| 2016 | 2017 | ||||||
| Price: | 21.00 | EPS | .60 | 1.35 | |||
| Shares Out. (in M): | 33 | P/E | 35 | 15.5 | |||
| Market Cap (in $M): | 700 | P/FCF | 15 | 8 | |||
| Net Debt (in $M): | -315 | EBIT | 20 | 45 | |||
| TEV (in $M): | 385 | TEV/EBIT | 20 | 8.5 | |||
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- Investment Technology Group ITG 10/03/2000
Description
ITG’s segments are as follows:
Electronic Brokerage includes algorithmic trading, routing to exchanges and other trading venues, and POSIT—one of the largest, most established “dark pools” in the world. The Company historically executed roughly 3% of daily volume in US equities, 3.5% of daily notional in Europe, and roughly 0.50% of daily activity in Asia-Pacific. ITG trades electronically in 40 countries and operate POSIT in 35 of those. We understand that the Company’s electronic brokerage is expanding into fixed income trading and FX based on recent management commentary.
Research Sales and Trading provides data driven equity research to approximately 300 companies, and includes a focused energy research segment stemming from an acquisition of Ross Smith Energy Group in 2011. The Company began growing this segment in earnest 2010, and spent approximately $110mm since 2010 in this space. This segment remains highly controversial among investors given the lackluster performance and growth, and as discussed below the company recently divested a large part of this division for a sizeable sum.
Platforms includes ITG’s order management and execution management systems.
Analytics enables portfolio managers and traders to improve execution performance before the trade happens (pre-trade) and during trading (real-time) by providing reliable trading analytics and risk models that help them perform predictive analyses, manage risk, change strategy and reduce trading costs.
The stock price chart below frames our conversation on what happened to ITG in the summer of ’15 and why we think it’s a solid opportunity going forward:
Background Details
§ ITG is a well-established and dominant player in the cash equities trading business. The company operates one of the largest dark pools globally, and has historically benefited from engrained customer relationships relating to its platforms and analytics business lines.
§ ITG could aptly be described as a good house in a bad neighborhood (this was, in fact, what IR relayed to us in a conversation). The US cash equities market has been struggling with stagnant / declining volumes, competitive pressures, and shift in business mix toward sell-side activity that’s negatively impacted trading margins.
§ Dating back to 2007 (with D.E. Shaw), ITG has seen activist investors weigh in on strategic options for the Company and discuss a variety of management problems. Most recently, in July 2014 Philadelphia Financial of San Francisco (“Philly Financial”) and Voce Capital (“Voce”) filed a 13D and attempted to force the board to replace management or put the Company up for sale. These firms continue to be active in the stock.
§ Philly and Voce focused on management’s poor historical capital allocation policies and multi-year negative EPS growth. Ultimately, through their efforts, ITG agreed to a significant board shakeup and replacement of key management.
§ ITG witnessed a significant selloff in August 2015 due to SEC violations stemming from prop trading activity in 2010 and 2011. The CEO and legal counsel were fired, which we describe in more detail later in this memo. The fallout from this complaint was significant. The Company reported a +30% reduction in trading volumes as customers (primarily buyside) evacuated ITG’s trading platforms, and the share price declined 50% in July/August. Said differently, this prop trading infraction – which generated $2mm in gross revenues during its operation – cost ITG +$20mm in cash (~$0.60 per share) and wiped +~$400 mm off its market cap. Ouch.
§ A key question stemming from the SEC complaint and driver of the selloff is whether ITG could repair the damage done, and how long would that take. We were (and are) of the opinion that the Company will not go out of business, which implies an interesting buying opportunity.
ITG essentially has no debt (there are some short term bank loans that we exclude here, however those are tied to share settlement and are not recourse to parent). The Company’s cash balance has ballooned in 2015 following the sale of a research asset in December ’15. It’s debatable how much of this cash is truly ‘free’; we expect management to continue to take actions to make company’s internal operations more efficient.
Key Developments & Catalysts since SEC Fine (July ’15)
Post the SEC issue, we believed there were several actionable catalysts that would drive the stock higher, several of which have come to fruition:
- Replacement of CEO - Frank Troise stepped in as CEO in January 2016. We believe this is important for two reasons: (i) the prior CEO had a poor reputation for performance and capital allocation. We view the recruitment of Troise, who previously ran JPMorgan’s electronic trading division and was actually at ITG prior to that, as a significant ‘refresh’ to revitalize the corporate DNA and to prove to angry clients that ITG was working to rectify its previous indiscretions. Moreover, Troise is completing an end to end business review of all activities, which may result in additional business units being divested (see point (ii) below). We have talked with JPM employees, and the common thread is that Troise was highly regarded by his team and respected within the organization. He essentially built JPM’s electronic trading platform.
- Asset sales - In November 2015, the company announced the sale of its Calgary-based energy research division for $120.5mm, increasing tangible book value by $3.00 per share. The former CEO was a notoriously poor capital allocator; to that point, since 2010 ITG has impaired in excess of $500mm of goodwill (equivalent to ~70% of the current market cap). Effectively, the prior management team massively overpaid for bad deals and over the years wasted over 70% of the current share price. We viewed the streamlining of ITG and divestiture of non-core assets as a positive catalyst, and we think there are other potential assets that may be divested.
- Management/BoD refresh - There has been a broader refresh of the management team and board of directors, partly at the behest of activist investors who has been involved with the business for the past several years. Importantly, we highlight the formation of a ‘Capital Allocation Committee’, which includes a few notable hedge fund investors including a prominent ex-partner at JANA. With this committee in place, we feel confident that the past blunders will not be repeated.
- Ability to win back clients – We view the management refresh as critical to winning back business. We show recent data below for ITG’s dark pool market share, which shows a significant decline in July / August 2015 and a subsequent slow movement in the right direction. We understand that Troise has been on several ‘apology tours’ and the vast majority of clients are back using ITG for some trading activity. The main goal now is to get customer volumes back to where they were pre-SEC claim. Sell side analysts remain focused on the monthly trends and performance of ITG’s electronic trading volumes, and we believe this is overly myopic. We believe that liquidity will beget liquidity, and it is only a matter of time before ITG returns to its pre-SEC fine position in the market.
- New strategy announced in July - As Troise completes his strategic review in the coming months, we anticipate a new strategic plan to be discussed during the Q2 conference call in July and see that as a key catalyst. The company has a significant amount of cash (particularly following the asset sale discussed above), which is currently dilutive to shareholders as cash generates no earnings or value to shareholders. Troise understands this; while he has some leeway to understand the ins and outs of the company to decide where he wants to focus the business going forward, he knows that he does not have an eternity before shareholders start to demand that available capital be put to use for the benefit of shareholders. The clock is ticking.
We believe Troise will likely refocus the company’s efforts on electronic trading, and will seek to more aggressively return capital to shareholders through stock buybacks. Alternatively, he may seek to deploy capital accretively into other electronic trading businesses. There have been multiple rumors around a merger with Convergex (another trading platform). We do not think this is a near-term certainty, however there is a reasonable likelihood that management will look to buy attractive assets that are reasonably priced and fit well within the existing structure (we would simply be surprised if a large deal is consummated as opposed to potentially smaller tuck-ins).
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Ongoing activist campaign – As noted, there has been a non-traditional activist involved in this business for the last year. We believe they are thoughtful and fully invested in the success of this enterprise, and to date we have been in support of their behind-the-scene activities.
Valuation
We show a simple valuation analysis below based on 2017 estimated performance. We highlight that our upside EBITDA estimate is actually below ITG’s pre-SEC fine EBITDA (pro forma for the research platform asset sale). Said differently, the high end of our projection below assumes that ITG does not do anything to generate additional EBITDA over the next 18 months and is not fully successful convincing old clients to once again use ITG’s trading platforms and products. We are also assuming approximately $80-$90mm of share repurchases, which we actually think may be conservative if no new deals are done. In the 2014 - 2015 time frame, the company repurchased approximately 5.5mm shares for +$100mm (and during this time the business fell apart due to the SEC violation). Finally we are assuming $100mm of net free cash, which again is likely conservative given the prodigious amount of FCF generated by this business (current cash balance in excess of $330mm). We show the implied valuation multiples, which show that in our Base-Upside case we see a share price leading to $25.00 - $30.00 per share, implying a 2017 adjusted PE multiple in the range of 13.0x – 15.0x.
Based on all of these items, we feel the risk reward here is extremely compelling, leaving us with meaningful upside optionality with what we believe is a low risk of capital impairment. Further to this point and the quality of the business, we point to an amazing statistic: only once in the last 20 years has this company not generated positive cash from operations. It is a solid fee collecting business, and we look forward to seeing what Troise and his staff will do with this asset.
Cashflow
Since 2010, the Company has generated nearly $730mm of EBITDA, which converted into ~$270mm of LFCF (>40% of the current market cap). The Company allocated +$106mm into acquisitions (primarily on the research side with mixed and arguably negative results that have been thoroughly lamented by investors). Importantly we point out that the Company has deployed nearly $240mm into share repurchases since 2010, including +$100mm in the ’14-15 time period.
We also highlight that ex WC and acquisitions, the Company has generated positive FCF each year, including 2015.
Additional Litigation Detail:
ITG was charged with violating federal securities law in the operation of its dark pool and in the misuse of customer information. According to the complaint, the infractions occurred between April 2010 and July 2011.
ITG has historically promoted itself as being an agency-only broker with no conflicts of interests with its customers, and moreover repeatedly prided itself on the integrity of its customer information. Counter to this public positioning, management shockingly initiated ‘Project Omega’ in early 2010. Omega accessed live feeds of customer orders and execution information and traded algorithmically based on that information. The Omega group poached employees who were vastly familiar with the algorithms that ITG’s complex product offerings utilized. The SEC charged ITG with willfully violating various sections of the Securities Act, including failure to inform customers of potential conflicts of interest and failure to keep customer information confidential. The Company and the SEC settled for approximately $20 million.
We have reviewed the SEC complaint, and note a few points that in our opinion mitigate the severity of this issue:
1) While the scale of this illegal - and quite frankly incredibly foolish – endeavor does not mitigate ITG’s level of guilt, we point out that the whole scheme generated approximately $2 million of gross revenues. It was not a gigantic scam that created significant and ongoing levels of profitability, which is actually what happened with some of ITG’s peers.
2) Importantly, Project Omega identified and traded with ONLY sell-side subscribers ITG’s dark pool. This is important because the buyside customer reaction to the SEC probe has been markedly worse than the sell-side. We think it is reasonable that as the dust settles, buyside customers may find some comfort from the fact that their trades weren’t impacted (the claim can be made that sell-side orders originate from a separate buyside customer, but we think the second-level impact is less important). We understand from the Company that they are essentially proving this fact to clients, which we take as a good sign for customers’ willingness to reestablish relationships with the Company.
3) Finally, according to the SEC: “even within ITG, Project Omega was only to be discussed on a ’need-to-know’ basis, and even the customer-facing side of ITG was not informed of Omega’s existence.”
The CEO became aware that Omega was trading on live-feed information in Dec 2010, and the project was suspended and restarted without a live feed. Ultimately the project was cancelled and the executive in charge was fired (he moved on to become head of trading at AQR until being recently put on leave).
Based on conversations with analysts who cover the name, it was decided internally that the project did not meet a materiality test required for public disclosure. As such, we think the overall issues were limited in scope to a small group of people.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
We point to the July Q2 call. The CEO will lay out the strategy going forward, which will contain embedded catalysts, namely: (i) potential accretive M&A activity, (ii) potential additional divestiture activity, (iii) discussion of additional return of capital through share purchases. In the meantime, the goal will be to continue to slowy regain market share and put up reasonable performance figures.
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