Description

Key Tenets:

• No market making / trading firm has ever been able to sustain a competitive advantage over an extended period. Over time, trading businesses become a return on capital business and thus valuation becomes tied to tangible book value.

• Virtu has negative tangible book value.

• Virtu’s ability to translate volatility into revenue is showing signs of degradation – an early warning that their competitive advantage is eroding.

• Precipitous decline in forward earnings estimates since IPO.

• No earnings visibility – senior management has no idea what they will earn tomorrow, let alone next week or next year.

• Share price supported by a dividend that we believe will soon be cut.

• Market seems unaware of outsized near-term cash needs and lack of dividend coverage. Misconception has been exacerbated by management’s misleading disclosures.

• The declining profitability and (soon to be) dividends combined with no earnings visibility will force investors to look at tangible valuation metrics such as book value (which is de minims) and tangible book value (which is negative).

Quick Virtu Financial Overview:

Virtu Financial is an electronic high frequency trading firm in equities, foreign exchange, commodities, options, and fixed income.  The company claims that its strategies are ‘market-making’ type strategies with two-sided liquidity on over two hundred markets across the globe. The company likes to give simple examples of posting bid/ask quotes and capturing the spread, but realistically it’s clear that such a mundane strategy would be quickly copied by others and not generate such outsized returns.  Most likely, only a handful of Virtu insiders really know how Virtu generates such outsized profits.  While Virtu claims to not rely on speed for their strategies, the Wall Street Journal reported in August that Virtu was investing alongside Citadel and Jump Trading to install microwave towers from Chicago to Seattle, then connect to an undersea cable to Asia.  Given such an investment, it is hard to believe that speed is not paramount to their strategies.  (In full disclosure, our firm has invested in microwave technology as well and it is deployed in our kitchen to heat up leftovers).

The firm was founded by Vincent Viola who was a pit trader at the New York Mercantile Exchange before becoming the Chairman from 2001 through 2004.  Viola co-founded Virtu with Douglas Cifu in 2008 before merging the firm with proprietary trading shop Madison Tyler (also co-founded by Mr. Viola) with the backing of Silver Lake Partners.

Virtu had initially planned to go public in April 2014, but the issue was postponed due to high frequency trading scrutiny in the media following Michael Lewis’s Flash Boys book.  One year later the firm was able to go public in April 2015 at $19.00 after Brad Katsuyama, CEO of IEX and hero of Flash Boys, publicly stated that Virtu is a ‘good HFT’ firm.  This may have coincided with Virtu being a very large trading firm on IEX.  As we will detail later, the company has since reported a series of earnings misses with a clear profitability deterioration driving shares to $13.15, but still well above its tangible book value of zero.

Virtu has been an amazing profit machine.  Bullish initiation reports pointed to the company’s outsized 65%+ adjusted EBITDA margins, its track record of only losing money one day in 6 years, and a return on equity in excess of 35%.  We take the opposite view – how is a simple trading firm able to generate such outsized returns and how long until competition erodes these eye popping metrics of profitability? What exactly Is Virtu’s sustainable competitive advantage that enables a trading firm to generate an infinite return on capital?  Like the rest of the investing community, including VIRT’s shareholders - we don’t know - but we see clear signs that profitability is eroding meaning competition is likely catching up.

Market Making: Unsustainable Competitive Advantage results in a History of Failures:

Market making firms have historically generated outsized returns in one of two ways: 1) market structures with advantageous rules for a few firms; or, 2) firms with a technology advantage. Competitive advantages from market structures last until the rules change.  Competitive advantages from technology last until competitors copy the technology.  Below we highlight key examples.  Historically, the clearest sign that competitive advantages are about to go away is when the owners of these firms seek liquidity and sell their ownership.

FIRMS THAT HISTORICALLY BENEFITED FROM STRUCTURAL ADVANTAGES

At one time, there existed a market structure that gave certain trading firms a rule based advantage, but in return the firms were expected to provide capital and liquidity in times of market stress.

NYSE Specialist System - From Buttonwood Tree to Reg NMS: An example of this structure was the NYSE specialist firms with their preferred location on the floor and control of the limit order book.  After regulators uncovered the specialist ‘pennying’ scandal, the NYSE rules were forced to change, the central limit order book opened and competition was introduced.  Profitability evaporated and publicly traded NYSE specialists such as LaBranche and Van Der Moolen went from trading based upon P/E multiples and multiples of tangible book value - to trading below liquidation value.  Did Michael LaBranche see this coming?  Possibly, the business was private for multiple generations, but managed to IPO just a few years before market structure changed.

NASDAQ Market Makers from Start of NASD to End of Fractions.  Knight Capital Group, which then traded under the symbol NITE, was a darling of the 1990s internet craze. As retail investors opened their first online trading accounts and traded internet stocks, NITE, a consortium formed by retail brokers, was on the back-end filling orders in the wholesale market, with spreads quoted in fractions (so equal to a minimum 12c spread) and no order handling rules. Competition in the wholesale market started to erode NITE’s profitability by the late 90s, but when quoting moved to decimals, profits evaporated and shares were soon trading below tangible book value.

Another leading market maker Herzog Heine Geduld saw the changes coming and sold themselves for $914 million to the usual go-to acquisition sucker Merrill Lynch.  Despite spending nearly $1 billion on the acquisition, Merrill never seemed to mention it again.

FIRMS THAT HISTORICALLY BENEFITED FROM TECHNOLOGY ADVANTAGES

The second competitive advantage we have seen in market making is in the use of technology. Companies find technology that gives them a trading advantage to either better price securities or price them faster.

Timberhill in Options Market Making.  Thomas Peterffy was an innovator in option markets carrying around his self-built computer on trading floors to give himself an advantage in pricing options (his computer was later banned), but his investment in technology and pricing mechanisms flourished.  When his market making firm came public in 2007, the company was the model of profitability.  However, competition has caught up with Timberhill and now Mr. Peterffy has to field questions on his investor calls about liquidating the market making business (the parent company has done fine because the retail brokerage side of the business has flourished).  To Mr. Peterffy’s credit, when he came public he was open to investors that the future was in the brokerage business and market making would be in decline.

Automated Trading Desk had a technology advantage when they sold to Citi for $680 million in 2007.  We visited ATD’s trading offices in South Carolina in 2001 when they were still based in a strip mall.  The company was so profitable that they were mid-construction on their new 68,000 square foot headquarters.  How did they do it?  Management explained their business as quite simple.  The former CEO, Steve Swanson, was quoted as saying their model “was analogous to a human trader”.  In our meeting, they explained a computer generated a bid and an ask and ATD made their money by capturing the spread.  A human, they explained, could do the same, but a computer could do it across many more securities without the compensation expenses of a human trader.  It all seemed so simple.  But clearly something changed because when ATD was sold this year to Citadel, the price was too low to even disclose.

Getco had a speed advantage when it raised capital at a $1 Billion valuation.  We visited Getco’s offices in 2007 and management simply explained that their business was an electronic market maker.  A computer generated a bid and a computer generated an ask and their profits were made by capturing the spread (basically the exact same example used by ATD management).  Wow, it seemed so simple, but if it was really that simple what changed starting in 2012?  Did the computers forget how to make electronic bid / ask quotes?  Profitability started to plummet.  By the time Getco merged with Knight, the company was no longer profitable and Knight management consistently declines to reveal Getco profitability.  From researching Getco’s challenges later and relying on industry contacts, we believe that Getco had a speed advantage but after several years of obscene profitability, competing firms made the investment to catch up.

Lucid had a short window of advantage in the FX markets.  Lucid used this window to suck in a buyer in FXCM.  The year before Lucid was purchased the company produced 76% EBITDA margins using short term strategies to trade FX on electronic markets, claiming to never hold positions for more than a few seconds.  However, profitability seemed to decline no sooner than after the company was purchased and Lucid insiders sold their restricted shares the first day they became unrestricted. Once Reuters caught that Lucid had broken their trading rules by gaining access to a second connection on the Thomson Reuters matching platform, profitability took another leg down.  FXCM is still trying to sell Lucid as part of the sale of core assets to pay down Leucadia debt.  This sale process has dragged on due to the lack of buyers for this deteriorating business.

Infinium Capital is another classic example as the company went from one of the top 25 high-frequency trading firms to losing $6.6M in 2012.  Employees sued the company for being tricked into swapping loans to a company affiliate for equity, which resulted in a $4M loss when the equity was deemed worthless.  Larry Tabb, CEO of the Tabb Group, offered this explanation for the rapid decline, “It sounds like they ran into a brick wall like a lot of the other guys”.

Each of the firms discussed above saw a precipitous decline in revenue abruptly beginning after a year with peak revenue.  VIRT is expecting to see its first ever revenue decline in 2016 despite a nearly identical VIX (16.2 vs 16.7).  We see this as an ominous precursor to the fate of peers (see below).

Note: Year 2 peak revenue year for 4 market makers shown.

Goldman Sachs is considered by many to be the preeminent trading firm in the world. Yet today, the company trades at just above tangible book value. Goldman Sachs for a long stretch traded as high as 2 to 3x tangible book, but that was pre-financial crisis and we now know that they had to employ massive amounts of leverage to generate returns to justify these valuations. (Note: 3x tangible book value for VIRT would equal a price target of zero).

Below we show several stock charts of pure market making firms detailed prior:

Van Der Moolen:

LaBranch & Co:

Knight Capital Group (NITE):

Business Model Advantage Contracting Per Regression:

Much was made about Virtu’s unparalleled daily profitability given in the S-1 when the firm went public.  The extremely high level of profitability begged the question, “what is Virtu doing that is so consistently profitable?”  Management’s explanation was that they were simply doing plain vanilla two-sided market making and scale benefits were driving the differentiated profits.  If VIRT is simply a spread business, shouldn’t revenue be a function of volume x spread?  Instead both management and investors focus on volume and volatility and VIRT’s results have strong correlation with VIX.

However, despite the firm continuing to possess a diverse set of exposures and scale benefits, since the IPO the firm has shown a clearly defined downward trend in translating volatility into revenue. VIRT has missed earnings estimates 4 of the 6 quarters they have been public and seen a significant cut in EPS estimates since the time of the IPO.

We have tracked VIRT's progress since the IPO by using a regression of VIRT's net trading income versus the VIX.  Historically, this showed a high correlation, until the last four quarters have diluted the regression meaningfully (shown below).  The key here is that the last four data points have tilted the trend line lower as VIRT is not able to produce as much NTI per increment of VIX as they have in the past.  This is similar to what was seen at Getco in 2012 when they started a precipitous decline in profitability.

$40m+ of Distributions Due to “Members” (i.e. insiders)

Investors recently have debated if Virtu is covering their dividend (it seems odd to us that a factual question is up for debate).  From the calculations shown later, we show that in the first half of 2016, Virtu has covered the dividend, but only before cash paid to members as distributions.  Additionally, there are two large payments upcoming to members (i.e. company insiders) that total $40M+ that are not in sell-side dividend forecasts.  We discuss both below:

1. $30m of distributions owed to members in connection from the IPO: The company has noted that $30M is remaining to pay out to members from cash on hand in connection with the IPO.  Please see the below from page 26 of the August 10Q.

2. $8M-$17M of distributions owed to members for tax shield agreement: The company also has agreed to make payments to certain Virtu members generally equal to 85% of the applicable cash tax savings.  This is quantified as ranging between $8M - $17M below in the August 10Q. While the existence of the tax agreement is not a surprise, the surprise is that the company has been accruing the benefit, but not yet paid out the cash to insiders, which contractually must occur before year end.

The Operating Company Has Not and Will Not Cover its Dividends and Distributions

When we bring these two upcoming dividends/distributions into the analysis, we see the company is paying out well more than 100% of cash flow from operations since the IPO.  Interestingly, this analysis gives rich context to the recent debt restructuring the company did which entailed a $37M increase in the level of debt, despite declining levels of EBITDA.  

Note: 2015 is for 2Q15-4Q15.  Assume flat normalized adjusted income as well as a flat estimate for other add backs in 4Q16.  We assume steady distributions to members for 3Q and 4Q

What If This Trend Continues?

We believe the profitability degradation from the historical regression will continue and could put debt covenants at risk.  We lay out a potential scenario below where the VIX averages 15 and VIRT net trading income follows a similar revenue per day per unit of VIX as seen in 2016.  We want to emphasize two key assumptions we are using: 1) a 15 VIX is in line with the five-year average, but above 3Q; and, 2) no further degradation of trading profitability, despite clear signs of degradation in 2016.

The outcome is the company would produce ~$0.17 per share in adjusted EPS and ~$50M in adjusted EBITDA a quarter if we assume a 25% adjusted net income margin and a 55% adjusted EBITDA margin, respectively.  This would lead the company to not be able to cover the dividend.

We see this scenario as optimistic as VIRT is seeing a continued deterioration in revenue per day per unit of VIX (shown below).  The last four quarters have seen a significant drop in this revenue follow through and 2016 year to date the metric is down 15%.  

Note: 2016 year to date versus 2015 average.

We think the 15% decline in this ratio is likely a reasonable proxy for the rate of degradation going forward, which would lead to even lower EBITDA (even to our above scenario).  This would clearly bring dividend coverage and debt covenants even more into the foreground.  Here, if the company were to sustain a $150M adjusted EBITDA annual run rate (as shown in the two figures above), the company would quickly become in jeopardy of tripping debt covenants of 2.75x net debt / EBITDA.

Conclusion & Valuation:

VIRT followed the game plan of every other trading firm to ever raise capital by selling at the peak and convincing new investors that “we have a sustainable competitive advantage in trading so investors should value us on a multiple of earnings” only to report disappointing results in short order.  We see early signs of VIRT’s competitive advantage already breaking down with each earnings result.  We believe declining revenue and EBITDA margins are likely in the future and would not be surprised if the firm becomes unprofitable within a few years.  In all the cases we outlined earlier in this write up, investors reached a point of valuing these trading firms at discounts to tangible book or liquidation value.  But this time is different, because VIRT does not have positive tangible equity so we do not know what investors will look to as VIRT’s competitive advantages are competed away.

Disclosures

The author is net short Virtu at the time of this article’s publication. In addition, the author’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this article.

The author wrote this article itself and it expresses its own opinions.  It is not receiving compensation for this article. In addition, the author has no business relationship with any company whose stock is mentioned in this article.

The author does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision.  

Disclaimers

There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this article. The author will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this article, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this article.

Information pertaining to this article is obtained from Bloomberg, Yahoo Finance, Google Finance, and the SEC Database, among other sources. If these sources contained faulty or old information it could be incorporated into this analysis.

No Investment Advice

This article is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This article is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. The price and value of securities referred to in this article will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this article may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.

Catalyst

We believe continued earnings dissappointments will lead to an eventual dividend cut and breach of debt covenants.