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Background

Investment Technology Group (ITG) is an independent agency broker and investment research firm whose primary assets include the dark pool liquidity solution - POSIT Marketplace, execution management system - Triton, transaction cost analysis tool - TCA. The POSIT matching system was launched in 1987 and grown to become the leading source of off-exchange liquidity for large institutional investors in the US.

The POSIT Marketplace uses dark pool aggregation technology to provide anonymous matching of equity orders i.e. the identity of the trading entity, position, order size is not revealed to the other side nor to the brokers. This is specially useful in trading large blocks and small, illiquid stocks. Triton provides analytical tools for trade execution management and creation of execution strategy. TCA provides tools for post-trade cost analysis and strategy optimization.

In addition, ITG also provides solutions for portfolio construction, management and optimization. Thus, ITG stands as a one-stop shop for institutional investor needs centered on equity trade execution and management. Its customers can be categorized into three groups: (1) passive equity funds such as index funds, ETFs (2) actively managed long equity funds such as mutual funds, pension funds (3) hedge funds.

Temporary Blip or Secular Trend?

As shown in the table below, ITG's US equity trading volume has grown at a CAGR of 9% since 2000. However, the stock market performance of the last few years has spooked investors. 2008 and 2009 saw net flows out of domestic equity funds at 159 billion dollars and 39 billion dollars respectively. This trend has continued through 2010 with investors continuing to flee to a large extent to bond funds. This has resulted in reduced equity trading activity amongst the core institutional client base for ITG and hence reduced revenue.

ITG US Operations Trading Volume

Average Daily Volume:

  • 2000: 65 mn
  • 2001: 91 mn
  • 2002: 98 mn
  • 2003: 81 mn
  • 2004: 82 mn
  • 2005: 105 mn
  • 2006: 153 mn
  • 2007: 195 mn
  • 2008: 213 mn
  • 2009: 202 mn

With ITG's operation highly leveraged to equity trading volumes, its margins have suffered in recent quarters. However, the company remains profitable and generated 12.5 million dollars in its most recently reported quarter. ITG's management has taken and continues to take steps to reduce the cost structure by reducing staff levels and consolidating its operations in line with its revenues.

A Game Changer?

With lack of visibility on market conditions for equity trading, the management has recently taken steps to expand its addressable market. It acquired Majestic Investment Research (now ITG Investment Research) last October for ~ $56 million. Majestic provides data driven equity research on 200 companies and 17 industry sectors.

With this acquisition, ITG is now categorized as a research broker and can target a larger share of client commision spending. ITG plans to take advantage of the scalability inherent to the investment research business by aggressively expanding into new sectors and geographies. In addition, opportunities for cross selling across ITG legacy products and ITG investment research exist and have been acknowledged by the management.

Also, ITG bought an equity stake in another research firm - Disclosure Insight. Disclosure Insight provides research reports on SEC filings, accounting/auditor problems, etc for public companies.

Besides US, ITG has operations in Canada, Europe and Asia with most of the ITG products available to clients in those markets. Non-US operations contributed 31.5% of YTD 2010 revenues. As in the US, as equity volumes increase in these regions, ITG stands to benefit.

Valuation

At the end of 3Q 2010, ITG had $339 mn cash and $11.2 mn debt. Taking into account the Majestic acquisition, the net cash stands at ~ $272 mn. With an equity market value of ~ $750 mn, the EV is ~ $480 mn, a value of ~ $11 a share. In current market conditions for equity trading, ITG continues to earn ~ $1 on a per share basis.

As volumes improve, the operating leverage inherent to the business model will push a major portion of the additional revenue to earnings. Note that ITG averaged more than $2 per share of earnings from 2005 to 2008. In addition, the recently added ITG investment research should have an accretive effect. Management expects the acquisition to add to earnings in 2011.

Other Notes

ITG has shown commitment to returning value to share holders. It had bought back ~ 3 million shares in the first 9 months of 2010 and has authorization for 3.6 million additional shares.

Disclosure: Author is long ITG.

Source: Investment Technology Group's Improved Playbook: Time to Go Long?