This month has shown that febrile markets are on a knife-edge. A host of different hazards – sovereign debt, Libya, inflation, and China to name just a few – could each trigger mega panic attacks. Bad news for the faint-hearted, but great news for Tullet Prebon, the world’s second-largest inter-dealer broker.
It makes money by charging commissions to execute over-the-counter (OTC) transactions in exotic financial derivatives (eg, interest-rate swaps, Treasuries and energy) for its clients. The more volatility there is, the more orders come in. Importantly, Tullet doesn’t own the underlying assets either, but simply transfers them between parties, thus mitigating its exposure to counter-party risk.
Why is the stock trading on a paltry forward price-to-earnings (p/e) ratio of less than nine, then? Well, there was a lull in activity last year, thanks to the banking sector being put on a sounder footing. Also, profits stumbled 10% after 50 brokers on its North American dealing desk defected to rival BGC Partners. Tullett is pursuing a legal claim against BGC and seeking substantial damages.
Tullet Prebon (LSE: TLPR)
To compound the problem, politicians around the world are discussing ways of regulating the enormous $600trn OTC market to improve transparency to prevent another credit crunch. This is a valid concern, since over 80% of Tullet’s brokerage is presently concluded over the phone on an anonymous basis.
CEO Terry Smith is not too concerned, though. The company is beefing up its IT platforms and should be fully compliant when any decision is made. Indeed, he believes Tullet will be one of only three inter-dealer brokers that has the governance, cash reserves (£68m) and audit records to satisfy the strictest standards. Besides, the introduction of electronic clearing could actually expand the OTC market – mirroring the effect that the arrival of automatic trading had on futures, foreign exchange and other asset classes. Consequently, any decrease in margins should be partly compensated for by much higher throughput.
The City is forecasting 2011 turnover and underlying earnings per share of £943m and 46p respectively, along with a 16.5p dividend (4% yield). I would value the stock on a seven times EBITA multiple which, after adding back the cash, delivers an intrinsic worth of about 525p. Short-term results could even beat expectations, given the turbulence currently playing out on oil, natural gas, nuclear and carbon emission markets.
In short, Tullet represents a cheap, solid counter-cyclical play.
Recommendation: SPECULATIVE BUY at 407p (market cap £875m)