Cohen & Co Inc. quarterly report, Q2 FY2011

Business context and reporting period

Institutional Financial Markets, Inc. (IFMI), formerly Cohen & Company Inc., filed this unaudited Form 10-Q for the quarter ended June 30, 2011. The firm specializes in credit-related fixed-income markets and reports Capital Markets, Asset Management and Principal Investing segments. Dollar amounts below are in millions unless stated otherwise.

Comparisons are affected by the January 2011 acquisition of JVB and the May 31, 2011 interim acquisition of 69.9% of PrinceRidge. PrinceRidge’s transaction remained subject to final FINRA approval at filing; its results were included from June 1.

Financial performance and position

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Total revenue	$23.457	$35.811	$55.771	$77.544
Operating income (loss)	$(8.178)	$4.704	$(6.591)	$10.954
Net income (loss)	$(5.057)	$3.197	$(4.644)	$7.758
Net income (loss) attributable to IFMI	$(3.371)	$2.060	$(2.996)	$4.975
Basic EPS	$(0.31)	$0.20	$(0.28)	$0.48

• Q2 revenue fell 34%; first-half revenue fell 28%. Q2 operating margin was approximately negative 34.9%, versus positive 13.1% a year earlier.
• First-half operating cash flow was $15.716, versus cash used of $33.597 in the prior-year period. Investing activities used $5.464 and financing activities used $4.287. Cash rose by $6.214 to $50.160.
• At June 30, total assets were $455.733 and total liabilities were $351.101. Permanent equity was $89.161; redeemable non-controlling interest was $15.471.
• Debt carrying value was $42.140, down from $44.688 at year-end 2010. Separately, repurchase-agreement liabilities were $178.998, against resale-agreement receivables of $158.099. The company reported no additional availability under its 2010 credit facility.
• Assets under management were approximately $9.345 billion, compared with $10.319 billion at December 2010 and $14.487 billion at June 2010. AUM includes assets for which IFMI may charge no or nominal fees.
• Broker-dealer and UK regulatory capital totaled $57.293 against stated minimum requirements of $2.807; subsidiaries were reported in compliance.

Material changes versus prior comparable periods

• Q2 net trading revenue declined 18% to $16.240 despite contributions from acquired JVB and PrinceRidge; management cited lower trading volumes and stronger comparable leveraged-credit results in 2010. First-half net trading revenue rose 2% to $43.514, partly due to the acquisitions.
• Principal transactions and other income was $0.831 in Q2 versus $8.472; for the first half it was a loss of $0.208 versus income of $19.999. The prior-year period benefited from much larger fair-value gains, including gains on Star Asia and other investments.
• First-half asset-management revenue declined 14% to $11.225, reflecting lower investment-fund and managed-account fees, defaults and deferrals in underlying assets, and the sale of advisory contracts. New-issue and advisory revenue fell 40% to $1.240.
• First-half operating expenses decreased 6% to $62.362, with lower cash compensation partly offset by increased clearing, execution and other costs. Equity-based compensation rose to $5.426 from $1.821.
• Equity-method affiliate income was $4.530 for the first half, including IFMI’s $4.359 share of an incentive fee recognized by a Deep Value general partner after a fund liquidation. This was a significant, event-driven contributor.

Outlook, commentary and risks

• Management said cash and the trading portfolio were expected to support ongoing operating needs, but noted uncertainty about replacing existing financing or obtaining additional financing on favorable terms. No numerical earnings or revenue guidance was provided.
• Management cited corporate-bond brokerage margin compression and expected continued competition. Its response included expanding securitized-product and European platforms, electronic trading, smaller-customer coverage, and the JVB and PrinceRidge acquisitions; success was not assured.
• IFMI’s $35.761 investment in Star Asia represented 84% of its $42.561 other-investment portfolio. The filing attributed a first-half fair-value reduction of $4.150 to Japanese investments affected by the earthquake, tsunami and nuclear disaster. Star Asia’s valuation and Japanese real-estate exposure are material risks.
• Fair-value estimates involve judgment; $42.368 of other investments and $18.829 of trading investments were Level 3 at June 30, relying on significant unobservable inputs. Reported values may differ from realizable sale prices.
• Repurchase financing creates collateral, margin-call and counterparty risks. IFMI said it had met margin calls to date but could not assure it would meet future collateral demands. At June 30, repurchase obligations were full-recourse and securities pledged as collateral had a fair value of $191.842.
• The PrinceRidge acquisition could be unwound if final FINRA approval is not obtained, or approval could carry conditions that reduce expected benefits. Approximately $20.0 million of Operating LLC cash and $59.6 million of net assets were subject to withdrawal restrictions related to PrinceRidge.
• In July 2011, holders exchanged $7.621 principal amount, about 39%, of the 7.625% convertible notes for new 10.50% notes. This extended the earliest holder put date on the exchanged notes from May 2012 to May 2014, but increased the coupon. IFMI recorded a $0.104 extinguishment loss in July.
• Other contingencies include Sentinel-related litigation, an RMBS securities lawsuit and an Alesco XIV guarantee with a recorded liability of $1.084 and maximum potential loss of $8.750. No contingent liability was recorded for the cited Sentinel litigation; the FDIC dismissed the Riverside action without prejudice in April 2011. A $25 million FundCore commitment remained unfunded pending warehouse financing.
• The board declared a $0.05-per-share dividend payable in September 2011. Management cautioned that future dividends depend on distributions from the Operating LLC, liquidity, regulatory and business considerations, and debt restrictions.

Most important facts for investors to verify

• Whether FINRA granted final approval for the PrinceRidge transaction, and the eventual integration costs, results and distribution restrictions.
• How much of reported earnings depends on volatile trading, Level 3 valuations, Star Asia marks and the Deep Value incentive fee.
• Whether operating cash generation persists, given its reliance on trading-related balance-sheet movements, and whether liquidity can meet repo margin calls and debt maturities.
• The completed note exchange’s impact on interest costs and the remaining put dates and refinancing needs for debt.
• Developments, potential exposure and accounting treatment for the disclosed litigation, guarantee and FundCore commitment.
• Whether the $0.05 dividend can be sustained given the Operating LLC’s distribution discretion and restricted assets.