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Rating:Does a Billion Dollar Bet on Rydex Make Sense? Not Rated 3.8 Email Routing List Email & Route  Print Print
Friday, June 15, 2007

Does a Billion Dollar Bet on Rydex Make Sense?

Reported by Neil Anderson, Managing Editor

The financial press is buzzing with the word that either E*Trade or Invesco could pay as much as $1 billion to buy Rydex, but what that coverage lacks is an answer to the question: "Does the deal make sense?"

Perhaps it does. Rydex is currently the number seven provider of exchange-traded funds with just more than $6 billion in 52 ETFs, according to stats from Morgan Stanley. Invesco would vault into a tie for the number three slot with Vanguard if it is able to add Rydex's ETFs to its PowerShares family. If E*Trade, or any of the other bidders, wins the bidding, the ETF market will see a new issuer jump into the space.

Still, a look at the financials of both Invesco and Rydex suggests that to pay so much for Rydex would be a large gamble for either firm.

Mitchell H. Caplan
E*Trade Financial
CEO and director
E*Trade has a market cap of a hair more than $10.5 billion and $1.6 billion of cash on hand as of March 31. Those numbers mean that to pay the Viragh trust $1 billion for Rydex, E*Trade CEO Mitch Caplan would either have to: issue stock equal to nearly one-tenth of the entire company, leaving shareholders exposed to dilution if the merger worked out badly; or bet almost two-thirds of E-Trade's available cash on a non-core product line.

Both choices entail placing a big and therefore risky bet on the discount brokerage firm's ability to grow the ETF family growth. Could Caplan win such a bet?

Schwab, through its OneSource institutional mutual fund supermarket, is a key distribution outlet for Rydex. Many of the market-timing financial advisors targeted by Rydex use Schwab for their clearing and custody. Schwab and E-Trade are, of course, fierce rivals; so why would Schwab -- or TD Ameritrade or Fidelity -- want to help promote more Rydex distribution if Rydex were suddenly under the E*Trade umbrella?

And without the help of the big three advisor custodians, how would E*Trade increase Rydex's distribution to make a solid return on its deal investment? Caplan needs his decision-makers to ask and answer this question to his satisfaction before pulling the trigger on such a deal.

Martin Flanagan
president and CEO
On the surface, the deal could make more sense for Invesco CEO Martin Flanagan. The mutual fund holding company previously known as Amvescap already owns ETF issuer PowerShares and would see itself ride into the number three slot in the ETF industry if it added Rydex to that portfolio.

Invesco structured the PowerShares deal to minimize its risk, backloading much of the payment. It paid $60 million up front for for the ETF issuer and a minimum of $170 million of contingent payments. Ultimately, it paid $700 million, according to press reports.

Importantly, Invesco appears likely to realize real gains with Rydex in its portfolio. Invesco would certainly be able to cut Rydex's costs by combining its back office and wholesaling forces with that of PowerShares. Invesco also has a wholesaling force that distributes through full service brokerages and wirehouses, giving it the relationships to potentially increase Rydex's distribution (without threatening Schwab and TD). It also has a strong presence in the bank and insurance distribution channels.

While Invesco looks like a better buyer on paper, its market cap of roughly $5 billion makes the rumored $1 billion Rydex price tag look a bit tough to swallow.

There are also internal signs that Invesco is not currently a buyer. Last week Invesco cut loose its two top distribution executives: Gene Needles, CEO and chairman of AIM Distributors, and James Steuve, its sales chief (read "Invesco Ousts AIM Distributors' Chief").

That Invesco would reassign such critical leaders even as it is doing final due diligence on a deal worth one-fifth of its market cap is almost unthinkable.

Distribution will be key to making the deal a success ... and neither E*Trade nor Invesco appears to be ready to provide the needed distribution boost.
* * *
ETF Market Share Leaders
Issuer No. ETFs ETF AUM
Share %
Barclays 136 $291.9 59.0%
State Street 59 103.3 20.9
Vanguard 32 34.7 7.0
PowerShares# 75 28.1 5.7
World Gold Trust Services 1 9.9 2.0
BoNY/Merrill (HOLDRs) 17 7.2 1.5
Rydex 25 6.0 1.2
ProShares 52 5.0 1.0
Wisdom Tree 36 3.9 0.8
DB Commodity Svs 11 1.8 0.4
Victoria Bay 2 0.9 0.2
Van Eck 5 0.8 0.2
Claymore 21 0.6 0.1
First Trust 31 0.4 0.1
Fidelity 1 0.1 0.0
XShares Advisors 17 0.1 0.0
Ziegler Capital 1 NM 0.0
# Owned by Invesco
Source: Bloomberg, Morgan Stanley Research

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