Keeping an Eye on Refco

Many an investor watched the stunning rise in shares of the Chicago Mercantile Exchange (NYSE: CME  ) over the past two years. The exchange's secret is rapidly rising order flow in transactions -- it's Grand Central Station for clearing trades in futures and derivatives during the middle of a commodity boom and unprecedented volatility in everything from interest rates to currencies to cattle.

Until recently, though, there wasn't any other pure play available to investors looking to capitalize on this rising order flow. Enter Refco (NYSE: RFX  ) , a brokerage firm specializing in futures and derivatives trading that went public on Aug. 11. If you believe we're in the midst of a commodities bull market that could last a decade or more, then this is definitely a company to keep an eye on.

A futures contract for the uninitiated is a contract often purchased on margin for the future delivery of a raw material or a currency, or even stocks or bonds. Futures contracts have been around since the dawn of capitalism, and aside from speculation, they allow buyers and sellers the chance to lock in a given price for a given product. Part of the reason Southwest Airlines (NYSE: LUV  ) , for example, remains profitable is that the company has locked in the cost of its oil for years to come.

Order flow has risen at an annual rate of nearly 79 % at Refco over the past four years, to 460.9 million contracts cleared in 2004 -- a figure that rivals the transaction volume of the Chicago Board of Trade, which itself is slated to go public. There's also talk of the New York Mercantile Exchange going public.

But let's look closer at Refco. The company, which began operations in 1969, is where Hillary Clinton parlayed $1,000 into $100,000 trading cattle futures during the 1970s.

One plus is that the company never trades for its own account; thus, it never puts itself in a conflict of interest with clients. Another is that exchanges tend to become known for a given contract, such as the oil contracts traded on NYMEX, but Refco can process these contracts regardless of exchange. If trading dries up in cattle or cocoa futures at one exchange, it may just as easily rise in copper and soybeans at another exchange, so Refco benefits from order flow regardless of what futures contract is in play.

Earnings grew to $187 million in fiscal year 2004 from $61 million in 2000, a compounded rate of nearly 33%. But there's a very real possibility that the trend won't continue this year.

As of May 2005, Refco carried $1.2 billion in long-term debt, mostly resulting from a corporate reincorporation and changes in ownership. Though $200 million of the stock-offering money will pay off debt, more than half of the IPO money was bagged by stockholders selling out. That debt has already hit earnings, which came in at $42.6 million for the most recent quarter, compared with $59.3 million in the year-ago period.

Aside from the 26.5 million in shares offered recently, there's an additional 101 million shares that could eventually make their way to market. So Refco is definitely making money, but I'd keep an eye on how well the market absorbs those additional shares if they come to market and how quickly the company progresses in paying off its debt load.

Dean Paton is a freelance writer who would be one step away from food stamps were it not for his financial investments. He does not own any of shares mentioned and can be reached at mrdeanpaton@yahoo.com.


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