation where our customers are incentivized to keep as much as of that corn and bean crop on hand.

And when they do that, they roll every quarter their hedges with us.

And of course, we make money every time they do that.

We haven't had a carry market for a long period of time now, which basically means there's been no incentive for the grain elevators to really hold onto the corn or the beans.

And they push them out just as and when the markets needed them.

We're in a slightly different situation now.

And traditionally, this is a good setup for us.

Does it make sense?

Yes, great.

Thank you for your time.

Russell Mollen, Nine Ten Capital.

Can you just walk me through, as a follow-up to that discussion on the cash management and going out just $400 million?

What are the risks associated with that type of move if a customer calls on their own funds?

Or what are you exposed to by doing something like this, other than the interest rate risk that you, in theory, would be taking?

But just on the other side of it, what could go wrong?

Let me try and see if I can run through all of this.

The first risk is an opportunity cost.

We lock up our money, and it turns out, it would have been better had we don't nothing.

Because short-term interest rates go to 5% and we're locked in at 2%.

So that's not necessarily a cost or a risk, but it's an opportunity cost.

You say, gee, if we had not done that, we would be making more money now.

So to address that, that's why we've laddered our approach.

We're earning more than we did before.

But we want to make sure, as interest rates increase, we have instruments rolling off that we can replace at a higher rate, or just leave at the T-bill rate, if that's acceptable to us.

So that's the first commercial risk for us is are we taking an undue opportunity cost by locking into something when it would have been better maybe to do nothing and wait?

So that's a challenge for us and we always think about that and laddering is how we address that.

The other risk we have is there's tied-up capital now.

That's the biggest change that's happened.

So whether we go buy treasuries or whether we enter into interest rate swaps, there is real capital that is used to do that.

If we buy treasuries in the FCM, we have capital haircuts on that, which approximate the margin requirements if we do a swap.

So either way, we are using capital to enhance and provide these earnings, which is why we sat down and set ourselves some very hard targets about how much equity capital we can dedicate to this process.

Previously, it was a free ride.

It ain't a free ride anymore.

And we've got to do that in the context of -- we want to make sure that we have enough capital for the growth in our business, or any changes in regulatory environments.

If we commit too much capital to this, we may find ourselves constrained in other areas.

And I would say our first priority is to make sure we have enough capital to handle the growth in our business.

That's our first priority.

So this is the second priority.

So there's a risk that if we are too aggressive, we may end up tying up too much capital in this interest rate enhancement program and find ourselves a little short on capital for our core business.

In that eventuality, we can sell the underlying instruments.

But there may be a mark-to-market loss on those instruments if we do it (inaudible) profit.

So that's another risk.

So we're going into this pretty cautiously and we've made sure that we're not dedicating huge amounts of capital to this.

And we're setting pretty high rates of return incrementally on every dollar, just to make sure we get the best bang for the buck.

The other side of it is we are investing what we believe to be the sustainable, long-term portion of our [seg] fund interest earning assets.

If those assets get recalled by customers, we could find we're in a mismatched situation.

And in fact, we just have an outright position in treasuries.

For example, if we end up that we've got $1.5 billion of treasuries invested across the curve, because we were sitting on $2 billion of [seg] funds, if that drops to $1 billion, we've got a $1 billion of [seg] funds, but we've invested $1.5 billion in treasuries.

We have a $500 million mismatch there.

And that would be an outright position at that point, so it wouldn't be enhancing interest rate earnings.

This would just be taking a view on treasuries.

And we would have to finance those treasuries and decide whether we wanted to continue taking that view, or we would want to sell those treasuries and reduce our holdings down to something that more approximates our [seg] fund.

Our view is not to take a proprietary view here.

Our view is to enhance the interest rate potential we have in our [seg] funds.

So the way we're addressing that is we never want to invest more than about 70% of our [seg] funds.

And that's going to be laddered every quarter.

And we also want to make sure that we are only really investing what we believe to be the long-term core [seg] funds that we have on hand.

So we should never be anywhere close to our maximum [seg] funds.

I think that would exacerbate this risk and could arise in a situation where, for a quarter or two, we may have more invested in treasuries than we actually have in [seg] funds.

And I'm not sure we really want to do that.

Does that answer all your questions, Russell?

Yes, that's perfect.

Thank you.

This is Bill.

I would just add one thing, and it's not really a risk, but it's just more -- on the swap side of it, as we enter into these swaps, those are derivatives that are going to have to be mark-to-marketed over the period we're holding the swaps.

So even though we've got a fixed long-term rate, the long end of it is floating short-term rates.

So as those move up and down, we could see ultimately, mark-to-market moves in that derivative over time.

And just remember, on the other side of that, we're actually holding short term treasury bills or money market funds.

So we're covered on that short term side.

But on the swap side, you're going to see some noise as it's mark-to-marketed.

So in periods of just generally rising rates or generally flat rates, it's not going to be a lot.

But if interest rates do pop a little better, the curve steepens.

You could see some mark-to-market noise on that, that ultimately, we'll benefit on the physical side with the short-term rates as well that'll offset those cash flows.

But just -- it could make earnings a little lumpy one quarter or another.

Got it.

Okay.

Any other questions, Russell?

No.

Steven [Spurse], International Asset Advisory.

I had a question concerning the return on equity.

I know 5, 10 years ago, you had a target more in that 16% to 18%.

And quite frankly, there were times where you were hitting the 20%, and even a little bit higher at times.

Now, the target over the last few years has been more in that 15%.

And here, I think we just reported 4.4% on the ROE.

What's it going to take to get it back up to 15% as far as a level that we're achieving?

We all wish for the good old days when our business was unregulated and (inaudible) we had now, right?

Right.

This question has come up a lot.

And a lot of our investors have said to us, man, shouldn't you change your targets?

And aren't you being too aggressive?

And our response to that has been if you go back to -- gee, I may get the year wrong; 2012, I believe, was the year -- which we're in the middle of the financial crisis and things weren't great.

But we had a little bit of volatility going on in the markets.

We made a 16% ROE that year.

So we feel that since then, we've come through a pretty tough period where we've had a lot of regulatory change on the Dodd-Frank side.

We've had market fallouts because of MF Global.

We've had droughts and things in some of our biggest business areas.

We've had volatility fall.

So we've had just -- it's all a sorry list of excuses, but we've had a lot of things working against us.

And clearly, that's been reflected in a declining ROE.

There's no doubt about it.

So firstly, we always want to make sure our ROE is a long-term target.

There's no point in having a target if you're going to change it every time you have a small change in market conditions because then it's not a target.

It's just a -- I don't know what it is at that point.

We run our business for the long term; we want to have long-term targets.

And by definition, anything that is a cycle or is a short-term anomaly shouldn't cause you to change your long-term targets.

And we believe a lot of what we've come through has been short term and cyclical.

And we're now moving through to the other side of that.

What is not short term is regulatory costs have fundamentally changed.

You have to put more capital up against your business.

And there's a different environment out there in terms of who the competitors are.

And we think, in many ways, it's a positive environment for us because we may be picking up business as the shakeout in the industry continues.

So you put that all into the mix.

We're not sure, honestly, whether we should adjust our target or not.

What we are seeing is most banks and investment banks out there are making between 5% and 10% ROE.

That's what we're doing.

Does that mean that's what we're going to carry on making when market conditions return to a more normalized environment?

No.

We know that if interest rates get back to 2% on the short end with a decent yield curve, that's probably 5 percentage points of ROE at least that just gets added to the bottom line.

And historically, that's been a normal interest rate environment.

We're in a very abnormal interest rate environment now.

So I think we can easily see, just through interest rates, a little pickup in volatility.

And despite all the regulatory costs and capital requirements, we can see that in that more normal environment, we should be at 12%-plus.

15% is going to be challenging for us.

But this is a target and we want to shoot for it.

And we want to hold ourselves accountable to a long-term target that we believe is challenging, but achievable in a normal market environment.

And that's what we still believe.

We may be deluding ourselves, but that's what we believe.

And the qualifications for that are a more normal market environment, where interest rates are zero.

I think interest rates being zero is abnormal.

So I think all of these things are starting to come our way now.

Interest rates are starting to increase.

We have a yield curve now.

We could, as the previous question or two questions ago -- if we had fully invested our interest rate program, we could add something like $9 million to $12 million or $13 million to the bottom line now just by doing that.

We've got to do it prudently and we've got to do it carefully.

If short-term interest rates go up beyond that, that's going to be another $15 million on top of that.

So there's a lot of things that are starting to turn our way.

And we think we're well positioned to pick up market share.

And when you're making $0.50 on the dollar of every incremental revenue dollar, a 10% increase in our top line revenue more than doubles our bottom line.

So if we can grow our revenues 10% to 20% over the next 2 years; if we can get some interest rates back in the market; and if we can have even a little bit of volatility, I think we can make 15% ROE.

That sounds good.

You've done a great job considering.

I think when you all took over, the book value was what, a little bit below $2?

Yes, it was $1.70.

$1.70, and we're at $18?

Yes, exactly.

Thank you for that (inaudible).

(Inaudible).

Let me reiterate, it ain't going to be easy to get there and it ain't going to happen quickly.

But we think we can there, so --

Very good.

Mr. O'Conner, there are no further questions.

Wow, that was more questions than we've ever had on a conference call.

So that's great.

So we like it when people ask questions.

So thanks, everyone.

Thanks for the people who asked questions.

We appreciate it.

And thanks for listening.

We will talk next time.

Ladies and gentlemen, thank you for participating in today's conference.

This does conclude today's program.

You may all disconnect.

And everyone, have a great day.