THE HEDGEYE EDGE
Virtu Financial's (VIRT) business is no longer responding to volatility like it used to and its most recent quarterly revenue results are well below historical levels per unit of volatility. Knight Capital's business, recently acquired by Virtu, looks challenged by the recent Ameritrade/Scottrade deal as Scottrade market maker allocations to Knight will go from ~19% before the deal, to ~6% under Ameritrade. In addition, payment for order flow (or market maker costs) will go up as Ameritrade gets paid ~$2.60 per trade allocated to wholesale market making, versus ~$1.60 per trade charged by the former Scottrade.
INTERMEDIATE TERM (TREND)
We are also concerned that the company is thinly capitalized and that $1 billion in tangible equity capital is not enough for the very liquidity intensive market making business at Knight. In addition, 84% of trading capital at the NewCo. is now debt financed versus much lower levels at other public brokers.
We have fair value at ~$6-$11 per share or -29% to -65% below current market prices, which we estimate will put the firm's dividend at risk. In an upside scenario, if all goes well, we only model +15% upside to $19, putting risk/reward skewed to a lower equity value.
LONG TERM (TAIL)
We are concerned that both the legacy high frequency trading business (VIRT) and the wholesale market making business (KCG) are facing secular challenges and we outline an earnings opportunity well below consensus. Our probabilistic earnings range in our base and bear cases is $0.60 - $0.90 per share, -26% to -57% below consensus.