DBRS Confirms GMP Capital at Pfd-3 (low)

DBRS has confirmed the Pfd-3 (low) rating on the Preferred Share obligations of GMP Capital Inc. (GMP or the Company) with a Stable trend. The rating reflects the strength of the Company’s business franchise as a premier provider of investment banking and capital markets products and services to its targeted market of mid-sized Canadian companies, most of whom operate in the resource and energy sectors. Following the issue of preferred shares in early 2011, the Company’s capitalization has become relatively more aggressive as a result of $66 million in share buybacks completed during the first nine months of 2011. At current levels of financial leverage, the Company’s financial flexibility is somewhat impaired. A continued slump in underwriting and trading activities, which DBRS does not expect to recover in the short to medium term given the weak global economic outlook and continued absence of investor confidence, will prevent a material improvement in this condition in the medium term. Nevertheless, DBRS remains comfortable with the Pfd-3 (low) rating, given the Company’s flexible cost base and its excess regulatory capital at its operating subsidiaries.

The business model of the Company hinges on a number of variables including the health of equity capital markets generally, commodity prices, the outlook for corporate profitability and economic growth as well as investor confidence. Generally, DBRS would expect all of these factors to move in synchronization with each other, making GMP highly leveraged to the state of the Canadian economy. Taken on their own, such exposures would not warrant an investment grade rating for the Company. The risk of these exposures is somewhat mitigated by the Company’s low capital and liquidity requirements, its strong market position in its chosen niches, and a flexible expense base accompanied by a strong entrepreneurial culture.

The nature of the Company’s capital markets products and services as well as its cyclical client base expose it to a great deal of revenue volatility related to economic and market cycles, including both capital and commodity markets. Equity market returns in the mid-cap, small-cap, energy and materials sub-indices of the Toronto Stock Exchange (TSX) that house the vast majority of the Company’s clients are traditionally more volatile than the broader TSX index. Fortunately, reduced operating leverage due to a highly variable expense base mitigates the full impact of such revenue volatility on net earnings and cash flow available to service financial obligations. For example, a 24.4% decline in capital markets revenues in the first nine months of 2011 was accompanied by a matching 23.8% drop in variable compensation. As total compensation represents over 70% of all expenses and variable comp is 71.2% of total compensation, the Company experienced a 6.2% reduction in expenses overall, which resulted in a $36.6 million operating income in the first nine months notwithstanding the slump in revenue-generating activity and principal trading losses. In good years, profitability is correspondingly high, reflecting strong margins associated with the value-added nature of the Company’s products and services.

The Company’s focus on the capital market needs of mid-market companies (including the provision of equity underwriting, M&A advisory services, and sales and trading of their shares in the public market) has traditionally kept the Company firmly in the top tier of the league tables on the basis of its execution capabilities. Servicing mid-market companies is a unique undertaking involving the cultivation of long-term relationships and accommodation of client needs through their life cycle from start-up through maturation. The Company’s entrepreneurial culture is therefore in alignment with the culture of many of its clients. In putting its capital at risk temporarily, in order to provide liquidity to facilitate trading in its clients’ shares, the Company has become one of the largest equity traders on the TSX and Toronto Venture Exchange (TSXV). However, more recently, a flight to quality has caused the Company to slip in terms of equity block trading rank to sixth place in Q3, 2011 (a 6.7% share) as fewer mid-cap shares are being traded relative to large cap, which is not the Company’s chosen market. In order to achieve better execution, the Company has a research and sales and trading platform which caters to those institutional investors for which the mid-market is attractive. As a major competitor in this niche, the Company is somewhat protected from competitive pressures found in more commoditized products and services associated with large cap stocks and more liquid securities, though there are signs that large investment dealers are attempting to pick up market share in the Company’s mid-market niche. The Company’s challenge in capital markets is therefore to continue to preserve and cultivate its relationships and to leverage its expertise in the resource sectors by building its sales and trading capabilities outside of Canada where the Company hopes to earn 35% of its revenues within the next five years, up from just 15% today.

To this end, the strategic initiative to acquire Miller Tabak Roberts Securities, LLC (MTR) (recently renamed GMP Securities, LLC), is regarded favourably as it adds to the Company’s product offerings in U.S. fixed income markets including high-yield debt and convertible bonds, areas the Company has targeted for growth as a complement to its established equity offerings for both issuers and investors. As an agency trader of fixed income instruments, MTR does not add materially to the Company’s required level of operating capital or accompanying risk exposures. The Company is especially interested in leveraging MTR’s existing buy-side relationships and distribution capabilities, which do not overlap with the Company’s existing U.S. buy-side accounts. The two companies share a common entrepreneurial culture and integration is not expected to be a material challenge. With a cash cost of USD 33 million, a 50% earn-out of USD 11 million, and common shares worth USD 15 million, the transaction is not overwhelming, though it does generate approximately $40 million in goodwill. The Australian growth initiative, while small, is expected to have good synergies with the Company’s existing resource company expertise and its listing experience in Canada.

The capital markets business, while employing the usual short-term collateralized banking facilities required to operate as a broker-dealer, retains good financial flexibility with regulatory capital thresholds easily exceeded at all regulated subsidiaries. In addition, the Company is not currently drawing on its $17.5 million subordinated standby facility, which remains available to qualify as capital pursuant to Investment Industry Regulatory Organization of Canada (IIROC) requirements. The Company’s cash flow from operations is also capable of supporting current operations. There are few liquidity concerns given the Company’s small principal investment and uncollateralized inventory positions.

Complementing the capital markets business is the Company’s approximately 33% non-controlling ownership interest in Richardson GMP Limited (R-GMP), which was formed as the result of the late 2009 merger between the Company’s private client business and the wealth management business of Richardson Partners Financial Limited (RPFL). Both entities had been focused on the high net worth segment of retail investors and have generally been very highly rated by their housed retail investment advisors in terms of IT capability and customer responsiveness. The wealth management business has accounted for roughly 10% of Company operating earnings in recent years. The merger with RPFL was undertaken to maximize scale advantages and expense and revenue synergies that would support the profitability of both entities. As of 2011, with integration costs behind it, R-GMP is on its way to sustained levels of profitability. While the retail wealth management/financial advisory business is typically not regarded as having a lot of profit potential given the high cost of distribution in Canada, DBRS expects that a more productive advisor network and increasing assets under administration (AUA) will result in R-GMP representing an increasing proportion of Company earnings over time. With just under $13 billion in AUA, this business also has good potential revenue synergies with the Company’s capital markets business and its remaining asset management business. Having an interest in this highly regarded retail distribution channel positions the Company for a larger share of the economics in equity underwriting syndicates in which it participates.

The Company’s alternative asset management or hedge fund business remains a source of modest diversification and revenue synergies with the wealth management segment, as its fee-based revenue potentially provides an annuity-type stream of earnings in contrast to the Company’s core capital markets business where revenues are inherently more volatile. GMP Investment Management L.P. (GMP Investment Management), with over $575 million in AUM (at September 30, 2011), has been a steady contributor to the Company’s earnings, including certain principal positions in the underlying AUM. There are some revenue synergies between GMP Investment Management and R-GMP, as a notable level of AUM is held by R-GMP retail clients. With the subcontracting of the Edgestone fund management to the original Edgestone principals, the Company has come full circle on the Edgestone acquisition. In retrospect, none of the original reasons for the acquisition were realized. DBRS expects that enhanced risk management processes, a new senior management team, and enhanced board governance should help to avoid such episodes in the future.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Global Methodology for Rating Banks and Banking Organisations, which can be found on our website under Methodologies.