A Bullish Case for Piper Jaffray (PJC)

The financial stocks in the U.S. and Europe have been decimated for fearing a Lehman like domino effect due to a potential Greek default, and because of the concern about a world-wide double dip recession. Some of the stocks are trading near their 2009 lows, just before Tim Geithner explicitly guaranteed the top "too-big-to-fail" financial institutions. One such stock is Piper Jaffray (PJC), which closed at $18.3 on Sept. 22. The stock bounced off its low since and has been trading close to $19.

Relative to its competitors, Piper Jaffray is much smaller and therefore much easier to manage. It also has a much simpler business. Its investment banking, institutional brokerage and asset management services, represented 50%, 32% and 13% of the total revenue in 2010 respectively. It does not engage proprietary trading, which can be very risky as shown in the recent case involving a rogue trader who booked a $2.3 billion loss at UBS. Furthermore, it does not have a prime brokerage business serving hedge funds. The prime brokerage business is a margin and commission business. However, it can be risky because the prime broker may have to take ownership of a troubled client hedge fund whose loss exceeds its capital due to excessive risk-taking.

If one were to use the ratio of total tangible assets to its tangible book to measure leverage, Piper uses roughly a third of the leverage in comparison with its competitors. As shown in the enclosed table, the Piper's ratio is about 4 and over 12 for JPMorgan (JPM), Goldman Sachs (GS), Jefferies (JEF), Morgan Stanley (MS), Bank of America (BAC) and Citibank (C) respectively. It survived the financial crisis of 2008 without taking TARP. As a matter of fact, they only had an operational loss of $75 million in 2008. They could have been profitable, had they significantly cut the compensation cost of $249 million. Another plus for the company, in this environment, is that they have very limited exposure in Europe both in terms of revenue (less than than 4% of the total) and the long-lived assets (less than 0.1%).

Key Risks

• First of all, this is not the industry for the long term share holders because of the excessive risk-taking and compensation. Furthermore, the commission or spread based institutional brokerage business has been experiencing industry-wide decline. Owners of the stock should consider exiting as soon as the financial crises subside and industry recovers. 
• Any financial institution that relies on short-term funding are at the mercy of the market perception of its credit worthiness. PJC currently relies on Repos (65%), commercial paper (23%) and short-term bank loans (12%) for its $513 million financing needs. I think this is not a significant risk given the friendly Fed under Bernanke.
• The company may have indirect exposures to risky financial institutions or sovereign debt through derivative contracts. 
• PJC is too small to qualify for too-big-to-fail insurance that the Fed and Treasury implicitly provides. In other words, PJC may be allowed to bust while its larger competitors will be bailed out in a crisis. 

Conclusion

At the current price of $19 a share, PJC is trading at a 35% discount to its tangible book value of $29.25 and PE ratio of 15.4 (using their EPS of $1.23 in 2010). Although, PJC is not the cheapest in terms of the discount to its tangible book or PE, but it is by far simplest and the least risky relative to the major shops on Wall Street. As we learned from the last financial crisis, what killed a financial institution was its leverage and amount of risky assets (New Century, Countrywide, Bear Stearns, Lehman Brothers, WaMu, etc.) in the last crisis. In summary, I believe PJC is the most attractive brokerage stock to own and can potentially offer a great deal of upside once the financial turmoil subsides and confidence returns.