Description

ITG is an electronic trading firm whose primary asset is the Posit matching system, also called "the match". Posit is a growing source of liquidity for professional money managers. At a specified time each hour of the trading day, investors can place a buy or a sell order into Posit. If someone has placed the other side of the trade into Posit, the trade will occur midway between the bid and the ask. If there is no one on the other side of the trade, the order is canceled. It is a very useful method to purchase blocks of illiquid stocks without moving the market and also a way to protect identity or size in a stock. ITG has other related operations, but I believe that ownership of this asset is the basis for an investment in the company.

Posit Historical Numbers

Average Year Over Year
Daily Volume Growth

1993 6.2mn
1994 7.6mn 23%
1995 8.9mn 17%
1996 13.2mn 48%
1997 14.5mn 10%
1998 23.2mn 60%
1999 25.7mn 11%
2000 32.4mn 26%

What makes Posit Attractive

1. Historic growth in Posit, see above.
2. Posit will experience a positive "network effect". As volume grows in Posit it makes Posit a more useful tool for other investors, fueling growth along. This effect has been overused recently in the investment world as a reason to purchase many internet companies where it didn't truly exist, but it truly makes sense here. As sources of liquidity grow, they become more important to the investor.
3. Posit is a superior way to trade for most institutional investors, because it is anonymous and it does not reveal position or order size to anyone (brokers or other side) in the process. It may not be optimal for someone who specializes in trading blocks at discount, but for the majority of investors, the ability not to reveal identity or size is very valuable. It not only trades at a fair price, but much more than other ECN's, Posit is designed to get size done.
4. Large amounts of capital have been invested in competing systems and other forms of electronic trading. Optimark, the much heralded system from the founders of Instinet, raised $100mn in July of last year (obviously a poor investment) and was recently shut down because of a lack of trading liquidity and a $6mn per month burn rate. I am not saying that the Optimark valuation is a worthwhile benchmark, but it does show the interest of investors in this area. Archipelago raised capital from Instinet last July at a valuation of roughly $200mn. Island is another ECN owned by Datek, also raised money at a valuation of around $200mn, but only has about $20mn in annual revenue. Goldman, Merrill, E-Trade, Instinet, and many more have been making investments in startups at high valuations that are many years behind Posit.
5. Posit requires a very low capital expenditure level from ITG.
6. Possible public offerings of NASDAQ, NYSE, and Instinet will provide three ready buyers, all looking for ways to expand trading liquidity. It is a great way for NASDAQ and NYSE to enter each others markets and it also seems to make a logical fit for Instinet.
7. Absent a transaction, a compelling valuation given the longer term growth prospects of electronic trading and ITG's already strong position in the market.
8. Beginning in April, a prohibition on member dealers trading of certain stocks off the floor of the NYSE by SEC Rule 390, are now eligible. These companies, which listed on the NYSE prior to 1979, account for almost 50% of NYSE volume and 1/3 of NYSE companies. Of course, member dealers only accounted for a certain percentage of this volume.

Valuation

The stock currently trades at about $40 with 31mn shares outstanding for a current market cap of $1.24bn. Subtracting out roughly $4 per share in excess cash, results in a current price of $36. Current estimates are for about $2.00 in earnings this year, growing to about $2.40 next year. Subtracting out the interest income on the cash, but adding back the losses on long term investments that are expensed, leaves earnings unchanged. Depreciation and Amortization of about $.40/share has been roughly equal to capital expenditures plus capitalized software, so earnings are pretty equal to cash flow. At 15x earnings, you can invest in a company whose rapidly growing main product, requires little cash to continue its 30% growth rate of the last 5 years, and who has many potential strategic partners over the next several years.

The Other Businesses

ITG also runs operations that it calls Electronic Trading Desk (21% of revenue), where it basically executes trades for clients and a segment called Client (25% of revenue), where they install a sophisticated program trading system at large client locations. Both are good businesses, but neither is the gem that is Posit.

Catalyst

A possible buyer in the next several years. Earnings growth over time, could cause multiple expansion. If not, expect the company to continue buying back shares at these levels with excess cash