Description

We are recommending a long on KCG Holdings, formerly known at Knight Trading Group. Knight is an electronic market making firm formed by the merger of Knight Trading with Getco. Knight was traditionally a wholesale market maker and Getco historically a high frequency trading firm, similar to the recent IPO of Virtu, ticker VIRT.

I'KCG is a classic sum of the parts story, with one key difference - Management is taking the steps necessary to spin off the parts to realize value. To the extend the market is not recognizing this value, management will keep spinning off parts and reinvest the cash in the current business via aggressive share buybacks.

I'm not going to spend any time debating the legitimacy of HFT trading as there is not enough time or space here for such a debate. Ultimately, Mr. Market decided last week that they love HFT trading as shown by Virtu's 15x oversubscribed IPO and current 17x cash EPS valuation (adding back stock comp). Virtu does not have any tangible book value, while KCG trades at a discount to tangible book value. So for investors that want to bash HFT trading, I'd recommend shorting VIRT.

Last month KCG finalized its sale of Hotspot to BATS for $435m, over 20% of the EV of the company. We estimate Hotspot had a very low carrying value, which will drive a sizeable mark up to tangible book. Additionally, because KCG has large deferred tax assets (from its highly publicized 2012 trading error which required a re-cap of the company), most of these proceeds will go straight to cash. We estimate tangible book value increases from $11.76 per share to just over $14 per share following this sale so shares today are trading at a 10% discount to tangible book.

Buybacks are coming! KCG was blacked out from buybacks while Hotspot was being marketed because the potential sale price was such a significant percentage of the company's market capitalization. Once the sale was finalized, the company was already in its earnings blackout period prior to 1Q15 results on May 1. So once KCG reports earnings, we expect a buyback announcement (likely announced on the same day). We think a tender offer may be the only way the company is able to deploy such a large amount of cash in buybacks today and are hopeful of this outcome. Right now, the company has cash available for buybacks representing at least 30% of the market cap. As a percentage of float, the percentages are significantly greater because over 47% of the company is held by General Atlantic and Jefferies. We would not expect Jefferies to be a seller at these prices because they last purchased shares very clost to today's price (March 2014 @ $12.00). If the proceeds were used to buy back stock at today's prices (a discount to TBV per share), tangible book moves to almost $15.

Its important to note that KCG recently refinanced their debt to lower the cost but also make buybacks less restrictive. The new debt financing gives the company significant buyback flexibility.

KCG has another hidden asset in their 17% ownership of BATS Global Markets. We believe BATS could IPO in late 2015 and using data from their last debt offering, we estimate this stake is worth over $200m. Marking the BATS investment to market, we estimate pro forma tangible book value goes to $16. If the BATS proceeds are deployed into buybacks, we estimate tangible book value goes to $16.60 and our pro forma share count would decline to 70m shares. Alternatively, KCG could spin off the BATS shares which would be more tax efficient, but limit the buyback.

We are then left with four main assets: Getco (HFT), Legacy Knight (wholesale), Bondpoint, a leading electronic trading platform for retail fixed-income, and their execution/DMA/also business. Bondpoint could be easily sold as it could be considered very strategic. There are few successful electronic bond platforms and Bondpoint is one. Legacy Knight before the trading error averaged $200m of pretax cash flow before the trading error and merger. We believe these trading businesses could be folded into another trading/brokerage firm and require very little capital (note that Virtu currently operates with negative tangible equity). Today, KCG operates with nearly $600m of cash and $1.7B of tangible equity (pro forma for Hotspot sale). If the company liquidated these assets, we estimate the following proceeds:

Pro Forma Tangible Book After Hotspot Sale: $1.7B

Pro Forma Tangible Book After BATS IPO: $1.8B

Pro Forma Tangible Book After Sale of Bondpoint and Algos: $1.9B

Getco: Shut down

We are then left with just the wholesale business that historically earned $200m pretax and would likely only need about $250m of tangible equity to run. If the wholesale business is sold for 5x pretax or $1B, plus excess capital of $1.65B ($1.9B less $250m required capital to run the wholesale business), total sale price would be $2.65B or $23 / share. To the extent the company can buyback shares at today's prices, this liquidation value could increase significantly. 

Comparison to Virtu (VIRT)

As mentioned earlier, the recent IPO of Virtu provides the first public comparable to KCG in a long time. Virtu explained on their road show that they simply are an electronic market maker on exchange and earn their trading profits by posting electronic bid / ask spreads. Virtu claims a key barrier to entry in their business is scale and pointed to their $80m annual spend on communications and telecom. KCG spent almost twice as much in 2014!  I would argue that KCG's wholesale market making business is more defensible because it a relationship business and hard for new entry. For example, when KCG had its trading error and needed to raise capital, Ameritrade, one of their largest customers participated in the raise to help ensure KCG's survival. 

Profitability Comparison: Virtu is More Profitable, But Difference Less than Appears

Virtu is more profitable - however the difference is likely not as great as perceived. Virtu is expect to have 53% operating margins in 2015. When we adjust KCG's expenses to match Virtu's presentation (i.e. adding back stock comp and normalizing D&A to match capex), we estimate KCG's margins are expected to be 30% in 2015. So not quite as impressive at Virtu's expected 53% but still quite strong.

Virtu is operating with negative tangible equity, thus an infinite return. KCG's return on tangible equity is expected to be only 8% in 2015. However, we would argue that this is more a function of KCG being over-capitalized. We estimate KCG's wholesale market making business can operating on $250m of tangible equity which would represent a cash return of over 50% on tangible equity.

Valuation: KCG vs Virtu

@ 12/31/14

Tangible Book Value Per Share

KCG POSITIVE $11.76 / share stated, $14.20 pro forma for sale of Hotspot and growing from retained earnings and accretive buybacks

VIRT NEGATIVE $3 / Share with limited prospects fro growth given the 70 - 100% payout ratio commitment from management

Price to 2015E Earnings, Adding back stock Comp*

KCG 9x

VIRT 17x

*I fundamentally disagree with this add back, but VIRT was marketed on EPS estimates that add back stock comp so for comparison, I have done the same for KCG

** Street estimates for KCG do not reflect the Hotspot Sale that after buybacks will be highly accretive

Note: the above does not add back KCG's D&A in excess of recurring capex. If we were to make this adjustment, it would increase pro forma EPS by 27c and the adjusted P/E multiple would be 7x.

Catalyst

We expect KCG to announce a large buyback, possibly a cash tender , along with their earnings report for 1Q15 earnings. This will be accretive to EPS, tangible book value and generally supporting of the stock.

Second, the company's largest holders, General Atlantic and Jefferies, are financially motivated and aligned with the public. We believe this financial motivated shareholders will continue to push the company to sell non-core assets, repurhcase stock and ultimate Jefferies, with the backing fo Leucadia's balance sheet, could be the buyer of Knight's wholesale market making business.