Description

 

About the Company

TradeStation is an online broker targeting highly active or semi-professional retail traders. The company has healthy 34% pretax margins despite severe pressure from a low interest rate environment, grows at 20%+, yet trades at 2x 2009 EV/EBITDA. TRAD’s product offering is differentiated from its peers because it first enables customers to back test trading strategies and then allows their customers to basically put their predefined trading strategy on autopilot, having the computer and its predefined formula execute the trades.

 

To help explain TradeStation’s product offering, it is probably best to give a quick example. Let’s say that I have a theory: I think that when futures are up in the morning, that I could make money buying heavily shorted names, holding for 10 minutes and then selling. I could run a test on TradeStation’s software to look at past trading history to see if this would have worked in the past. So first, I would define what is “up” in the futures market, so I would write in the formula to only check on days futures are up more than 1% before the market open. On those days, I could have it identify all stocks with more than 30 days short interest and probably some minimum of trading volume. The back testing software would then search for this situation and identify and compute the results in a report that shows my total profit, my % of winning days, IRR, etc. If I’m happy with my backtesting results, I can then have the software execute the strategy going forward. To do this backtesting, clients must use a proprietary programming language called “EasyLanguage”. Learning this language is a hurdle to attracting new customers, but it also acts as a barrier to entry and discourages customers from moving to a competitor because the model would not move with them.

 

I have been skeptical in the past that a hobbyist quant trader would be able to make money using this platform. The company has never provided any data to support that their customers succeed and they occasionally have a loss from customers blowing up (never more than a few hundred-thousand so immaterial to TRAD’s results). But the one point I can’t dispute is that the model is successful at attracting high quality customers that are extremely active. The majority of online brokers such as Schwab, E*Trade, and Ameritrade have moved their focus to attracting investors and gathering assets. Meanwhile, TradeStation stays solely focused on serving traders.

 

Growth Metrics

 

                                                2005                2006                2007                2008E*

Accounts                                  24,000             31,500             36,736             42,700

  % change                                    32%                 31%                 17%                 16%

 

DARTs                                    42,715             60,718             79,928             105,356

  % change                                    28%                 42%                 32%                 32%

 

Client Assets                            1.3B                 1.6B                 1.8B                 1.9B    

  % change                                    11%                 19%                 12%                   5%

 

Commission Revenue                $65.6m            $78.8m            $100.0m          $125.5m

  % change                                    17%                 20%                 27%                 26%

 

Total Revenue                          $96.6m            $128.5m          $151.6m          $159.0m

  % change                                    35%                 33%                 18%                   5%

 

Pretax                                      32.1                 50.0                 56.1                 50.7

  % change                                  124%                 55%                 12%               -10%

 

*2008 revenue has been hurt by interest rate cuts as described below. This lost high margin net interest income hurts margins and pretax. Additionally, expenses are higher from various growth initiates and a $1.2m one-time noncash option charge due to founders ownership declining below 25%.

 

 

Our Thesis

We are attracted to TradeStation because of the company’s proven ability to attract new accounts and grow DARTs (daily average revenue trades). For 2008 we are conservatively estimating accounts will grow by 16%, client assets by 5%, and DARTs by 32% during a disasterous bear market. The second part that made us interested in this investment is that pricing finally appears to be stabilizing. In 2006, their average revenue / trade declined 94c from the prior year. In 2007, it dropped only 18c and in the last 3 quarters, the rate has been stable.  This is likely partially because of product mix – more futures and options accounts that have higher rates and less price pressure. But regardless of the reason, stable pricing will mean DART growth will directly translate to revenue growth. The second reason we like TradeStation is that its balance sheet is flush with cash of nearly $3.00 per share and no debt. Given the current low stock price and low yields on cash, share buybacks are highly accretive.

 

TradeStation is sensitive to the level of short-term interest rates because it earns interest off client’s cash balances and credits the client back only 50 bps (for small balances they credit zero). So higher absolute interest rates result in higher interest income.  In their latest 10Q, the company reported that each 25 bps change to Fed Funds would impact annual EPS by 3.6c. Several years ago we pitched the TradeStation short on VIC largely based upon their interest rate sensitivity. At that time, a low rate environment would have resulted in TRAD becoming unprofitable. The difference now is that the company has greater scale. So today, the company will remain profitable even if the Fed cuts rates to zero. In fact, we estimate that at Fed Funds rate of zero, run-rate EPS would be $0.48 (see sensitivity table below). Additionally, with Fed Funds currently at 1.5%, longer-term, rates are more likely to be higher than lower than the current levels. So we believe TRAD’s earnings power is near its cyclical trough.

 

Its important to note that TradeStation is able to credit its clients back such a small amount because of their client type. Clients choose TradeStation because of their high performance trading platform, back testing technology, and automated executions – not because they are seeking high cash yields. The benefit of focusing on traders as opposed to investors. The positive is they earn sizable high margin interest income off client cash balances. The negative is that it makes the company more sensitive to interest rates.

 

Potential Catalysts

We expect a 3Q earnings beat: We believe that the high level of volatility will lead to an EPS beat in 3Q and is off to an excellent start for 4Q.  Sandier estimates industry DARTs were up 30%+ in September and historically TradeStation has outperformed the industry. If TRAD is just inline with the industry, they should report at least 19c of EPS vs company guidance of a range of 15 to 19c. Because we believe TradeStation again outperformed the industry and we have been a bit heavy on expense estimates, we think the quarter is more likely 20c. October volumes are estimated to be up 20% from the already strong September volumes. I would point to today’s action in Optionsxpress as a good example of the type of stock action to expect – up 17% today. Stocks can have outsized upward moves when an EPS beat is accompanied by an absurdly low valuation. OXPS beat by 1c and before the beat was at 5x EV / run-rate EBITDA. TRAD today is at 2.6x EV / run-rate EBITDA and we expect a beat.

 

Accelerated Buyback: we estimate 3Q cash per share will be $3.05 so nearly half of TradeStation’s market cap is in cash. Because cash is yielding such small amounts currently, buybacks become highly accretive. I estimate that if the company would repurchase $100m of their own shares ($127m cash @ June and no debt), EPS would increase by 0.39c or a 52% increase from current run-rate. The company has long said they are retaining cash in order to pursue acquisitions. But with no acquisitions completed in the last 8 years and cash yielding almost nothing, we believe an accelerate buyback is likely. If the company does want to pursue acquisitions, they can buyback $100m of stock and still have $80 million available for acquisitions (assume a very conservative borrowing capacity of 2x EBITDA and 100% cash financed deal). TradeStation’s own enterprise value is only $160 million so an $80 million acquisition would represent half of their current enterprise value. I don’t believe TradeStation would want to do such a large deal and they do not have a track record that shows they could complete such a large deal.

 

	3Q08E		With $100m
	Run-Rate	Adj.	Buyback
Pretax	52.4	(1.5)	50.9
Taxes	(20.5)		(20.0)
Rate	39.2%		39.2%
Net Income	31.9		30.9
Shares	42.8	(15.4)	27.4
EPS	0.74		1.13
% increase			52%
Cash	124	(100)
Share Price	6.50
Cash Yield	1.5%	1.5%

 

 

The company is unbelievably cheap when we look at enterprise value multiples because of the excessive amount of cash with almost no yield. We believe most investors are missing this high level of cash not earning interest and thus a buyback would unlock substantial value.

 

Earnings and Valuation Sensitivity to Interest Rates

 

Below are tables showing the company’s earnings power under various interest rate scenarios. We have used our 3Q estimates in the first table. The second table  assumes 2009 trading commissions grow by 10% from 3Q08E levels at 50% incremental margins. This should be extremely conservative estimates because 10% commission growth would be about half of historical levels and it assumes zero growth in client balances.

 

Note: our enterprise value only adds back the company’s $127m of corporate cash on the balance sheet. Client segregated cash is not added back as its an operating item. However, when computing interest rate sensitivity, we have accounted for the impact to both client and corporate cash.

 

Price	6.50
Mkt Cap	284.7
EV	161
Valuation on 3Q08E Run-Rate Results
	3Q08E	< = = = = = = = Quarterly Sensitivity = = = = = = = >
Avg Fed Fund Rate	2.0%	0.0%	0.5%	1.0%	1.5%	2.0%	2.5%	3.0%	2.5%	4.0%
Aftertax	8.5	5.2	6.0	6.8	7.6	8.5	9.3	10.1	10.9	11.7
Shares	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8
EPS	0.19	0.12	0.14	0.16	0.17	0.19	0.21	0.23	0.25	0.27
P/E		13.7	11.8	10.4	9.3	8.4	7.7	7.1	6.5	6.1
Est. Int. on Free Cash		-	0.2	0.3	0.5	0.6	0.8	0.9	0.8	1.2
D&A		1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1
Taxes		3.4	3.9	4.4	5.0	5.5	6.0	6.5	7.1	7.6
EBITDA		9.7	10.9	12.1	13.2	14.4	15.6	16.8	18.3	19.2
EV / Run-Rate EBITDA		4.1	3.7	3.3	3.0	2.8	2.6	2.4	2.2	2.1
Valuation on 2009E Results - Assumes 10% Growth in Commission Revenue
Price	6.50
Mkt Cap	284.7
EV	130
	2009	< = = = = = = = Quarterly Sensitivity = = = = = = = >
Avg Fed Fund Rate	2.0%	0.0%	0.5%	1.0%	1.5%	2.0%	2.5%	3.0%	2.5%	4.0%
Aftertax	8.5	6.2	7.0	7.8	8.6	9.4	10.2	11.0	11.8	12.7
Shares	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8	43.8
EPS	0.19	0.14	0.16	0.18	0.20	0.21	0.23	0.25	0.27	0.29
P/E		11.6	10.2	9.1	8.3	7.6	7.0	6.4	6.0	5.6
Est. Int. on Free Cash		-	0.2	0.3	0.5	0.6	0.8	0.9	0.8	1.2
D&A		1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1
Taxes		4.0	4.5	5.0	5.6	6.1	6.6	7.1	7.7	8.2
EBITDA		11.2	12.4	13.6	14.8	16.0	17.2	18.3	19.8	20.7
EV / Run-Rate EBITDA		2.9	2.6	2.4	2.2	2.0	1.9	1.8	1.6	1.6

Catalyst

Potential Catalysts

We expect a 3Q earnings beat: We believe that the high level of volatility will lead to an EPS beat in 3Q and is off to an excellent start for 4Q. Sandier estimates industry DARTs were up 30%+ in September and historically TradeStation has outperformed the industry. If TRAD is just inline with the industry, they should report at least 19c of EPS vs company guidance of a range of 15 to 19c. Because we believe TradeStation again outperformed the industry and we have been a bit heavy on expense estimates, we think the quarter is more likely 20c. October volumes are estimated to be up 20% from the already strong September volumes. I would point to today’s action in Optionsxpress as a good example of the type of stock action to expect – up 17% today. Stocks can have outsized upward moves when an EPS beat is accompanied by an absurdly low valuation. OXPS beat by 1c and before the beat was at 5x EV / run-rate EBITDA. TRAD today is at 2.6x EV / run-rate EBITDA and we expect a beat.



Accelerated Buyback: we estimate 3Q cash per share will be $3.05 so nearly half of TradeStation’s market cap is in cash. Because cash is yielding such small amounts currently, buybacks become highly accretive. I estimate that if the company would repurchase $100m of their own shares ($127m cash @ June and no debt), EPS would increase by 0.39c or a 52% increase from current run-rate.