When people hear the word "trading," they think of companies such as TD Ameritrade (NASDAQ:AMTD) and E*Trade Financial (NASDAQ:ETFC)or the major exchanges such as the Nasdaq OMX Group. However, one of the largest markets in the world is the foreign exchange market, and FXCM (NYSE:FXCM), an up-and-coming company in the sector, is worth a look. The foreign exchange market is evolving and this company is evolving with it, which could mean long-term profitability for shareholders.
A little history
FXCM, which is short for "Forex Capital Markets," is a U.S.-based foreign exchange broker. The company uses its own trading platforms, as well as others including MetaTrader.
One unique trait of the forex business is the very high margin that it allows retail clients. The higher levels of margin allow investors to gain a great deal of exposure to foreign currencies while limiting their risk to a relatively small amount of money. FXCM allows up to 50:1 leverage, letting investors amplify their positions while only tying up a small amount of their money.
FXCM currently has a roster of about 183,000 active customers worldwide. While this sounds like a lot, consider the customer count for other brokerages: E*Trade has slightly fewer than 3 million brokerage accounts.
Financials: lots of cash and a good value
Despite its relatively small size, FXCM has built a nice financial position that includes $374 million in cash as of the most recent quarter with $144 million of total long-term debt for a net cash position of $230 million.
FXCM's $630 million market cap implies that the business is valued at just $420 million, a valuation that is extremely low for such a rapidly growing company (more on valuation in a bit). Over the past several years, FXCM has done an excellent job growing its revenue and its cash stockpile. In fact, FXCM has grown revenue from about $323 million in 2009 to an estimated $489 million this year, an increase of about 51.4% in just five years. Cash on hand has grown 167%, from $140 million to $374 million.
Mixed results, but good where it counts
The company is seeing mixed results in trading volumes, but not necessarily in a bad way. Retail traders seem to be trading less, with $285 billion in retail trades taking place in September, about 6% less than in the same month last year.
Most analysts see activity picking up over the next few years due to higher anticipated volatility in the currency markets. This could result from U.S. monetary policy changes (the "taper") expected in the near future, as well as from interest rate volatility. According to analysts at Credit Suisse Group, retail trading should grow at a 10%-12% annual rate over the next couple of years.
Institutional investors are another story. Likely due to an increased focus on this segment, complete with specialized trading platforms and increased levels of service, institutional trading volumes have tripled. While retail still makes up 61% of FXCM's trading volume, institutional accounts could be the catalyst to take the brokerage to the next level.
On the issue of valuation, it doesn't seem like the market is pricing in the dramatic increase in institutional business that FXCM has seen lately. FXCM is projected to earn $0.88 per share in 2013, more than 50% over what the company earned last year. Earnings are expected to grow to $1.14 and $1.36 in 2014 and 2015, respectively. This means a total profit of $43.3 million next year.
Excluding the $230 million in net cash mentioned earlier, FXCM is valued at slightly more than $417 million. This means that FXCM trades for just 9.6 times forward earnings, with earnings growth of 29% and 19% expected during the next two years. In other words, the fact that FXCM trades for 20.7 times trailing earnings doesn't tell the whole story.
Other brokerages look downright expensive, especially when you consider FXCM's valuation. TD Ameritrade trades for about 23.4 times forward earnings, and the company has had stagnant revenue since 2007, even after some big acquisitions. With millions of clients, there simply isn't as much room to grow as there used to be, but share price doesn't seem to reflect that.
E*Trade, whose share price has more than doubled in the past year, trades for about 22 times forward earnings. Even after the gains, E*Trade shares are worth about 7% of their pre-financial crisis value due to dilution (the company needed financial help, thanks to bad mortgage assets). With some of the risk from the mortgage mess still hanging over its head, E*Trade has simply come too far, too fast, and is no longer worth the risk.
What's the long-term potential?
Since FXCM decided to focus on fine-tuning its offerings and targeting professional clients, the results have been nothing short of spectacular. Despite this, there is still tremendous room for growth.
Foreign exchange is the single largest market in the world by overall trading volume. Most of this is now handled through banks, with total currency trading volume estimated to be above $5 trillion per day. If FXCM could get its hands on even 1% of the total market, it would mean about $1.2 trillion per month flowing through the company's trading platforms, about three times the current total.
This seems completely reasonable given the astronomical growth rate of FXCM's institutional business, and could be just the tip of the iceberg as foreign exchange markets begin to heat up. Especially as the Fed comes into focus.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends and owns shares of TD Ameritrade. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.