Refco...Bloodbath....or Opportunity?

Sometimes screaming opportunities may just sound like someone getting their arms ripped off.


If you knew anyone who owns Refco stock over the past two days, you know what someone getting their arms ripped off sounds like. It has been a terrible two days for Refco shareholders. On Monday the company announced that it had engaged in, but not disclosed, a related party transaction with CEO Phil Bennett. Bennett, who owns 33% of Refco, also controlled another company, this second company assumed $400 million plus in debts owed to Refco.

Refco's CFO noticed some unusual transactions and reported it to the board, who asked Bennett to step down. Then they announced it to the public, and the share price got slaughtered, down 45% on Monday.

For most of Tuesday the stock was halted, when it finally started trading in the last hour of the day, it dropped an additional 10%. Right now investors are skittish, the market has done a lot of bad things to investors over the past five years, but nothing worse than what happened to Enron and WorldCom shareholders. If there is one thing that scares investors today it is executive and accounting fraud. The big concern is how far did this go at Refco, right now nobody knows.

So where is the opportunity?

These were probably bad debts, in other words the people who originally owed money to Refco were not going to pay them. Speculation is that if Bennett's related party hadn't assumed the debts, Refco would have had to write them off, reducing Refco's assets. Instead Bennett paid them in full, in cash. Refco traded $430 million or so in bad debt for $430 million in cash.

The company is a pretty good company. They are one of the biggest futures brokers in the world, and the largest FCM. They broker all types of derivatives contracts and actually do more daily volume than the CME. They also have a good fixed income dealing business. Both of these markets are growing quickly, most people expect derivatives trading to grow at close to 20% per year over the next few years. None of this has changed, the business is the same.

The KU APM class did Refco as a research case a few weeks ago. At the time the share price was about $28 per share. The class thought the shares were fairly valued and never bought shares of the company. Today the share price is below $14 per share.

Investors are right to be scared when accounting problems crop up, and bad management can be a non-starter. But Refco may not fall into that category. The company's balance sheet is actually stronger than before, and the core business is untouched. The company deserves to trade at a discount, but a 50% plus discount?

If Refco eventually trades up to 75% of its pre controversy price, investors would be sitting on a 50% gain, and own shares of what was an attractive growth story. It is the essence of speculation, but it may be a one time hit to a good business, and there are a lot of investors who have made a lot of money with those kind of stories.


Timothy Burger
timothyb(at)timothyburger.com