Why We Like JMP Group

For some time now we've been bullish on boutique investment banks.  In the fall of 2007, as the current crisis began to unfold, we predicted a shake-up in the highly concentrated investment banking model.  The crisis of the past 2 years has only served to underscore our belief (a belief shared by others) that the conglomerate model of investment banking cannot stand, and that smaller, more nimble, research-driven shops will be the winners.

One of the shining examples in this regard is JMP Group (JMP), a San Francisco-based boutique founded in 2000 by Montgomery Securities alumni Joe Jolson and Carter Mack.  JMP went public in 2007, and as a result has had to build its business in one of the worst market environments of the past century.  Nevertheless, JMP has survived, and in fact has thrived, capitalizing on the distress of its larger competitors, capturing talented managers fleeing ailing bulge bracket firms, and partnering with Qatalyst Group, a technology boutique founded by veteran tech banker Frank Quattrone.

JMP's recent financials are impressive.  Having posted a net loss in Q4 of 2008, the company returned to profitability in the first quarter of this year with EPS of $.03.  In the most recent quarter, the company posted record revenues, nearly doubling from $25.02 million to $49.63 million.  Revenues increased in all core business areas with the exception of asset management, which actually fell by 50%.  Quarterly EPS increased 667% to $.20.  JMP's balance sheet is strong, with $55.7 million in non-deposit cash and marketable securities, and minimal debt (8.5% d/e ratio).

But can the company continue to post such numbers?  We believe it can.  Management has clearly proven itself by building and sustaining a viable investment banking franchise in the midst of utter turmoil and uncertainty in the global economy.  In addition to being a beneficiary of the bulge bracket meltdown, we believe JMP stands to benefit greatly from increased M&A activity and, yes, the eventual return of the IPO market.  The universe of venture and private equity-backed companies continues to grow with no end in sight, and will provide a healthy stream of dealflow by mid-2010.

Developing Your Acquisition Profile

We recently blogged about an emerging trend in social media acquisitions: buying up assets and talent as opposed to streams of cash flows (i.e. entire enterprises).  We concluded that start-ups should consider positioning themselves as potential targets for asset acquirers.  But how can this be accomplished?

First, you must redefine the profile of your core customer.  While you should of course remain focused on your current user base (and growing it, if your value proposition involves increased market share or lead generation), your customers are now potential acquirers.  Determine what industries your product would serve, then generate a list of customers in each.  Recognize that you are now selling yourself as an off-the-shelf IT solution and, as is the case when contemplating an in-house IT project, you must justify the expenditure by demonstrating the ways your product can create value for the buyer's business.  For each customer, place yourself in the role of CIO.  How does your product fit into the customer's IT strategy?  Will your product help to streamline operations?  Increase market share?  Lower the buyer's customer acquisition costs?

Once you have the answers to these questions you can begin to approach prospective acquirers.  You may find that many will be receptive to your overtures, especially as the economy continues to improve and IT budgets increase.  However, once your pitch is complete the response you are likely to hear is: "You've got a quality product, a great team, and we see the benefits you can bring to a company like ours.  But why should we pay you what you're asking when we can build a comparable system for far less, or even outsource the development to India and get a comparable product for $50,000?"  In other words, why should they pay you more than replacement cost for a non-cash-generating asset?  For your response, you have several options:

Lower Total Cost of Ownership (TCO) /
Higher Return on Investment (ROI)
If possible, demonstrate how the all-in cost of acquiring you will be less than a custom-built application for the duration of a typical project length (five years). Point out that your costs are clear and are known upfront, whereas an outsourced or even an in-house build can suffer from significant cost overruns and result in outsize maintenance and support costs over time.  If applicable, underscore how your product will deliver a pool of account leads or eyeballs for CPM purposes, and, preferably, that your acquisition will result in an increased conversion rate for the buyer.  If the deal entails the transfer of human capital, underscore management's intimate bottom-up knowledge of the product as a key driver of value going forward.

Quality Control
Point out that, while an outsourced custom solution presents an attractive business option, it can be difficult to administer and, given the inherent complexity of software development, can often result in buggy code, sluggish performance, and an overall brittle application. Moreover, the identification and resolution of bugs occurs over time and in the live production environment. The result is at best an inferior product, and at worst additional costs in the form of lost productivity, lost customers and revenue, and additional capital outlays.

Evolving Functionality
Explain that custom-built applications tend to be rigid in their satisfaction of specific client requirements and do not provide the necessary flexibility to handle future changes. With your knowledgeable team in place, the customer will have the capability to regularly enhance the application with additional features, and to upgrade existing functionality. Conversely, upgrading a custom application will require a significant level of effort and expenditure.

Faster Time-to-Market
In addition to valuable resources, a custom-built application requires a substantial investment of time. Requirements analysis, design, development, testing, implementation, maintenance and support are all important factors when considering in-house or outsourced development.  Acquiring your product, however, will enable the customer to deploy in a matter of days as opposed to weeks.

Obviously you will want more than replacement cost, but how can you justify this?  In the absence of cash flows, you need to identify the unique value your product will bring to the acquirer over time.  They key is being able to the quantify the value, and to demonstrate it in dollar terms. This is difficult, and will likely require customizing your product's value proposition for each buyer, but with a bit of research and reasonable assumptions, not impossible.  In our next post we will focus on various methods for valuing your product as an asset acquisition.

Wanted: Healthcare Finance Start-Ups

For all its faults (and there are many), free market capitalism is arguably one of the most powerful engines of innovation the world has ever seen.  Time and again solutions to some of society's most challenging and seemingly insurmountable problems have arisen from the pursuit of profit.  It is time that this power be brought to bear on one of the most urgent problems of our time - affordable health care.

Like most industries, healthcare has embraced the Internet as a powerful communications tool, with scores of websites providing information, reviews, and recommendations.  The healthcare industry has also been one of the early adopters of social networking, a technology which seems tailor made for individuals seeking valuable peer perspectives on providers and available treatments, as well as advice and support.  Various digital media have recently emerged as a means for individuals to measure their "life stream data," to track their progress toward a healthier lifestyle.  Yet, ironically, while never before have consumers been so empowered with respect to their own care, the ability to pay for such care has never been so uncertain.

We believe an enormous opportunity exists in the application of digital media to healthcare finance.  A project of this scale would require as much financial as technological innovation, but we need look no further than P2P lending for inspiration in this regard.  People lending money to complete strangers would have been unthinkable ten years ago, and yet today we find individuals lending millions of dollars to fund everything from a new business venture, to home improvement, to a master's degree.  Likewise, we are (finally) seeing the first indications of P2P-type technology being applied to corporate finance (Sprowtt).

The democratizing effect of "Health 2.0" technologies has been shown to contribute significantly to administrative cost reductions, and this is an excellent start.  But is time to take the larger step of revolutionizing healthcare affordability. The surprising success of the P2P finance model should provide ample incentive for financial technology entrepreneurs with unconventional ideas.  The winner of this race will be rewarded . . . handsomely.

E*Trade Rumblings

There has been much commentary recently regarding the takeover potential of E*Trade (ETFC).  Analysts are largely bullish on the stock citing the bottoming of the housing market and resulting stabilization of ETFC's outsize mortgage portfolio, as well as the strength of ETFC's core brokerage business.  Recently selling pressure has been attributed to portfolio rebalancing by institutions with greater than 9.9% exposure.

Likely suitors include Schwab (SCHW) and TD Ameritrade (AMTD), both of whom have expressed interest in E*Trade's 2.7 million retail accounts.  However, we disagree with the contention that larger institutions such as Wells Fargo (WFC) or Goldman Sachs (GS) could also make a play.  While yes, these companies would be better positioned from a balance sheet standpoint to absorb E*Trade's mortgage portfolio, the synergy is simply not there, particularly in the case of GS.  The bigger question still is whether ETFC would even want to sell.  With the economy improving, and with the company still maintaining a highly competitive position, any offer would have to be at a considerable premium to the current price of $1.70.

Stripping away its balance sheet woes, ETFC is fundamentally strong.  The company is successfully growing its account base, as well as its brokerage-related cash while keeping operating expenses low.  In addition, ETFC continues to deploy cutting-edge desktop and mobile trading technologies, and remains one of the most recognized brands in online trading. 

Apart from its takeover potential, we believe ETFC is a strong buy at current levels with a one year price target of $5.00.

Facebook Credit Arbitrage

We have watched with great interest Facebook's slow motion deployment of its virtual currency, Facebook Credits.  One of the more obvious steps has been to offer payment options for Credits in 15 different currencies (70% of the network's users reside outside of the United States).  From an implementation standpoint, however, this could be tricky given the volatility of the currency markets. 

While exploring the Gift Shop shortly after Facebook's announcement, we discovered that this medium may in fact present opportunities for currency arbitrage.  Facebook has since changed the process for Gift Shop transactions.  Users now must choose their currency option under Account Settings - Payments, rather than make that choice at the time of purchase.  In addition, it would seem that the option to purchase additional Credits (i.e. more than what is necessary to effect the current transaction) has temporarily gone away.  Nevertheless, our conclusions still hold.

Facebook's local currency quotations are not in real time.  In fact, they appear to be based on the previous day's closing value, and they apparently remain fixed for the following day.  This means that Credit buyers have the ability to exploit this time distortion, and the pricing differential which may result.  Depending on volatility, buyers could realize a substantial discount.  Here's how it works:

1. Identify currencies experiencing a meaningful (i.e. 2% or more) intraday drop against the USD from the previous day's close.
2. Purchase credits in that currency (quoted at the previous day's close).
3. The purchase is converted into USD by your credit card company (for which you will be charged a conversion fee ranging from 1 to 3% of the transaction).
4. Enjoy your discounted Credits, or perhaps resell your Credits for dollars using Facebook's proposed transfer system when it becomes available.

Now, there are numerous caveats and assumptions here, not the least of which being that when using any of the myriad currency converters available to derive current exchange rates we are quoted the bank or wholesale rate - that is, the rate which applies to transactions sized in the millions of dollars.  Whether credit card companies use this rate when converting your transaction is a bit of a mystery, thus transaction costs could substantially erode if not wipe out any discount.  Also, this is of course not true arbitrage in the sense that (as of yet) Credits cannot be readily converted back into hard currency via Facebook.  But to the extent that Credits can be used as currency in the Gift Shop and within a growing list of popular Facebook applications, it's as close as you can get.  Should Facebook roll out its Credit transfer system (currently under private beta), however, things could get interesting.  Theoretically, one could buy Credits in a currency experiencing a significant intraday drop against the dollar, then use the Credit transfer system to offer Credits in USD at less than the going Facebook rate.  Using any number of payment providers to effect the transaction, the arbitrage is complete.

As with any arb trade designed to exploit tiny price differentials, in order to realize any meaningful return substantial sums would have to be involved.  Transaction costs (the credit card conversion fee and the payment provider's fee) would have to be minimal, and the rate at which credit card companies convert purchases into your home currency would be a factor as well.  Nevertheless, we find this to be an intriguing possibility, and as Facebook inches closer to full deployment of its virtual currency, we will continue to monitor.  We hope that Facebook will be hedging their exposure.