Knight Capital's (NYSE:KCG) stock went up by 21.3% after a pair of takeover bids for the self-immolating broker hit the newswires in early December. Eventually Getco LLC raised its offer to purchase Knight to more than $1.4 billion in a cash and stock offer, valuing the broker at $3.75 per share, which is 51% above its pre-takeover-rumor price on 23rd November and still 5.7% more than its current price of $3.47 per share, December 26th. According to the offer, Knight Capital CEO Tom Joyce would join the new company as a non-executive chairman. Similarly, Virtu Financials LLC had made a $3.00 per share all cash offer in which Joyce would serve as one of the top three executives. Both Getco and Virtu are among the top shareholders of Knight Capital after the last minute rescue over the summer.
Both companies reportedly have the backing of unnamed private equity firms and seem willing to increase their bids if required. Meanwhile it is also learned that besides the two firms, Knight Capital's board have other offers on their table as well. Interestingly, Joyce himself declared earlier that Knight Capital is not up for sale but it was either the pressure from investors or the fact the Joyce's term is set to expire by the end of this year that prompted the chief to change his mind. Following the sale of its core unit, it is logical to assume that Knight's mortgage and foreign exchange trading arms will be up for grabs.
Earlier this year, Knight Capital mistakenly put through what they said was supposed to be 4 months' worth of trades in 45 minutes. On the first day of August, a software glitch created a massive $440 million trading loss. The company's premier clientele, which includes the biggest U.S. brokerage firm TD Ameritrade (NYSE:AMTD) as well as Virtu, Getco, Blackstone (NYSE:BX) and Stifel Financial (NYSE:SF) were not happy with their money being dumped on the market but came to Knight's rescue and injected nearly $400 million into the company with Getco purchasing 23.8% of the company. Its main customers now own about 70% of Knight. .
Financial service is a confidence game whose players have long memories. Such a colossal mistake is enough to see that confidence evaporate. And once you've lost powerful people money they will not be favorably disposed to lose money with you again. Since that day the stock has been crushed, likely by the very same people who lost money in the first place; shorting the company below its value in order to buy up the remains at a discount. TD Ameritrade, in particular, deals exclusively with Knight and as such is handcuffed to their future.
To be honest, brokering wasn't much of a business for Knight before the fatal glitch. Plot a 10 year chart of the S&P 500 (AMEX:SPY) and volume - I suggest a monthly chart - and you will see an inverse correlation between price and volume, i.e. the markets have been rising for the past four years in ever-declining volume. Their margins were thin and falling before the glitch. As the central banks continue to clamp down on volatility to keep the markets from imploding this will only get worse. So, fundamentally Knight is a company with a wounded reputation in a shrinking business.
While Knight's revenue has been rising since the financial crisis began, its margins have been falling as brokering has become more commoditized. Volume in U.S. equities has been exceptionally light in 2012. Net margins have fallen from 19.3% in 2008 to just 6.0% in the first half of 2012.
KCG Net Margin
2012 - 1st Half
In my view, the S&P 500 has been in a broadly defined range for more than 12 years and as the world struggles with real debt deflation and monetary inflation to forestall the losses, the non-financial sectors of the economy are being hollowed out. Volume where real money changes hands -- and not broker/dealer churn -- cannot rise when retail investors cannot afford to put money in the markets. In the U.S., the number of people on food stamps is nearly 50 million. Youth unemployment is over 20% and most of the jobs being created are part-time. Where is the next generation of investors going to come from to maintain the importance of financial firms like Knight?
Knight Capital wouldn't be a good investment under these conditions even if the fateful day had never occurred. At this point, the M&A activity surrounding what is left will only be of interest to traders looking to play the headlines while investors should steer clear of the sector until global fundamentals improve.