Description
Knight Trading is a low beta stock in a bad market, and a high beta stock in a good market. It has a rock solid balance sheet, significant competitive advantages, substantial trading liquidity and reasonable management. Its valuation is badly discounted to intrinsic value, and badly misunderstood. And its margin of safety is considerable.
What NITE does: NITE has 2 businesses: Equity market making, and money management. The main business is the market making one. It has changed dramatically, and for the better, over the past 3-4 years. NITE is the market leader in equity market making. It executes 15% of all non-listed equity trades in the US, with a focus on small and mid cap equities. NITE's control of liquidity pools is a substantial barrier to entry, and is the answer to concerns about ECN competition. The business is highly automated and possesses significant economies of scale, which tempers the competitive threat from bulge bracket brokers. NITE takes no proprietary positions, it is execution only, and the daily VAR of its book is very low, on the order of $1mm. NITE goes home at night with little risk, and the firm has not experienced at significant trading error in its history. It is the best positioned player in a market very similar to many transaction processing markets, though one where volumes fluctaute dramatically. NITE has zero influence, obviously, on the level of demand for its services. NITE historically derived a substantial portion of its order flow from pay for pay deals with online retail brokers. AMTD continues to be a source of substantial order flow for NITE, but NITE has focused the past 2 years on gaining share of institutional order flow. Its marketing pitch resonates with us: No proprietary competition, no paying inflated commission dollars for undifferentiated sellside research, low cost best execution service, especially for middle and small cap stocks. NITE executes 2.5% of all institutional order flow, and believes it can raise its institutional share to 4% over the next 2 years. In many respects, the trends in the institutional money management business are its friend.
NITE's money management business is also fundamentally sound and attractive. It owns Deephaven, a $3.2B hedge fund whose assets have doubled in the past 18 months. The BKF Capital strain has a lot of good information on the demand trend for hedge fund investments, and Deephaven is similar to the Levin hedge funds: Arbitrage focused, low volatility, consistent performers, experiencing dramatic asset growth. Deephaven has generated 13-14% returns net to investors over its 15 year life, and prior to this year, had had 7 negative months in the prior 10 years. Its performance this year has suffered, and it is up less than 2%. Its strategies are sensitive to rates, volatility and corporate transaction levels. Assets have continued to flow into the firm despite its low returns this year, though performance is clearly a risk over the medium term.
Regulatory issues: NITE has settled all prior regulatory investigations into past practices. The firm no longer trades its own book. Management has been replaced. There is no meaningful regulatory overhang on the business.
The balance sheet: Properly understood, NITE has a tremendous amount of cash, on the order of $1B of net cash on its balance sheet, or roughly $8.00 per share. We feel the cash balance provides investors with a significant margin of safety in the investment, and is worth detailing at some length. Using June 30 numbers, NITE had $223mm of cash listed in the cash and cash equivalent line of its balance sheet. It had $208mm invested in Deephaven. The Deephaven investment is liquid with 90 day notice to the fund, is not required for Deephaven to operate, and carries relatively little risk of capital loss. We value it at $208mm. NITE's working capital balance can be derived by taking securities owned and broker/dealer receivables and subtracting securites sold and broker/dealer payables. This working capital balance fluctuates consistently between $300 and $350mm, as seen by doing the math over the prior 10 quarters. The balance was $340mm on June 30. This is cash. A portion of this capital is required to operate the business, and will be deducted at the end of this paragraph. NITE sold its third business, its options market making business, to Citigroup 3 weeks ago for $250mm in cash, plus payment of a $65mm note to the NITE holding company. The valuation of the options business sale was 2.5x book and 19x trailing net earnings. The net cash inflow after tax from this sale is $225mm. NITE has 113mm basic shares, and 8mm options in the money. We use 121mm shares, and include the $50mm in options proceeds in our cash balance. NITE owns 7% of the ISE (International Securities Exchange), an electronic options market that it retains ownership of after the Citigroup deal. The ISE has filed to go public, and at the cover price of less than 2x book, this 7% stake is worth $35mm. $223mm plus $208mm plus $340mm plus $225mm plus $50mm plus $35mm is $1.11 billion in cash. We estimate NITE requires $50mm of capital to run its equity market making business. Regulatory capital is $150mm, but its VAR is low, and broker dealer margins cover the balance of capital requirements. There is little question NITE management feels our math on this point is aggressive, but we feel it accruately reflects the manner in which a private owner of NITE would capitalize the business. NITE has a $55mm after tax cash outflow coming off its balance sheet for the regulatory settlement announced in June and funded after June 30. And NITE has a $45mm capital commitment for the move of its facilities to a new and mostly empty building in Jersey City over the next 12-18 months. Net of these liabilities, NITE's free cash balance is $950mm or $8.00/share.
Deephaven's valuation: We think Deephaven is worth $100-125mm. Deephaven has about $10mm of absolutely fixed costs. Use a 1% management fee on its $3.2B, although Deephaven charges many many expenses to investors, so we feel this math is conservative. 50% of the economics of the fund go to the managers. (I am pleading the 5th rather than commenting on that one). 32mm less 10mm fixed costs is 22m, 50% of that is 11mm, after tax is 7-8mm or $0.06/share. Should we pay 15x that number? Given the growth potential and performance stability, I say yes. Ignoring the performance fees, that implies $0.90 of value. But let me go on. If Deephaven makes 8% once, it generates 256mm of trading profit, 20% of 256mm is 52mm, NITE gets 26mm pretax, 17mm after tax, capitalizing that 17mm at 1x earnings is $0.14/share. If we value Deephaven at $1.00/share, we are saying the firm is worth 3.7% of assets. $0.80-$1.00 for all of Deephaven strikes us as about right.
Equity market making: An important part of our investment case rests on the assumption that, even if volumes and volatility in the equity markets are low, the market making business can break even. Through increasing automation and some modest expense management, NITE management believes this to be true. In a really ugly environment, if NITE can break even, the investment becomes, in our view, very easy. Q204 saw low volumes and low volatility, and the equity market making business generated $0.05/share of earnings and $0.07/share of free cash flow. Its average performance over the past 10 quarters is $0.07/earnings and 0.09/share of fcf. In Q403, it did $0.13 of earnings. We think the business is fairly valued at $3.00 on its own, and will trade better in a better environment. So we think NITE is worth $12.00 all in. It is worth pointing out that, in January of this year, the stock consistently traded in the $14-15 range.
Capital allocation: On the announcement of the Citigroup deal, NITE annoucned a $160mm stock buyback. We expect additional buybacks will occur upon the completion of this one if the stock has not recovered.
What can happpen next: Should NITE be an independent public company? Would it have strategic value to a buyer? Our answers are no and yes. Could NITE choose to buy something itself? Yes, though its first action since the market's malaise set in was to sell a business, for a very good price, and announce a big buyback. We think management's judgment is reasonable, and they are there to make money. The CEO owns 4mm options struck at $6.00, and our guess is their intrinsic value accounts for greater than 50% of his net worth.
Catalyst
Buyback of 15% of shares outstanding; incremental buybacks or outright sale; stock market recovery.