KNIGHT CAPITAL GROUP INC KCG W
July 27, 2011 - 12:56am EST by
85bears
2011 2012
Price: 11.25 EPS $0.95 $1.32
Shares Out. (in M): 93 P/E 12.0x 8.5x
Market Cap (in $M): 1,000 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 1,000 TEV/EBIT 0.0x 0.0x

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Description

The opportunity
KCG is a unique financial asset that offers compelling upside (50-100%) with limited downside risk (10%).  At the recent stock price, investors pay a low multiple on trough earnings for the core business while getting two valuable items for free - 1) a high growth/high margin electronic trading business and 2) a free call option on market volatility.  The idea is compelling now given the recent selloff in the stock and the latest disclosures by management which the market has not yet noticed. 

The business
KCG provides a diverse set of services.  Its primary business is market making, where KCG is the leading market maker in US equities, consistently leading UBS, Merrill Lynch, Morgan Stanley, Citi, Barclays and other global banks in total shares traded.  Knight also developed leading electronic trading platforms for equities (Knight Direct), fixed income (BondPoint), options, and currency trading (Hotspot).  The company has full-service equities and fixed income sales & trading businesses, a small asset management business, a research organization, and a capital markets team.  In general, the two key drivers of KCG's business are trading volumes and volatility.  Higher volumes and higher volatility translate to more revenue and higher margins. 

Why has the stock languished?
Like most financial companies, KCG has suffered from the financial crisis.  There are both market and company reasons for this.  The market factors should be obvious to most public market investors:  very low volumes and low volatility.  This has reduced revenue and profitability at KCG. 

However, the company has limited its own profitability.  KCG chose to expand through the financial crisis and grew in fixed income, options, international sales & trading, research, capital markets, and asset management.  While some of these ventures have generated growth and profitability, the company has consistently reported losses from new ventures over the last couple years.  Losses have averaged ~$10m/quarter over the last several quarters from these new venture "investments".  Q1 losses were $9.3m and Q2 losses were $13.7m.  Management did indicate in the Q2 2011 earnings call that it will be conducting a strategic review of its loss making investments. 

Another company specific issue has been compensation guarantees.  KCG gave guarantees to its new fixed income team in 2009 and early 2010.  Those guarantees created operating losses starting in mid-2010 as fixed income trading volumes fell and are still creating losses today.  Total compensation guarantees of $63m in 2011 drop to $20m in 2012 and expire sometime during 2012.

Differentiation vs. other financial companies
Despite these challenges, KCG is among a small group of financial companies that have generated profits throughout the financial crisis.  KCG has consistently made money regardless of market conditions.  In fact, going back to 2005, the company has had only 1 quarter of loss and that was less than $0.04/share on a GAAP basis.  Below are the historical earnings by quarter: 

 

1Q05

2Q05

3Q05

4Q05

 

Avg quarterly

Operating EPS

 $0.05

 $ (0.00)

 $0.26

 $0.16

 

 $0.12

GAAP EPS

 $0.04

 $ (0.04)

 $0.23

 $0.41

 

 

 

 

 

 

 

 

 

 

1Q06

2Q06

3Q06

4Q06

 

 

Operating EPS

 $0.52

 $0.26

 $0.26

 $0.51

 

 $0.39

GAAP EPS

 $0.47

 $0.29

 $0.30

 $0.63

 

 

 

 

 

 

 

 

 

 

1Q07

2Q07

3Q07

4Q07

 

 

Operating EPS

 $0.32

 $0.23

 $0.09

 $0.50

 

 $0.28

GAAP EPS

 $0.31

 $0.24

 $0.14

 $0.52

 

 

 

 

 

 

 

 

 

 

1Q08

2Q08

3Q08

4Q08

 

 

Operating EPS

 $0.35

 $0.32

 $0.42

 $0.56

 

 $0.41

GAAP EPS

 $0.35

 $0.32

 $0.40

 $0.89

 

 

 

 

 

 

 

 

 

 

1Q09

2Q09

3Q09

4Q09

 

 

Operating EPS

 $0.33

 $0.44

 $0.32

 $0.34

 

 $0.36

GAAP EPS

 $0.10

 $0.39

 $0.31

 $0.46

 

 

 

 

 

 

 

 

 

 

1Q10

2Q10

3Q10

4Q10

 

 

Operating EPS

 $0.30

 $0.58

 $0.11

 $0.08

 

 $0.27

GAAP EPS

 $0.30

 $0.58

 $0.00

 $0.10

 

 

 

 

 

 

 

 

 

 

1Q11

2Q11

 

 

 

 

Operating EPS

 $0.33

 $0.19

 

 

 

 $0.26

GAAP EPS

 $0.33

 $0.19

 

 

 

 

Why investors are valuing KCG incorrectly
Investors are not distinguishing between the core earnings for KCG and its loss making initiatives.  Investors are applying 11x earnings to the entire business for the YTD.  This implies negative $300m of value for loss making initiatives. 

YTD 2011 Earnings            
  Pre tax After tax FY AT Multiple Value $ per share
Profitable businesses    103      63  125 11.0x      1,377  $14.54
Unprofitable investments    (23)     (14)   (28) 11.0x      (309)  $(3.26)
Total company     80     49    97      $11.28
A better way to value the unprofitable investments is to make an assumption about how long they will continue (as 11 years seems excessive).  If you were to assume 2 years of continued loss at the YTD 2011 pace and no eventual profitability from these ventures, then the unprofitable initiatives are worth -$0.60/share (2 years is arbitrary, though it would seem unlikely that management would be talking about strategic review of unprofitable business now and then allow more than a couple years of continued losses).  This makes KCG in total worth ~$14 per share.  But this still understates the true value of the stock.
 
What is new now
Historically KCG has been a black box.  Financial disclosure by business has been very limited, and the segment reporting and operating metrics have made it difficult to interpret results and project financial performance. 

However, on the 2Q 2011 earnings call, KCG gave the financial performance of its fast growing electronic trading businesses - BondPoint (electronic fixed income trading platform), Knight Direct (electronic equities and options platform), and Hotspot (electronic currency trading).  According to the company, these businesses are generating $50m of operating income and operating at 25-30% margin (implying $150m-200m of revenue).  Reported operating statistics suggest these businesses are growing at 60% at Hotspot, 18% at Knight Direct, and 13% at BondPoint.

I believe this disclosure was important, as it highlighted a major source of value that the market has been ignoring.  Using comparable company multiples of 20-25x, these electronic platforms are conservatively worth $6.50-$8.00/share.  MKTX is probably the closest comparable, and it trades at 25x earnings and has expected EPS growth of mid teens on 10% revenue growth next year.  MKTX has $175m of revenue and $67m of EBIT (39% margin), making it very similar in size to KCG's growth platforms ($150-200m of revenue based on 25-30% margin).  Other larger electronic exchanges and marketplaces trade close to 20x earnings and have even lower growth.  Examples include CME (17x earnings and low teens eps growth), ICE (20x earnings and mid- to high-teens eps growth), and CBOE (17x earnings and 20%+ earnings growth).  These exchanges are given high multiples as they generate very high incremental margins, require low levels of capital, and have good long term growth prospects.  I believe that either investors will recognize this value and increase the overall multiple for KCG, or the company will figure out a way to monetize some of this value.

The new disclosure also helps to add up the pieces of KCG in a new and more relevant way (for valuation purposes) than current segment reporting.  Assuming the electronic platforms described above generated annualized operating earnings ~$50m run rate in the first half, and taking $9.3m and $13.7m of operating loss in Q1 and Q2, the "core" market making/sales & trading/other pre-tax income of $47m in Q1 and $31m in Q2.   Applying 12x EPS to "core" (in line with current and recent multiple), 20x eps to "growth electronic platforms", and assuming 2 more years of losses on "investments" yields $15-21/share of value for KCG.  I would argue this analysis is conservative as we are applying average multiples on trough earnings in "core", using low end of peer multiples for the "growth", and assuming 2 more years of losses on "investments" despite management's recent commitment to a strategic review of loss making businesses.  At 12x "core" earnings, 25x "growth" earnings, and 1 year of continued "investment" losses, the implied value of KCG is $17-23/share.

Q1 2011               Q2 2011              
  Pre tax After tax FY AT Multiple Value

$/share

    Pre tax After tax FY AT Multiple Value $ per share
Core mkt making 47 29 115 12.0x    1,380   $14.57   Core mkt making 31 19 74 12.0x    890   $9.39
Electronic platforms 13 8 31 20.0x     610   $6.44   Electronic platforms 13 8 31 20.0x    610  $6.44
Investments  (9) (6) (23) 2.0x     (45)  $(0.48)   Investments (14) (8) (33) 2.0x    (67)  $(0.71)
Total 50 31 123      $20.53   Total   30 18 71      $15.13

More value to come
KCG is and can continue to manage its cost structure to create even more value.

On the Q2 2011 earnings call, the company committed to a strategic review of all of its businesses.  While the outcome is to be determined, management has suggested that there are opportunities for cost reduction to align the cost structure to the current low volume environment.  This would go beyond the elimination of loss making initiatives described above by cutting costs in the core market making and sales & trading platforms to right-size to the current trading environment.

As described above, fixed income guarantees expire in the next 12 months.  The big decline occurs at the end of 2011.  KCG has not disclosed the exact earnings benefit, but a reasonable estimate seems to be $25m of savings.  KCG generated 15-20% margin in FICC prior to taking losses on the guarantees.  Margins fell to about breakeven in late 2010 and early 2011.  Assuming a sustainable 10% margin without the guarantees (lower than historical) and $250m of run rate revenue in FICC (lower than current operating level), KCG could generate an incremental $25m of pretax earnings beginning in 2012.  This is worth an additional $2/share at 12x eps.

KCG also recently established a self-clearing capability.  The company was paying Merrill Lynch under a previous contract through June 30, 2011.  On a forward basis, the company expects $6-8m of pre-tax savings, or $0.50-0.60/share of additional upside at 12x eps.

Valuation
Putting it all together, I see KCG conservatively worth $17.50-23.50/share.  At the low end, this assumes 12x for "core", 20x for "growth", 2 years of "investment" losses, $25m of savings from FICC guarantees expiring, $6m of savings from self-clearing, and no other cost cuts at market making/sales & trading.  The high end incorporates 25x eps for "growth", 1 year of "investment" loss, and $8m of savings from self-clearing.  I believe both of these scenarios are conservative as the "core" is still operating near trough earnings levels and more cost cuts are achievable.

KCG also provides an investor with an embedded call option on market volatility.  Market selloffs and dislocations are accompanied by high trading volumes and spikes in volatility which actually increase the profitability for KCG.  In fact, in the worst quarters for the market in recent history, (Q3 2008, Q4 2008, Q1 2009, Q2 2010), KCG has generated its most profitable quarters ($0.40, $0.56, $0.33, and $0.58 of EPS respectively). 

Downside
Downside in KCG is limited.  I see 10% downside from here to current tangible book value ($10.40).  Year end tangible book value should be closer to $11/share, so at $10.13 (down 10% from current levels), KCG would trade at ~90% of TBV.  Also, as highlighted above, KCG provides a natural hedge to market sell offs, which should limit downside in a market sell off scenario.

Risks
Continued slow trading and low volatility
Management does not cut cost structure or eliminate any "investment" initiatives

Catalysts
Investors focus on value of electronic trading platforms
Results of strategic review
Cost savings from self-clearing realized
Market volumes recover
Market volatility increases

Catalyst

Investors focus on value of electronic trading platforms
Results of strategic review
Cost savings from self-clearing realized
Market volumes recover
Market volatility increases
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    Description

    The opportunity
    KCG is a unique financial asset that offers compelling upside (50-100%) with limited downside risk (10%).  At the recent stock price, investors pay a low multiple on trough earnings for the core business while getting two valuable items for free - 1) a high growth/high margin electronic trading business and 2) a free call option on market volatility.  The idea is compelling now given the recent selloff in the stock and the latest disclosures by management which the market has not yet noticed. 

    The business
    KCG provides a diverse set of services.  Its primary business is market making, where KCG is the leading market maker in US equities, consistently leading UBS, Merrill Lynch, Morgan Stanley, Citi, Barclays and other global banks in total shares traded.  Knight also developed leading electronic trading platforms for equities (Knight Direct), fixed income (BondPoint), options, and currency trading (Hotspot).  The company has full-service equities and fixed income sales & trading businesses, a small asset management business, a research organization, and a capital markets team.  In general, the two key drivers of KCG's business are trading volumes and volatility.  Higher volumes and higher volatility translate to more revenue and higher margins. 

    Why has the stock languished?
    Like most financial companies, KCG has suffered from the financial crisis.  There are both market and company reasons for this.  The market factors should be obvious to most public market investors:  very low volumes and low volatility.  This has reduced revenue and profitability at KCG. 

    However, the company has limited its own profitability.  KCG chose to expand through the financial crisis and grew in fixed income, options, international sales & trading, research, capital markets, and asset management.  While some of these ventures have generated growth and profitability, the company has consistently reported losses from new ventures over the last couple years.  Losses have averaged ~$10m/quarter over the last several quarters from these new venture "investments".  Q1 losses were $9.3m and Q2 losses were $13.7m.  Management did indicate in the Q2 2011 earnings call that it will be conducting a strategic review of its loss making investments. 

    Another company specific issue has been compensation guarantees.  KCG gave guarantees to its new fixed income team in 2009 and early 2010.  Those guarantees created operating losses starting in mid-2010 as fixed income trading volumes fell and are still creating losses today.  Total compensation guarantees of $63m in 2011 drop to $20m in 2012 and expire sometime during 2012.

    Differentiation vs. other financial companies
    Despite these challenges, KCG is among a small group of financial companies that have generated profits throughout the financial crisis.  KCG has consistently made money regardless of market conditions.  In fact, going back to 2005, the company has had only 1 quarter of loss and that was less than $0.04/share on a GAAP basis.  Below are the historical earnings by quarter: 

     

    1Q05

    2Q05

    3Q05

    4Q05

     

    Avg quarterly

    Operating EPS

     $0.05

     $ (0.00)

     $0.26

     $0.16

     

     $0.12

    GAAP EPS

     $0.04

     $ (0.04)

     $0.23

     $0.41

     

     

     

     

     

     

     

     

     

     

    1Q06

    2Q06

    3Q06

    4Q06

     

     

    Operating EPS

     $0.52

     $0.26

     $0.26

     $0.51

     

     $0.39

    GAAP EPS

     $0.47

     $0.29

     $0.30

     $0.63

     

     

     

     

     

     

     

     

     

     

    1Q07

    2Q07

    3Q07

    4Q07

     

     

    Operating EPS

     $0.32

     $0.23

     $0.09

     $0.50

     

     $0.28

    GAAP EPS

     $0.31

     $0.24

     $0.14

     $0.52

     

     

     

     

     

     

     

     

     

     

    1Q08

    2Q08

    3Q08

    4Q08

     

     

    Operating EPS

     $0.35

     $0.32

     $0.42

     $0.56

     

     $0.41

    GAAP EPS

     $0.35

     $0.32

     $0.40

     $0.89

     

     

     

     

     

     

     

     

     

     

    1Q09

    2Q09

    3Q09

    4Q09

     

     

    Operating EPS

     $0.33

     $0.44

     $0.32

     $0.34

     

     $0.36

    GAAP EPS

     $0.10

     $0.39

     $0.31

     $0.46

     

     

     

     

     

     

     

     

     

     

    1Q10

    2Q10

    3Q10

    4Q10

     

     

    Operating EPS

     $0.30

     $0.58

     $0.11

     $0.08

     

     $0.27

    GAAP EPS

     $0.30

     $0.58

     $0.00

     $0.10

     

     

     

     

     

     

     

     

     

     

    1Q11

    2Q11

     

     

     

     

    Operating EPS

     $0.33

     $0.19

     

     

     

     $0.26

    GAAP EPS

     $0.33

     $0.19

     

     

     

     

    Why investors are valuing KCG incorrectly
    Investors are not distinguishing between the core earnings for KCG and its loss making initiatives.  Investors are applying 11x earnings to the entire business for the YTD.  This implies negative $300m of value for loss making initiatives. 

    YTD 2011 Earnings            
      Pre tax After tax FY AT Multiple Value $ per share
    Profitable businesses    103      63  125 11.0x      1,377  $14.54
    Unprofitable investments    (23)     (14)   (28) 11.0x      (309)  $(3.26)
    Total company     80     49    97      $11.28
    A better way to value the unprofitable investments is to make an assumption about how long they will continue (as 11 years seems excessive).  If you were to assume 2 years of continued loss at the YTD 2011 pace and no eventual profitability from these ventures, then the unprofitable initiatives are worth -$0.60/share (2 years is arbitrary, though it would seem unlikely that management would be talking about strategic review of unprofitable business now and then allow more than a couple years of continued losses).  This makes KCG in total worth ~$14 per share.  But this still understates the true value of the stock.
     
    What is new now
    Historically KCG has been a black box.  Financial disclosure by business has been very limited, and the segment reporting and operating metrics have made it difficult to interpret results and project financial performance. 

    However, on the 2Q 2011 earnings call, KCG gave the financial performance of its fast growing electronic trading businesses - BondPoint (electronic fixed income trading platform), Knight Direct (electronic equities and options platform), and Hotspot (electronic currency trading).  According to the company, these businesses are generating $50m of operating income and operating at 25-30% margin (implying $150m-200m of revenue).  Reported operating statistics suggest these businesses are growing at 60% at Hotspot, 18% at Knight Direct, and 13% at BondPoint.

    I believe this disclosure was important, as it highlighted a major source of value that the market has been ignoring.  Using comparable company multiples of 20-25x, these electronic platforms are conservatively worth $6.50-$8.00/share.  MKTX is probably the closest comparable, and it trades at 25x earnings and has expected EPS growth of mid teens on 10% revenue growth next year.  MKTX has $175m of revenue and $67m of EBIT (39% margin), making it very similar in size to KCG's growth platforms ($150-200m of revenue based on 25-30% margin).  Other larger electronic exchanges and marketplaces trade close to 20x earnings and have even lower growth.  Examples include CME (17x earnings and low teens eps growth), ICE (20x earnings and mid- to high-teens eps growth), and CBOE (17x earnings and 20%+ earnings growth).  These exchanges are given high multiples as they generate very high incremental margins, require low levels of capital, and have good long term growth prospects.  I believe that either investors will recognize this value and increase the overall multiple for KCG, or the company will figure out a way to monetize some of this value.

    The new disclosure also helps to add up the pieces of KCG in a new and more relevant way (for valuation purposes) than current segment reporting.  Assuming the electronic platforms described above generated annualized operating earnings ~$50m run rate in the first half, and taking $9.3m and $13.7m of operating loss in Q1 and Q2, the "core" market making/sales & trading/other pre-tax income of $47m in Q1 and $31m in Q2.   Applying 12x EPS to "core" (in line with current and recent multiple), 20x eps to "growth electronic platforms", and assuming 2 more years of losses on "investments" yields $15-21/share of value for KCG.  I would argue this analysis is conservative as we are applying average multiples on trough earnings in "core", using low end of peer multiples for the "growth", and assuming 2 more years of losses on "investments" despite management's recent commitment to a strategic review of loss making businesses.  At 12x "core" earnings, 25x "growth" earnings, and 1 year of continued "investment" losses, the implied value of KCG is $17-23/share.

    Q1 2011               Q2 2011              
      Pre tax After tax FY AT Multiple Value

    $/share

        Pre tax After tax FY AT Multiple Value $ per share
    Core mkt making 47 29 115 12.0x    1,380   $14.57   Core mkt making 31 19 74 12.0x    890   $9.39
    Electronic platforms 13 8 31 20.0x     610   $6.44   Electronic platforms 13 8 31 20.0x    610  $6.44
    Investments  (9) (6) (23) 2.0x     (45)  $(0.48)   Investments (14) (8) (33) 2.0x    (67)  $(0.71)
    Total 50 31 123      $20.53   Total   30 18 71      $15.13

    More value to come
    KCG is and can continue to manage its cost structure to create even more value.

    On the Q2 2011 earnings call, the company committed to a strategic review of all of its businesses.  While the outcome is to be determined, management has suggested that there are opportunities for cost reduction to align the cost structure to the current low volume environment.  This would go beyond the elimination of loss making initiatives described above by cutting costs in the core market making and sales & trading platforms to right-size to the current trading environment.

    As described above, fixed income guarantees expire in the next 12 months.  The big decline occurs at the end of 2011.  KCG has not disclosed the exact earnings benefit, but a reasonable estimate seems to be $25m of savings.  KCG generated 15-20% margin in FICC prior to taking losses on the guarantees.  Margins fell to about breakeven in late 2010 and early 2011.  Assuming a sustainable 10% margin without the guarantees (lower than historical) and $250m of run rate revenue in FICC (lower than current operating level), KCG could generate an incremental $25m of pretax earnings beginning in 2012.  This is worth an additional $2/share at 12x eps.

    KCG also recently established a self-clearing capability.  The company was paying Merrill Lynch under a previous contract through June 30, 2011.  On a forward basis, the company expects $6-8m of pre-tax savings, or $0.50-0.60/share of additional upside at 12x eps.

    Valuation
    Putting it all together, I see KCG conservatively worth $17.50-23.50/share.  At the low end, this assumes 12x for "core", 20x for "growth", 2 years of "investment" losses, $25m of savings from FICC guarantees expiring, $6m of savings from self-clearing, and no other cost cuts at market making/sales & trading.  The high end incorporates 25x eps for "growth", 1 year of "investment" loss, and $8m of savings from self-clearing.  I believe both of these scenarios are conservative as the "core" is still operating near trough earnings levels and more cost cuts are achievable.

    KCG also provides an investor with an embedded call option on market volatility.  Market selloffs and dislocations are accompanied by high trading volumes and spikes in volatility which actually increase the profitability for KCG.  In fact, in the worst quarters for the market in recent history, (Q3 2008, Q4 2008, Q1 2009, Q2 2010), KCG has generated its most profitable quarters ($0.40, $0.56, $0.33, and $0.58 of EPS respectively). 

    Downside
    Downside in KCG is limited.  I see 10% downside from here to current tangible book value ($10.40).  Year end tangible book value should be closer to $11/share, so at $10.13 (down 10% from current levels), KCG would trade at ~90% of TBV.  Also, as highlighted above, KCG provides a natural hedge to market sell offs, which should limit downside in a market sell off scenario.

    Risks
    Continued slow trading and low volatility
    Management does not cut cost structure or eliminate any "investment" initiatives

    Catalysts
    Investors focus on value of electronic trading platforms
    Results of strategic review
    Cost savings from self-clearing realized
    Market volumes recover
    Market volatility increases

    Catalyst

    Investors focus on value of electronic trading platforms
    Results of strategic review
    Cost savings from self-clearing realized
    Market volumes recover
    Market volatility increases
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