Boutique investment bank Cowen Group (NASDAQ:COWN) went public last month and made its first earnings announcement yesterday. However, despite a 56% increase in revenues year over year, I'm not convinced this firm is a future superstar.
Before I explain, let's take a look at the numbers. Second-quarter net income was $5.6 million, compared to a net loss of $2 million in the prior-year quarter. The swing to profitability was driven by strong growth in capital raising (equity underwriting and private placements) and principal transactions in the sales and trading division. M&A was a notable laggard -- advisory fees were down 31% year over year.
On the expense side, the adjusted ratio of compensation expense to total revenues was 58%, at the low end of Cowen's earlier guidance. However, this puts Cowen at the high end of the pay scale for investment banks; its closest peer, Thomas Weisel Partners Group (NASDAQ:TWPG), has an explicit target range of 55%-58% for compensation expense as a percentage of net revenues. (Weisel's ratio was 56% in the second quarter.)
Looking ahead, it's difficult for me to be enthusiastic about the firm's prospects. Cowen caters to growth companies in five sectors: technology, media, telecoms, health care, and consumer goods. In my previous article on Cowen, I mentioned this narrow business focus as a fundamental risk, and I believe it could manifest itself over the near term in two ways:
- Small deal pipelines produce greater volatility in the number of closed transactions, with a corresponding effect on revenues and earnings. This quarter's 31% year-over-year decline in advisory fees resulted from a drop in the number of closed transactions on which Cowen acted as advisor, from four in the prior year to two this quarter.
- Equity underwriting (IPOs and secondary share offerings) is generally sensitive to overall market conditions. However, in the prevailing challenging market environment, investors are especially chilly toward smaller growth companies, Cowen's target market. Midway through the third quarter, there have already been 14 IPO withdrawals, compared to 13 for the entire second quarter. Cowen was lead manager on two IPOs withdrawn this quarter, for Alien Technology and QuatRx Pharmaceuticals. For a company with 21 offerings in its filed backlog, this loss is significant.
As of Tuesday's close, Cowen's shares were nearly 12% below its IPO offer price, making Cowen one of the 10 worst IPO performers of the last three months. With a limited operating history as an independent entity and patchy results over the last five years, assigning a value to Cowen is an uncertain exercise at best. Despite its post-IPO drop, I wouldn't recommend a purchase at these levels. Instead, I'd look at banks without a specific industry focus, such as Lazard (NYSE:LAZ) or Greenhill (NYSE:GHL).
Besides, investors have increased choice when it comes to boutique investment banks: Evercore Partners (NYSE:EVR) met with a warm reception when it went public last Friday. On the same day, KBW -- better known as Keefe, Bruyette & Woods, a boutique firm that focuses on the financial services industry -- also filed for an IPO.
Further fiscal Foolishness:
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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.
